**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

 

Washington, D.C. 20549

 

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**FORM 10-K**

 

 **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OFTHE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from April 1, 2001 to December 31,2001**

 

**Commission File number 0-24294**

 

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**Media ArtsGroup, Inc.**

 

(Exact name of registrantas specified in its charter)

 
| **Delaware**                                                     | **77-0354419**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
|                                                             |                                  |
| **900 Lightpost Way**                                            | **95037**                             |
| Morgan Hill, California                                          | (Zip code)                            |
| (Address of principal  executive offices)                        |                                  |

** **

**Registrant’s telephone number, including area code:  (408) 201-5000**

 

**Securities registered pursuant to Section 12(b) of the Act:**

 

**Common Stock, $0.01 Par Value**

**(Title of class)**

 

**Securities registered pursuant to section 12(g) of the Act:None**

 

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                Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.       Yes x    No o

 

                Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§ 229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatement incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  x

 

                The aggregatemarket value of the voting stock held by non-affiliates of the registrant,based upon the closing price of the Common Stock on April 19, 2002, as reportedon the New York Stock Exchange was approximately $20,260,000 Shares of CommonStock held by each executive officer and director and by each person who owns5% or more of the outstanding Common Stock have been excluded in that suchpersons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusivedetermination for other purposes.

 

                The number ofshares of the registrant’s $0.01 par value Common Stock outstanding on April17, 2002, was 13,534,163.

 

                Part IIIincorporates by reference from the definitive proxy statement for the registrant’s2002 annual meeting of stockholders to be filed with the Commission pursuant toRegulation 14A not later than 120 days after the end of the fiscal year coveredby this Form.

 

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#### **PART I**

 

 

*Some of the statements contained in this Annual Report onForm 10-K are forward-looking statements, including but not limited to thosespecifically identified as such, that involve risks and uncertainties.  The statements contained in the Report onForm 10-K that are not purely historical are forward-looking statements withinthe meaning of Section 27A of the Securities Act and Section 21E of theExchange Act, including, without limitation, statements regarding the Company’sexpectations, beliefs, intentions or strategies regarding the future.  All forward-looking statements included inthis Report on Form 10-K are based on information available to the Company onthe date hereof, and the Company assumes no obligation to update any suchforward-looking statements.  These statementsinvolve known and unknown risks, uncertainties and other factors, which maycause the Company’s actual results to differ materially from those implied bythe forward-looking statements.  In somecases, you can identify forward-looking statements by terminology such as“may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,”“estimates,” “predicts,” “potential,” or “continue” or the negative of theseterms or other comparable terminology. Although the Company believes that the expectations reflected in theforward-looking statements are reasonable, the Company cannot guarantee futureresults, levels of activity, performance or achievements.  Moreover, neither any other person nor theCompany assumes responsibility for the accuracy and completeness of suchstatements.  Important factors that maycause actual results to differ from expectations include those discussed in“Risk Factors” beginning on page 6 of this document.*

 

#### **Item 1.  Business**

 

**Overview**

 

Media Arts Group, Inc. isthe leading designer, manufacturer, marketer and branded retailer of fine-artreproductions, art-based home decorative accessories, collectibles and giftproducts based upon artwork by Thomas Kinkade. Primary products include canvas lithographs that feature Thomas Kinkade’sunique use of light and his peaceful and inspiring themes.  The Company believes that the Thomas Kinkadelifestyle brand appeals to a wide range of consumers because its messagecelebrates home, family, nature and traditions and its products help to createpositive environments in which to live and work. The Company serves a broadconsumer base by offering products at a variety of price points, managingdistribution through branded distribution channels of independently owned andoperated Thomas Kinkade Signature GalleriesTM and Showcase Galleries.  The Company has also developed strategicmarketing relationships with companies such as Hallmark Cards, Inc. and QVC,Inc. with gift print products generally designed to sell at retail price pointsranging from $50 to $300 and between $900 and $10,000 for limited edition paperand canvas lithographs.  Products areprimarily distributed through an extensive distribution network including 344Signature Galleries, approximately 361 Showcase Galleries, 3 Company ownedretail stores and approximately 4,000 other independent gift and collectibleretailers.  This broad distributionnetwork has enabled the development of Thomas Kinkade into a leading art-basedbrand.

 

In April 1999, theCompany made the strategic decision to eliminate ownership in the Company ownedThomas Kinkade Stores and focus on the development of branded distributionthrough independent dealers.  Since thattime, ownership in 30 Company owned Thomas Kinkade Stores was transferred toexisting and new Signature Gallery dealers.

 

The Company has developeda “pull” marketing strategy, which is a fundamental shift toward advertisingand marketing campaigns designed to increase consumer traffic at authorizeddealer locations.  The Company is completingits restructuring of the organization to focus its resources exclusively on theThomas Kinkade brand.  The Company iscommitted to providing consistent quality, on-time delivery and marketingsupport to dealers.

 

In December 2001, the Company made the strategic decision to discontinuethe sales, distribution and marketing of art products of the three artists thatthe Company represented other than Thomas Kinkade.  The decision was based primarily on the general down-turn in theeconomy and the Company’s refocus on, and investment of development resourcesinto, the Thomas Kinkade brand.  TheCompany has restructured its relationship with two of the artists such that theartists will have access to certain of the Company’s distribution channels andother limited support, which will permit existing dealers of their products topurchase products directly from the artists. The Company does not plan to license any more Masters of Lightgalleries  (i.e., those galleriesdevoted exclusively to the sale of works of the three artists) and willencourage the Masters of Light gallery owners to offer products from not onlythe three artists but also those from Thomas Kinkade and other artists.

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#### **Products**

 

The Company’s currentproduct offerings include framed and unframed limited edition reproductions oforiginal artwork produced by Thomas Kinkade, as well as books, stationery itemsand other home accessories and gift products that feature Mr. Kinkade’s uniqueuse of light and his peaceful, warm and inspiring themes.  The following paragraphs describe theCompany’s product categories and creative process.

 

*Product Categories. *Art based products are generallycategorized as limited or open editions. Limited editions are high quality canvas and paper lithographs producedin limited quantities, each of which is accompanied by a certificate ofauthenticity stating the size of the edition and the number of the print.  Open editions are products that are producedin unlimited quantities and sold indefinitely. For the nine-month period ended December 31, 2001, limited editions andopen editions represented 25.7% and 34.7% of the Company’s net sales,respectively.

 

*Creative Process. *The majority of offered products arebased on the artwork of Thomas Kinkade, a winner of multiple awards from theNational Association of Limited Edition Dealers, including Artist of the Yearand Graphic Artist of the Year.  Mr.Kinkade paints in his Northern California studio and on location whiletraveling.  Mr. Kinkade is known for hisunique use of light and the manner in which his paintings reflect changes inthe intensity of the ambient lighting and provide a warm and inviting lifestylemessage to the customer.

 

The Company and Mr.Kinkade operate under a licensing agreement dated December 3, 1997 (the“License”).  Under the terms of theLicense,  Mr. Kinkade is contractuallyobligated to provide 150 paintings during the 15 year period commencingDecember 3, 1997, with at least 10 paintings to be delivered during each of thefirst five years.  The Company also hasperpetual and exclusive rights to produce and sell additional products based ona previously existing library of over 170 Thomas Kinkade images.  The License also grants the exclusive rightto produce, sell, distribute and promote reproductions of Mr. Kinkade’s artworkin any form and the right to use the name and likeness of Mr. Kinkade inpromoting the sale of our products and development of any brand name associatedwith Mr. Kinkade.  The Company’s productdevelopment department collaborates with Mr. Kinkade, dealers, the salesdepartment and strategic business partners to create and develop newproducts.  Proposed new products aretested and pre-marketed prior to product introductions.

 

#### **Distribution**

 

The Company’s products are distributed through 344 independent ThomasKinkade Signature Galleries, approximately 361 Showcase Galleries,  3 Company owned stores and a network ofapproximately 4,000 other independent art dealers.  The Company has also developed strategic marketing relationshipswith partners such as Hallmark and QVC. The Company seeks to strengthen itsexisting art based brands and increase sales by expanding the network ofbranded and other independent galleries, expanding distribution through strategicbusiness relationships and expanding its popular licensed products.

 

*Thomas Kinkade Signature Galleries. *The independently owned, licensed Thomas KinkadeSignature Galleries and the Company owned Thomas Kinkade Stores provide warmand inviting environments that convey Thomas Kinkade’s lifestyle message anddisplay Thomas Kinkade reproductions and other products as they might appear ina customer’s home.  In 1996, theSignature Gallery program was initiated in order to develop a network of storesowned and operated by individual entrepreneurs selling only Thomas Kinkadeproducts.  The Company believes that theSignature Gallery program avails itself of regional knowledge of localSignature Gallery owners to strengthen the Thomas Kinkade brand and broaden thedistribution network, with limited investment. In the year ended March 31, 2000, the Company began to expand SignatureGalleries into international markets. At December 31, 2001 there were threeSignature Galleries operating in Europe (two in England and one in Scotland)and one in Canada.  As of December 31,2001, 344 Signature Galleries were in operation worldwide, representingapproximately $43.6 million in revenue for the nine-month period ended December31, 2001.  The Company intends to continueexpansion of the Signature Gallery program into communities not served by theCompany’s dealer network.

 

Prospective SignatureGallery owners must submit a comprehensive business plan and satisfy certainfinancial criteria including minimum start-up capital and net worthrequirements in order to qualify. Signature Gallery owners agree to display a broad collection of ThomasKinkade images.  Through thequalification and selection process, the Company attempts to select dealerswith the highest probability of long term success. Signature Gallery ownershave the opportunity to attend comprehensive training programs at the Companyand have limited use of the Thomas Kinkade name.  Signature Galleries also have the right to receive automaticshipment of each new limited 

 

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edition release and haverights to purchase certain exclusive limited edition inventory.  In addition, Signature Galleries have theopportunity to participate in exclusive promotional events.

 

During the year endedMarch 31, 2000, the Company made the strategic decision to cease directownership and operation of Company owned Thomas Kinkade Stores, in favor ofincreasing the focus on Signature Gallery expansion.  As of December 31, 2001, only two Company owned Thomas Kinkadestores and one other Company owned store were in operation.

 

*Other Independent Dealers. *Ourproducts are also sold to approximately 4,000 other independent dealers,including independent gift and collectible retailers, art galleries and framestores located principally in the United States and, to a lesser extent, inCanada.  Dealers are separated into fivedealer levels, with each level operating under different criteria.  Dealer levels range from Open EditionAccounts, which are authorized to purchase only open edition products and canbe opened with an initial minimum purchase of $500, to Showcase Dealers, whichare stores-within-stores, that are committed to purchase a minimum of $30,000annually in limited edition canvas and paper products.  Dealers can be elevated to a higher dealerlevel by increasing sales of Kinkade products. Likewise, dealers who do not meet annual revenue targets may bepositioned at a lower dealer level.  Asof December 31, 2001, there were approximately 361 Showcase Dealers, 593Premier Dealers, 528 Certified Dealers, 750 Authorized Dealers and 1,900 OpenEdition Accounts.

 

#### **Strategic BusinessRelationships**

 

The Company has enteredinto agreements with leading consumer marketing companies to build brandawareness, generate additional sales by reaching a larger audience of consumersand leverage the expertise of these companies in sales and marketing,manufacturing and distribution.  Forexample, the Thomas Kinkade brand has received substantial publicity under astrategic licensing agreement with Sparrow Records, a division of EMI ChristianMusic Group, which is a member of EMI Recorded Music, through the production,marketing and distribution of a music CD entitled Music of Light. ThomasKinkade brand products are also sold through direct marketing on QVC and through direct mailcatalogs.  Paper lithographs, openedition gift prints and other home accessory and gift products were featured onQVC shows generating retail sales for QVC in excess of $10 million in the ninemonth period ended December 31, 2001. The Company intends to continue to develop strategic businessrelationships with leading consumer marketing companies throughout the world.

 

Also, the investment inadvertising and marketing of licensed Thomas Kinkade product by licensees ofour products enhances the brand's overall reach. In 2001, licensees that haveconducted external advertising and marketing of Thomas Kinkade products includeThe Bradford Exchange and Teleflora. The Company intends to continue to developstrategic relationships with licensees that will undertake such advertising andmarketing campaigns.

 

#### **Sales andMarketing**

 

The Company’s sales andmarketing activities include an in-house sales force that sells to and servicesdealer accounts and provides training assistance for in-house and retail dealersales personnel, marketing and promotional programs and a consumer-orientedThomas Kinkade Collectors’ Society, each of which is described below.

 

In early 2002, the Company completed a reorganization of its sales,marketing and product development areas designed to focus attention on existingprofitable products and markets, while at the same time improve customerservice, assist individual dealers with promotion and create an effectivemarketing strategy through improved media campaigns designed to increasecustomer traffic into authorized dealers.

 

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The Company intends to expand its product-appropriate distributionconcept (i.e.*,*****certain products will not be available inall channels).  This will serve tobetter differentiate between the Company’s market channels and target specificproducts for specific markets. Strategically, the Company will continue to build the SignatureGalleries as the flagships of the Thomas Kinkade brand.

 

Expansion of markets will be pursued by the sales organization, withemphasis on expansion of distribution channels within North America, and, to alimited extent, in Western Europe.

 

As part of its corporate citizen mission, during the past year, theCompany developed and strengthened key strategic relationships with charitableorganizations. None were more significant than its relationship with TheSalvation Army.  Two prints generatedcharitable contributions nearing $2 million for The Salvation Army.  The charity recognized Thomas Kinkade forhis efforts, by naming him the honorary chairman of The Salvation Army’s AnnualKettle Drive.

 

*In-HouseSales Force. *After the reorganization of the in-housesales force, it consists of a Vice President supported by two Regional SalesManagers, ten District Sales Managers, a Director of Sales Operations, tenSignature Gallery Relationship Managers, one Director of Gallery Development,one Director of Inside Sales and one Key Account Manager.  The sales force is generally compensated ona salary plus commission basis.  Many ofthese sales personnel are experienced in the fine art, gift and collectiblesand direct sales industries.  DistrictSales Managers make regular visits to all authorized dealers, and visitpotential new dealers.  In-house salesand customer support personnel provide ongoing on-site and customer servicesupport to gallery owners.

 

As part of the reorganization of the Company’s sales and marketingorganizations, the Company closed its Retail Development Team’s operations inMonterey, California.  The team had beenresponsible for expansion and training of the Signature Gallery distributionchannel.  The team’s functions will beintegrated into the Company’s sales organization.  Exclusive consultative sales personnel will work with individualSignature Galleries to provide training programs and product support forgallery owners.  The Company’s priortraining program, Thomas Kinkade University, was closed in 2001.

 

*MarketingPrograms. *The Company designs and sells promotionalmaterials, including postcards, catalogs and videotapes, to Signature Galleriesand independent dealers to enhance direct marketing to consumers.  In addition, a print advertising allowanceprogram is available to Signature Galleries on a co-operative basis.  Signature Galleries and other high levelindependent dealers may also participate in regional events (including artistappearances) organized by the Company. Advertising is also funded by theCompany’s strategic business partners, such as exclusive shows on QVC.

 

*ThomasKinkade Collectors’ Society. *The Company sponsors and operates acollectors club for consumers of Thomas Kinkade products.  As of December  31, 2001, the Thomas Kinkade Collectors’ Society hadapproximately 26,900 members, with an annual membership fee of $50.  Membership in the Society includes quarterlynewsletters and current information about Mr. Kinkade’s artwork, includingupcoming releases and events, as well as the opportunity to purchase “MemberOnly” product offerings.

 

#### **Manufacturing andProduction**

 

Canvas lithographs are manufactured, assembled, warehoused and shippedfrom the Company’s production facility in Morgan Hill, California.  Most three-dimensional products and giftitems, as well as paper lithographs and giclee prints, are manufactured bythird parties under separate manufacturing or licensing arrangements.

 

The Company’s proprietary manufacturing process for a canvas lithographbegins with an original painting. The painting is photographed and atransparency is created and approved by the artist. The Company’s artistic teamdevelops a paper lithograph that represents the exact image of the originalpainting.  The paper lithographs are thenprinted and sent to the manufacturing facility, where they are sent through adouble authentication signing process, inspected, transferred to canvas andhand-highlighted.  The manufacturingcycle takes approximately four days to complete.   Finished canvas lithographs are shipped either framed orunframed, in accordance with customer order specifications.  Third party vendors supply the frames,paper, canvas, paint and other raw materials and components used in the canvaslithograph production process.

 

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The Company is committed to assuring that products meet rigid qualitystandards and continually evaluates its manufacturing processes and supplierrelations to maintain quality control. Systematic quality control procedures, including spot inspections andregular inspection check stations, are in place at various points in themanufacturing process.  In order toimprove quality control, shorten production time and increase capacity, theCompany may automate certain portions of the production process, invest inpackaging, conveyance and MIS equipment, vertically integrate certainmanufacturing processes and develop further improvements in the lithographmanufacturing process or outsource some or all of its processes.

 

#### **Backlog**

 

Because products are generally shipped within a short period afterreceipt of an order, the Company has a limited backlog of unfilled orders.  As a result, sales in any quarter aresubstantially dependent on orders booked and shipped in that quarter.

 

#### **Employees**

 

As of December 31, 2001, the Company employed 642 employees, including407 in manufacturing and distribution, 143 in sales and marketing, 20 in retailsales and administration and 72 in corporate administration.   The Company believes that labor relationsare satisfactory and has never experienced a work stoppage.  As of February 28, 2002, the Companyemployed 583 employees, including 353 in manufacturing and distribution, 138 insales and marketing, 19 in retail sales and administration and 73 in corporateadministration.

 

#### **Risk Factors**

 

Investing in the Company’s common stock involves a high degree ofrisk.  The risks described below are notthe only ones facing the Company. Additional risks not presently known to the Company or that the Companydeems immaterial may also impair the Company’s business operations.  Any of the following risks could materiallyadversely affect the Company’s business, operating results and financialcondition and could result in a complete loss of your investment.

 

*The Company Faces Risks Related to Its Dependence on OneArtist.*  If the license agreement with Thomas Kinkadewere terminated or if he were unable or unwilling to produce new artwork forany reason, the loss of Mr. Kinkade’s services would have a material adverseeffect on the Company’s business, operating results, financial position andcash flow.  Moreover, the availableremedies in the event of a breach of the license agreement by Mr. Kinkade arelimited to monetary damages because the license is a personal servicecontract.  Upon any loss of Mr.Kinkade’s services, the Company may seek to expand the number of products basedupon Mr. Kinkade’s then existing images, to the extent Mr. Kinkade has notterminated the Company’s rights thereto, and/or develop relationships withother artists and offer products based upon their work. In addition, theCompany is highly dependent upon continued customer demand for products basedupon the artwork of Thomas Kinkade.  Anydecline in sales of such products in existing markets or any failure of suchproducts to gain consumer acceptance in new market channels would have amaterial adverse effect on the Company’s business, financial position,operating results and cash flow.

 

*The Company Faces Risks Associated with Expansion ofDistribution Channels*.  The Company’s strategyincludes expansion of its distribution channels.  The ability to increase revenues will depend, in large part, uponthe effectiveness of this implementation strategy and the market’s continuedacceptance of Thomas Kinkade art.  TheCompany intends to direct capital and personnel resources toward enhancingretail support services to licensed gallery owners, improving manufacturingsystems and streamlining systems and procedures.

 

The planned expansion ofexclusive, branded galleries is dependent upon a number of factors, includingthe Company’s ability to locate suitable sites, identify appropriate owners andintegrate them into the dealership network, as well as the ability of such ownersto effectively promote and sell products. The Company intends to establish galleries in certain geographic marketsthat may present competitive challenges that have not been experienced to date.  In addition, new stores may open in theproximity of existing galleries and dealers, which may reduce sales to existinglocations. Furthermore, the laws of certain states may limit the Company’sability to terminate, cancel or refuse to renew dealer agreements with dealersoperating in those states.  Failure of theCompany to achieve planned expansion of exclusive, branded galleries or of thegalleries to remain profitable could have a material adverse effect on theCompany’s business, financial position, operating results and cash flow.  There can be no assurance that the Companywill be able to identify suitable owners for Signature Galleries’ plannedexpansion or that such owners will become effective distributors for ourproducts.

 

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*TheCompany May Have Difficulty Effectively Managing Expansion*. The Company’s strategy for introducing new brands and products andexpanding distribution channels could place a significant strain on managementand operations.  The Company hasrecently hired a new Chief Executive Officer, Chief Financial Officer, GeneralCounsel, Vice President of Manufacturing and Vice President of Sales to meetthe challenges of managing not only future growth, but also issues resultingfrom rapid growth over the past several years.

 

Expansion requires theneed to address changing operational demands and to implement and developsystems and procedures to appropriately deal with those changes.  There can be no assurance that the increaseddemands will be anticipated. In addition, labor staffing may need to beincreased or other efficiencies may need to be implemented in order to satisfyany significant future increase in product sales. The failure to increaseoperational and manufacturing capacity in a timely and effective manner, whilemaintaining rigid product quality and customer service standards, could resultin a failure to meet demand on a timely basis. The inability to increase manufacturing capacity would have a materialadverse effect on the business and results of operations.  Failure to continue to upgrade operating andfinancial control systems and address operational inefficiencies, could have amaterial adverse effect on the Company and its results of operations. There canbe no assurance that such systems and controls will be adequate to sustain andeffectively monitor future growth. Moreover, in the event any overproduction results from expansionactivities, the oversupply of product could, among other things, reduce theperceived value and collectability of products, resulting in reduced demand forproducts, particularly, highly popular limited editions.  Any reductions in sales or margins resultingfrom a decrease in demand could have a material adverse effect on the Company’sbusiness, financial position, operating results and cash flows.

 

*The Company Faces Risks Related to Its Dependence uponConsumer Preferences.* Sales of existing and newproducts depend significantly upon continued consumer demand for the ThomasKinkade brand and products.  Demand forproducts can be affected generally by consumer preferences, which are subjectto frequent and unanticipated changes. The Company is dependent upon the ability to continue to produceappealing and popular Thomas Kinkade art-based products that anticipate, gaugeand respond in a timely manner to changing consumer demands andpreferences.  Failure to anticipate andrespond to changes in consumer preferences could lead to, among other things,lower sales, excess inventories, diminished consumer loyalty and lower margins,all of which would have a material adverse effect on the business and resultsof operations.  There can be noassurance that the current level of demand for products based upon Mr.Kinkade’s artwork will be sustained or grow. Any decline in the demand for suchproducts or failure of demand to grow would have a material adverse effect onthe Company’s business, financial position, operating results and cash flow.

 

*The Company Faces Risks Related to Its Introduction of NewProduct Lines.*  A significant element of the Company’sbusiness strategy has been to expand the Thomas Kinkade brand into new productlines.  Historically, substantially allsales from Thomas Kinkade products were generated through sales of limitededition and open edition wall art products and through other home decorativeaccessories and gift products.  As newproducts are developed, there can be no assurance that these potentially newproducts can be successfully marketed or that any of the new product lines willgain market acceptance. The inability to market new products could result inlower than anticipated sales for such products and adversely affect the imageand value of the Thomas Kinkade brand.

 

*The Company Faces a Number of Risks Related to Product SalesThrough Third Parties.*  Retail product distribution,as well as communication with the end customer, is primarily conducted byindependent dealers, including Signature Gallery owners whose stores may bearthe Thomas Kinkade name.  The Companyhas entered into licensing agreements with Signature Gallery owners grantingthem limited use of the Thomas Kinkade name. However, the failure of these dealers to properly represent theCompany’s products could damage its reputation or the reputation of ThomasKinkade and adversely affect the Company’s ability to build the Thomas Kinkadebrand, resulting in a material adverse effect on the business, consolidatedfinancial position, operating results and cash flows of the Company.  Although we conduct our business through anindependently owned and operated dealer network, state business opportunity andfranchise laws may impact our relationships with our dealers.  Certain of our dealers may sell productsthat may compete with our products. While we encourage our dealers to focus on our products through marketand support programs, these dealers may give greater superiority to products ofcompetitors.  Some of our dealers mayexperience financial difficulties, which could adversely impact our collectionof accounts receivables.  The Companyregularly reviews the collectability and credit-worthiness of its dealers todetermine an appropriate allowance for doubtful accounts.  The Company’s uncollectable accounts couldexceed its current or future allowances.

 

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*The Company Faces Risks Due to Reliance on Third Parties.* The Company utilizes third parties to manufacture certain products andsupply certain materials and components for use in the manufacturingprocesses.  Reliance on third partymanufacturers involves a number of risks, including the lack of control overthe manufacturing process and the potential absence or unavailability ofadequate capacity.  Most of theCompany’s three-dimensional products and gift items are manufactured by thirdparties under licensing or manufacturing arrangements.  The failure of any of these third partymanufacturers to produce products that meet rigid specifications could resultin lower sales or otherwise adversely affect consumer perceptions of companybrands and products.  Poor consumerperception could have a material adverse effect on the business, consolidatedfinancial position, operating results and cash flows.

 

In addition, third party vendors also supply the paper, canvas, paintand other raw materials and components used in the canvas lithograph productionprocess.  The failure of any of thesethird party vendors to produce products that meet rigid specifications couldresult in lower sales or otherwise adversely affect consumer perceptions of theKinkade brand and products.  The Companyrelies on third party vendors to supply frames for its limited edition andother wall art products.  Although theCompany maintains relationships with several framing suppliers, in the pastshortages from framing suppliers has been problematic.  Any significant shortage could lead tocancellations of customer orders or delays in placement of orders.  There can be no assurance that the Companywill not encounter shortages in the future, and any prolonged shortage ofpaper, canvas, paint, frames or other materials could have a material adverseeffect on the Company’s business, consolidated financial position, operatingresults and cash flows.

 

*Changes in Economic Conditions and Consumer Spending CouldAdversely Impact the Company’s Sales.* The homedecorative accessories, collectibles and gift product industries are subject tocyclical variations.  Purchases of theseproducts are discretionary for consumers and, therefore, such purchases tend todecline during periods of recession in the national or regional economies andmay also decline at other times, and may be subject to seasonal cycles. TheCompany’s success depends, in part, upon a number of economic factors relatingto discretionary consumer spending, including employment rates, business conditions,future economic prospects, interest rates and tax rates. In addition, thebusiness is sensitive to consumer spending patterns and preferences.  Shifts in consumer discretionary spendingaway from home decorative accessories, collectibles or gift products, as wellas general declines in consumer spending, could have a material adverse effecton the Company’s business, financial position, operating results and cash flow.

 

*Critical Personnel May be Difficult to Attract, Assimilateand Retain.* The Company is dependent upon the efforts ofexecutive officers and other key personnel, as well as its ability to continueto attract and retain qualified personnel in the future.  Key man insurance in the amount of approximately$40 million on the lives of certain key personnel, including Thomas Kinkade, iscurrently maintained by the Company. The loss of certain executive officers and key personnel or inability toattract and retain qualified personnel in the future could have a materialadverse effect on the business and results of operations.

 

*Seasonalityand Fluctuations in Operating Results.*  The Company’sbusiness has experienced, and is expected to continue to experience,significant seasonal fluctuations in net sales and income.  The Company’s net sales historically havebeen highest in the December quarter and lower in the subsequent March and Junequarters.  The Company believes that theseasonal effect is due to customer buying patterns, particularly with respectto holiday purchases, and is typical of the home decorative accessories,collectibles and gift product industries. The Company expects these seasonaltrends to continue in the foreseeable future.

 

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The Company’s quarterly operating results have fluctuated significantlyin the past and may continue to fluctuate as a result of numerous factorsincluding:

 

·        Changein demand for the art of Thomas Kinkade and the Company’s Thomas Kinkadeproducts (including new product categories and series);

·        TheCompany’s ability to achieve its expansion plans;

·        Thetiming, mix and number of new product releases;

·        Thecontinued successful implementation of the Signature Gallery program;

·        Thesuccessful entrance into new distribution channels, both foreign and domestic,and new retail concepts;

·        Expansionof new distribution domestically and abroad;

·        TheCompany’s ability to implement strategic business alliances;

·        TheCompany’s ability to hire and train new manufacturing, sales and administrativepersonnel;

·        Continuedimplementation of manufacturing efficiencies;

·        Timingof product deliveries; and

·        Theability to absorb other operating costs.

 

In addition, since a significant portion of the Company’s net sales aregenerated from orders received in the quarter, sales in any quarter aresubstantially dependent on orders booked in that quarter.  Results of operations may also fluctuatebased on extraordinary events. Accordingly, the results of operations in any quarter will notnecessarily be indicative of the results that may be achieved for a full fiscalyear or any future quarter. Fluctuations in operating results may also result in volatility in theprice of the Company’s Common Stock.

 

*TheCompany Faces Significant Competition.*  The art-basedhome decorative accessories, collectibles and gift products industries arehighly fragmented and competitive. Participants in these industries compete generally on the basis ofproduct and brand appeal, quality, price and service.  The Company’s product line competes with products marketed bynumerous regional, national and foreign companies that are distributed througha variety of retail formats including department stores, mass merchants, artand gift galleries and frame shops, bookstores, mall-based specialty retailers,direct response marketing programs, catalogs, and furniture and home décorstores.  The number of marketers andretail outlets selling home decorative accessories, collectibles and giftproducts has increased in recent years, and the entry of these companiestogether with the lack of significant barriers to entry may result in increasedcompetition.  The Company intends toexpand exclusive branded galleries in new geographic markets and thosegalleries may encounter competitive challenges that have not been previously experienced.  Such competition could have a materialadverse effect on the Company’s business, financial position, operating resultsand cash flow.  Some competitors havebetter resources, including name recognition, capital resources, morediversified product offerings and broader distribution channels.  The Company’s success is highly dependentupon its ability to produce a wide variety of products with a broad range ofcustomer appeal and provide ready consumer access to such products.

 

*TheCompany Relies Heavily on Intellectually Property Rights.* The Company relies on a combination of contractual rights, trademarks,trade secrets, copyrights and patents to establish and protect proprietaryrights in its products and brands. Moreover, steps taken by the Company to protect its products and brandmay not deter their misuse or theft. The Company is aware of a number of unauthorized uses of its productsand brand.  Litigation may be necessaryto enforce and protect the Company’s intellectual property rights.  Such litigation could be expensive anddivert management’s attention away from the operation of the business.

 

*Pendingor Future Litigation. *From time to time, the Company has beensubject to litigation.  Where theCompany can make a reasonable estimate of the liability relating to pendinglitigation, it records a related liability. As additional information becomes available, the Company assesses thepotential liability and revises estimates as appropriate.  However, because of uncertainties relating tolitigation, the amount of the Company’s estimates may ultimately be differentfrom the actual amount.  In addition tothe related cost and use of cash, pending or future litigation could cause thediversion of management’s attention and resources.

 

9

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*TheCompany Has Liability on Certain Leases on Property Where It Is Not a Tenant*. The Company is a guarantor or assignor on facility leases for 21 of thepreviously Company owned stores sold to third parties.  If the purchaser defaults on the facilitylease, the lessor has the right to seek remedy from the Company.  The Company has established a liability forrent for leases where there is evidence of default or potential default and theassociated liability is probable and reasonably estimable.  Their can be no assurance that the Companywill not ultimately incur obligations in excess of these estimates which couldhave a material adverse effect on the Company’s financial position, results ofoperations and cash flows.

 

#### **Item 2.  Properties**

 

The Company’s manufacturing, distribution, sales and marketing,administration and executive offices are in three newly constructed leasedcampus facilities in Morgan Hill, California encompassing approximately 400,000square feet.  As of December 31, 2001,the Company directly operated retail operations located in three leased sitesin the United States ranging from 900 to 1,500 square feet, with an aggregateof approximately 4,000 square feet.  TheCompany believes that its existing facilities are adequate for its present andfuture needs.

 

#### **Item 3.  Legal Proceedings**

 

From time to time, theCompany is involved in various legal proceedings arising from the normal courseof business activities.  In addition,from time to time, dealers assert claims against the Company arising out oftheir contracts and relationship with the Company in the form of letters andother forms of communication. Currently, the Company does not believe that any of these legalproceedings or claims are material.

 

On October 12, 2000, acomplaint was filed in Los Angeles County Superior Court against the Companyand others by former dealers of the Company alleging, among other things,violations of the California statutory laws pertaining to franchises.  In December 2001, the matter was settledwith no material impact on the Company's financial position, results ofoperations and cash flows.

 

On March 9, 2001, acomplaint for declaratory relief was filed in Santa Clara County Superior Courtagainst Thomas Kinkade, the Company and others by George and Esther Goff.  The Company subsequently filed a complaintin the United States District Court for the Northern District of Californiaagainst Mr. Goff.  On October 9, 2001,the cases were settled with no material impact on the Company's financialposition, results of operations and cash flows.

 

#### **Item 4.  Submission of Matters to a Vote ofSecurities Holders.**

 

None.

 

10

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**PART II**

 

#### **Item 5.  Market for the Registrant’s Common Stock andRelated Stockholders’ Matters**

 

The Company’s stock hasbeen traded on the New York Stock Exchange since December 7, 1998 under thesymbol MDA.  Previously, it had beentraded on the Nasdaq National Market since the Company’s initial publicoffering on August 10, 1994 under the symbol ARTS.  The following table sets forth, for the periods indicated, thehigh and low closing sales prices for the Company’s Common Stock as reported bythe New York Stock Exchange:

 
| **Years ended  March 31, and  Nine-month period  ended December 31,** |   | **High** |   | **Low** |   |
|-----------------------------------------------------------------------|--------|----------|--------|---------|--------|
| Year ended March 31, 2000                                             |   |     |   |    |   |
| First Quarter                                                         |   | 10.31    |   | 4.00    |   |
| Second Quarter                                                        |   | 6.50     |   | 4.31    |   |
| Third Quarter                                                         |   | 4.44     |   | 3.06    |   |
| Fourth Quarter                                                        |   | 9.00     |   | 3.69    |   |
| Year ended March 31, 2001                                             |   |     |   |    |   |
| First Quarter                                                         |   | 6.69     |   | 3.88    |   |
| Second Quarter                                                        |   | 4.31     |   | 3.38    |   |
| Third Quarter                                                         |   | 5.31     |   | 3.38    |   |
| Fourth Quarter                                                        |   | 5.50     |   | 4.13    |   |
| Nine-month period ended December 31, 2001                             |   |     |   |    |   |
| Three months ended June 30                                            |   | 4.30     |   | 2.47    |   |
| Three months ended September 30                                       |   | 3.35     |   | 2.01    |   |
| Three months ended December 31                                        |   | 3.60     |   | 1.95    |   |

 

As of December 31, 2001there were approximately 477 holders of record of the Company’s Common Stock.

 

The Company has neverpaid cash dividends on its Common Stock. The Company’s current intent is to retain earnings, if any, for use inthe business and the Company does not anticipate paying cash dividends in theforeseeable future.

#### ** **

11

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#### **Item 6.  Selected Financial Data**

 

On January 24, 2002, the Company’s Board of Directors changed thefiscal year to a calendar year effective December 31, 2001. The selectedfinancial data for the nine-month periods ended December 31, 2001 and the yearsended March 31, 2001, 2000, and 1999 have been derived from the Company’saudited financial statements (except as where otherwise indicated).  The consolidated balance sheet data as ofDecember 31, 2000 and the consolidated statement of operations data for thenine-month period ended December 31, 2000 are derived from the Company’sunaudited quarterly consolidated financial statements.  The selected financial data should be readin conjunction with Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” and the Company’s consolidated financialstatements and the notes thereto included elsewhere in this annual report.

 
|                                                              |   | **Nine-months  ended December 31,** |   | **Year ended March 31,** |   |
|-------------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------|--------|
| ***(In thousands, except per share and  gallery data)***          |   | **2001**                            |   | **2000**                 |   | **2001** |   | **2000** |   | **1999** |   |
|                                                              |   |                                |   |                     |   |   |   |   |   |   |   |
| **Selected Statement of Operations Data:**                        |   |                                |   |                     |   |   |   |   |   |   |   |
| Net sales                                                         |   | $                                   | 80,894 |                     | $      | 106,841 |   | $ | 132,091 |   | $ | 141,065 |   | $ | 129,204 |   |
| Gross profit                                                      |   | 34,456                              |   | 64,935                   |   | 76,436 |   | 87,918 |   | 84,261 |   |
| Total operating  expenses                                         |   | 52,962                              |   | 47,243                   |   | 62,753 |   | 64,805 |   | 55,033 |   |
| Operating income (loss)                                           |   | (18,506                             | )      | 17,692                   |   | 13,683 |   | 23,113 |   | 29,228 |   |
| Income (loss) from continuing operations                          |   | (12,750                             | )      | 11,111                   |   | 8,904 |   | 14,150 |   | 18,352 |   |
| Income from discontinued operations                               |   | 1,869                               |   | —                   |   | — |   | — |   | — |   |
| Net income (loss)                                                 |   | (10,881                             | )      | 11,111                   |   | 8,904 |   | 14,150 |   | 18,352 |   |
| Income (loss) from continuing operations per share  (diluted) (1) |   | (0.97                               | )      | 0.84                     |   | 0.67 |   | 1.07 |   | 1.34 |   |
| Income from discontinued operations per share (diluted)           |   | 0.15                                |   | —                   |   | — |   | — |   | — |   |
| Net income (loss) per share (diluted) (1)                         |   | (0.82                               | )      | 0.84                     |   | 0.67 |   | 1.07 |   | 1.34 |   |
|                                                              |   |                                |   |                     |   |   |   |   |   |   |   |
| **Selected Operating Data:**                                      |   |                                |   |                     |   |   |   |   |   |   |   |
| Number of company owned  Thomas Kinkade Stores                    |   | 2                                   |   | —                   |   | 2 |   | 7 |   | 32 |   |
| Number of other company  owned stores                             |   | 1                                   |   | —                   |   | 1 |   | — |   | — |   |
| Number of independently  owned Thomas Kinkade                     |   |                                |   |                     |   |   |   |   |   |   |   |
| Signature Galleries                                               |   | 344                                 |   | 358                      |   | 357 |   | 297 |   | 169 |   |
| Number of independently  owned Masters of Light                   |   |                                |   |                     |   |   |   |   |   |   |   |
| Galleries                                                         |   | 14                                  |   | —                   |   | 3 |   | — |   | — |   |
|                                                              |   |                                |   |                     |   |   |   |   |   |   |   |
| **Selected Balance Sheet Data:**                                  |   |                                |   |                     |   |   |   |   |   |   |   |
| Cash and cash  equivalents                                        |   | $                                   | 2,148  |                     | $      | 8,438 |   | $ | 5,136 |   | $ | 5,544 |   | $ | 6,361 |   |
| Working capital                                                   |   | 39,969                              |   | 65,187                   |   | 57,294 |   | 47,367 |   | 41,785 |   |
| Total assets                                                      |   | 85,490                              |   | 102,320                  |   | 93,428 |   | 88,780 |   | 68,146 |   |
| Long-term obligations                                             |   | —                              |   | 243                      |   | 4,539 |   | 4,211 |   | 2,108 |   |
| Stockholders' equity                                              |   | 64,798                              |   | 77,690                   |   | 75,589 |   | 66,408 |   | 51,791 |   |

----

(1)          See Note 1 of Notes to Consolidated FinancialStatements for an explanation of the determination of shares used in computingincome (loss) per share.

 

Quarterly data for thenine-month period ended December 31, 2001 and for the year ended March 31, 2001is presented under Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

#### ** **

#### **12**

#### ****

####  

#### **Item 7.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

#### **Change of FiscalYear**

 

On January 24, 2002, theBoard of Directors of the Company changed the fiscal year to a calendar yeareffective December 31, 2001.

 

Financial data for thenine-month period ended December 31, 2001 and the years ended March 31, 2001,March 31, 2000, March 31, 1999 and March 31, 1998 have been derived from theCompany’s audited financial statements. Financial data for the nine-month period ended December 31, 2000 arederived from the Company’s unaudited quarterly consolidated financialstatements.

#### ** **

#### **Overview**

 

Media Arts Group, Inc.,founded in 1990, is the leading designer, manufacturer, marketer and brandedretailer of fine-art reproductions, art-based home decorative accessories,collectibles and gift products primarily based upon artwork by ThomasKinkade.  The Company operates in threemarket segments: wholesale, retail from three stores (for product testingpurposes) and internet retail sales. During the nine-month period ended December31, 2001, retail and internet retail sales were below 10% of the total netconsolidated sales for the Company. Net sales in the wholesale market segmentdecreased 23.7 % from the nine-month period ended December 31, 2000 primarilydue to the current general economic slowdown which began in the fourth quarterof calendar 2000 and impacted the Company’s sales throughout the nine-monthperiod ended December 31, 2001.  Inaddition, net wholesale sales to the retail and internet segment decreased34.1% from the nine-month period ended December 31, 2000 due to the sameeconomic slowdown described above.

 

During the nine-monthperiod ended December 31, 2001, the Company’s principal products includedlimited and open edition canvas and paper lithograph reproductions of theartwork of Thomas Kinkade, and other artists. During the nine-month period ended December 31, 2001, canvas and paperlithograph sales accounted for 60.4% of the Company’s net sales.  The Company continues to expand the ThomasKinkade product lines to include home decorative accessories, collectibles andgift products featuring the artwork of Thomas Kinkade.  In December 2001, the Company made thestrategic decision to discontinue the sales, distribution and marketing of artproducts based on artists other than Thomas Kinkade.  The decision was based primarily on the general down-turn in theeconomy and the Company’s refocus on, and investment of development resourcesinto, the Thomas Kinkade brand.  TheCompany notified the artists in January 2002 and has restructured its relationshipwith two of the artists such that the artists will have access to certain ofthe Company’s distribution channels and other limited support, which willpermit existing dealers of their products to purchase products directly fromthe artists.  The Company does not planto license any more Masters of Light galleries (i.e., those galleries devotedexclusively to the sale of works of the other artists) and will encourage theMasters of Light gallery owners to offer products from not only the threeartists but also those of Thomas Kinkade and of other artists.

 

The Company is focused onexpansion of controlled branded distribution, by distributing products throughbranded Thomas Kinkade Signature Galleries as well as other independentdealers.  In 1996, as part of theCompany’s strategy of expanding branded distribution, the Company initiated theThomas Kinkade Signature Gallery program. The independently owned and operated galleries exclusively sell productsbased on the artwork of Thomas Kinkade. During the nine-month period ended December 31, 2001, sales to SignatureGalleries accounted for 53.9% of consolidated net sales, compared to 52.1% forthe nine-month period ended December 31, 2000 and 52.6% in the year ended March31, 2001, 47.1% in the year ended March 31, 2000 and 31.3% in the year endedMarch 31, 1999.  At December 31, 2001,there were 344 Signature Galleries in operation.

 

In 1993, the Company initiated the Company owned retail Thomas KinkadeStores, which exclusively sell Thomas Kinkade products.  These stores accounted for 2.0% ofconsolidated net sales for the nine-month period ended December 31, 2001,compared to 2.3% for the nine-month period ended December 31, 2000, 2.1% forthe year ended March 31, 2001, 11.9% for the year ended March 31, 2000 and21.2% for the year ended March 31, 1999. As part of the Company’s retail strategy, in April 1999 it announced itsintention to de-emphasize these capital-intensive, Company owned stores andevaluate opportunities where Signature Gallery owners may purchase thesestores.  During the year ended March 31,2001, the Company transferred four of the remaining seven Company owned storesto Signature Gallery owners and closed one Company owned store.  The Company anticipates transferring one ofthe two Thomas Kinkade Stores during calendar 2002, and it currently plans onretaining the Company’s Northern California flagship store indefinitely.

 

13

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The Company also marketsits products through over 4,000 other independent dealer accounts organizedinto various incentive and commitment levels and through QVC, a cabletelevision shopping network. Additionally, the Company has established distribution alliances withmajor partners such as Avon, Hallmark and La-Z-Boy.

 

#### **Results ofOperations**

 

The following table setsforth, for the periods indicated, the percentage relationship of certain itemsfrom the Company’s consolidated income statement to net sales.

 
|                                                                   |   | **Nine-months  ended December 31,** |   | **Year ended  March 31,** |   |
|------------------------------------------------------------------------|--------|-------------------------------------|--------|---------------------------|--------|
|                                                                   |   | **2001**                            |   | **2000**                  |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                   |   |                                |   |                      |   |   |   |   |   |   |   |
| Net sales                                                              |   | 100.0                               | %      | 100.0                     | %      | 100.0 | % | 100.0 | % | 100.0 | % |
| Cost of sales                                                          |   | 57.4                                |   | 39.2                      |   | 42.1 |   | 37.7 |   | 34.8 |   |
| Gross margin                                                           |   | 42.6                                |   | 60.8                      |   | 57.9 |   | 62.3 |   | 65.2 |   |
| Operating expenses:                                                    |   |                                |   |                      |   |   |   |   |   |   |   |
| Selling and marketing                                                  |   | 25.3                                |   | 20.1                      |   | 22.5 |   | 25.0 |   | 25.7 |   |
| General and administrative                                             |   | 37.8                                |   | 21.7                      |   | 23.1 |   | 20.9 |   | 16.9 |   |
| Write-down of Internet business assets                                 |   | 2.4                                 |   | 2.4                       |   | 1.9 |   | — |   | — |   |
| Total operating expenses                                               |   | 65.5                                |   | 44.2                      |   | 47.5 |   | 45.9 |   | 42.6 |   |
|                                                                   |   |                                |   |                      |   |   |   |   |   |   |   |
| Operating income (loss)                                                |   | (22.9                               | )      | 16.5                      |   | 10.4 |   | 16.4 |   | 22.6 |   |
| Interest income (expense)                                              |   | 0.3                                 |   | (0.1                      | )      | — |   | — |   | 0.4 |   |
| Gain on sales of company owned store                                   |   | 0.1                                 |   | —                    |   | 0.3 |   | — |   | — |   |
| Income (loss) before taxes                                             |   | (22.5                               | )      | 16.4                      |   | 10.7 |   | 16.4 |   | 23.0 |   |
| Provision for (benefit from) income taxes                              |   | (6.7                                | )      | 6.1                       |   | 4.0 |   | 6.4 |   | 8.8 |   |
| Net income (loss) from continuing operations                           |   | (15.8                               | )      | 10.3                      |   | 6.7 |   | 10.0 |   | 14.2 |   |
| Discontinued Operations — tax benefits from closure of subsidiary |   | (2.3                                | )      | —                    |   | — |   | — |   | — |   |
| Net income (loss)                                                      |   | (13.5                               | )%     | 10.3                      | %      | 6.7 | % | 10.0 | % | 14.2 | % |

 

*Net sales*.  TheCompany’s net sales were $80.9 million for the nine-month period ended December31, 2001, as compared with $106.8 million for the nine-month period endedDecember 31, 2000 and $132.1 million, $141.1 million and $129.2 million for theyears ended March 31, 2001, 2000, and 1999, respectively.  The decrease in net sales for the nine-monthperiod ended December 31, 2001 as compared with the nine-month period endedDecember 31, 2000 and for the years ended March 31, 2001, 2000 and 1999 was dueprimarily to the economic slowdown which began in the fourth quarter ofcalendar 2000.  The increase in netsales in the year ended March 31, 2000 compared to the year ended March 31, 1999was primarily due to an increase in the number of independent dealers andincreased revenue from licensing arrangements.

14

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*Grossprofit. *Cost of sales consists primarily of raw material andcomponent costs, manufacturing and supervisory labor, manufacturing overheadcosts and royalties.

 
|                          |   | **Nine Months  Ended December 31** |   | **Year Ended March 31,** |   |
|-------------------------------|--------|------------------------------------|--------|--------------------------|--------|
|                          |   | **2001**                           |   | **2000**                 |   | **2001** |   | **2000** |   | **1999** |   |
|                          |   |                               |   |                     |   |   |   |   |   |   |   |
| Gross profit *(in  millions)* |   | $                                  | 34.5   |                     | $      | 64.9 |   | $ | 76.4 |   | $ | 87.9 |   | $ | 84.3 |   |
| Gross profit percent          |   | 42.6                               | %      | 60.8                     | %      | 57.9 | % | 62.3 | % | 65.2 | % |
|                               |        |                                    |        |                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

The decline in gross profit for the nine-month period ended December31, 2001 as compared to the nine-month period ended December 31, 2000 wasprimarily due to lower sales levels in the nine-month period ended December 31,2001 which resulted in manufacturing inefficiencies and unabsorbed overheadwhich were expensed as period costs. Other factors which adversely impacted gross profit in the nine-monthperiod ended December 31, 2001 were the increase in inventory reserves for slow-moving3-D products of approximately $2.0 million, and the reserve created for thedecline in value of inventories due to the discontinuance of three artists’product lines of approximately $1.8 million. The decline in gross profit in theyear ended March 31, 2001 compared to the year ended March 31, 2000 wasprimarily due to lower retail sales from the disposal of Company ownedgalleries, lower than anticipated wholesale revenues which resulted inunabsorbed overhead and changes to product mix. The decline in gross margin inthe year ended March 31, 2000 compared to the year ended March 31, 1999 wasprimarily due to the loss of retail margin resulting from the transfer of 26Company owned Thomas Kinkade Stores to Signature Gallery owners during the yearended March 31, 2000.

 

*Sellingand marketing expenses*.  Selling and marketingexpenses consist primarily of salaries and commissions, as well as advertisingand promotional expenses.

 
|                                   |   | **Nine Months  Ended December 31** |   | **Year Ended March 31,** |   |
|----------------------------------------|--------|------------------------------------|--------|--------------------------|--------|
|                                   |   | **2001**                           |   | **2000**                 |   | **2001** |   | **2000** |   | **1999** |   |
|                                   |   |                               |   |                     |   |   |   |   |   |   |   |
| Selling and marketing *(in  millions)* |   | $                                  | 20.4   |                     | $      | 21.5 |   | $ | 29.7 |   | $ | 35.3 |   | $ | 33.2 |   |
| Percent of net sales                   |   | 25.3                               | %      | 20.1                     | %      | 22.5 | % | 25.0 | % | 25.7 | % |
|                                        |        |                                    |        |                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

Selling and marketing expenses decreased in the nine-month period endedDecember 31, 2001 as compared with the nine-month period ended December 31,2000 due to reduced compensation and commission expenses resulting from lowersales volume in the period.

 

The increase in sales and marketing as a percentage of net sales in thenine-month period ended December 31, 2001 as compared with the nine-monthperiod ended December 31, 2000 was primarily due to the lower sales volume inthe period.

 

Selling and marketing expenses decreased in the year ended March 31,2001 compared to the year ended March 31, 2000 primarily due to reducedcompensation costs resulting from lower than anticipated wholesale sales.  Selling and marketing expenses increased inthe year ended March 31, 2000 compared to the year ended March 31, 1999primarily due to higher advertising and promotional costs related to enhancedretail support for the Company’s independent dealers and its Company ownedstores.

 

The decrease in selling and marketing expenses as a percent of netsales in the year ended March 31, 2001 compared to the year ended March 31,2000 was primarily due to reduced compensation costs resulting from lower thananticipated wholesale sales.  Thedecrease in selling and marketing expenses as a percent of net sales in theyear ended March 31, 2000 compared to the year ended March 31, 1999 wasprimarily due to effective cost management of the significant portion of fixedselling and marketing costs.

 

 

15

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*Generaland administrative expenses*.  General andadministrative expenses consist primarily of salaries and bonuses, rent expenseand professional services such as legal and accounting fees.

 
|                                                  |   | **Nine-month  period ended December 31** |   | **Year ended March 31,** |   |
|-------------------------------------------------------|--------|------------------------------------------|--------|--------------------------|--------|
|                                                  |   | **2001**                                 |   | **2000**                 |   | **2001** |   | **2000** |   | **1999** |   |
|                                                  |   |                                     |   |                     |   |   |   |   |   |   |   |
| General and administrative  expenses *(in  millions)* |   | $                                        | 30.6   |                     | $      | 23.2 |   | $ | 30.5 |   | $ | 29.5 |   | $ | 21.8 |   |
| Percent of net sales                                  |   | 37.8                                     | %      | 21.7                     | %      | 23.1 | % | 20.9 | % | 16.9 | % |
|                                                       |        |                                          |        |                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

General administrative expenses increased in the nine-month periodended December 31, 2001 as compared with the nine-month period ended December31, 2000 due to the significant charges for severance pay for terminatedemployees of approximately $2.7 million, Morgan Hill relocation costs andexecutive recruiting fees of approximately $1.0 million and increased theallowance for doubtful accounts relating to accounts receivable and notesreceivable by $7.8 million due to the current economic environment.

 

General and administrative expenses increased as a percentage of netsales in the nine-month period ended December 31, 2001 as compared with thenine-month period ended December 31, 2000 due to the lower sales volume and thecharges explained above.

 

In the year ended March 31, 2001, general and administrative expensesremained relatively consistent with the year ended March 31, 2000 due toseveral offsetting factors including decreased expenses associated with theoperation of Company owned retail stores, increased internet businessoperations, and costs of $1.8 million associated with the withdrawn proposal toacquire the Company.  In the year endedMarch 31, 2000, general and administrative expenses increased compared to theyear ended March 31, 1999 due primarily to $5.7 million in new internetbusiness expenses related to the operations of Exclaim and a non-recurringcharge of  $1.3 million for severancepayments relating to cost reductions and certain settlement payments under keymanagement contracts.

 

General and administrative expenses increased as a percent of net salesin the year ended March 31, 2001 compared to the year ended March 31, 2000 dueto the increase in Exclaim’s internet operations and with the withdrawnproposal to acquire the Company. General and administrative expenses increased as a percent of net salesin the year ended March 31, 2000 compared to the year ended March 31, 1999 dueto the significant amount of Exclaim’s general and administrative expenses andthe non-recurring charge as compared to the increase in net sales.

 

*Write-downof internet business assets*.  In thenine-month period ended December 31, 2001, the Company incurred a charge of$2.0 million primarily related to the write-off of the remaining book value ofthe Company’s original thomaskinkade.com e-commerce website.  In the year ended March 31, 2001, theCompany significantly reduced the funding of its Exclaim operations due to thesignificant cash requirements related to its software development activitiesand the inability to obtain outside sources of capital. Accordingly, theCompany incurred a $2.5 million charge for the nine-month period ended December31, 2000 and the year ended March 31, 2001 in connection with the write-downand discontinuance of assets related to Exclaim.

 

*Wholesalesegment*.  Net sales to wholesale accounts includesales to the Company’s branded distribution channel, including independentlyowned Signature Galleries, Showcase dealers, the two Company owned ThomasKinkade Stores and other independent dealers and strategic partners and revenuegenerated from licensing arrangements, as well as revenue generated from theCompany’s e-commerce web-site, thomaskinkade.com.  Net sales to wholesale customers before intersegment eliminationsdecreased 23.7% to $80.4 million in the nine-month period ended December 31,2001 as compared to $105.4 million for the nine-month period ended December 31,2000. The decrease in net sales for this segment was due primarily to theeconomic slowdown that began in the fourth quarter of calendar 2000 and thereduction of the number of Signature Galleries to 344 at December 31, 2001 ascompared to 358 at December 31, 2000. Net sales to Signature Galleriesdecreased by 21.8% to $43.6 million for the nine-month period ended December31, 2001 as compared to $55.6 million for the nine-month period ended December31, 2000.

 

16

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Net sales to wholesale customers before intersegment eliminationsdecreased 2.1% to $130.3 million in the year ended March 31, 2001 compared to$133.1 million in the year ended March 31, 2000.  The decrease in net sales for this segment was primarily due tothe general economic slowdown which began in the fourth quarter of calendar2000 and impacted sales in the fourth quarter. Net sales to Signature Galleries increased 4.7% to $69.4 million in theyear ended March 31, 2001 from $66.3 million in the year ended March 31, 2000due to an increase in the number of Signature Galleries to 357 as of March 31,2001 from 297 as of March 31, 2000.

 

Net sales in the wholesale segment before intersegment eliminations of$133.1 million in the year ended March 31, 2000 reflected an increase of 13.8%compared to net sales of $116.9 million in the year ended March 31, 1999.  The increase in net sales for this segmentwas primarily due to the growth in the number of Signature Galleries to 297 atthe end of the year ended March 31, 2000 compared to 169 at the end of the yearended March 31, 1999 and increased promotional activities and programs duringthe year ended March 31, 2000.  Sales toSignature Galleries increased 64.1% to $66.3 million in the year ended March31, 2000 from $40.4 million in the year ended March 31, 1999.

 

Operating income (loss) for the Company’s wholesale segment beforeintersegment eliminations decreased by 151.1% to an operating loss of $14.4million for the nine-month period ended December 31, 2001 compared to anoperating profit of $28.2 for the nine-month period ended December 31, 2000.The decrease in operating income is primarily due to the lower sales volume andthe related gross margins as well as the significant charges incurred in thenine-month period ended December 31, 2001 of $16.7 million, for severance pay,increases in inventory reserves for slow moving inventory, and increases in thebad debt reserves for uncollectable accounts and notes receivable.

 

Operating income for the Company’s wholesale segment beforeintersegment eliminations decreased 28.8% to $25.5 million in the year endedMarch 31, 2001 compared to $35.8 million in the year ended March 31, 2000primarily due to lower than expected net sales and gross margins and $1.8million in costs associated with the withdrawn proposal to acquire theCompany.  Operating margin for thewholesale segment before intersegment eliminations decreased to 19.5% in theyear ended March 31, 2001 from 26.9% in the year ended March 31, 2000 as aresult of lower than expected sales volumes and gross margins and the costs inconnection with the withdrawn proposal to acquire the Company.

 

Operating income for the Company’s wholesale segment beforeintersegment eliminations increased 7.8% to $35.8 million in the year endedMarch 31, 2000 compared to $33.2 million in the year ended March 31, 1999primarily due to increased net sales offset by a non-recurring charge of $1.3million for severance payments relating to cost reductions and certainsettlement payments under key management contracts and increased advertisingand promotional costs related to enhanced retail support for the Company’sindependent dealers and its owned stores. Operating margin for the wholesale segment before intersegmenteliminations decreased to 26.9% in the year ended March 31, 2000 from 28.4% inthe year ended March 31, 1999 as a result of the non-recurring charge andincreased advertising and promotional costs as compared to the increase in netsales.

 

*Retailsegment*.  Net sales of the retail segment consist ofsales by the two Company owned retail Thomas Kinkade Stores and one otherCompany owned store.  The Company’sretail segment purchases products from the Company’s wholesale segment at thesame price as external wholesale customers. Net sales for the retail segment decreased by 36.0% to $1.6 million forthe nine-month period ended December 31, 2001 compared to $2.5 million for thenine-month period ended December 31, 2000. The decrease in sales is primarilydue to the economic slowdown that began in the fourth quarter of 2000.

 

Net sales for the retail segment decreased 83.2% to $2.8 million in theyear ended March 31, 2001 compared to $16.8 million in the year ended March 31,2000.  The decrease in net sales was dueto the transfer of four Thomas Kinkade Stores to Signature Gallery owners andthe closure of one Company owned store during the year ended March 31,2001.  There were two Thomas KinkadeStores and one other Company owned store at the end of the year ended March 31,2001 compared to seven Company owned Thomas Kinkade Stores at the end of theyear ended March 31, 2000.  The Companyrecognized $457,000 in gain on sales of Company owned stores in the year endedMarch 31, 2001.  The gain recognitionwas based on the cost recovery method. Due to the continued uncertainty of the collectibility of the notesreceivable in their entirety, the Company has reported the net of the notesreceivable and deferred gains as other assets at March 31, 2001.

 

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Retail segment net sales of $16.8 million in the year ended March 31,2000 represents a decrease of 38.5% compared to $27.4 million in the year endedMarch 31, 1999.  The decrease in netsales was due primarily to the opening of one Company owned store and thesubsequent transfer of 26 Company owned stores to Signature Gallery ownersduring the year ended March 31, 2000. There were seven Company owned stores at the end of the year ended March31, 2000 compared to 32 at the end of the year ended March 31, 1999.  The Company did not recognize any gains onthe sales of Company owned stores in the year ended March 31, 2000 due to thesignificant notes receivable that have been taken.

 

Operating loss for the Company’s retail segment decreased by 8.3% to$1.1 million for the nine-month period ended December 31, 2001 as compared toan operating loss of $1.2 million for the nine-month period ended December 31,2000.

 

Operating loss for the Company’s retail segment decreased 62.7% to $1.5million in the year ended March 31, 2001 compared to $4.0 million in the yearended March 31, 2000.  This decrease inoperating loss was due primarily to the sales of less profitable Company ownedstores.

 

Operating loss for the Company’s retail segment increased 90.3% to $4.0million in the year ended March 31, 2000 compared to $2.1 million in the yearended March 31, 1999.  This increase inoperating loss was primarily due to the sale of more profitable stores,decreased sales and increased per store advertising and promotional activities.

 

*InternetApplication Service Provider segment.*  The Company’sInternet Application Service Provider (“ASP”) segment consists solely of theoperations of Exclaim, which supports a retail operating system, Storefront,which is used by independently owned Thomas Kinkade Signature Galleries.  Through the period ended September 30, 2000,Exclaim was also developing Marketplace, a vertical business-to-business tradecommunity that would link buyers and sellers together to create supply chainefficiencies within the fine art, gift and collectibles, furniture and homedécor industries.  In September 2000,the Company significantly reduced the funding of Exclaim’s operations andstopped development of the Marketplace product.  Accordingly, the Company incurred a $2.5 million charge in thenine-month period ended December 31, 2000 and the year ended March 31, 2001 inconnection with the write-down of assets related to the Marketplaceproduct.  In the nine-month period endedDecember 31, 2001, the Company ceased funding the Storefront system and closedthe remaining operations of Exclaim.

 

Net sales in the ASP segment decreased 51.6% to $59,000 in the yearended March 31, 2001 compared to $122,000 in the year ended March 31,2000.  The decrease in net sales was dueprimarily to Storefront license pricing changes.  Net sales for the ASP segment consist of subscription fees paidby retailers for access to Storefront, a web-based gift store and gallerymanagement system.  Storefront isdesigned to assist gallery owners with inventory management, customer contactmanagement and automated purchasing and point of sale processing.  In the fourth quarter of the year endedMarch 31, 2001, Exclaim’s operations consisted of continued support of theStorefront retail operating system that is used by a significant number of theCompany’s Signature Galleries.  As ofMarch 31, 2001, net sales of Storefront were made solely to Signature Galleries.  There were no ASP segment operations duringthe year ended March 31, 1999.

 

Operating losses for the ASP segment increased 58.1% to $10.8 millionin the year ended March 31, 2001 compared to $6.9 million in the year endedMarch 31, 2000.  The increase inoperating losses was primarily due to the $2.5 million write-down ofMarketplace related assets as well as a significant expansion of productdevelopment operations of Exclaim in the first six months of the year endedMarch 31, 2001.  Operating expenses ofthe ASP segment consist primarily of salaries and consulting expenses relatedto the development of Exclaim’s products. There were no ASP segment operations during the year ended March 31,1999.

 

*DiscontinuedOperations.*Inthe year ended March 31, 1997, the Company discontinued a business segment andprovided a tax reserve related to the losses incurred by the segment. In thenine-month period ended December 31, 2001, this reserve was released andrecorded in a manner similar to the source of the loss in the year ended March31, 1997.  Accordingly, the Companyrecorded a tax benefit of $1.9 million in the nine-month period ended December31, 2001 representing the tax benefit from the closure of a subsidiary inSeptember of 1996.

 

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*Interestincome (expense)*.  Net interest income for the nine-monthperiod ended December 31, 2001 was $259,000 as compared to a net expense of$55,000 for the nine-month period ended December 31, 2000. The increase in netinterest income is primarily due to interest received from notes receivablefrom the sale of the Company’s owned stores that began in the year ended March31, 2001.

 

Net interest income was $9,000 in the year ended March 31, 2001compared to $3,000 and $504,000 in the year ended March 31, 2000 and 1999,respectively. The increase in net interest income in the year ended March 31,2001 as compared to the year ended March 31, 2000 was due primarily to thehigher average interest rate in the year ended March 31, 2001.   The decrease in net interest income in theyear ended March 31, 2000 as compared to the year ended March 31, 1999 wasprimarily due to lower cash balances resulting from the continued funding ofExclaim.

 

*Provisionfor (benefit from) income taxes*.  The benefitfrom income taxes was $5.4 million for the nine-month period ended December 31,2001 as compared with a provision of $6.5 million for the nine-month periodended December 31, 2000, and $5.2 million, $9.0 million and $11.4 million forthe years ended March 31, 2001, 2000 and 1999, respectively. The Company’seffective income tax rate for the nine-month period ended December 31, 2001 was30% compared to 37% for the nine-month period ended December 31, 2000 and37.1%, 38.8%, and 38.3% for the years ended March 31, 2001, 2000, and 1999,respectively.

 

#### **Liquidity and Capital Resources**

 

The Company’s primary source of funds during the nine-month periodended December 31, 2001 has been from operating activities and the Company’sbank line-of-credit.  Working capital asof December 31, 2001 was $40.0 million, compared to $57.3 million as of March31, 2001.

 

Net cash provided by operations was $9.5 million for the nine-monthperiod ended December 31, 2001 as compared with $3.3 million for the nine-monthperiod ended December 31, 2000 and $5.9 million,  $10.6 million and $1.8 million for the years ended March 31,2001, 2000 and 1999, respectively.  Netcash provided by operations in the nine-month period ended December 31, 2001consisted primarily of changes in assets and liabilities including: thedecrease in accounts receivable of $5.2 million, the decrease in inventories of$9.7 million and the decrease in related party receivables, prepaid expensesand other assets of $374,000 and the increase in commissions payable, accruedcompensation, accrued royalties, and other accrued expenses of $5.2 million.These were offset by the increase in income taxes receivable of $1.6 million,and the decrease in accounts payable and deferred compensation liability of$3.8 million. Net cash was utilized by operations to fund the net loss of $10.9million as adjusted by non-cash items including: depreciation and amortizationof $5.0 million, a loss from the write-down of Exclaim assets of $2.0 million,and amortization of stock based compensation of $27,000 offset by the gainrecognized on Company owned stores of $103,000 and the increase in deferredincome taxes of $1.8 million. The inventory decrease was due primarily to theincreases in inventory reserves for slow moving and three-dimensional inventoryand the increased shipments for the quarter ended December 31, 2001.  The decrease in accounts receivable was dueto improved collections and increases in bad debt reserves. The decrease inaccounts payable was due to the timing and amounts of vendor payments in thequarter ended December 31, 2001. The changes in income taxes receivable wasprimarily due to the operating losses in the nine-month period ended December31, 2001 which will be carried back for refunds of prior taxes paid.

 

Net cash provided by operations for the nine-month period endedDecember 31, 2000 consisted primarily of net income of $11.1 million asadjusted by non-cash items including depreciation and amortization of $4.3million, loss from the write-down of Exclaim assets of $2.5 million, off set byan increase of $1.9 million in deferred taxes and the changes in assets andliabilities including: a $869,000 increase in accounts payable, $211,000increase in commissions payable, and a $2.7 million increase in income taxespayable and accrued liabilities offset by an increase in accounts receivable of$7.3 million, $5.6 million increase in inventories, $2.0 million increase inprepaid expenses and other assets, and a $1.7 million decrease in accruedcompensation and other accrued expenses.

 

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Net cash provided by operations in the year ended March 31, 2001consisted primarily of net income of $8.9 million as adjusted by non-cash itemsincluding: depreciation of $5.9 million, loss from the write-down of Exclaimassets of $2.5 million, and the changes in assets and liabilities including: a$3.2 million decrease in accounts receivable and a $2.2 million increase inaccounts payable, offset by a $5.9 million increase in inventories, a $4.3million decrease in income taxes payable and a $2.4 million increase in incometaxes receivable.  Inventory increaseddue primarily to seasonal increases, lower than expected wholesale sales andthe addition of new artists.  Theincrease in accounts payable was due to the timing and amounts of vendorpayments in the last quarter of the year ended March 31, 2001.  The decrease in accounts receivable was dueprimarily to lower sales in the year ended March 31, 2001.  The changes in income taxes payable andreceivable were primarily due to overpayments of estimated taxes resulting froman unanticipated operating loss in the fourth quarter of the year ended March31, 2001.

 

Net cash provided by operations for the year ended March 31, 2000 was$10.6 million, which consisted of net income adjusted by increases in accountsreceivable, inventories and other assets, offset by increases in accountspayable and deferred compensation costs. Accounts receivable increased in the year ended March 31, 2000 primarilyas a result of the significant increase in branded distribution, wherebySignature and Showcase customers receive preferential payment terms.  The increase in inventories in the yearended March 31, 2000 was attributed to increased distribution and the purchaseof full edition sizes of the new releases during the first half of the year, aswell as an increase in product offerings, including new frame choices.  Other assets increased in the year endedMarch 31, 2000 due to notes receivable taken on the sale of 26 Company ownedstores.  The increase in accountspayable was due to the timing and amounts of vendor payments in the lastquarter of the year ended March 31, 2000. The increase in deferred compensation costs was attributable to theincreased amount of compensation deferred by deferred compensation planparticipants during the year ended March 31, 2000.

 

Net cash provided by operations for the year ended March 31, 1999 was$1.8 million, which consisted of net income adjusted by increases ininventories, accounts receivable, deferred income taxes and prepaid expensesand other current assets, as well as decreases in accrued compensationcosts.  The increase in inventories inthe year ended March 31, 1999 was attributed to increased distribution and theincreased number of Company owned stores. Accounts receivable increased in the year ended March 31, 1999 due tothe timing of releases during the fourth quarter of that year, and because ofan increase in branded distribution, whereby Signature and Showcase customersreceive preferential payment terms. Prepaid expenses and other assets increased in the year ended March 31,1999 due to an increase in prepaid promotional expenses.  The decrease in accrued compensation costswas attributed to the timing and amounts of compensation payments in the lastquarter of the year ended March 31, 1999.

 

Net cash used in investing activities was $13.9 million for thenine-month period ended December 31, 2001, $394,000 for the nine-month periodended December 31, 2000, $6.3 million in the year-ended March 31, 2001, $11.7million in the year-ended March 31, 2000, and $9.2 million in the year-endedMarch 31, 1999.

 

Net cash used in investing activities in the nine-month period endedDecember 31, 2001 related primarily to capital expenditures of  $12.8 million for leasehold improvements forthe Morgan Hill facility, property and equipment, and computer hardware andsoftware. Cash was also used in investing activities for the purchase of notesreceivable of $1.6 million. These were partially offset by net cash generatedby the sales, collections and related financing of galleries sold to SignatureGallery dealers and the decrease in cash surrender values of life insurancepolicies.

 

Net cash used in investing activities for the nine-month period endedDecember 31, 2000 related primarily to capital expenditures of $2.6 million,the purchase of a note receivable of $600,000, and the increase in the cashsurrender value of life insurance of $65,000. These were offset by the receiptof $2.2 million in proceeds from the sale of galleries and $600,000 from thepayments received for notes receivable.

 

Net cash used in investing activities in the year ended March 31, 2001related primarily to capital expenditures of $7.8 million for leaseholdimprovements in progress on the new facilities in Morgan Hill, California,property and equipment and investment in Internet related technologies.  This was partially offset by net cashgenerated by the sales, collections and related financing of galleries sold toSignature Gallery dealers.

 

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Net cash used in investing activities in the year ended March 31, 2000consisted primarily of $12.7 million invested in the development of Exclaim’sInternet related products, the e-commerce website thomaskinkade.com and capitalexpenditures for property and equipment.

 

Net cash used in investing activities in the year ended March 31, 1999consisted primarily of $8.0 million for the purchase of computer systems andsoftware products, leasehold improvements for newly opened Thomas KinkadeStores and property and equipment for manufacturing and fulfillment capacity.

 

Net cash provided by financing activities was $1.5 million in thenine-month period ended December 31, 2001 as compared with $36,000 for thenine-month period ended December 31, 2000 and $233,000 in the year ended March31, 2000. Net cash used in financing activities was $42,000 in the year endedMarch 31, 2001 and $2.7 million in the year ended March 31, 1999.  Net cash provided by financing activitiesrelated to the borrowings under the bank line-of-credit of  $12.5 million offset by the repayments of$11.0 million, and the proceeds of $63,000 related to the exercise of optionsthrough the Company’s Common Stock and the issuance of Common Stock through theCompany’s Employee Stock Purchase Plan. These were offset by the principalpayments of $110,000 under a capital lease obligation.

 

Net cash provided by financing activities for the nine-month periodended December 31, 2000 related to amounts received from the sale of CommonStock, net of applicable expenses of $96,000 offset by $60,000 payments madeunder a capital lease obligation.

 

Net cash used in financing activities in the year ended March 31, 2001related to payments of $210,000 under a capital lease obligation, offset byproceeds of $168,000 related to the exercise of options for the Company’sCommon Stock and the issuance of Common Stock through its Employee StockPurchase Plan.

 

Net cash provided by financing activities in the year ended March 31,2000 related to proceeds of $751,000 generated from the issuance of CommonStock through the exercise of stock options offset by the expenditure of$518,000 for the purchase of 74,300 shares of the Company’s Common Stock underits stock repurchase program at an average price of $6.96 per share.

 

Net cash used in financing activities in the year ended March 31, 1999related primarily to the expenditure of $3.7 million for the purchase of278,600 shares of the Company’s Common Stock under its stock repurchase programat an average price of $13.27 per share. This expenditure was partially offset by proceeds of $1.0 milliongenerated from the issuance of the Company’s Common Stock through the exerciseof stock options and warrants.

 

The Company secured a bank line-of-credit facility that bears interestat either the bank’s current reference rate plus 0.25% or the effective LIBORrate plus 1.75%, at the Company’s discretion. The Company renegotiated thefacility in January, 2002 due to its being non-compliant with some of thefinancial covenants as originally negotiated. The new agreement specified that the credit facility will bear interestat the bank’s current reference rate plus 3% or an effective rate of interestof 7.75%. There were $1.5 million of outstanding borrowings under this creditfacility as of December 31, 2001. All of the borrowings have subsequently beenrepaid. The total amount available to borrow under the line-of-credit was $20million at December 31, 2001. However, effective January 15, 2002, certainterms and covenants within the line-of-credit were amended, and accordingly,the total amount of the borrowings available was reduced to $15 million. AtDecember 31, 2001, the Company was not in compliance with all of the revisedfinancial covenants.

 

On April 15, 2002, the Company secured a $20 million revolving bankline-of-credit with Comerica Bank-California to replace the line-of-creditdiscussed above.  The term of thefacility is 360 days.  The amount availableto be borrowed is $15 million prior to the time the Company satisfies certainfinancial covenants.  Borrowings underthe facility bear interest at the bank’s prime rate plus 0.25%.  There is a 0.25% non-usage fee on unborrowedamounts under the facility, which fee is reduced to 0.125% if the Companysatisfies certain financial covenants. The facility is secured by substantially all of the Company’sassets.  The Company must satisfycertain normal and customary conditions relating to documentation, protectionand perfection of the bank’s security interest and other matters prior to theCompany’s initial borrowing under the facility.  

 

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The Companycompleted its move to its new offices and manufacturing facilities in MorganHill, California during the nine-month period ended December 31, 2001.

 

As of December 31,2001, the following future minimum lease payments are due under leaseobligations:

 
| ***(In thousands)***          |   | **Operating  Leases** |   | **Capital  Lease** |   |
|-------------------------------|--------|-----------------------|--------|--------------------|--------|
| **Fiscal Year**               |   |                  |
| 2002                          |   | $                     | 5,107  |               | $      | 583 |   |
| 2003                          |   | 5,104                 |   | —             |   |
| 2004                          |   | 5,204                 |   | —             |   |
| 2005                          |   | 5,347                 |   | —             |   |
| 2006                          |   | 5,499                 |   | —             |   |
| Thereafter                    |   | 62,078                |   | —             |   |
| Total minimum  lease payments |   | $                     | 88,339 |               | 583    |   |
| Interest                      |   |                  |   | 74                 |   |
| Total                         |   |                  |   |               | $      | 655 |   |

 

In addition, theCompany is the guarantor or assignor on facility leases for twenty-two of thepreviously Company owned stores sold to third parties. If the purchaserdefaults on the facility lease, the lessor has the right to seek remedy fromthe guarantor or assignor. Therefore at December 31, 2001, the Companyestablished a liability for such guarantee and assignments of approximately$1.0 million for leases where there was known evidence of default or strongevidence that a default situation was forthcoming.  The total third party rental payments due under guaranteed orassigned leases is approximately $10 million with such leases expiring atvarious times through January 2010.

 

The Company had no purchase commitments outstanding as of December 31,2001.

 

The Company’s working capital requirements in the foreseeable futurewill change depending on operating results, rate of expansion or any otherchanges to its operating plan needed to respond to competition, acquisitionopportunities or unexpected events.  TheCompany and its management believe that its current cash and cash equivalentbalance together with net income from operations and existing borrowingcapacity under the Company’s line-of-credit will be sufficient to meet itsworking capital requirements for at least the next 12 months.  The Company may consider alternativefinancing, such as issuance of additional equity or convertible debt securitiesor obtaining further credit facilities, if market conditions make suchalternatives financially attractive.

 

#### **Seasonality and Fluctuations in Operating Results**

 

The Company’s business has experienced, and is expected to continue toexperience, significant seasonal fluctuations in net sales and income.  The Company’s net sales historically havebeen highest in the December quarter and lower in the subsequent March and Junequarters.  The Company believes that theseasonal effect is due to customer buying patterns, particularly with respectto holiday purchases, and is typical of the home decorative accessories,collectibles and gift product industries. The Company expects these seasonaltrends to continue in the foreseeable future.

 

The Company’s quarterly operating results have fluctuated significantlyin the past and may continue to fluctuate as a result of numerous factorsincluding:

 

·        Changein demand for the art of Thomas Kinkade and the Company’s Thomas Kinkadeproducts (including new product categories and series);

·        TheCompany’s ability to achieve its expansion plans;

·        Thetiming, mix and number of new product releases;

·        Thecontinued successful implementation of the Signature Gallery program;

·        Thesuccessful entrance into new distribution channels, both foreign and domestic,and new retail concepts;

·        Expansionof new distribution domestically and abroad;

·        TheCompany’s ability to implement strategic business alliances;

·        TheCompany’s ability to hire and train new manufacturing, sales and administrativepersonnel;

·        Continuedimplementation of manufacturing efficiencies;

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·        Timingof product deliveries; and

·        Theability to absorb other operating costs.

 

In addition, since a significant portion of the Company’s net sales aregenerated from orders received in the quarter, sales in any quarter aresubstantially dependent on orders booked in that quarter.  Results of operations may also fluctuatebased on extraordinary events. Accordingly, the results of operations in any quarter will notnecessarily be indicative of the results that may be achieved for a full fiscalyear or any future quarter.  Fluctuationsin operating results may also result in volatility in the price of theCompany’s Common Stock.

 

**SupplementaryFinancial Data (unaudited)**

 

The following table sets forth the Company’s unaudited summaryquarterly data for the nine-month period ended December 31, 2001 and the yearsended March 31, 2001 and March 31, 2000.

 
| ***(UNAUDITED, IN THOUSANDS EXCEPT PER SHARE AMOUNTS)*** |   | **Year ended March 31, 2000** |   | **Year ended March 31, 2001** |   | **Nine Month Period ended December 31, 2001** |   |
|----------------------------------------------------------|--------|-------------------------------|--------|-------------------------------|--------|-----------------------------------------------|--------|
|                                                     |   | **March Quarter**             |   | **June Quarter**              |   | **September Quarter**                         |   | **December Quarter** |   | **March Quarter** |   | **June Quarter** |   | **September Quarter** |   | **December Quarter** |   |
| Net sales                                                |   | $                             | 35,879 |                          | $      | 29,583                                        |   | $ | 36,191 |   | $ | 41,056 |   | $ | 25,261 |   | $ | 24,437 |   | $ | 24,781 |   | $ | 31,676 |   |
| Gross profit                                             |   | 23,197                        |   | 18,575                        |   | 22,140                                        |   | 24,220 |   | 11,501 |   | 11,881 |   | 12,295 |   | 10,280 |   |
| Total operating expenses                                 |   | 17,141                        |   | 15,631                        |   | 17,557                                        |   | 14,055 |   | 15,510 |   | 13,922 |   | 18,032 |   | 21,008 |   |
| Operating income (loss)                                  |   | 6,056                         |   | 2,944                         |   | 4,583                                         |   | 10,165 |   | (4,009 | ) | (1,987 | ) | (5,737 | ) | (10,728 | ) |
| Income (loss) from continuing operations                 |   | 3,828                         |   | 1,884                         |   | 2,855                                         |   | 6,372 |   | (2,207 | ) | (1,251 | ) | (3,481 | ) | (8,018 | ) |
| Net income (loss)                                        |   | 3,828                         |   | 1,884                         |   | 2,855                                         |   | 6,372 |   | (2,207 | ) | (1,251 | ) | (3,481 | ) | (6,149 | ) |
| Income (loss) per share from continuing operations       |   | 0.28                          |   | 0.14                          |   | 0.22                                          |   | 0.48 |   | (0.17 | ) | (0.09 | ) | (0.26 | ) | (0.61 | ) |
| Net income (loss)   per share (diluted)             |   | 0.28                          |   | 0.14                          |   | 0.22                                          |   | 0.48 |   | (0.17 | ) | (0.09 | ) | (0.26 | ) | (0.47 | ) |
|                                                     |   |                          |   |                          |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| AS A PERCENTAGE OF SALES                                 |   |                          |   |                          |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| Net sales                                                |   | 100.0                         | %      | 100.0                         | %      | 100.0                                         | %      | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
| Gross profit                                             |   | 64.7                          |   | 62.8                          |   | 61.2                                          |   | 59.0 |   | 45.5 |   | 48.6 |   | 49.6 |   | 32.5 |   |
| Total operating expenses                                 |   | 47.8                          |   | 52.8                          |   | 48.5                                          |   | 34.3 |   | 61.4 |   | 57.0 |   | 72.8 |   | 66.3 |   |
| Operating income (loss)                                  |   | 16.9                          |   | 10.0                          |   | 12.7                                          |   | 24.7 |   | (15.9 | ) | (8.1 | ) | (22.3 | ) | (33.9 | ) |
| Income (loss) from continuing operations                 |   | 16.9                          |   | 10.0                          |   | 12.7                                          |   | 24.7 |   | (15.9 | ) | (8.1 | ) | (22.3 | ) | (25.3 | ) |
| Net income (loss)                                        |   | 10.7                          |   | 6.4                           |   | 7.9                                           |   | 15.5 |   | (8.7 | ) | (5.1 | ) | (14.0 | ) | (19.4 | ) |
|                                                          |        |                               |        |                               |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

#### ** **

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#### **Outlook**

 

*Some of the statements contained in this Annual Report onForm 10-K are forward-looking statements, including but not limited to thosespecifically identified as such, that involve risks and uncertainties.  The statements contained in the Report onForm 10-K that are not purely historical are forward-looking statements withinthe meaning of Section 27A of the Securities Act and Section 21E of theExchange Act, including, without limitation, statements regarding the Company’sexpectations, beliefs, intentions or strategies regarding the future.  All forward-looking statements included inthis Report on Form 10-K are based on information available to the Company onthe date hereof, and the Company assumes no obligation to update any suchforward-looking statements.  Thesestatements involve known and unknown risks, uncertainties and other factors,which may cause the Company’s actual results to differ materially from thoseimplied by the forward-looking statements. In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“believes,” “estimates,” “predicts,” “potential,” or “continue” or the negativeof these terms or other comparable terminology.  Although the Company believes that the expectations reflected inthe forward-looking statements are reasonable, the Company cannot guaranteefuture results, levels of activity, performance or achievements.  Moreover, neither any other person nor the Companyassumes responsibility for the accuracy and completeness of suchstatements.  Important factors that maycause actual results to differ from expectations include those discussed in“Risk Factors” beginning on page 6 of this document.*

 

As part of the Company’s strategy of continued expansion of brandeddistribution and developing new brands, the Company expects to focus on thefollowing activities during 2002:

 

·        Seekopportunities to increase retail distribution primarily through the ThomasKinkade Signature Gallery program and expansion of distribution channels,

·        Developthe licensing program and publishing agreements and other strategicrelationships,

·        Seekand evaluate new product ideas to enhance the Company’s product line offerings,

·        Seekand evaluate new brand extension ideas to enhance the reach of the Company’sexisting brands,

·        DevelopThomas Kinkade Studios to generate new artwork under the direction of Mr.Kinkade.

 

As a result ofimplementing these strategies the Company anticipates that 2002 operatingresults will include:

 

·        Alevel of revenues consistent with average revenues over the last sevenquarters  (this assumption is based onthe current economic environment),

·        Aslight increase in gross profit margin due to changes in product mix and theanticipated cost saving and reorganization initiatives instituted by theCompany in the latter part of 2001 and first quarter of 2002,

·        Areduction in selling and marketing, expenses as a percent of net sales due tocost saving and reorganization initiatives discussed above,

·        Adecrease in general and administrative expenses due to the Company’s efforts toreduce expenses as a result of cost saving and reorganization initiativesdiscussed above.

 

#### **Critical Accounting Policies**

 

*RevenueRecognition.*  The Company recognizes revenue from grossproduct sales, including freight charges, in compliance with Staff AccountingBulletin No. 101 (“SAB 101”) which require that title and risk of loss havepassed to the customer, there is persuasive evidence of an arrangement,delivery has occurred or services have been rendered, the sales price is fixedand determinable, collectibility is reasonably assured, and customer acceptancecriteria, if any, have been successfully demonstrated.

 

*ProductReturns and Other Sales Allowances and Bad Debts.* The Company records reserves for doubtful accounts, product returns,exchanges and credits for marketing, advertising, and other sales incentivesbased upon reasonable estimates derived by an analysis of historical data ofits accounts and notes receivable, revenues, bad debts, product returns,marketing, advertising and other sales incentives, as well as customercredit-worthiness, current economic trends, and changes in the customer’spayment terms. Should actual economic trends and customer credit-worthinessbecome less favorable than projected the Company may be required to increaseits future reserve estimates which may have a detrimental impact on theCompany’s financial position, results of 

 

24

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operations and cash flows. In addition, the Company has an agreementwith several of its customers offering a six-month return policy. Currently,these arrangements have not had a material impact on the Company’s reserveanalysis. However, there can be no assurance in the future that this returnpolicy may not be expanded to other customers or other channels ofdistribution. Therefore, changes or increases to this policy may, also,adversely impact future reserve estimates.

 

*Excessand Obsolete Inventory Reserves.* The Companyrecords a reserve for excess and obsolete inventory based upon reasonableestimates derived by an analysis of inventory turnover, product demand andfuture salability, and market conditions. If actual market conditions orproduct demand and salability are less favorable than projected by management,additional reserves may be required which may have a detrimental impact on theCompany’s financial position and results of operations*.*

 

*Liabilityfor Rent. *Over the past several years, the Companyhas entered into various sales contracts in which it transferred its Companyowned stores. As part of the negotiations with existing landlords, the remainsas a lessee behind the new tenant and has a contingent liability in the eventof default by the tenant for the rental commitments for the remaining leaselife of the transferred stores. At December 31, 2001, the Company determinedthat it may be required to pay rent on the remaining lease commitments untilthe lease is either renegotiated or the property is subleased. Therefore, theCompany has established a liability for such guarantee and assignments basedupon reasonable estimates derived by an analysis of the past rental paymenthistory of the store owner, location of the property, current market andeconomic conditions, the potential for re-negotiation of the lease terms andthe possibility of subleasing the property. If these conditions are less favorable than projected by management,additional reserves or outlays of cash maybe necessary in order to comply withthe Company’s rental guarantees or assignments which may have a detrimentalimpact on the Company’s financial position, results of operations and cash flow*.*

 

*Impairmentof Long-Lived Assets.* The Company reviews itslong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of the asset may not be recoverable. Whensuch “triggering” events occur, the Company compares the carrying value oflong-lived assets to the undiscounted expected future cash flows related tothose assets. If this comparison indicates that an impairment is present, theamount of the impairment is calculated using discounted expected cash flowsusing a weighted average cost of capital. There is no assurance that futureevents will not significantly impair the existing long-lived assets of theCompany that may have a detrimental impact on the Company’s financial position,results of operations and cash flow*.*

 

*RelatedParty Transactions.* The Company will, from time to time, enterinto transactions with parties that have relationships with the Company’sofficers or directors or that have a significant ownership interest in theCompany. Such transactions are reviewed by the Board of Directors and aresubject to the prior approval of members of the Board of Directors who do nothave a personal interest in the applicable transaction. The Company disclosesall material transactions that, in management’s judgement, constitute relatedparty transactions. Related parties include subsidiaries, members of theCompany’s management, and owners of a significant percentage of common stockand their family members.

 

*IncomeTaxes. *The Company estimates income taxes in each of thejurisdictions in which it operates. This process requires the Company toestimate its current tax exposure together with assessing temporary differencesresulting from the treatment of items such as depreciation and charitablecontributions, for tax and accounting purposes. These differences result indeferred tax assets and liabilities, which are included in the Company’sconsolidated balance sheet. The Company must assess the likelihood that itsdeferred tax assets will be recovered from future taxable income and, to theextent that management believes recovery is not likely, establish a valuationallowance. Therefore, any increases to the valuation allowance due to changesin the tax law or future business circumstances may have a detrimental impacton the Company’s financial position, results of operations and cash flow.

 

##### ***Recent Accounting Pronouncements***

 

In August 2001,the FASB issued Statement of Financial Accounting Standards No. 143 (SFAS No.143), “Accounting for Asset Retirement Obligations”, which is effective forfiscal years beginning after June 15, 2002. SFAS No. 143 requires that the fair value of a liability for an assetretirement obligation be recognized in the 

 

25

----

 

period in which itis incurred if a reasonable estimate of fair value can be made, with theassociated asset retirement costs capitalized as part of the carrying amount ofthe long-lived asset.  The Company iscurrently assessing the impact of SFAS 143 on the Company’s consolidatedfinancial position, results of operations and cash flows.

 

In August 2001,the FASB issued Statement of Financial Accounting Standards No. 144 (SFAS 144),“Accounting for the Impairment or Disposal of Long-Lived Assets”, which iseffective for fiscal years beginning after December 15, 2001.  SFAS 144 supersedes FASB Statement No. 121, “Accountingfor the Impairment or Disposal of Long-Live Assets and for Long-Lived Assets toBe Disposed Of”, and the accounting and reporting provisions relating to thedisposal of a segment of a business of Accounting Principles Board Opinion No.30.  The Company is currently assessingthe impact of SFAS 144 on the Company’s consolidated financial position,results of operations and cash flows.

 

In September of2001, the FASB Emerging Issues Task Force, or EITF, issued EITF Issue No.01-09, “Accounting for Consideration Given by Vendor to a Customer or aReseller of the Vendor’s Products,” which is a codification of EITF Issues No.00-25, “Vendor Income Statement Characterization of Consideration Paid to aReseller of the Vendor’s Products: No. 00-14, “Accounting for Certain SalesIncentives,” and No. 00-22, “Accounting for “Points” and Certain Other Time-orVolume-Based Sales Incentive Offers and Offers for Free Products or Services tobe Delivered in the Future.”  EITF00-25, as codified by EITF 01-09, established the treatment in the statement ofoperations of vendor consideration to resellers of a vendor’s products.  EITF 01-09 is effective for the interim andyear-end periods beginning after December 15, 2001.  The Company does not expect the adoption of EITF issue No. 01-09to have a material impact on the Company’s consolidated financial position,results of operations and cash flow.

 

**Item 7(A).                              Financial market risks**

 

The Company’s exposure to market risk for changes in interest ratesrelates primarily to its investment portfolio and borrowings. The Company doesnot use derivative financial instruments in its investment portfolio and itsinvestment portfolio only includes highly liquid instruments purchased with anoriginal maturity of 90 days or less and are considered to be cashequivalents.  The Company did not haveshort-term investments as of December 31, 2001, March 31, 2001 and March 31,2000.  The Company is subject tofluctuating interest rates that may impact, adversely or otherwise, its resultsfrom operations or cash flows for its variable rate cash and cash equivalentsand borrowings.  The Company does notexpect any material loss with respect to its investment portfolio.  All sales are denominated in U.S.dollars.  As the Company has only aninsignificant amount of vendor payments denominated in foreign currencies, theCompany’s foreign exchange risk is considered immaterial to its consolidatedfinancial position, results of operations or cash flows.  The table below presents principal amountsand related weighted average interest rates for the Company’s investmentportfolio and debt obligations.

 
|                                               |   | **December  31, 2001** |     | **March 31,** |     |
|----------------------------------------------------|--------|------------------------|----------|---------------|----------|
| ***(In thousands)***                               |   |                   | **2001** |          | **2000** |   |
| **ASSETS**                                         |   |                   |     |          |     |   |   |
| Cash and cash  equivalents                         |   | $                      | 2,148    |          | $        | 5,136 |   | $ | 5,544 |   |
| Average interest  rate                             |   | 1.3                    | %        | 4.9           | %        | 3.6 | % |
| **LIABILITIES**                                    |   |                   |     |          |     |   |   |
| Bank  line-of-credit                               |   | $                      | 1,500    |          | $        | — |   | — |   |
| Interest rate  (bank reference rate plus 0.25%)(1) |   | 5.0                    | %        | 8.3           | %        | 9.0 | % |
| Capital lease  obligation                          |   | $                      | 583      |          | $        | 693 |   | $ | — |   |
| Fixed interest  rate                               |   | 10.2                   | %        | 10.2          | %        | — |   |
| Convertible note  payable to related party         |   | $                      | 1,200    |          | $        | 1,200 |   | $ | 1,200 |   |
| Fixed interest  rate                               |   | 8.0                    | %        | 8.0           | %        | 8.0 | % |

----

(1)          rate subsequently changed to bankreference rate plus 3.0% on January 15, 2002 with the signing of Amendment 7.

 

#### **26**

#### ****

 

#### **Item 8.    Financial Statement and Supplementary Data**

 

The Financial Statements and supplemental data required by this itemare set forth at the pages indicated at Item 14(a).

 

#### **Item 9.    Changes in and Disagreements with Accountantson Accounting and Financial Disclosure**

 

None

#### ** **

27

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#### ** **

#### **PART III**

 

#### **Item 10.  Directors and Executive Officers of the Registrant**

 

The information regarding directors required by this Item isincorporated by reference from the definitive proxy statement for the Company’s2002 annual meeting of stockholders to be filed with the Securities andExchange Commission pursuant to Regulation 14A not later than 120 days afterthe end of the fiscal year covered by this Form 10-K (the “Proxy Statement”).

 

Information required by this Item with respect to compliance withSection 16(a) of the Securities Exchange Act of 1934 is incorporated byreference from the Proxy Statement under the caption “SECTION 16(a) BENEFICIALOWNERSHIP REPORTING COMPLIANCE”

 

 

#### **Item 11.  Executive Compensation**

 

The information requiredby this Item is incorporated by reference from the Proxy Statement under thecaption “EXECUTIVE COMPENSATION.”

 

 

#### **Item 12.  Security Ownership of Certain Beneficial Owners and Management**

 

The information requiredby this Item is incorporated by reference from the Proxy Statement under thecaption “SECURITY OWNERSHIP OF MANAGEMENT AND PRINCIPAL SHAREHOLDERS.”

 

 

#### **Item 13.  Certain Relationships and Related Transactions**

 

The information requiredby this Item is incorporated by reference from the Proxy Statement under thecaption “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.”

 

28

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#### **PART IV**

 

#### **Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K**

 
| (a)    | The following documents  are filed as part of this Form:                                                                                                                                                                                                                                                                         |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                             |   | **Page** |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   | 1.                                                                                                                                                                                                                                                                                                                               | Financial Statements: |   |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Report of  Independent Accountants | 30 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Consolidated  Balance Sheets at December 31, 2001, March 31, 2001 and March 31, 2000 | 31 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Consolidated Statements  of Operations for the nine-month periods ended December 31, 2001and 2000  (unaudited), and the years ended March 31,  2001, 2000, and 1999 | 32 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Consolidated Statements  of Stockholders’ Equity for the nine-month period ended December 31, 2001 and  the years ended March 31, 2001, 2000, and 1999 | 33 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Consolidated  Statements of Cash Flows for the nine-month periods ended December 31, 2001  and 2000 (unaudited), and the years ended March 31, 2001, 2000, and 1999 | 34 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Notes to  Consolidated Financial Statements | 35 |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   | 2.                                                                                                                                                                                                                                                                                                                               | Financial Statement  Schedule: |   |
|   |                                                                                                                                                                                                                                                                                                                             |   |   |
|   |                                                                                                                                                                                                                                                                                                                             | Schedule II. Valuation and Qualifying Accounts and  Reserves for the nine-month period ended December 31, 2001, and the years  ended March 31, 2001, 2000, and 1999 | 49 |
|   |                                                                                                                                                                                                                                                                                                                             |   |
|   |                                                                                                                                                                                                                                                                                                                             | All other schedules are  omitted because they are not applicable or the required information is shown  in the consolidated financial statements or notes thereto. |   |
|   |                                                                                                                                                                                                                                                                                                                             |   |
|   | 3.                                                                                                                                                                                                                                                                                                                               | Exhibits:  See Index to Exhibits on page 50.  The Exhibits listed in the accompanying  Index to Exhibits are filed or incorporated by reference as part of this  report. |   |
|   |                                                                                                                                                                                                                                                                                                                             |   |
| (b)    | Reports on Form 8-K:                                                                                                                                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                             |
|   | On December 17, 2001, a  report on Form 8-K was filed reporting on the amendment of the Company’s line  of credit with Bank of America, the extension of the expiration of the line  of credit to January 15, 2002, and the Company’s borrowings under the line of  credit and cash and cash equivalents at such time. |

 

 

29

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#### **REPORT OF INDEPENDENT ACCOUNTANTS**

 

 

To the Board of Directorsand

 Stockholders of Media Arts Group, Inc.

 

                In our opinion, the consolidated financial statementslisted in the index appearing under Item 14(a)(1) on page 31 present fairly, in all materialrespects, the financial position of Media Arts Group, Inc. and its subsidiariesat December 31, 2001, March 31, 2001, and March 31, 2000 and the results oftheir operations and their cash flows for the nine-month period ended December31, 2001 and each of the three years in the period ended March 31, 2001, inconformity with accounting principles generally accepted in the United Statesof America.  In addition, in ouropinion, the financial statement schedule listed in the index appearing underItem 14(a)(2) on page 31presents fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related consolidated financialstatements.  These financial statementsand financial statement schedule are the responsibility of the Company’smanagement; our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audits.  We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for the opinion expressed above.

 

 

 

/s/  PricewaterhouseCoopers LLP

 

San Jose, California

March 28, 2002 except asto Note 12 which date is April 15, 2002

 

30

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**MEDIAARTS GROUP, INC.**

#### **CONSOLIDATEDBALANCE SHEETS**

 
| ***(In thousands,  except share data)***                                                                                                                                                                                                                                                                      |   | **December  31, 2001** |     | **March 31,** |     |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|----------|---------------|----------|
|                                                                                                                                                                                                                                                                                                          |   |                   | **2001** |          | **2000** |   |
| **ASSETS**                                                                                                                                                                                                                                                                                                    |   |                   |     |          |     |   |   |
| Current  assets:                                                                                                                                                                                                                                                                                              |   |                   |     |          |     |   |   |
| Cash  and cash equivalents                                                                                                                                                                                                                                                                                    |   | $                      | 2,148    |          | $        | 5,136 |   | $ | 5,544 |   |
| Accounts  receivable, net of allowance for doubtful accounts and sales returns of  $8,493, $2,986 and $1,793                                                                                                                                                                                                  |   | 20,178                 |     | 24,745        |     | 27,844 |   |
| Receivables  from related parties                                                                                                                                                                                                                                                                             |   | 152                    |     | 216           |     | 178 |   |
| Inventories                                                                                                                                                                                                                                                                                                   |   | 18,271                 |     | 28,006        |     | 22,102 |   |
| Prepaid  expenses and other current assets                                                                                                                                                                                                                                                                    |   | 6,094                  |     | 5,606         |     | 4,823 |   |
| Cash  surrender value of life insurance                                                                                                                                                                                                                                                                       |   | 2,476                  |     | —        |     | — |   |
| Deferred  income taxes                                                                                                                                                                                                                                                                                        |   | 9,778                  |     | 4,503         |     | 5,037 |   |
| Income  taxes receivable                                                                                                                                                                                                                                                                                      |   | 1,564                  |     | 2,382         |     | — |   |
| Total  current assets                                                                                                                                                                                                                                                                                         |   | 60,661                 |     | 70,594        |     | 65,528 |   |
| Property  and equipment, net                                                                                                                                                                                                                                                                                  |   | 23,106                 |     | 17,287        |     | 17,780 |   |
| Notes  receivable                                                                                                                                                                                                                                                                                             |   | 347                    |     | 450           |     | 341 |   |
| Cash  surrender value of life insurance                                                                                                                                                                                                                                                                       |   | —                 |     | 2,569         |     | 2.569 |   |
| Long-term  deferred income taxes                                                                                                                                                                                                                                                                              |   | 332                    |     | 1,413         |     | 191 |   |
| Other  assets                                                                                                                                                                                                                                                                                                 |   | 1,044                  |     | 1,115         |     | 2,371 |   |
| Total  assets                                                                                                                                                                                                                                                                                                 |   | $                      | 85,490   |          | $        | 93,428 |   | $ | 88,780 |   |
|                                                                                                                                                                                                                                                                                                          |   |                   |     |          |     |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                |   |                   |     |          |     |   |   |
| Current  liabilities:                                                                                                                                                                                                                                                                                         |   |                   |     |          |     |   |   |
| Bank  line of credit                                                                                                                                                                                                                                                                                          |   | $                      | 1,500    |          | $        | — |   | $ | — |   |
| Convertible  notes payable to related party                                                                                                                                                                                                                                                                   |   | 1,200                  |     | —        |     | — |   |
| Accounts  payable                                                                                                                                                                                                                                                                                             |   | 6,401                  |     | 9,832         |     | 8,640 |   |
| Commissions  payable                                                                                                                                                                                                                                                                                          |   | 609                    |     | 183           |     | 945 |   |
| Accrued  royalties                                                                                                                                                                                                                                                                                            |   | 1,547                  |     | 478           |     | 726 |   |
| Accrued  compensation costs                                                                                                                                                                                                                                                                                   |   | 1,885                  |     | 1,535         |     | 2,710 |   |
| Deferred  compensation costs                                                                                                                                                                                                                                                                                  |   | 2,524                  |     | —        |     | 868 |   |
| Accrued  expenses                                                                                                                                                                                                                                                                                             |   | 4,443                  |     | 1,053         |     | 4,272 |   |
| Capital  lease obligation, current                                                                                                                                                                                                                                                                            |   | 583                    |     | 219           |     | — |   |
| Total  current liabilities                                                                                                                                                                                                                                                                                    |   | 20,692                 |     | 13,300        |     | 18,161 |   |
| Capital  lease obligation, long-term                                                                                                                                                                                                                                                                          |   | —                 |     | 474           |     | — |   |
| Deferred  compensation costs                                                                                                                                                                                                                                                                                  |   | —                 |     | 2,865         |     | 3,011 |   |
| Convertible  notes payable to related party                                                                                                                                                                                                                                                                   |   | —                 |     | 1,200         |     | 1,200 |   |
| Total  liabilities                                                                                                                                                                                                                                                                                            |   | 20,692                 |     | 17,839        |     | 22,372 |   |
|                                                                                                                                                                                                                                                                                                          |   |                   |     |          |     |   |   |
| Commitments  and contingencies (Note 6)                                                                                                                                                                                                                                                                       |   |                   |     |          |     |   |   |
|                                                                                                                                                                                                                                                                                                          |   |                   |     |          |     |   |   |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                   |   |                   |     |          |     |   |   |
| Preferred  Stock, $0.01 par value; 1,000,000 shares authorized; none issued or  outstanding                                                                                                                                                                                                                   |   | —                 |     | —        |     | — |   |
| Common  Stock, $0.01 par value; 80,000,000 shares authorized; 13,534,175 shares  issued and 13,217,771 shares outstanding at December 31, 2001; 13,509,175  shares issued and 13,187,596 shares outstanding at March 31, 2001; 13,474,085  shares issued and 13,140,546 shares, outstanding at March 31, 2000 |   | 90                     |     | 90            |     | 90 |   |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                   |   | 38,616                 |     | 38,794        |     | 38,638 |   |
| Deferred  stock-based compensation                                                                                                                                                                                                                                                                            |   | (3                     | )        | (260          | )        | (337 | ) |
| Retained  earnings                                                                                                                                                                                                                                                                                            |   | 29,770                 |     | 40,707        |     | 32,126 |   |
| Treasury  Stock, 316,404 shares at cost at December 31, 2001; 321,579 shares at cost at  March 31, 2001; 333,539 shares at cost at March 31, 2000                                                                                                                                                             |   | (3,675                 | )        | (3,742        | )        | (4,109 | ) |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                              |   | 64,798                 |     | 75,589        |     | 66,408 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                              |   | $                      | 85,490   |          | $        | 93,428 |   | $ | 88,780 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

31

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**MEDIA ARTS GROUP, INC.**

#### **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ***(In thousands,  except per share data)***                           |   | **Nine  Months  Ended December 31** |    | **Year Ended  March 31,** |   |
|------------------------------------------------------------------------|--------|-------------------------------------|---------|---------------------------|--------|
|                                                                   |   | **2001**                            |    | **2000**                  |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                   |   |                                |    | **(unaudited)**           |   |   |   |   |   |   |   |
| Net  sales                                                             |   | $                                   | 80,894  |                      | $      | 106,841 |   | $ | 132,091 |   | $ | 141,065 |   | $ | 129,204 |   |
| Cost  of sales                                                         |   | 46,438                              |    | 41,906                    |   | 55,655 |   | 53,147 |   | 44,943 |   |
| Gross  profit                                                          |   | 34,456                              |    | 64,935                    |   | 76,436 |   | 87,918 |   | 84,261 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Operating  expenses:                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Selling  and marketing                                                 |   | 20,422                              |    | 21,526                    |   | 29,707 |   | 35,266 |   | 33,192 |   |
| General  and administrative                                            |   | 30,579                              |    | 23,176                    |   | 30,532 |   | 29,539 |   | 21,841 |   |
| Write-down  of Internet business assets                                |   | 1,961                               |    | 2,541                     |   | 2,514 |   | — |   | — |   |
| Total  operating expenses                                              |   | 52,962                              |    | 47,243                    |   | 62,753 |   | 64,805 |   | 55,033 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Operating  income (loss)                                               |   | (18,506                             | )       | 17,692                    |   | 13,683 |   | 23,113 |   | 29,228 |   |
| Interest  income (expense), net                                        |   | 259                                 |    | (55                       | )      | 9 |   | 3 |   | 504 |   |
| Gain  on sales of company owned stores                                 |   | 103                                 |    | —                    |   | 457 |   | — |   | — |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Income  (loss) before income taxes                                     |   | (18,144                             | )       | 17,637                    |   | 14,149 |   | 23,116 |   | 29,732 |   |
| Provision  for (benefit from) income taxes                             |   | (5,394                              | )       | 6,526                     |   | 5,245 |   | 8,966 |   | 11,380 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Income  (loss) from continuing operations                              |   | (12,750                             | )       | 11,111                    |   | 8,904 |   | 14,150 |   | 18,352 |   |
| Discontinued  operations — tax benefit from closure of subsidiary |   | 1,869                               |    | —                    |   | — |   | — |   | — |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Net  income (loss)                                                     |   | $                                   | (10,881 | )                         | $      | 11,111 |   | $ | 8,904 |   | $ | 14,150 |   | $ | 18,352 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Income  (loss) per share from continuing operations:                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Basic                                                                  |   | $                                   | (0.97   | )                         | $      | 0.84 |   | $ | 0.68 |   | $ | 1.09 |   | $ | 1.42 |   |
| Diluted                                                                |   | $                                   | (0.97   | )                         | $      | 0.84 |   | $ | 0.67 |   | $ | 1.07 |   | $ | 1.34 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Income  from discontinued operations:                                  |   |                                |    |                      |   |   |   |   |   |   |   |
| Basic                                                                  |   | 0.15                                |    | —                    |   | — |   | — |   | — |   |
| Diluted                                                                |   | 0.15                                |    | —                    |   | — |   | — |   | — |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Net  income (loss) per share:                                          |   |                                |    |                      |   |   |   |   |   |   |   |
| Basic                                                                  |   | $                                   | (0.82   | )                         | $      | 0.84 |   | $ | 0.68 |   | $ | 1.09 |   | $ | 1.42 |   |
| Diluted                                                                |   | $                                   | (0.82   | )                         | $      | 0.84 |   | $ | 0.67 |   | $ | 1.07 |   | $ | 1.34 |   |
|                                                                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Shares  used in income (loss) per share computation:                   |   |                                |    |                      |   |   |   |   |   |   |   |
| Basic                                                                  |   | 13,201                              |    | 13,160                    |   | 13,168 |   | 12,983 |   | 12,924 |   |
| Diluted                                                                |   | 13,201                              |    | 13,224                    |   | 13,247 |   | 13,198 |   | 13,744 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

32

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**MEDIA ARTS GROUP, INC.**

#### **CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

 

 
| ***(In thousands)***                                       |   | **Common  Stock** |   | **Additional**

**Paid-in** |   | **Deferred  stock-based**

**compensation** |   | **Retained  Earnings  (Accumulated** |         | **Treasury  Stock** |       |   |       |
|------------------------------------------------------------|--------|-------------------|--------|-----------------------------|--------|---------------------------------------------|--------|--------------------------------------|--------------|---------------------|------------|--------|------------|
|                                                       |   | **Shares**        |   | **Amount**                  |   | **Capital**                                 |   |                                 | **Deficit)** |                | **Shares** |   | **Amount** |   | **Total** |   |
| Balance  at March 31, 1998                                 |   | 12,668            |   | $                           | 85     |                                        | $      | 35,410                               |         | $                   | —     |   | $          | (376 | ) | — |   | $ | — |   | $ | 35,119 |   |
| Issuance  of common stock on exercise of options           |   | 280               |   | 3                           |   | 976                                         |   | —                               |         | —              |       | — |       | — |   | 979 |   |
| Issuance  of common stock on exercise of warrants          |   | 276               |   | —                      |   | 6                                           |   | —                               |         | —              |       | — |       | — |   | 6 |   |
| Sale  of treasury stock under employee stock purchase plan |   | —            |   | —                      |   | —                                      |   | —                               |         | —              |       | 5      |       | 56 |   | 56 |   |
| Tax  benefit of stock option transactions                  |   | —            |   | —                      |   | 975                                         |   | —                               |         | —              |       | — |       | — |   | 975 |   |
| Purchase  of treasury stock                                |   | —            |   | —                      |   | —                                      |   | —                               |         | (279                | )          | (3,696 | )          | (3,696 | ) |   |   |
| Net  income                                                |   | —            |   | —                      |   | —                                      |   | —                               |         | 18,352              |       | — |       | — |   | 18,352 |   |
|                                                       |   |              |   |                        |   |                                        |   |                                 |         |                |       |   |       |   |   |   |   |
| Balance  at March 31, 1999                                 |   | 13,224            |   | 88                          |   | 37,367                                      |   | —                               |         | 17,976              |       | (274   | )          | (3,640 | ) | 51,791 |   |
| Issuance  of common stock on exercise of options           |   | 250               |   | 2                           |   | 700                                         |   | —                               |         | —              |       | — |       | — |   | 702 |   |
| Sale  of treasury stock under employee stock purchase plan |   | —            |   | —                      |   | —                                      |   | —                               |         | —              |       | 14     |       | 49 |   | 49 |   |
| Adjustment  to fair value of deferred stock compensation   |   | —            |   | —                      |   | 337                                         |   | (337                                 | )            | —              |       | — |       | — |   | — |   |
| Tax  benefit of stock option transactions                  |   | —            |   | —                      |   | 234                                         |   | —                               |         | —              |       | — |       | — |   | 234 |   |
| Purchase  of treasury stock                                |   | —            |   | —                      |   | —                                      |   | —                               |         | —              |       | (74    | )          | (518 | ) | (518 | ) |
| Net  income                                                |   | —            |   | —                      |   | —                                      |   | —                               |         | 14,150              |       | — |       | — |   | 14,150 |   |
|                                                       |   |              |   |                        |   |                                        |   |                                 |         |                |       |   |       |   |   |   |   |
| Balance  at March 31, 2000                                 |   | 13,474            |   | 90                          |   | 38,638                                      |   | (337                                 | )            | 32,126              |       | (334   | )          | (4,109 | ) | 66,408 |   |
| Issuance  of common stock on exercise of options           |   | 35                |   | —                      |   | 124                                         |   | —                               |         | —              |       | — |       | — |   | 124 |   |
| Sale  of treasury stock under employee stock purchase plan |   | —            |   | —                      |   | —                                      |   | —                               |         | (323                | )          | 12     |       | 367 |   | 44 |   |
| Adjustment  to fair value of deferred stock compensation   |   | —            |   | —                      |   | 21                                          |   | (21                                  | )            | —              |       | — |       | — |   | — |   |
| Amortization  of stock-based compensation                  |   | —            |   | —                      |   | —                                      |   | 98                                   |         | —              |       | — |       | — |   | 98 |   |
| Tax  benefit of stock option transactions                  |   | —            |   | —                      |   | 11                                          |   | —                               |         | —              |       | — |       | — |   | 11 |   |
| Net  income                                                |   | —            |   | —                      |   | —                                      |   | —                               |         | 8,904               |       | — |       | — |   | 8,904 |   |
|                                                       |   |              |   |                        |   |                                        |   |                                 |         |                |       |   |       |   |   |   |   |
| Balance  at March 31, 2001                                 |   | 13,509            |   | 90                          |   | 38,794                                      |   | (260                                 | )            | 40,707              |       | (322   | )          | (3,742 | ) | 75,589 |   |
| Issuance  of common stock on exercise of options           |   | 25                |   | —                      |   | 52                                          |   | —                               |         | —              |       | — |       | — |   | 52 |   |
| Sale  of treasury stock under employee stock purchase plan |   | —            |   | —                      |   | —                                      |   | —                               |         | (56                 | )          | 6      |       | 67 |   | 11 |   |
| Adjustment  to fair value of deferred stock compensation   |   | —            |   | —                      |   | (230                                        | )      | 230                                  |         | —              |       | — |       | — |   | — |   |
| Amortization  of stock-based compensation                  |   | —            |   | —                      |   | —                                      |   | 27                                   |         | —              |       | — |       | — |   | 27 |   |
| Net  loss                                                  |   | —            |   | —                      |   | —                                      |   | —                               |         | (10,881             | )          | — |       | — |   | (10,881 | ) |
|                                                       |   |              |   |                        |   |                                        |   |                                 |         |                |       |   |       |   |   |   |   |
| Balance  at December  31, 2001                        |   | 13,534            |   | $                           | 90     |                                        | $      | 38,616                               |         | $                   | (3         | )      | $          | 29,770 |   |   | (316 | )  | $ | (3,675 | ) | $ | 64,798 |   |
|                                                            |        |                   |        |                             |        |                                             |        |                                      |              |                     |            |        |            |  |  |  |  |  |  |  |  |  |  |  |

** **

The accompanying notes are an integral part of theseconsolidated financial statements.

 

33

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**MEDIA ARTS GROUP, INC.**

#### **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                |   | **Nine  Months  Ended December 31** |    | **Year Ended  March 31,** |   |
|-------------------------------------------------------------------------------------------|--------|-------------------------------------|---------|---------------------------|--------|
| ***(In thousands)***                                                                      |   | **2001**                            |    | **2000**                  |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                      |   |                                |    | **(unaudited)**           |   |   |   |   |   |   |   |
| Cash  flows from operating activities:                                                    |   |                                |    |                      |   |   |   |   |   |   |   |
| Net  income (loss)                                                                        |   | $                                   | (10,881 | )                         | $      | 11,111 |   | $ | 8,904 |   | $ | 14,150 |   | $ | 18,352 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |   |                                |    |                      |   |   |   |   |   |   |   |
| Depreciation  and amortization                                                            |   | 5,033                               |    | 4,255                     |   | 5,900 |   | 4,185 |   | 2,424 |   |
| Loss  from write-down of Internet business assets                                         |   | 1,961                               |    | 2,541                     |   | 2,514 |   | — |   | — |   |
| Loss  on disposal of fixed assets                                                         |   | —                              |    | 66                        |   | — |   | — |   | — |   |
| Gain  on sales of company owned stores                                                    |   | (103                                | )       | —                    |   | (457 | ) | — |   | — |   |
| Amortization  of stock-based compensation                                                 |   | 27                                  |    | 71                        |   | 98 |   | — |   | — |   |
| Tax  benefit of stock option transactions                                                 |   | -                                   |    | —                    |   | 11 |   | 234 |   | 975 |   |
| Deferred  income taxes                                                                    |   | (1,811                              | )       | (1,870                    | )      | (688 | ) | 60 |   | (3,410 | ) |
| Changes  in assets and liabilities:                                                       |   |                                |    |                      |   |   |   |   |   |   |   |
| Accounts  receivable                                                                      |   | 5,227                               |    | (7,251                    | )      | 3,151 |   | (7,255 | ) | (6,455 | ) |
| Receivables  from related parties                                                         |   | 64                                  |    | —                    |   | (38 | ) | (105 | ) | 5 |   |
| Inventories                                                                               |   | 9,735                               |    | (5,597                    | )      | (5,904 | ) | (5,419 | ) | (7,191 | ) |
| Prepaid  expenses and other current assets                                                |   | 146                                 |    | (1,049                    | )      | (1,266 | ) | 244 |   | (2,291 | ) |
| Income  taxes receivable                                                                  |   | (1,564                              | )       | —                    |   | (2,382 | ) | 611 |   | (578 | ) |
| Other  assets                                                                             |   | 162                                 |    | (1,016                    | )      | 233 |   | (2,098 | ) | 23 |   |
| Accounts  payable                                                                         |   | (3,431                              | )       | 869                       |   | 2,245 |   | 3,757 |   | (52 | ) |
| Commissions  payable                                                                      |   | 426                                 |    | 211                       |   | (762 | ) | (36 | ) | (22 | ) |
| Accrued  compensation costs                                                               |   | 350                                 |    | (1,497                    | )      | (1175 | ) | 436 |   | (1,607 | ) |
| Deferred  compensation costs                                                              |   | (341                                | )       | (95                       | )      | (146 | ) | 2,103 |   | 908 |   |
| Income  taxes payable                                                                     |   | —                              |    | 2,668                     |   | (4,272 | ) | 1,463 |   | 618 |   |
| Accrued  royalties                                                                        |   | 1,069                               |    | 124                       |   | (248 | ) | (61 | ) | 686 |   |
| Accrued  expenses                                                                         |   | 3,392                               |    | (289                      | )      | 185 |   | (1,074 | ) | (536 | ) |
| Net  cash provided by operating activities                                                |   | 9,461                               |    | 3,252                     |   | 5,903 |   | 10,643 |   | 1,849 |   |
|                                                                                      |   |                                |    |                      |   |   |   |   |   |   |   |
| Cash  flows from investing activities:                                                    |   |                                |    |                      |   |   |   |   |   |   |   |
| Acquisition  of property and equipment                                                    |   | (12,807                             | )       | (2,597                    | )      | (7,838 | ) | (12,737 | ) | (7,993 | ) |
| Proceeds  from disposals of galleries                                                     |   | 106                                 |    | 2,188                     |   | 1,321 |   | 1,674 |   |   |   |
| Proceeds  from payments of notes receivable                                               |   | 289                                 |    | 680                       |   | 848 |   | 1,019 |   | — |   |
| Purchase  of notes receivable                                                             |   | (1,585                              | )       | (600                      | )      | (600 | ) | — |   | — |   |
| Decrease  (increase) in cash surrender value of life insurance                            |   | 95                                  |    | (65                       | )      | — |   | (1,649 | ) | (920 | ) |
| Acquisition  of gallery, net of cash acquired                                             |   | —                              |    | —                    |   | — |   | — |   | (321 | ) |
| Net cash  used in investing activities                                                    |   | (13,902                             | )       | (394                      | )      | (6,269 | ) | (11,693 | ) | (9,234 | ) |
|                                                                                      |   |                                |    |                      |   |   |   |   |   |   |   |
| Cash  flows from financing activities:                                                    |   |                                |    |                      |   |   |   |   |   |   |   |
| Borrowing  on line of credit                                                              |   | 12,500                              |    | —                    |   | — |   | — |   | — |   |
| Payments  on line of credit                                                               |   | (11,000                             | )       | —                    |   | — |   | — |   | — |   |
| Proceeds  from issuance of Common Stock, net                                              |   | 63                                  |    | 96                        |   | 168 |   | 751 |   | 1,041 |   |
| Repayment  of capital lease obligation                                                    |   | (110                                | )       | (60                       | )      | (210 | ) | — |   | — |   |
| Purchase  of Common Stock                                                                 |   | —                              |    | —                    |   | (518 | ) | (3,696 | ) |   |   |
| Net  cash provided by (used in) financing activities                                      |   | 1,453                               |    | 36                        |   | (42 | ) | 233 |   | (2,655 | ) |
|                                                                                      |   |                                |    |                      |   |   |   |   |   |   |   |
| Net  increase (decrease) in cash and cash equivalents                                     |   | (2,988                              | )       | 2,894                     |   | (408 | ) | (817 | ) | (10,040 | ) |
| Cash  and cash equivalents at beginning of year                                           |   | 5,136                               |    | 5,544                     |   | 5,544 |   | 6,361 |   | 16,401 |   |
| Cash  and cash equivalents at end of year                                                 |   | $                                   | 2,148   |                      | $      | 8,438 |   | $ | 5,136 |   | $ | 5,544 |   | $ | 6,361 |   |
|                                                                                      |   |                                |    |                      |   |   |   |   |   |   |   |
| Supplemental  cash flow disclosures:                                                      |   |                                |    |                      |   |   |   |   |   |   |   |
| Income  taxes paid                                                                        |   | $                                   | —  |                      | $      | 5,735 |   | $ | 12,676 |   | $ | 6,689 |   | $ | 13,779 |   |
| Interest  paid                                                                            |   | 441                                 |    | 191                       |   | 215 |   | 96 |   | 175 |   |
| Non-cash  investing and financing activities (Note 10)                                    |   |                                |    |                      |   |   |   |   |   |   |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

** **

34

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**MEDIA ARTS GROUP, INC.**

#### **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

#### **NOTE 1 - THECOMPANY AND SIGNIFICANT ACCOUNTING POLICIES**

 

##### ***The Company***

 

Media Arts Group,Inc. (the “Company” or “Media Arts”) is the leading designer, manufacturer,marketer and branded retailer of fine-art reproductions, art-based homedecorative accessories, collectibles and gift products based upon artwork byThomas Kinkade.  The Company’s primaryproducts are canvas and paper lithographs as well as other forms of fine-artreproductions.  The Company distributesproducts through a variety of distribution channels, including corporate andindependently owned retail stores, independent dealers and strategic partners.

 

Thomas KinkadeSignature Galleries are independently owned. Prospective Signature Galleryowners must submit a comprehensive business plan and satisfy certain financialcriteria including minimum start-up capital and net worth requirements in orderto qualify. Signature Gallery owners agree to display a broad collection ofThomas Kinkade images. Signature Gallery owners have the opportunity to attendcomprehensive training programs at the Company and have limited use of theThomas Kinkade name. Signature Galleries also have the right to receiveautomatic shipment of each new limited edition release and have rights to purchasecertain exclusive limited edition inventory. In addition, Signature Gallerieshave the opportunity to participate in exclusive promotional events. TheCompany's contractual obligations to the Signature Gallery owners includepermitting the limited use of the Thomas Kinkade name and other trademarks andobserving territory assignments.

 

Media Arts wasincorporated in Delaware on April 28, 1993 and at December 31, 2001, includedLightpost Publishing, Inc., Thomas Kinkade Stores, Inc. (“TK Stores”), ThomasKinkade Media, Inc., MAGI Sales, Inc. and Exclaim Technologies, Inc.(“Exclaim”), all of which are wholly owned subsidiaries incorporated inCalifornia.

 

***Liquidity***

 

The Company’s working capital requirements in the foreseeable futurewill change depending on operating results, rate of expansion or any otherchanges to its operating plan needed to respond to competition, acquisitionopportunities or unexpected events.  TheCompany and its management believe that its current cash and cash equivalentbalance together with net income from operations and existing borrowingcapacity under the Company’s line-of-credit will be sufficient to meet itsworking capital requirements for at least the next 12 months.  The Company may consider alternativefinancing, such as issuance of additional equity or convertible debt securitiesor obtaining further credit facilities, if market conditions make suchalternatives financially attractive.

 

##### ***Basis ofpresentation***

 

The consolidatedfinancial statements include the accounts of Media Arts and its wholly ownedsubsidiaries.  All significantintercompany balances and transactions have been eliminated in consolidation.

 

On January 24,2002, the Company’s Board of Directors changed the fiscal year to a calendaryear effective December 31, 2001.

 

Financial data forthe nine-month period ended December 31, 2000 are derived from the Company’sunaudited quarterly consolidated financial statements. In the opinion ofmanagement, this unaudited financial information reflects all materialadjustments (consisting solely of normal recurring adjustments) necessary for afair presentation of the financial position, operating results and cash flowsfor the nine-month period ended December 31, 2000.

 

##### ***Use of Estimates***

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples in the United States of America requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Estimates are used in the accounting for revenues, allowance fordoubtful accounts, product returns and other sales allowances, inventoryreserves, depreciation and amortization, lease guarantees, long-lived assetsand income taxes. Actual results could differ from those estimates.

 

35

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***Revenue Recognition***

 

The Company recognizes revenue from gross product sales, includingfreight charges, and revenues from the license of its products, in compliancewith Staff Accounting Bulletin No. 101 (“SAB 101”) which require that title andrisk of loss have passed to the customer, there is persuasive evidence of anarrangement, delivery has occurred or services have been rendered, the salesprice is fixed and determinable, collectibility is reasonably assured, andcustomer acceptance criteria, if any, have been successfully demonstrated.

 

##### ***Impairment ofLong-Lived Assets***

 

Long-lived assets and certain identifiable intangible assets to be heldand used are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of the asset may not berecoverable. When such “triggering” events occur, the Company compares thecarrying value of long-lived assets to the undiscounted expected future cashflows related to those assets. If this comparison indicates that an impairmentis present, the amount of the impairment is calculated using discountedexpected cash flow using a weighted average cost of capital.  Determination of recoverability is based onan estimate of undiscounted future cash flows resulting from the use of theasset and its eventual disposition. Measurement of an impairment loss for long-lived assets and certainidentifiable intangible assets that management expects to hold and use are basedon the fair value of the asset. Long-lived assets and certain identifiable intangible assets to bedisposed of are reported at the lower of carrying amount or fair value lesscosts to sell.

 

##### ***Income Taxes***

 

Income tax expense is based on pre-tax financial accounting income.Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbasis.  Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled.  Valuationallowances are established when necessary to reduce deferred tax assets to theamount expected to be realized.

 

##### ***Cash and cashequivalents***

 

Highly liquidinvestments with original maturities of three months or less are classified ascash and cash equivalents.

 

##### ***Concentration ofcredit and foreign currency risks***

 

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist mainly of trade accounts receivable from distributors and retaildealers, who operate primarily in the collectible art industry in the UnitedStates, Canada, England and Scotland. Currently, the Company’s sales to Canada, England and Scotland are notsignificant.  Consequently, its foreignexchange risk is deemed insignificant. The Company offers credit terms on the sale of its products and performsongoing credit evaluations of its customers’ financial condition, but generallyrequires no collateral. The Company maintains an allowance for doubtfulaccounts based on the collectibility of all accounts receivable.

 

##### ***Inventories***

 

Inventories arestated at the lower of cost or market. Cost is determined on a standard cost basis which approximates thefirst-in, first-out (FIFO) method. Appropriate consideration is given to obsolescence, excessive levels,deterioration and other factors in evaluating net realizable value.

 

36

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##### ***Property andequipment***

 

Property andequipment is stated at cost less accumulated depreciation and amortization.Repairs and maintenance costs are expensed as incurred. Depreciation and amortizationare computed on a straight-line basis over the following estimated usefullives:

 

 
| Machinery and equipment         |   | 5 years                         |   |
|---------------------------------|--------|---------------------------------|--------|
| Furniture and fixtures          |   | 7 years                         |   |
| Leasehold improvements          |   | 7 to 10 years or life  of lease |   |
| Computer  hardware and software |   | 3 to 5 years                    |   |
| Vehicles                        |   | 4 to 5 years                    |   |

 

##### ***Advertising***

 

The Companyexpenses the production costs of advertising as the expenses are incurred.  The production costs of advertising consistprimarily of magazine and radio advertisements, agency fees and other directproduction costs.  The advertisingexpense for the nine-month period ended December 31, 2001 was $3.9 million ascompared with $3.1 million (unaudited) for the nine-month period ended December31, 2000 and  $5.1 million, $2.8million, and $1.9 million for the years ended March 31, 2001, 2000 and 1999,respectively.

##### *** ***

##### ***Stock-basedcompensation***

 

As permitted byStatement of Financial Accounting Standards ("SFAS") No. 123,“Accounting for Stock-Based Compensation,” the Company accounts for employeestock-based compensation in accordance with Accounting Principles Board("APB") Opinion No. 25, “Accounting for Stock Issued to Employees”,and Financial Accounting Standards Board ("FASB") Interpretation No.44 ("FIN 44"), “Accounting for Certain Transactions InvolvingStock-Based Compensation, and interpretation of APB Opinion No. 25” and relatedinterpretations in accounting for its stock-based compensation plans.  Stock-based compensation expense related tonon-employees is measured based on the fair value of the related stock oroptions in accordance with SFAS No. 123 and its interpretations.  Expense associated with stock-basedcompensation is amortized over the vesting period of each individual award.

 

##### ***Comprehensiveincome (loss)***

 

SFAS No. 130,“Reporting Comprehensive Income,” establishes standards for reporting anddisplaying comprehensive income (loss) and its components in a full set ofgeneral-purpose financial statements. There was no difference between the Company’s net income (loss) and itstotal comprehensive income (loss) for the nine-month period ended December 31,2001 and the nine-month period ended December 31, 2000 and the years endedMarch 31, 2001, 2000 and 1999.

 

37

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##### ***Net income (loss)per share***

 

Basic net income(loss) per common share is computed by dividing net income available to commonstockholders by the weighted average number of common shares outstanding duringthe period.  Diluted net income (loss) pershare is computed by dividing net income (loss) available to commonstockholders by the common and dilutive common equivalent shares outstandingduring the period.  Common equivalentshares are excluded from the computation of diluted net income (loss) per sharewhen their effect is antidilutive.  Thefollowing table reconciles weighted average common shares outstanding for basicnet income (loss) per share to diluted net income (loss) per share:

 
| ***(In thousands)***                                                                |   | **December  31,** |   | **March 31,**   |   |
|-------------------------------------------------------------------------------------|--------|-------------------|--------|-----------------|--------|
|                                                                                |   | **2001**          |   | **2000**        |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                |   |              |   | **(unaudited)** |   |   |   |   |   |   |   |
| Weighted average common shares outstanding for basic net income  (loss) per share   |   | 13,201            |   | 13,160          |   | 13,168 |   | 12,983 |   | 12,924 |   |
| Effect of dilutive securities:                                                      |   |              |   |            |   |   |   |   |   |   |   |
| Stock options and warrants                                                          |   | —            |   | 64              |   | 79 |   | 215 |   | 820 |   |
| Weighted average common shares outstanding for diluted net income  (loss) per share |   | 13,201            |   | 13,224          |   | 13,247 |   | 13,198 |   | 3,744 |   |

 

The effect ofdilutive securities excludes stock options that were antidilutive for thenine-month periods ended December 31, 2001 and 2000, and for the years endedMarch 31, 2001, 2000, and 1999 of 1,623,779, 1,619,706 (unaudited), 1,786,000,1,615,000 and 30,000, respectively.

##### *** ***

##### ***Recent accountingpronouncements***

 

In August 2001,SFAS No. 143, “Accounting for Asset Retirement Obligations”, was issued, whichis effective for fiscal years beginning after June 15, 2002.  SFAS No. 143 requires that the fair value ofa liability for an asset retirement obligation be recognized in the period inwhich it is incurred if a reasonable estimate of fair value can be made, withthe associated asset retirement costs capitalized as part of the carryingamount of the long-lived asset.  TheCompany is currently assessing the impact of SFAS 143 on the Company’sconsolidated financial position, results of operations and cash flows.

 

In August 2001,SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, wasissued, which is effective for fiscal years beginning after December 15,2001.  SFAS 144 supersedes FASBStatement No. 121, “Accounting for the Impairment or Disposal of Long-LiveAssets and for Long-Lived Assets to Be Disposed Of”, and the accounting andreporting provisions relating to the disposal of a segment of a business of APBNo. 30, "Reporting the Results of Operations - Reporting the Effects ofDisposal of a Segment of a Business, and Extraordinary, Unusual andInfrequently Occurring Events and Transactions.''  The Company is currently assessing the impact of SFAS 144 on theCompany’s consolidated financial position, results of operations and cashflows.

 

In September of2001, the FASB Emerging Issues Task Force ("EITF") issued EITF IssueNo. 01-09, “Accounting for Consideration Given by Vendor to a Customer or aReseller of the Vendor’s Products,” which is a codification of EITF Issues No.00-25, “Vendor Income Statement Characterization of Consideration Paid to aReseller of the Vendor’s Products: No. 00-14, “Accounting for Certain SalesIncentives,” and No. 00-22, “Accounting for “Points” and Certain Other Time-orVolume-Based Sales Incentive Offers and Offers for Free Products or Services tobe Delivered in the Future.”  EITF00-25, as codified by EITF 01-09, established the treatment in the statement ofoperations of vendor consideration to resellers of a vendor’s products.  EITF 01-09 is effective for the interim andyear-end periods beginning after December 15, 2001.  The Company does not expect the adoption of EITF 01-09 to have amaterial impact on the Company’s consolidated financial position, results ofoperations and cash flow.

 

38

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#### **NOTE 2 — BALANCE SHEET COMPONENTS**

 

#### ***Inventories***

 

Inventories atfiscal year ends were as follows:

 
| ***(In thousands)*** |   | **December  31** |   | **March 31** |   |
|----------------------|--------|------------------|--------|--------------|--------|
|                 |   | **2001**         |   | **2001**     |   | **2000** |   |
| Raw materials        |   | $                | 7,606  |         | $      | 12,477 |   | $ | 7,642 |   |
| Work in process      |   | 6,705            |   | 3,292        |   | 1,727 |   |
| Finished goods       |   | 3,960            |   | 12,237       |   | 12,733 |   |
|                 |   | $                | 18,271 |         | $      | 28,006 |   | $ | 22,102 |   |

 

#### ***Propertyand equipment***

 

Property andequipment at fiscal year ends were as follows:

 
| ***(In thousands)***                            |   | **December  31** |   | **March 31 ,** |   |
|-------------------------------------------------|--------|------------------|--------|----------------|--------|
|                                            |   | **2001**         |   | **2001**       |   | **2000** |   |
| Machinery and  equipment                        |   | $                | 4,400  |           | $      | 2,892 |   | $ | 1,961 |   |
| Furniture and  fixtures                         |   | 4,901            |   | 3,589          |   | 3,429 |   |
| Leasehold  improvements                         |   | 13,690           |   | 2,680          |   | 3,146 |   |
| Computer  hardware and software                 |   | 10,531           |   | 16,134         |   | 17,348 |   |
| Vehicles                                        |   | 588              |   | 584            |   | 554 |   |
| Construction in  progress                       |   | —           |   | 4,540          |   | — |   |
|                                            |   | 34,110           |   | 30,419         |   | 26,438 |   |
| Less accumulated  depreciation and amortization |   | 11,004           |   | 13,132         |   | 8,658 |   |
|                                            |   | $                | 23,106 |           | $      | 17,287 |   | $ | 17,780 |   |

 

During the yearended March 31, 2001, the Company purchased $745,000 of computer hardware andsoftware under a capital lease. Depreciation for property and equipment acquired under the capital leasewas $659,000 for the nine-month period ended December 31, 2001 and $86,000 forthe year ended March 31, 2001.

 

 

#### **NOTE 3 — RELATED PARTY TRANSACTIONS**

 

Certain originalartworks used for reproductions by the Company have been supplied by ThomasKinkade, a founder, director and significant stockholder of the Company, andremain his property.  The Companyincurred royalties to Mr. Kinkade under a licensing agreement in the amounts of$4,675,000, $6,451,000 (unaudited), $8,225,000, $9,685,000, and $10,697,000 forthe nine-month period ended December 31, 2001, the nine-month period endedDecember 31, 2000, and for the years ended March 31, 2001, 2000 and 1999,respectively.

 

Since August 1,2001, certain licensing activities and key accounts have been managed byCreative Brands Group, Inc.  The Companyand Creative Brands Group are currently in negotiations for Creative BrandsGroup to continue to perform such services. Any agreement between the partieswill be required to be approved by the disinterested members of the Board ofDirectors. Creative Brands Group is primarily owned by Kenneth E. Raasch, asignificant shareholder, co-founder and former member of the Board of Directorsof the Company.  For the nine-monthperiod ended December 31, 2001, the Company incurred commissions of $631,000 toCreative Brands Group, Inc. The commission rates under this arrangement are thesame as or less than the commission rates quoted to the Company by otherlicensing management companies. 

 

EffectiveSeptember 30, 2001, the Company converted $1.6 million of trade accountsreceivable, due from an entity in which a relative of Thomas Kinkade, a co-founderof the Company and a member of the Board of Directors, is an investor, into afull recourse three year promissory note. The balance is repayable in equalinstallments during the three-year period and bears interest of 12% per annum.The terms of this note are consistent with those of other notes the Company hasreceived from non-related parties in the sale of Company owned Thomas Kinkadestores. In addition, the related party is indebted to the Company for the saleof the Company owned Thomas Kinkade stores in Monterey and Carmel, Californiaas discussed below.

 

#### **39**

#### ****

####  

EffectiveSeptember 15, 1999, the Company sold the Company owned Thomas Kinkade Storeslocated in Monterey and Carmel, California to an entity in which a relative ofa founder and member of the Board of Directors is an investor.  Consideration for this sale consisted ofcash of $75,000 and an 8.5% promissory note in the amount of $1.1 million duein August 2006 with semi-annual principal and interest payments.  The inventory in the stores at the time ofthe transfer was sold under a separate transaction at normal wholesale priceswith extended payment terms.  The termsof this Company owned store sale are consistent with the terms for the sales ofother Company owned stores to non-related parties.  The Company commissioned an independent valuation of the Companyowned stores in Monterey and Carmel, California and the terms of the sale werebased upon the independent valuation. At December 31, 2001, the Company determined that the notes describedabove were impaired and accordingly wrote them down to estimated realizablevalue.

 

Effective May 27,1999, the Company entered into a separation and consulting agreement withKenneth E. Raasch, a founder, director and significant stockholder of theCompany.  Under the terms of theagreement Mr. Raasch provided consulting services to the Company throughDecember 31, 2000.  During thenine-month period ended December 31, 2001, the nine-month period ended December31, 2000, and the years ended March 31, 2001 and March 31, 2000, the Companypaid $14,000, $1,320,000 (unaudited), $990,000 and $1,100,000, respectively, for these consulting services.

 

On June 1, 1995,the Company acquired a gallery located in San Jose, California, owned andoperated by the spouse of a founder. Consideration for this acquisition consisted of cash of $31,000, an 8%promissory note in the amount of $299,000 which was repaid in July 1996 and an8% convertible note in the amount of $1,200,000 due in October 2002.  The convertible note is convertible intoCommon Stock of the Company at a conversion price of $7.25 per share (asadjusted in accordance with the terms of the convertible note).

#### ** **

#### **NOTE 4 — DEBT**

 

On October 27, 1999, the Company entered into a loan agreement (the“Loan Agreement”) with a bank for a $20,000,000 line-of-credit which included afacility for up to $10,000,000 in support of letters of credit. Borrowingsunder the Loan Agreement interest at either the bank’s current reference rateplus 0.25% or the effective LIBOR rate plus 1.75%, at the Company’s discretion.The Company renegotiated the facility in January, 2002 due to its beingnon-compliant with some of the financial covenants as originally negotiated.  The new agreement specified that the creditfacility will bear interest at the bank’s current reference rate plus 3% or aneffective rate of interest of 7.75%. There were $1.5 million of outstandingborrowings under this credit facility as of December 31, 2001. All of theborrowings have subsequently been repaid. The total amount available to borrowunder the line-of-credit was $20 million at December 31, 2001. However,effective January 15, 2002, certain terms and covenants within theline-of-credit were amended, and accordingly, the total amount of theborrowings available was reduced to $15 million. The Loan Agreement requiresthe maintenance of various financial covenants and does not permit the paymentof dividends without the prior written consent of the bank.  At December 31, 2001, the Company was not incompliance with all of the revised financial covenants.

 

On April 15, 2002,the Company secured a $20 million revolving bank line-of-credit (see Note 12).

 

#### **NOTE 5 — DEFERRED COMPENSATION PLANS**

 

The Company has anon-qualified deferred compensation plan which allows eligible employees anddirectors to annually elect to defer a portion of their compensation within themeanings of the related provisions under the Employee Retirement IncomeSecurity Act of 1974, as amended.  Thedeferred compensation together with accumulated earnings is distributable incash in specified future periods, on termination of employment, or at any othertime, subject to penalty.  Deferredcompensation and accumulated earnings totaled $2,524,000, $2,865,000, and$3,011,000 at December 31, 2001 and March 31, 2001 and 2000, respectively.  The deferred compensation plan is fullyfunded under a trust agreement whereby the Company pays to the trust amounts necessaryto pay premiums on life insurance policies carried to meet the obligationsunder the plan.  The Company may makediscretionary contributions to the plan. In the nine-month periods ended December 31, 2001 and 2000, and theyears ended March 31, 2001, 2000 and 1999, no employer contributions weremade.  In the event of the Company’sinsolvency, the assets held under the plan are subject to claims of theCompany’s creditors. The Company contemplates terminating the plan duringcalendar 2002 therefore, both the deferred compensation liability balance of$2,524,000 and its accompanying cash surrender value of life insurance policiesof $2,476,000 were reclassified to current liabilities and current assets,respectively.

 

 

40

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The Company has a qualifieddefined contribution retirement 401(k) plan, the Media Arts Group, Inc.FLEXPLUS Retirement Savings Plan (the “Savings Plan”), which is available toemployees who meet certain service requirements.  The Savings Plan permits employees to make contributions up tothe maximum limits allowable under the Internal Revenue Code section401(k).  Under the Savings Plan, theCompany may, at its discretion, match all or a portion of the employees’contribution under a predetermined formula. The Company’s contributions vest over five years.  Company contributions to the Savings Planwere $91,000, $87,000 (unaudited), $118,000, $145,000, and $65,000 for thenine-month period ended December 31, 2001, the nine-month period ended December31, 2000, and the years ended March 31, 2001, 2000, and 1999, respectively.

 

#### **NOTE 6 —COMMITMENTS AND CONTINGENCIES**

 

##### ***Leases***

 

The Companyentered into three noncancellable 15-year operating leases for facilities inMorgan Hill, California.  The threeleased facilities consist of a combined approximately 274,000 square feet ofoffice, manufacturing and warehouse space. The Company entered into an additional noncancellable 15 year operatinglease which would increase the development of the campus facility in MorganHill by approximately 126,000 square feet, for an aggregate of approximately400,000 square feet. The Company also has other noncancellable operating leasesfor facilities and capital leases for computer hardware and software.  Future minimum lease commitments undernoncancellable operating and capital leases as of December 31, 2001 are asfollows:

 

| ***(In thousands)***          |   | **Operating** |   | **Capital** |   |
|-------------------------------|--------|---------------|--------|-------------|--------|
| **Fiscal Year**               |   | **Leases**    |   | **Lease**   |   |
| 2002                          |   | $             | 5,107  |        | $      | 583 |   |
| 2003                          |   | 5,104         |   | —      |   |
| 2004                          |   | 5,204         |   | —      |   |
| 2005                          |   | 5,347         |   | —      |   |
| 2006                          |   | 5,499         |   | —      |   |
| Thereafter                    |   | 62,078        |   | —      |   |
| Total minimum  lease payments |   | $             | 88,339 |        | 583    |   |
| Interest                      |   |          |   | 74          |   |
| Total                         |   |          |   | $           | 655    |   |

 

In addition, theCompany is either a guarantor or assignor on facility leases for twenty-one ofthe previously Company owned stores sold to third parties. If the purchaserdefaults on the facility lease, the lessor has the right to seek remedy fromthe guarantor or assignor. Therefore at December 31, 2001, the Companyestablished a liability for such guarantee and assignments of approximately$1.0 million for leases where there was known evidence of default or strong evidence that a default situationwas forthcoming.  The total third partyrental payments due under guaranteed or assigned leases is approximately $10million with such leases expiring at various times through January 2010.

 

During the yearended March 31, 2001, Exclaim entered into a 36-month capital lease, bearinginterest at 10.2% per annum, for the purchase of $745,000 of computer hardwareand software.  Based on the Company’sdecision to stop funding Exclaim, the Company has abandoned the underlyingasset and reclassified the outstanding lease obligations to short term.

 

Rent expense underoperating leases was $6,841,000, $2,719,000 (unaudited), $3,464,000,$3,785,000, and $3,309,000 for the nine-month period ended December 31, 2001,the nine-month period ended December 31, 2000, and the years ended March 31,2001, 2000 and 1999, respectively.  TKStores maintains leases for certain art galleries that stipulate thatadditional rent will be payable if the revenues of those galleries exceed acertain amount.

 

41

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##### ***Litigation***

 

From time to time, theCompany is involved in various legal proceedings arising from the normal courseof business activities.  In addition,from time to time, dealers assert claims against the Company arising out oftheir contracts and relationship with the Company in the form of letters andother forms of communication. Currently, the Company does not believe that any of these legalproceedings or claims are likely to have a material adverse effect on theCompany's consolidated financial position, results of operations and cashflows.

 

On October 12,2000, a complaint was filed in Los Angeles County Superior Court against theCompany and others by former dealers of the Company alleging, among otherthings, violations of the California statutory laws pertaining tofranchises.  In December 2001, thematter was settled with no material impact on the Company's financial position,results of operations and cash flows.

 

On March 9, 2001, acomplaint for declaratory relief was filed in Santa Clara County Superior Courtagainst Thomas Kinkade, the Company and others by George and Esther Goff.  The Company subsequently filed a complaintin the United States District Court for the Northern District of Californiaagainst Mr. Goff.  On October 9, 2001,the cases were settled with no material impact on the Company's financialposition, results of operations and cash flows.

 

#### **NOTE 7 — STOCKHOLDERS’ EQUITY**

 

In conjunctionwith the negotiation of a license agreement with Thomas Kinkade in December1997, the Company issued to Thomas Kinkade an option to purchase 600,000 sharesof the Company’s Common Stock at an exercise price of $12.375 per share.

 

In February 1994,the Company adopted the Employee Stock Option Plan (the “Employee Plan”) andthe Stock Option Plan for Outside Directors (the “Directors Plan”) under which1,124,863 shares and 50,000 shares, respectively, of Common Stock were reservedfor issuance to employees and outside directors.

 

In September 1998,the Company adopted the Media Arts Group, Inc. Employee Stock Purchase Plan(the “Purchase Plan”) and reserved a total of 125,000 shares of the Company’sCommon Stock for issuance thereunder. The Purchase Plan permits eligible employees to acquire shares of theCompany’s Common Stock through payroll deductions.  The Purchase Plan provides that all eligible employees maypurchase the Company’s Common Stock at 85% of its fair market value on specificdates.  Sales under the Purchase Plan inthe nine-month period ended December 31, 2001 and in the years ended March 2001and 2000 were 5,031, 11,913 and14,729 shares of Common Stock, respectively, at a weighted average price of $2.15, $3.68 and $3.33, respectively,with a total selling price of approximately $10,800, $44,000 and $49,000,respectively.  As of December 31, 2001,no shares were available for purchase.

 

In September 1998,the Company adopted the Media Arts Group, Inc. 1998 Stock Incentive Plan (the“1998 Plan”).  The 1998 Plan replacedthe Employee Plan and the Directors Plan. Total shares reserved for issuance for the 1998 Plan were 1,436,581 andinclude ungranted shares remaining from the Employee Plan and the DirectorsPlan as of the inception of the 1998 Plan. Key employees of the Company, including, without limitation, independentcontractors, are eligible to receive awards under the 1998 Plan.  Directors who are not employees of theCompany or any of its subsidiaries are also eligible to receive grants underthe Plan.

 

Options grantedunder the Employee Plan, the Directors Plan and the 1998 Plan (the “Plans”) maybe either incentive stock options or non-qualified stock options.  Generally, the exercise price of optionsgranted under the Plans may not be less than the fair market value of theshares of the Company’s Common Stock on the date of grant.  However, in the case of options granted toan optionee who owns stock representing more than 10% of the voting power ofall classes of the Company’s stock, the exercise price must not be less than110% of the fair market value on the date of grant and the maximum term of suchoptions may not exceed five years.

 

Incentive stockoptions generally expire on the earlier of three months after termination ofemployment or ten years after date of grant. Non-qualified stock options generally expire on the earlier of sixmonths after termination of employment or ten years after date of grant.  The exercise price of non-qualified stockoptions must be equal to or greater than 85% of the fair market value of theCommon Stock on the date of grant.

 

42

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Under the terms ofthe Directors Plan and the 1998 Plan, when outside directors are appointed theyare entitled to receive a non-qualified stock option to purchase 5,000 sharesof Common Stock when appointed and are entitled to receive an option topurchase 5,000 shares of Common Stock after each year of service as an outsidedirector.  All such options vestimmediately and generally expire twelve months after termination of office orten years after date of grant.

 

The followingtable summarizes option activities under all Plans:

 

|                          |   |                             |   | **Options Outstanding**  |   |
|-------------------------------|--------|----------------------------------|--------|--------------------------|--------|
| ** **                    |   | **Options Available  for Grant** |   | **Options  Outstanding** |   | **Weighted Average Exercise Price** |   |
| Balance at March 31,  1998    |   | 315,281                          |   | 1,599,016                |   | $ | 7.15 |   |
| Reserved                      |   | 500,000                          |   | —                   |   | — |   |
| Granted                       |   | (596,498                         | )      | 596,498                  |   | 13.16 |   |
| Exercised                     |   | —                           |   | (269,842                 | )      | 3.52 |   |
| Expired                       |   | 51,300                           |   | (51,300                  | )      | 6.71 |   |
| Balance at March 31,  1999    |   | 270,083                          |   | 1,874,372                |   | 9.57 |   |
| Reserved                      |   | 650,000                          |   | —                   |   | — |   |
| Granted                       |   | (1,166,000                       | )      | 1,166,000                |   | 5.06 |   |
| Exercised                     |   | —                           |   | (249,705                 | )      | 2.85 |   |
| Expired                       |   | 396,095                          |   | (396,095                 | )      | 10.10 |   |
| Balance at March 31,  2000    |   | 150,178                          |   | 2,394,572                |   | 7.97 |   |
| Reserved                      |   | 1,650,000                        |   | —                   |   | — |   |
| Granted                       |   | (475,000                         | )      | 475,000                  |   | 4.48 |   |
| Exercised                     |   | —                           |   | (35,090                  | )      | 3.26 |   |
| Expired                       |   | 387,992                          |   | (387,992                 | )      | 9.91 |   |
| Balance at March 31,  2001    |   | 1,713,170                        |   | 2,446,490                |   | 7.37 |   |
| Reserved                      |   | —                           |   | —                   |   | — |   |
| Granted                       |   | (130,000                         | )      | 130,000                  |   | 3.25 |   |
| Exercised                     |   | —                           |   | (25,000                  | )      | 2.06 |   |
| Expired                       |   | 931,534                          |   | (931,534                 | )      | 5.27 |   |
| Balance at December 31,  2001 |   | 2,514,704                        |   | 1,619,956                |   | 8.08 |   |
|                               |        |                                  |        |                          |        |  |  |  |

 

On September 3,1998 the Company canceled 363,500 options with exercise prices between $19.19and $20.75 (a weighted average exercise price of $20.31).  New options were granted on September 17,1998 with an exercise price of $12.00 which generally vest over three yearsfrom the new grant date.

 

During the yearsended March 31, 2001 and 2000, the Company issued 25,000 and 65,000 non-qualifiedstock options to individuals who were neither employees nor directors at thefair market value of the Common Stock as of the date of grant.  In accordance with the provisions of SFASNo. 123, the Company has recorded as expense the fair value of the options asthey vest.  The estimated fair value,using the Black-Scholes model, of the option grants as of December 31, 2001,March 31, 2001 and 2000 were $230,000, $299,000 and $337,000, respectively.  During the nine-month period ended December31, 2001 and the year ended March 31, 2001 compensation expense of $27,000 and$98,000 was recorded.  No expense wasrecorded during the year ended March 31, 2000. In future years, the annual compensation expense computed in accordancewith SFAS No. 123 may increase or decrease due to changes in the estimated fairvalue of the option grants.

 

43

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As of December 31,2001, options to purchase 1,182,927 shares of Common Stock were fullyvested.  The following table summarizesinformation regarding stock options outstanding and exercisable at December 31,2001:

 
|                          |   | **Options Outstanding**                                               |   | **Options Exercisable**           |   |
|-------------------------------|--------|-----------------------------------------------------------------------|--------|-----------------------------------|--------|
| **Range of  Exercise Prices** |   | **Weighted**

**Average**

**Remaining**

**Number**

**Outstanding** |   | **Contractual**

**Life (years)** |   | **Weighted**

**Average**

**Exercise Price** |   | **Number**

**Exercisable** |   | **Weighted**

**Average**

**Exercise**

**Price** |   |
| $0.01                         | -      | $4.32                                                                 |   | 290,210                           |   | 7.5 |   | $ | 3.46 |   | 102,714 |   | $ | 3.52 |   |
| 4.33                          | -      | 6.49                                                                  |   | 512,562                           |   | 5.4 |   | 4.65 |   | 306,365 |   | 4.61 |   |
| 6.50                          | -      | 8.65                                                                  |   | 121,000                           |   | 6.7 |   | 8.09 |   | 77,664 |   | 7.94 |   |
| 8.66                          | — | 12.98                                                                 |   | 678,684                           |   | 5.8 |   | 12.33 |   | 678,684 |   | 12.33 |   |
| 12.99                         | — | 19.46                                                                 |   | 5,000                             |   | 6.2 |   | 18.50 |   | 5,000 |   | 18.50 |   |
| 19.47                         | -      | 21.63                                                                 |   | 12,500                            |   | 2.7 |   | 20.90 |   | 12,500 |   | 20.90 |   |
|                          |   |                                                                  |   | 1,619,956                         |   | 6.0 |   | $ | 8.08 |   | 1,182,927 |   | $ | 9.39 |   |
|                               |        |                                                                       |        |                                   |        |  |  |  |  |  |  |  |  |  |  |  |

 

The Companyapplies the provisions of APB No. 25 and related interpretations in accountingfor compensation expense under the Company’s option plans.  Had compensation expense under these plansbeen determined pursuant to SFAS No. 123, the Company’s net income (loss) andnet income (loss) per share would have been as follows:

 
| ***(In thousands, except per share data)*** |   | **Nine-month period ended December  31** |    | **Year ended March 31,** |   |
|---------------------------------------------|--------|------------------------------------------|---------|--------------------------|--------|
|                                        |   | **2001**                                 |    | **2001**                 |   | **2000** |   | **1999** |   |
| Net income  (loss)                          |   |                                     |    |                     |   |   |   |   |   |
| As reported                                 |   | $                                        | (10,881 | )                        | $      | 8,904 |   | $ | 14,150 |   | $ | 18,352 |   |
| Pro forma                                   |   | (10,959                                  | )       | 7,667                    |   | 13,386 |   | 18,088 |   |
|                                        |   |                                     |    |                     |   |   |   |   |   |
| Net income (loss) per share                 |   |                                     |    |                     |   |   |   |   |   |
| Basic:                                      |   |                                     |    |                     |   |   |   |   |   |
| As reported                                 |   | (0.82                                    | )       | 0.68                     |   | 1.09 |   | 1.42 |   |
| Pro forma                                   |   | (0.83                                    | )       | 0.49                     |   | 0.90 |   | 1.45 |   |
| Diluted:                                    |   |                                     |    |                     |   |   |   |   |   |
| As reported                                 |   | (0.82                                    | )       | 0.67                     |   | 1.07 |   | 1.34 |   |
| Pro forma                                   |   | (0.83                                    | )       | 0.49                     |   | 0.89 |   | 1.36 |   |
|                                             |        |                                          |         |                          |        |  |  |  |  |  |  |  |  |

 

The weightedaverage fair value of options granted pursuant to the Plans was $1.82, $2.69,$2.92, and $7.90 in the nine-month period ended December 31, 2001 and for theyears ended March 31, 2001, 2000 and 1999 respectively.

 

The fair value ofthe shares granted under the Company’s option plans was estimated using theBlack-Scholes model with the following assumptions: zero dividend yield; anexpected life of 4.5 years; expected volatility of 75%; and a risk-free interestrate of 1.5 %, 6.0%, 6.0% and 5.5% for the nine-month period ended December 31,2001 and for the years ended March 31, 2001, 2000 and 1999, respectively.  The pro forma amounts reflect compensationexpense related to stock options granted during the nine-month period endedDecember 31, 2001 and for the years ended March 31, 2001, 2000 and 1999only.  In future years, the annualcompensation expense computed in accordance with SFAS No. 123 may increase ordecrease relative to the fair value of stock options granted in those years.

 

44

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#### **NOTE 8 — INCOME TAXES**

 

The provision for(benefit from) income taxes consists of the following:

* *
|                 |   | **Nine-month  period ended  December 31,** |    | **Year ended  March 31,** |   |
|----------------------|--------|--------------------------------------------|---------|---------------------------|--------|
| ***(In thousands)*** |   | **2001**                                   |    | **2001**                  |   | **2000** |   | **1999** |   |
| Current:             |   |                                       |    |                      |   |   |   |   |   |
| Federal              |   | $                                          | (1,495  | )                         | $      | 4,527 |   | $ |  6,871 |   | $ |  12,027 |   |
| State                |   | 65                                         |    | 1,406                     |   | 2,035 |   | 2,763 |   |
|                 |   | (1,430                                     | )       | 5,933                     |   | 8,906 |   | 14,790 |   |
| Deferred:            |   |                                       |    |                      |   |   |   |   |   |
| Federal              |   | (2,602                                     | )       | (493                      | )      | 65 |   | (2,894 | ) |
| State                |   | (1,362                                     | )       | (195                      | )      | (5 | ) | (516 | ) |
|                 |   | (3,964)                                    |    | (688                      | )      | 60 |   | (3,410 | ) |
|                 |   | $                                          | (5,394) |                      | $      | 5,245 |   | $ | 8,966 |   | $ | 11,380 |   |

 

A reconciliationof income taxes computed at the federal statutory income tax rate to incometaxes reported in the statement of operations is as follows:

 
|                              |   | **Nine-month  period ended  December 31,** |   | **Year ended  March 31,** |   |
|-----------------------------------|--------|--------------------------------------------|--------|---------------------------|--------|
| ***(In thousands)***              |   | **2001**                                   |   | **2001**                  |   | **2000** |   | **1999** |   |
| Federal statutory income tax rate |   | 35                                         | %      | 35                        | %      | 35 | % | 35 | % |
| State income tax rate             |   | 9                                          |   | 9                         |   | 9 |   | 5 |   |
| Nondeductible Exclaim loss        |   | (11                                        | )      | —                    |   | — |   | — |   |
| Other                             |   | (3                                         | )      | (7                        | )      | (5 | ) | (2 | ) |
|                              |   | 30                                         | %      | 37                        | %      | 39 | % | 38 | % |
|                                   |        |                                            |        |                           |        |  |  |  |  |  |  |

 

     Net current deferred income tax assetsconsisted of :

 
|                                                |   | **December 31,** |   | **March 31,** |   |
|-----------------------------------------------------|--------|------------------|--------|---------------|--------|
| ***(In thousands)***                                |   | **2001**         |   | **2001**      |   | **2000** |   |
| Inventory  reserves and capitalized overhead        |   | $                | 4,295  |          | $      | 2,457 |   | $ | 3,255 |   |
| Allowances for  sales returns and doubtful accounts |   | 3,772            |   | 940           |   | 626 |   |
| State income taxes                                  |   | 273              |   | 556           |   | 694 |   |
| Accrued compensation costs                          |   | 1,028            |   | 274           |   | 299 |   |
| Other                                               |   | 410              |   | 276           |   | 163 |   |
| Net current deferred income tax assets              |   | $                | 9,778  |          | $      | 4,503 |   | $ | 5,037 |   |

 

     Net non-current deferred income tax assetsconsisted of :

 
|                                            |   | **December 31,** |   | **March 31,** |   |
|-------------------------------------------------|--------|------------------|--------|---------------|--------|
| ***(In thousands)***                            |   | **2001**         |   | **2001**      |   | **2000** |   |
| Deferred gain on  sales of company owned stores |   | $                | 1,056  |          | $      | 1,069 |   | $ | 1,150 |   |
| Deferred  compensation                          |   | —           |   | 1,168         |   | 1,223 |   |
| Depreciation and amortization                   |   | 2,123            |   | 1,282         |   | — |   |
| Internally developed software                   |   | (2,296           | )      | (2,146        | )      | (2,559 | ) |
| Other                                           |   | (551             | )      | 40            |   | 377 |   |
| Net non-current deferred income tax assets      |   | $                | 332    |          | $      | 1,413 |   | $ | 191 |   |

#### ** **

 

45

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In the year ended March 31, 1997, the Company discontinued a businesssegment and provided a tax reserve related to the losses incurred by thesegment. In the nine-month period ended December 31, 2001, this reserve wasreleased and recorded in a manner similar to the source of the loss in the yearended March 31, 1997.

 

#### **NOTE 9 - SALE OF COMPANY OWNED STORES**

 

During the yearended March 31, 2001, the Company closed one of its Company owned stores andsold four to Signature Gallery owners, bringing the total number of stores soldto 30.  Since the Company began sellingits owned stores, $1.7 million of inventory and $2.1 million of fixed assetshave been sold.  In addition, theCompany has received $5.0 million in notes receivable in connection with thesesales.  The terms on the notes aregenerally five to seven years and bear interest of 8.5% per annum.  The Company recognized $103,000 during thenine-month period ended December 31, 2001 and $457,000 in gain on sales ofCompany owned stores in the year ended March 31, 2001.  The gain recognition was based on the costrecovery method.  As of December 31,2001, the remaining deferred gains totaled $2.6 million.  Due to the uncertainty of the collectibilityof the notes receivable in their entirety, the Company has reported the net ofthe notes receivable and deferred gains as other assets at December 31, 2001.In addition, the Company has recorded a reserve of approximately $419,000 inthe nine-month period ended December 31, 2001 for the net balances that areimpaired.

 

 

#### **NOTE 10 — NON-CASH INVESTING AND FINANCING ACTIVITIES**

 

During September1999, the Company revised its credit policies by automating components of thecredit granting and customer order acceptance processes.  The changes in the Company’s credit policiesresulted in overall reductions in customer credit limits.  Due to this reduction, several customers whowere in compliance with the Company’s previous credit policy, were no longerable to place orders and receive product. Accordingly, $1.8 million of accounts receivable were converted to notesreceivable during September and October, 1999. The notes bear interest of 9.5% per annum and generally have one to twoyear terms with monthly principal and interest payments.  The Company maintains an allowance forpotential losses based on the collectibility of these notes receivable.

 

During the yearended March 31, 2001, equipment of $745,000 was purchased on capital leasefinancing terms.

 

#### **NOTE 11 — OPERATING SEGMENTS AND GEOGRAPHICINFORMATION**

 

The Company hasthree operating segments: wholesale, retail and Internet application serviceprovider (“ASP”).  The wholesale segmentincludes sales to the Company’s branded distribution channel (which includesCompany owned stores, and independently owned Thomas Kinkade Signature Galleriesand Showcase dealers), other independent dealers and strategic partners such asQVC, Avon and Hallmark, as well as sales generated from the Company’se-commerce web-sites, including thomaskinkade.com,.  The Company’s retail segment consists of sales by two Companyowned Thomas Kinkade Stores and one other Company owned store.  The retail segment purchases products fromthe wholesale segment at the same price as external wholesale customers.  The ASP segment consists of the operationsof Exclaim, which supports a retail operating system, Storefront, used byindependently owned Thomas Kinkade Signature Galleries.

 

46

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The operatingsegments have management teams that report directly to the Chief Operating DecisionMaker (“CODM”), as defined by Statement of Financial Accounting Standards No.131, “Disclosures about Segments of an Enterprise and RelatedInformation.”  The CODM evaluatesperformance and allocates resources to each operating segment.  Information on the Company’s reportablesegments for the nine-month period ended December 31, 2001, the nine-monthperiod ended December 31, 2000, and the years ended March 31, 2001, 2000 and1999 is as follows:

 
|                           |   | **Nine-month  period  ended December 31,** |    | **Year ended  March 31,** |   |
|--------------------------------|--------|--------------------------------------------|---------|---------------------------|--------|
| ***(In thousands)***           |   | **2001**                                   |    | **2000**                  |   | **2001** |   | **2000** |   | **1999** |   |
|                           |   |                                       |    | **(unaudited)**           |   |   |   |   |   |   |   |
| Revenues:                      |   |                                       |    |                      |   |   |   |   |   |   |   |
| External wholesale             |   | $                                          | 79,217  |                      | $      | 104,297 |   | $ | 129,207 |   | $ | 124,117 |   | $ | 101,849 |   |
| Intersegment wholesale         |   | 1,209                                      |    | 1,101                     |   | 1,114 |   | 8,957 |   | 15,097 |   |
| Retail                         |   | 1,634                                      |    | 2,485                     |   | 2,825 |   | 16,826 |   | 27,355 |   |
| ASP                            |   | 43                                         |    | 59                        |   | 59 |   | 122 |   | — |   |
| Eliminations                   |   | (1,209                                     | )       | (1,101                    | )      | (1,114 | ) | (8,957 | ) | (15,097 | ) |
| Total Company                  |   | $                                          | 80,894  |                      | $      | 106,841 |   | $ | 132,091 |   | $ | 141,065 |   | $ | 129,204 |   |
|                           |   |                                       |    |                      |   |   |   |   |   |   |   |
| Operating income (loss):       |   |                                       |    |                      |   |   |   |   |   |   |   |
| Wholesale                      |   | $                                          | (14,406 | )                         | $      | 28,182 |   | $ | 25,454 |   | $ | 35,755 |   | $ | 33,164 |   |
| Retail                         |   | (1,144                                     | )       | (1,238                    | )      | (1,505 | ) | (4,032 | ) | (2,119 | ) |
| ASP                            |   | (2,790                                     | )       | (9,615                    | )      | (10,842 | ) | (6,857 | ) | — |   |
| Eliminations                   |   | (166                                       | )       | 363                       |   | 576 |   | (1,753 | ) | 1,817 |   |
| Total Company                  |   | $                                          | (18,506 | )                         | $      | 17,692 |   | $ | 13,683 |   | $ | 23,113 |   | $ | 29,228 |   |
|                           |   |                                       |    |                      |   |   |   |   |   |   |   |
| Assets:                        |   |                                       |    |                      |   |   |   |   |   |   |   |
| Wholesale                      |   | $                                          | 83,498  |                      | $      | 99,629 |   | $ | 86,114 |   | $ | 82,945 |   | $ | 60,737 |   |
| Retail                         |   | 1,765                                      |    | 1,651                     |   | 2,984 |   | 3,261 |   | 11,558 |   |
| ASP                            |   | 606                                        |    | 1,543                     |   | 4,622 |   | 3,798 |   | — |   |
| Eliminations                   |   | (379                                       | )       | (555                      | )      | (292 | ) | (1,224 | ) | (4,149 | ) |
| Total Company                  |   | $                                          | 85,490  |                      | $      | 102,268 |   | $ | 93,428 |   | $ | 88,780 |   | $ | 68,146 |   |
|                           |   |                                       |    |                      |   |   |   |   |   |   |   |
| Depreciation and amortization: |   |                                       |    |                      |   |   |   |   |   |   |   |
| Wholesale                      |   | $                                          | 3,803   |                      | $      | 2,551 |   | $ | 3,912 |   | $ | 2,618 |   | $ | 1,886 |   |
| Retail                         |   | 44                                         |    | 293                       |   | 368 |   | 1,162 |   | 538 |   |
| ASP                            |   | 1,186                                      |    | 1,411                     |   | 1,620 |   | 405 |   | — |   |
| Total Company                  |   | $                                          | 5,033   |                      | $      | 4,255 |   | $ | 5,900 |   | $ | 4,185 |   | $ | 2,424 |   |
|                           |   |                                       |    |                      |   |   |   |   |   |   |   |
| Capital expenditures:          |   |                                       |    |                      |   |   |   |   |   |   |   |
| Wholesale                      |   | $                                          | 12,634  |                      | $      | 2,306 |   | $ | 6,527 |   | $ | 8,487 |   | $ | 4,734 |   |
| Retail                         |   | 70                                         |    | 81                        |   | 193 |   | 72 |   | 3,259 |   |
| ASP                            |   | 103                                        |    | 210                       |   | 1,118 |   | 4,178 |   | — |   |
| Total Company                  |   | $                                          | 12,807  |                      | $      | 2,597 |   | $ | 7,838 |   | $ | 12,737 |   | $ | 7,993 |   |

 

#### **47**

#### ****

####  

The Companycurrently does not sell to geographic regions outside the United States,Canada, England and Scotland.  Currentlyboth assets located in, and sales to, Canada, England and Scotland are notsignificant.  During the nine-monthperiod ended December 31, 2001, the nine-month period ended December 31, 2000and the years ended March 31, 2001, 2000 and 1999 no customer accounted formore than 10% of net sales or accounts receivable.

 

#### **NOTE 12 — SUBSEQUENT EVENTS**

 

##### ***Reduction inforce:***

 

In February, 2002, the Company implemented a reduction in force in which42 employees were informed that they were being terminated over the next 90days.  The Company estimates itsliability for this 2002 severance will be approximately $2.5 million.  The terminated employees include 9 inproduction and production related overheads, 22 in sales, 10 in marketing, and5 in administration.

 

***Employment Agreements:***

 

On January 9, 2002, the Company entered into a three-year employmentagreement with one of its officers. Compensation under the agreement, excluding performance bonus aggregates$300,000 per year for the calendar years ending 2002, 2003, and 2004. Theagreement also provides the officer to receive all salary and bonus paymentsthat would have been payable to him under the agreement after a change ofcontrol of the Company which results in the termination of the officer’semployment.

 

***Merger:***

* *

On March 26, 2002 Lightpost Publishing, Inc., Thomas Kinkade Media,Inc., MAGI Sales, Inc. and Exclaim Technologies were merged with and into theCompany.

 

***Line of Credit:***

 

On April 15, 2002,the Company secured a $20 million revolving bank line-of-credit with ComericaBank-California to replace the line-of-credit discussed in Note 4.  The term of the facility is 360 days.  The amount available to be borrowed is $15million prior to the time the Company satisfies certain financialcovenants.  Borrowings under thefacility bear interest at the bank’s prime rate plus 0.25%.  There is a 0.25% non-usage fee on unborrowedamounts under the facility, which fee is reduced to 0.125% if the Companysatisfies certain financial covenants. The facility is secured by substantially all of the Company’sassets.  The Company must satisfycertain normal and customary conditions relating to documentation, protectionand perfection of the bank’s security interest and other matters prior to theCompany’s initial borrowing under the facility.

 

48

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#### **Schedule II - Valuation and Qualifying Accounts andReserves**

 

**Media Arts Group, Inc. andSubsidiaries**

**(In thousands)**

 

 
| **Description**                                 |   | **Balance at**

**Beginning  of**

**Period** |   | **Charged to**

**Costs and**

**Expenses** |   | **Deductions** |   | **Balance**

**at End**

**of Period** |    |
|-------------------------------------------------|--------|-----------------------------------------------|--------|---------------------------------------------|--------|----------------|--------|----------------------------------------|---------|
|                                            |   |                                          |   |                                        |   |           |   |                                   |    |
| **Year  Ended March 31, 1999:**                 |   |                                          |   |                                        |   |           |   |                                   |    |
| Reserve for  Returns and Allowances             |   | $                                             | 1,616  |                                        | $      | 12,336         |   | $                                      | (12,744 | ) | $ | 1,208 |   |
| Allowance for  Doubtful Accounts                |   | 818                                           |   | 384                                         |   | (352           | )      | 850                                    |    |
| Provision for  Excess and Obsolete Inventory    |   | 670                                           |   | 1,668                                       |   | (1,363         | )      | 975                                    |    |
|                                            |   |                                          |   |                                        |   |           |   |                                   |    |
| **Year  Ended March 31, 2000:**                 |   |                                          |   |                                        |   |           |   |                                   |    |
| Reserve for Returns and Allowances              |   | 1,208                                         |   | 8,568                                       |   | (8,509         | )      | 1,267                                  |    |
| Allowance for Doubtful Accounts                 |   | 850                                           |   | 980                                         |   | (1,304         | )      | 526                                    |    |
| Provision for Excess and Obsolete Inventory     |   | 975                                           |   | 2,531                                       |   | (1,611         | )      | 1,895                                  |    |
|                                            |   |                                          |   |                                        |   |           |   |                                   |    |
| **Year  Ended March 31, 2001:**                 |   |                                          |   |                                        |   |           |   |                                   |    |
| Reserve for Returns and Allowances              |   | 1,267                                         |   | 9,027                                       |   | (8,744         | )      | 1,550                                  |    |
| Allowance for  Doubtful Accounts                |   |                                          | 526    |                                        |   | 1,824          |   |                                   | (914    | ) |   | 1,436 |   |
| Provision for  Excess and Obsolete Inventory    |   |                                          | 1,895  |                                        |   | 1,515          |   |                                   | (1,420  | ) |   | 1,990 |   |
|                                            |   |                                          |   |                                        |   |           |   |                                   |    |
| **Nine-Month  Period Ended December 31, 2001:** |   |                                          |   |                                        |   |           |   |                                   |    |
| Reserve for  Returns and Allowances             |   |                                          | 1,550  |                                        |   | 4,013          |   |                                   | (3,375  | ) |   | 2,188 |   |
| Allowance for Doubtful Accounts                 |   | 1,436                                         |   | 5,261                                       |   | (392           | )      | 6,305                                  |    |
| Allowance for notes receivable                  |   | —                                        |   | 1,937                                       |   | —         |   | 1,937                                  |    |
| Provision for Excess and Obsolete Inventory     |   | 1,990                                         |   | 5,619                                       |   | (1,178         | )      | 6,431                                  |    |

 

 

49

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#### **INDEX TO EXHIBITS FILED TOGETHER WITH THIS ANNUALREPORT**

 

(a)  Thefollowing exhibits are filed herewith:

 
| **Exhibit****Number** |   | **Exhibit  Title**                                                                                                                                                   |
|-----------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)                |   | Amended and Restated  Certificate of Incorporation.                                                                                                                  |
| 3.2(4)                |   | Bylaws.                                                                                                                                                              |
| 3.3(1)                |   | Form of Specimen Common  Stock Certificate.                                                                                                                          |
| 3.4(6)                |   | Amended and Restated  Certificate of Incorporation.                                                                                                                  |
| 10.5(4)*              |   | Amended Employment  Agreement between the Company and John Lackner, made and entered into as of  October 10, 1997.                                                   |
| 10.8(2)*              |   | Employment Agreement  entered into between the Company and Richard F. Barnett, dated as of March  31, 1996.                                                          |
| 10.12(4)              |   | License Agreement  entered into by the Company and Thomas Kinkade, effective as of December 3,  1997.                                                                |
| 10.20(3)              |   | Lease Agreement between  Limar Realty Corp. #36 and the Company, dated as of May 22, 1997.                                                                           |
| 10.25(4)              |   | Purchase and Sale  Agreement by and between the Company and Limar Realty Corp. #36, dated as of  June 3, 1997.                                                       |
| 10.26(4)              |   | Form of Director  Indemnity Agreement.                                                                                                                               |
| 10.27(4)*             |   | Second Amendment to  Employment Agreement between the Company and John R. Lackner, dated as of  February 11, 1998.                                                   |
| 10.29(5)*             |   | Employee Nonqualified  Stock Option Agreement entered into between the Company and Thomas Kinkade,  dated December 3, 1997.                                          |
| 10.32(7)*             |   | 1998 Stock Incentive  Plan.                                                                                                                                          |
| 10.33(8)              |   | Separation and  Consulting Agreement between the Company and Kenneth E. Raasch, dated as of  May 27, 1999.                                                           |
| 10.34(8)              |   | Stock Sale Agreement  between the Company and Kenneth E. Raasch, dated as of May 27, 1999.                                                                           |
| 10.38(9)              |   | Business Loan Agreement  between Bank of America and the Company, dated as of October 27, 1999 and  First Amendment to Loan Agreement, dated as of October 27, 1999. |
| 10.39(9)              |   | Lease Agreement between  TBI-Madrone I, LLC and the Company, dated as of December 20, 1999.                                                                          |
| 10.40(9)              |   | Lease Agreement between  TBI-Mission West, LLC and the Company, dated as of December 20, 1999.                                                                       |
| 10.41(9)              |   | Lease Agreement between  TBI-Mission West, LLC and the Company, dated as of December 20, 1999.                                                                       |
| 10.42(10)             |   | Consulting Agreement  entered into between the Company and Mike Kiley dated April 1, 2000.                                                                           |
| 10.43(11)             |   | Lease Agreement between  TBI-Mission West, LLC and the Company, dated as of June 30, 2000.                                                                           |
| 10.44(12)             |   | Second Amendment to  Loan Agreement between Bank of America and the Company, dated as of April 3,  2000.                                                             |
| 10.45(12)             |   | Third Amendment to Loan  Agreement between Bank of America and the Company, dated as of November 27,  2000.                                                          |
| 10.46(12)             |   | Fourth Amendment to  Loan Agreement between Bank of America and the Company, dated as of June 27,  2001.                                                             |
| 10.47(13)             |   | Fifth Amendment to Loan  Agreement between Bank of America and the Company, dated as of September 30,  2001.                                                         |
| 10.48(13)             |   | Employment Agreement  between the Company and Anthony Thomopoulos, dated June 19, 2001.                                                                              |
| 10.49(14)             |   | Sixth Amendment to Loan  Agreement between Bank of America and the Company, dated as of November 30,  2001.                                                          |
| 10.50                 |   | Seventh Amendment to  Loan Agreement between Bank of America and the Company, dated as of November  30, 2001                                                         |
| 10.51*                |   | Compensation Agreement, dated as of January 24,  2002, between the Company and Anthony Thomopoulos.                                                                  |
| 10.52*                |   | Employment Agreement between the Company and Herbert  D. Montgomery, dated January 9, 2002.                                                                          |
| 10.53                 |   | Loan and Security Agreement, dated as of April 15,  2002, between Comerica Bank-California and the Company                                                           |

 

 

50

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| 21.1 |   | Subsidiaries of the  Registrant.                                 |
|------|--------|------------------------------------------------------------------|
| 23.1 |   | Consent of  PricewaterhouseCoopers LLP, independent accountants. |
| 24.1 |   | Power of Attorney                                                |
| 27.1 |   | Not Applicable.                                                  |

 

----

*    Represents a managementcontract or compensation plan or arrangement.

 

(1) Incorporatedby reference from the Company’s Registration Statement on Form S-1 (File No.33-79744).

 

(2) Incorporatedby reference from the Company’s Form 10-K for the fiscal year ended March 31,1997 (File No. 0-24294).

 

(3) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period endedSeptember 30, 1997 (File No. 0-24294).

 

(4) Incorporatedby reference from the Company’s Registration Statement on Form S-1 (File No.333-42815)

 

(5) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period ended June30, 1998 (File No. 0-24294).

 

(6) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period endedSeptember 30, 1998 (File No. 0-24294).

 

(7) Incorporatedby reference from the Company’s Registration Statement on Form S-8 filedDecember 3, 1998 (File No. 333-68301).

 

(8) Incorporatedby reference from the Company’s Form 10-K for the fiscal year ended March 31,1999 (File No. 0-24294).

 

(9) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period endedDecember 31, 1999 (File No. 0-24294).

 

(10) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period ended June30, 2000 (File No. 0-24294).

 

(11) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period endedDecember 31, 2000 (File No. 0-24294).

 

(12) Incorporatedby reference from the Company’s Form 10-K for the fiscal year ended March 31,2001 (File No. 0-24294).

 

(13) Incorporatedby reference from the Company’s Form 10-Q for the quarterly period endedSeptember 30, 2001 (File No. 0-24294).

 

(14) Incorporatedby reference from the Company’s Form 8-K filed December 17, 2001 (File No.0-24294).

 

 

(b) The following financial statement schedule isfiled herewith:

 

      Schedule II — Valuation andQualifying Accounts and Reserves

 

51

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#### **SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on April 22, 2002 on itsbehalf by the undersigned, thereunto duly authorized.

 

 
| Media Arts Group, Inc.              |   |                                                 |
|-------------------------------------|--------|------------------------------------------------------|
|                                |   |                                                 |
| */s/  Ron D. Ford*             |   | *Chief Executive Officer and Director*               |
|  Ron D. Ford                   |   | *(Principal Executive Officer)*                      |
|                                |   |                                                 |
| */s/  Herbert D. Montgomery*   |   | *Executive Vice President, Chief Financial Officer,* |
|  Herbert D. Montgomery         |   | *and Director*                                       |
|                                |   | *(Principal Financial Officer)*                      |
|                                |   |                                                 |
| */s/  Anthony D.  Thomopoulos* |   | *Chairman of the Board of Directors*                 |
|  Anthony D. Thomopoulos        |   |                                                 |
|                                |   |                                                 |
| */s/  Thomas Kinkade*          |   | *Director*                                           |
|  Thomas Kinkade                |   |                                                 |
|                                |   |                                                 |
| * /s/  Moe Grzelakowski*  |   | *Director*                                           |
| Moe Grzelakowski                    |   |                                                 |
|                                |   |                                                 |
| */s/  Eric Halvorson*          |   | *Director*                                           |
| Eric Halvorson                      |   |                                                 |
|                                |   |                                                 |
| */s/  C. Joseph  LaBonte*      |   | *Director*                                           |
|  C. Joseph LaBonte             |   |                                                 |
|                                |   |                                                 |
| */s/  Donald Potter*           |   | *Director*                                           |
|  Donald Potter                 |   |                                                 |
|                                |   |                                                 |
| */s/  Richard  Stearns*        |   | *Director*                                           |
|  Richard Stearns               |   |                                                 |

 

 

52

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