UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  FORM
10-Q
  x
              
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the quarterly period ended July 31, 2008oro
              
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period from toCommission
      file number 001-13437
 
 
  SOURCE
INTERLINK COMPANIES, INC.
 (Exact
name of registrant as specified in its charter)
  Delaware
              
              20-2428299(State
      or other jurisdiction of
                incorporation
      or organization)
              
              (I.R.S.
      Employer Identification No.)27500
      Riverview Center Blvd., Suite 400
                Bonita Springs,
      Florida
              
              34134(Address
      of principal executive offices)
              
              (Zip
      Code)
 
  (239)
949-4450
 (Registrant’s
telephone number, including area code)
  Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 x Yeso No
  Indicate
by check mark whether the registrant is a large accelerated filer, an accelerate
filer, a non-accelerated filer, or a smaller reporting company.See definition of
“large accelerated filer,” “accelerated filer” and “smaller reporting company”
in Rule 12b-2 of the Exchange Act.(Check one):
 o Large
      accelerated filer
              
              x Accelerated
      filer
              
              o Non-accelerated
      filero Smaller reporting
      company
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act.
 o Yesx No
  As of
September 2, 2008, there were 52,320,837 shares of the Company’s common stock
outstanding.
   
   TABLE
OF CONTENTS
  PagePART I – FINANCIAL
      INFORMATIONITEM 1.
              
              FINANCIAL
      STATEMENTS
              
              3ITEM
      2.
              
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                AND RESULTS OF
      OPERATIONS
              
              22ITEM
      3.
              
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
      MARKET RISK
              
              36ITEM
      4.
              
              CONTROLS AND PROCEDURES
              
              36PART II – OTHER
      INFORMATIONITEM
      1.
              
              LEGAL
      PROCEEDINGS
              
              38ITEM
      1A.
              
              RISK
      FACTORS
              
              38ITEM
      2.
              
              UNREGISTERED SALES OF
      EQUITY SECURITIES AND USE OF PROCEEDS
              
              38ITEM
      3.
              
              DEFAULTS UPON SENIOR
      SECURITIES
              
              38ITEM
      4.
              
              SUBMISSION OF MATTERS
      TO A VOTE OF SECURITY HOLDERS
              
              38ITEM
      5.
              
              OTHER
      INFORMATION
              
              38ITEM
      6.
              
              EXHIBITS
              
              38
 
  
  1
  
 PART
I – FINANCIAL INFORMATION
  ITEM 1.
FINANCIAL STATEMENTS
  INDEX
OF FINANCIAL STATEMENTS
  PageConsolidated Balance
      Sheets as of July 31, 2008 (unaudited) and January 31,
      2008
              
              3Consolidated
      Statements of Operations for the three and six months ended July 31, 2008
      and 2007 (unaudited)
              
              5Consolidated
      Statement of Stockholders’ Equity for the six months ended July 31, 2008
      (unaudited)
              
              6Consolidated
      Statements of Cash Flows for the six months ended July 31, 2008 and 2007
      (unaudited)
              
              7Notes to Consolidated
      Financial Statements
              
              8
 
  
  2
  
 
 SOURCE INTERLINK COMPANIES, INC.
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands)
  July
      31,
              
              
              January 31,2008
              
              
              2008(unaudited)AssetsCurrent
      assetsCash
              
              $
              6,305
              
              
              $
              35,650Trade
      receivables, net
              
              
              144,322
              
              
              
              183,475Purchased
      claims receivable
              
              
              14,078
              
              
              
              14,412Inventories
              
              
              284,144
              
              
              
              290,507Deferred
      tax asset
              
              
              22,928
              
              
              
              23,107Other
              
              
              22,382
              
              
              
              20,679Total
      current assets
              
              
              494,159
              
              
              
              567,830Property,
      plants and equipment
              
              
              167,404
              
              
              
              150,612Less
      accumulated depreciation and amortization
              
              
              (55,623
              )
              
              
              (42,708
              )Net
      property, plants and equipment
              
              
              111,781
              
              
              
              107,904Other
      assetsGoodwill,
      net
              
              
              875,170
              
              
              
              1,069,835Intangibles,
      net
              
              
              540,135
              
              
              
              637,082Other
              
              
              60,919
              
              
              
              53,354Total other assets
              
              
              1,476,224
              
              
              
              1,760,271Total assets
              
              $
              2,082,164
              
              
              $
              2,436,005
 
  See
accompanying notes to Consolidated Financial Statements
  
  3
  
 SOURCE
INTERLINK COMPANIES, INC.
 CONSOLIDATED
BALANCE SHEETS (CONCLUDED)
 (in
thousands, except per share amounts)
  July
      31,
              
              
              January 31,2008
              
              
              2008(unaudited)Liabilities
      and Stockholders’ EquityCurrent
      liabilitiesAccounts
      payable (net of allowance for returns of $166,824 and $174,751
      at
                July
      31, 2008 and January 31, 2008, respectively)
              
              $
              329,912
              
              
              $
              372,429Accrued
      expenses
              
              
              107,420
              
              
              
              123,973Deferred
      revenue
              
              
              80,282
              
              
              
              79,918Current
      portion of obligations under capital leases
              
              
              1,359
              
              
              
              1,406Current
      maturities of debt
              
              
              14,161
              
              
              
              15,369Total
      current liabilities
              
              
              533,134
              
              
              
              593,095Deferred
      tax liability
              
              
              8,543
              
              
              
              8,944Obligations
      under capital leases, less current portion
              
              
              1,131
              
              
              
              1,826Debt,
      less current maturities
              
              
              1,401,972
              
              
              
              1,359,210Other
              
              
              16,498
              
              
              
              32,429Total liabilities
              
              
              1,961,278
              
              
              
              1,995,504Minority
      interest
              
              
              -
              
              
              
              25,978Commitments
      and contingenciesStockholders’
      equityContributed
      capital:Preferred
      stock, $0.01 par (2,000 shares authorized; none issued)
              
              
              -
              
              
              
              -Common
      stock, $0.01 par (100,000 shares authorized; 52,321 shares
                issued
      and outstanding at July 31, 2008 and January 31, 2008)
              
              
              523
              
              
              
              523Additional
      paid-in-capital
              
              
              476,974
              
              
              
              476,099Total
      contributed capital
              
              
              477,497
              
              
              
              476,622Accumulated
      deficit
              
              
              (362,407
              )
              
              
              (65,659
              )Accumulated
      other comprehensive income
              
              
              5,796
              
              
              
              3,560Total
      stockholders’ equity
              
              
              120,886
              
              
              
              414,523Total
      liabilities and stockholders’ equity
              
              $
              2,082,164
              
              
              $
              2,436,005
 
 
 See
accompanying notes to Consolidated Financial Statements
 
  4
  
 SOURCE
INTERLINK COMPANIES, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except per share amounts)
 (unaudited)
  Three months ended July
      31,
              
              
              Six months ended July
      31,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues,
      net:Distribution
              
              $
              442,734
              
              
              $
              419,778
              
              
              $
              930,528
              
              
              $
              880,479Advertising
              
              
              63,178
              
              
              
              -
              
              
              
              124,636
              
              
              
              -Circulation
              
              
              31,228
              
              
              
              -
              
              
              
              61,389
              
              
              
              -Manufacturing
              
              
              11,135
              
              
              
              6,855
              
              
              
              19,764
              
              
              
              14,009Claiming
      and information
              
              
              2,937
              
              
              
              3,254
              
              
              
              6,699
              
              
              
              6,280Other
              
              
              25,462
              
              
              
              4,259
              
              
              
              48,019
              
              
              
              8,784Total
      revenues, net
              
              
              576,674
              
              
              
              434,146
              
              
              
              1,191,035
              
              
              
              909,552Cost
      of goods sold
              
              
              391,291
              
              
              
              340,657
              
              
              
              811,513
              
              
              
              716,569Gross
      profit
              
              
              185,383
              
              
              
              93,489
              
              
              
              379,522
              
              
              
              192,983Distribution,
      circulation and fulfillment
              
              
              54,878
              
              
              
              40,473
              
              
              
              109,881
              
              
              
              83,031Selling,
      general and administrative expenses
              
              
              92,060
              
              
              
              39,285
              
              
              
              188,691
              
              
              
              80,560Depreciation
      and amortization
              
              
              17,878
              
              
              
              6,986
              
              
              
              36,102
              
              
              
              13,822Integration,
      consolidation and relocation expense
              
              
              1,340
              
              
              
              151
              
              
              
              4,048
              
              
              
              163Write
      off of acquisition related assets
              
              
              4,603
              
              
              
              -
              
              
              
              6,503
              
              
              
              -Impairment
      of goodwill and intangible assets
              
              
              -
              
              
              
              -
              
              
              
              270,847
              
              
              
              -Operating
      income (loss)
              
              
              14,624
              
              
              
              6,594
              
              
              
              (236,550
              )
              
              
              15,407Other
      expense:Interest
      expense
              
              
              (28,971
              )
              
              
              (2,894
              )
              
              
              (57,981
              )
              
              
              (6,461
              )Interest
      income
              
              
              114
              
              
              
              238
              
              
              
              272
              
              
              
              278Write
      off of deferred financing fees
              
              
              (1,048
              )
              
              
              -
              
              
              
              (1,048
              )
              
              
              -Other
      (expense) income:
              
              
              6
              
              
              
              128
              
              
              
              (405
              )
              
              
              199Total
      other expense
              
              
              (29,899
              )
              
              
              (2,528
              )
              
              
              (59,162
              )
              
              
              (5,984
              )(Loss)
      income from continuing operations, before income taxes
              
              
              (15,275
              )
              
              
              4,066
              
              
              
              (295,712
              )
              
              
              9,423Income
      tax expense
              
              
              -
              
              
              
              (1,627
              )
              
              
              -
              
              
              
              (3,769
              )Minority
      interest in income of subsidiary
              
              
              (630
              )
              
              
              -
              
              
              
              (1,036
              )
              
              
              -(Loss)
      income from continuing operations
              
              
              (15,905
              )
              
              
              2,439
              
              
              
              (296,748
              )
              
              
              5,654Loss
      from discontinued operations, net of taxes
              
              
              -
              
              
              
              (222
              )
              
              
              -
              
              
              
              (1,608
              )Net
      (loss) income
              
              $
              (15,905
              )
              
              $
              2,217
              
              
              $
              (296,748
              )
              
              $
              4,046(Loss)
      earnings per share – BasicContinuing
      operations
              
              $
              (0.30
              )
              
              $
              0.04
              
              
              $
              (5.67
              )
              
              $
              0.11Discontinued
      operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (0.03
              )Total
              
              $
              (0.30
              )
              
              $
              0.04
              
              
              $
              (5.67
              )
              
              $
              0.08(Loss)
      earnings per share – DilutedContinuing
      operations
              
              $
              (0.30
              )
              
              $
              0.04
              
              
              $
              (5.67
              )
              
              $
              0.11Discontinued
      operations
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (0.03
              )Total
              
              $
              (0.30
              )
              
              $
              0.04
              
              
              $
              (5.67
              )
              
              $
              0.08Weighted
      average shares outstanding – Basic
              
              
              52,321
              
              
              
              52,304
              
              
              
              52,321
              
              
              
              52,216Weighted
      average shares outstanding – Diluted
              
              
              52,321
              
              
              
              52,441
              
              
              
              52,321
              
              
              
              52,538
 
 
 See
accompanying notes to Consolidated Financial Statements
 
  5
  
 SOURCE
INTERLINK COMPANIES, INC.
 CONSOLIDATED
STATEMENT OF STOCKHOLDERS’ EQUITY
 (in
thousands)
  
 Common StockShares
              
              
              Amount
              
              
              Additional
      Paid-In Capital
              
              
              Accumulated
      Deficit
              
              
              Accumulated
      Other Comprehensive Income
              
              
              Total
      Stockholders EquityBalance,
      January 31, 2008
              
              
              52,321
              
              
              $
              523
              
              
              $
              476,099
              
              
              $
              (65,659
              )
              
              $
              3,560
              
              
              $
              414,523Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (296,748
              )
              
              
              -
              
              
              
              (296,748
              )Foreign
      currency translation
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (141
              )
              
              
              (141
              )Unrealized
      gain on interest rate swaps
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,377
              
              
              
              2,377Comprehensive
      income
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (296,748
              )
              
              
              2,236
              
              
              
              (294,512
              )Stock
      compensation expense
              
              
              -
              
              
              
              -
              
              
              
              130
              
              
              
              -
              
              
              
              -
              
              
              
              130Excess
      tax benefit from exercise ofstock
      options
              
              
              -
              
              
              
              -
              
              
              
              745
              
              
              
              -
              
              
              
              -
              
              
              
              745Balance,
      July 31, 2008
              
              
              52,321
              
              
              $
              523
              
              
              $
              476,974
              
              
              $
              (362,407
              )
              
              $
              5,796
              
              
              $
              120,886
 
 See
accompanying notes to Consolidated Financial Statements
  
  6
  
 SOURCE
INTERLINK COMPANIES, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
 (unaudited)
  Six
      months ended July 31,2008
              
              
              2007Operating
      ActivitiesNet
      (loss) income
              
              $
              (296,748
              )
              
              $
              4,046Minority
      interest in income of subsidiary
              
              
              1,036
              
              
              
              -Adjustments
      to reconcile net (loss) income to net cash provided by operating
      activities:Depreciation
      and amortization
              
              
              38,970
              
              
              
              14,368Amortization
      of deferred financing costs
              
              
              5,734
              
              
              
              306Provision
      for losses on accounts receivable
              
              
              3,381
              
              
              
              1,838Stock
      compensation expense
              
              
              130
              
              
              
              179Loss
      on sale of discontinued operation
              
              
              -
              
              
              
              730Impairment
      of goodwill and intangible assets
              
              
              270,847
              
              
              
              -Other
              
              
              1,002
              
              
              
              685Changes
      in assets and liabilities (excluding business
    acquisitions):Decrease
      in accounts receivable
              
              
              35,772
              
              
              
              36,307Decrease
      (increase) in inventories
              
              
              6,311
              
              
              
              (6,479
              )Decrease
      in other current and non-current assets
              
              
              926
              
              
              
              7,470Increase
      (decrease) in deferred revenue
              
              
              364
              
              
              
              (736
              )Decrease
      in accounts payable and other liabilities
              
              
              (55,570
              )
              
              
              (49,202
              )Cash
      provided by operating activities
              
              
              12,155
              
              
              
              9,512Investment
      ActivitiesCapital
      expenditures
              
              
              (18,953
              )
              
              
              (9,436
              )Purchase
      of claims
              
              
              (47,552
              )
              
              
              (47,587
              )Payments
      received on purchased claims
              
              
              47,886
              
              
              
              59,531Proceeds
      from sale of Wood Manufacturing division, net of cash
      transferred
              
              
              -
              
              
              
              9,828Acquisition
      of the remainder of Automotive.com, Inc.
              
              
              (42,000
              )
              
              
              -Other
              
              
              (1,947
              )
              
              
              (2,499
              )Cash
      (used in) provided by investing activities
              
              
              (62,566
              )
              
              
              9,837Financing
      ActivitiesDecrease
      in checks issued against revolving credit facility
              
              
              -
              
              
              
              (1,383
              )Borrowings
      (repayments) under credit facilities
              
              
              49,600
              
              
              
              (9,079
              )Payment
      of deferred purchase price liabilities
              
              
              (7,319
              )
              
              
              -Deferred
      financing costs
              
              
              (12,430
              )
              
              
              -Net
      (payments) borrowings on notes payable and capital leases
              
              
              (9,530
              )
              
              
              498Proceeds
      from the issuance of common stock
              
              
              -
              
              
              
              716Excess
      tax benefit from exercise of stock options
              
              
              745
              
              
              
              389Cash
      provided by (used in) financing activities
              
              
              21,066
              
              
              
              (8,859
              )(Decrease)
      increase in cash
              
              
              (29,345
              )
              
              
              10,490Cash,
      beginning of period
              
              
              35,650
              
              
              
              -Cash,
      end of period
              
              $
              6,305
              
              
              $
              10,490
 
 
 See
accompanying notes to Consolidated Financial Statements
  
  7
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 1.Nature
of Business and Basis of Presentation
  Source
Interlink Companies, Inc (“the Company”) is a premier publishing, marketing,
merchandising and fulfillment company of entertainment products including
magazines, DVDs, music CDs, books and related items, serving over 100,000 retail
locations throughout North America. The Company produces print and digital
content for consumers in North America through its media division, Source
Interlink Media (“SIM”), which was acquired on August 1, 2007.The Company also
sells and distributes entertainment products to leading mass merchandise
retailers, grocery stores, bookstore chains, music stores, drug stores and other
specialty retailers, as well as e-commerce retailers. It offers customers an
array of value-added content and services including enthusiast media
publications and online content, category management, product procurement,
fulfillment services, claims submission, information services and in-store
display fixturing.
 
 The
Company directly produces and delivers magazine, Internet and home entertainment
content to consumers. With the addition of SIM, it transformed from a leading
home entertainment distributor into a significant content owner.This array of
products and services, in combination with our value added services and
geographic reach, positions us to service the needs of America’s leading
retailers and to capitalize on the rapidly changing distribution and fulfillment
landscape.
 
 The
Company is one of the largest independent wholesalers of DVDs and CDs in North
America. It effectively operates as an extension of its customers’ operations.
Between its fulfillment, category management and e-commerce solutions, it
provides our customers with a complete solution to maximize the sales and
profitability of their home entertainment content products.
 
 The
consolidated financial statements included herein have been prepared by the
Company, without audit, pursuant to and in conformity with the instructions to
Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange
Commission (“SEC”).Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States (“GAAP”).In the opinion of the Company’s management, these unaudited
consolidated financial statements reflect all adjustments (consisting only of
normal recurring adjustments and reclassifications) necessary to present fairly
our results of operations and cash flows for the three and six months ended July
31, 2008 and 2007 and our financial position as of July 31, 2008.All significant
intercompany accounts and transactions have been eliminated from these
statements.The preparation of unaudited consolidated financial statements in
conformity with GAAP requires management to make estimates and assumptions that
affect the reported amount of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting
period.Because of this and the seasonality of the Company’s business, the
results of operations for such interim periods will not necessarily be
indicative of the results of operations and cash flows for the full fiscal year
or subsequent quarters.
  Certain
information and disclosures normally included in the notes to the annual
consolidated financial statements have been condensed or omitted from these
interim consolidated financial statements.Accordingly, these interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in our Annual
Report on Form 10-K (the “Annual Report”) for the fiscal year ended
January 31, 2008, as filed with the SEC on April 15, 2008, as amended May
30, 2008.
  The
Company’s segment reporting combines the Company’s business units in a logical
way that identifies business concentrations and synergies.Accordingly, beginning
in fiscal 2009, management has restructured the presentation of the Company’s
segments to better reflect the change in management and financial reporting of
the applicable units.The Company’s segments are heretofore presented as follows:
Media, Periodical Fulfillment Services, DVD and CD Fulfillment and Shared
Services.Prior reporting periods have been reclassified to conform to current
presentation to make prior period comparisons meaningful.
 
 Other
revenue includes online revenues, licensing revenues, barter revenues and event
revenues within our Media segment.
   8
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 Derivative
Financial Instruments
 
 As part
of our risk management strategy, we enter into derivative transactions to
mitigate loss exposures.Our derivative instruments are currently limited to an
interest rate swap which is not exchange-traded and is an over-the-counter
customized transaction.Our derivative exposure is with a counterparty that has a
long-term credit rating of A-1.
 
 Derivatives
that are designated as hedges are documented and evaluated for effectiveness in
accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities(“FAS 133”). The effective portion of
changes in the fair value of cash flow hedges is deferred in accumulated other
comprehensive income.In the event hedge accounting no longer applies, the
Company recognizes all changes in fair value of derivative instruments in the
other income (expense) section of its Consolidated Statement of Operations.The
Company ceases hedge accounting treatment if its evaluation of effectiveness no
longer justifies deferral of changes in fair value in accumulated other
comprehensive income.At that time, a reclassification from accumulated other
comprehensive income to earnings would occur.
 
 On April
11, 2008, the Company entered into an interest rate swap agreement with Wachovia
Bank, N.A. to hedge the Company’s exposure to fluctuations in LIBOR on $210.0
million of 1-month LIBOR-based debt through April 29, 2011.This swap agreement
qualifies for hedge accounting treatment in accordance with FAS
133.
 
 Goodwill
and Other Intangible Assets
 
 Goodwill
represents the excess of cost over the fair value of net assets acquired in
connection with business acquisitions. In accordance with Statement of Financial
Accounting Standards No. 142, Goodwill and Other IntangibleAssets (“FAS 142”), goodwill is evaluated at the reporting unit level,
which is defined as an operating segment or a component of an operating segment
that constitutes a business for which financial information is available and is
regularly reviewed by management. The Company assesses goodwill for impairment
at least annually in the absence of an indicator of possible impairment and
immediately upon an indicator of possible impairment. The annual impairment
review is completed in the first quarter of the fiscal year.
 
 In
assessing goodwill and intangible assets for impairment, we make estimates of
fair value which are based on our projection of revenues, operating costs, and
cash flows of each reporting unit considering historical and anticipated future
results, general economic and market conditions as well as the impact of planned
strategies. The Company combines the discounted cash flow fair value with
publicly traded company multiples (market comparison approach) and acquisition
multiples of comparable businesses (industry acquisition approach) to determine
fair value.Generally, we engage third party specialists to assist us with our
valuations. Changes in our judgments and projections could result in a
significantly different estimate of the fair value of the reporting units and
could result in an impairment of goodwill or other intangible
assets.
 
 If the
carrying amount of a reporting unit exceeds its fair value, the Company measures
the possible goodwill impairment based upon an allocation of the estimate of
fair value to the underlying assets and liabilities of the reporting unit,
including any previously unrecognized intangible assets, based upon known facts
and circumstances as if the acquisition occurred currently. The excess of the
fair value of the reporting unit over the amounts assigned to its assets and
liabilities is the implied fair value of goodwill.An impairment loss would be
recognized to the extent the carrying value of goodwill exceeds the implied fair
value of the goodwill.This test, performed in the first quarter of fiscal year
2009, indicated that goodwill and indefinite-lived intangible assets related to
the Media reportable segment were impaired.
 
 Impairment
losses, if any, are reflected in operating income or loss in the Consolidated
Statements of Operations.
 
 As a
result of our fiscal year 2009 FAS 142 first quarter impairment
analysis, we determined that certain tradenames of our Media reportable
segment were impaired and consequently recorded a charge of approximately $74.3
million during the first quarter. This determination was based largely on
management’s projections regarding the revenues from and profitability of
tradenames acquired on August 1, 2007.The combination of the analysis and other
factors discussed below, had an adverse impact on the anticipated future cash
flows used in the impairment analysis performed during the first quarter of
fiscal year 2009.The net carrying amount of the tradenames was $280.6 million at
the end of the first quarter of fiscal year 2009, after the impairment charge
was recorded.
  9
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 As a
result of our fiscal year 2009 FAS 142 annual first quarter impairment analysis,
we determined that the goodwill of our Media reportable segment was impaired and
consequently recorded an impairment charge of $196.5 million. This determination
was based largely on management’s projections regarding the revenues and
profitability of the Media reportable segment as well as the effects of the
recent credit market changes, the continued economic downturn and the related
effects on customer discretionary spending and print advertising. The charge was
measured on the basis of comparison of estimated fair values with corresponding
book values and relates primarily to goodwill recorded in connection with our
acquisition of SIM. These fair values were determined in accordance with Company
policy discussed above as well as FAS 142 and other relevant
guidance.
 
 Following
the impairment charges, goodwill totaled $873.8 million, of which $477.7 million
related to our Media reportable segment.Other intangible assets totaled $550.6
million, of which $478.3 million related to our Media reportable segment. Due to
uncertain market conditions and potential changes in our strategy and product
portfolio, it is possible that forecasts used to support our goodwill and
intangible assets may change in the future, which could result in additional
non-cash charges that would adversely affect our results of operations and
financial condition.
 
  Income
Taxes
  Statement
of Financial Accounting Standards No. 109 "Accounting for Income Taxes"
("FAS 109") requires that a valuation allowance be establishedwhen it is more likely
than not that all or a portion of deferred tax assetswill not be realized. A
review of all available positive and negative evidenceneeds to be considered,
including a company's performance, the marketenvironment in which
the company operates, the utilization of past tax credits,length of carryback and
carryforward periods, existing contracts or salesbacklog that will
result in future profits, etc.It further states that
forming a conclusion that a valuation allowance is notneeded is difficult
when there is negative evidence such as cumulative losses inrecent years.
Therefore, cumulative losses weigh heavily in the overall assessment. We
identified several significant developments which we considered in determining
the need to record a full valuation allowance in the current quarter, including
the continuing economic downturn and our projections regarding the near-term
revenues and profitability of our segments. As a result of our assessment, we
recorded a valuation allowance on deferred tax assets of approximately $108.7
million during the first quarter and increased that allowance to $115.1 million
in the second quarter of fiscal 2009.
 
 
 Recently
Issued Accounting Pronouncements
  FAS
No. 162
 In May
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted
Accounting Principles,(“FAS 162”) which is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing US GAAP financial statements.Prior
to issuance of FAS 162, the GAAP hierarchy was defined in the AICPA’s SAS 69,
The Meaning of Present Fairly
in Conformity with GAAP.The main change is that FAS 162 is directed to
the entity, whereas SAS 69 was directed to the auditor.FAS 162 becomes effective
60 days following the SEC’s approval of the Public Company Accounting Oversight
Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles.We do not expect
the adoption of FAS 162 to impact our future operations or financial
position.
 
 FSPNo. 142-3
 In April
2008, the FASB issued Staff Position No. FAS 142-3, Determination of the Useful Life of
Intangible Assets,(“FAS 142-3”), which amends the factors that must be
considered in developing renewal or extension assumptions used to determine the
useful life over which to amortize the cost of a recognized intangible asset
under FAS 142.FSP 142-3 must be adopted prospectively for intangible assets
acquired on or after January 1, 2009; intangible assets acquired prior to this
date are not affected by this FSP.
  10
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  FAS
No. 161
 In March
2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative
Instruments and Hedging Activities,(“FAS 161”)–an amendment of FAS
133.FAS 161 requires
enhanced disclosures about how and why an entity uses derivative instruments,
how derivative instruments and related hedge items are accounted for under FAS
133 and its interpretations and how they affect an entity’s financial position,
financial performance and cash flows.FAS 161 is effective for financial
statements issued for fiscal years and interim periods beginning after November
15, 2008, with early application encouraged. Since FAS 161 impacts disclosures
and not the accounting treatment for derivative instruments and hedged items,
adoption will not impact our results of operations or financial
condition.
  FAS
No. 157
 On
February 1, 2008, the Company adopted Statement of Financial Accounting
Standards No. 157, Fair
Value Measurements (“FAS 157”).In conjunction with the guidance in FAS
133, the Company records its derivative instruments on its Consolidated Balance
Sheets.As of April 30, 2008, its derivative instruments were valued at $2.4
million and are recorded in other assets.This value is based upon significant
observable Level II inputs in the form of publicly available interest rate
information.
   2.
Business Combinations
 
 On July
18, 2008, the Company purchased the remaining 19.9% of Automotive.com, Inc. for
$42.0 million in cash.The Company expects to realize numerous benefits as a
result of attaining total management control of the Autodigital business,
including operating synergies, cross-selling opportunities, improved customer
management and cost savings through rationalization and integration
strategies.This acquisition resulted in the retirement of $41.3 million,
including minority interests, of obligations to the prior minority interest
holders and a $0.7 million increase in amortizable intangible assets.The
purchase price was funded by additional borrowings under the Company’s Revolving
Credit Facility.
  11
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 3.
Trade Receivables
  Trade
receivables consist of the following:
  July
      31,
                
                
                January 31,(in thousands)
                
                2008
                
                
                2008(unaudited)Trade
      receivables
                
                $
                339,030
                
                
                $
                411,968Less
      allowances for:Sales
      returns and other
                
                
                170,535
                
                
                
                202,569Doubtful
      accounts
                
                
                24,173
                
                
                
                25,924Total
      allowances
                
                
                194,708
                
                
                
                228,493Trade
      receivables, net
                
                $
                144,322
                
                
                $
                183,475
 4.
Inventories
  Inventories
consist of the following:
  July
      31,
                
                
                January 31,(in thousands)
                
                2008
                
                
                2008(unaudited)Raw
      materials
                
                $
                11,966
                
                
                $
                8,854Work-in-process
                
                
                2,274
                
                
                
                1,322Finished
      goods:Pre-recorded
      music and video
                
                
                142,670
                
                
                
                149,765Magazines
      and books
                
                
                126,547
                
                
                
                127,067Display
      fixtures
                
                
                687
                
                
                
                3,499Inventories
                
                $
                284,144
                
                
                $
                290,507
   In the
event pre-recorded music and video or magazines and books are not sold, the vast
majority are returnable for credit from our vendors.
  12
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 5.
Goodwill and intangibles
  The
Company’s intangibles consist of the following:
   July
      31,
                
                
                January 31,(in thousands)
                
                2008
                
                
                2008(unaudited)Amortized
      intangible assetsCustomer
      lists and relationships
                
                $
                285,921
                
                
                $
                285,345Trade
      names
                
                
                2,000
                
                
                
                2,400Content
                
                
                20,380
                
                
                
                20,382Non-compete
      agreements
                
                
                4,577
                
                
                
                4,350Software
                
                
                16,340
                
                
                
                16,340Total
      intangibles
                
                
                329,218
                
                
                
                328,817Accumulated
      amortizationCustomer
      lists and relationships
                
                
                (52,654
                )
                
                
                (31,986
                )Trade
      names
                
                
                (717
                )
                
                
                (250
                )Content
                
                
                (2,038
                )
                
                
                (1,019
                )Non-compete
      agreements
                
                
                (3,059
                )
                
                
                (2,518
                )Software
                
                
                (9,776
                )
                
                
                (8,317
                )Total
      accumulated amortization
                
                
                (68,244
                )
                
                
                (44,090
                )Net
      amortized intangible assets
                
                
                260,974
                
                
                
                284,727Indefinite
      lived trade names
                
                
                279,161
                
                
                
                352,355Intangibles,
      net
                
                $
                540,135
                
                
                $
                637,082
 
  As
discussed above, our fiscal year 2009 FAS 142 annual first quarter impairment
analysis determined that certain of our tradenames were impaired and
consequently we recorded a charge of approximately $74.3 million during the
first quarter. See Note 1 – Nature of Business and Basis of
Presentation.
 
 As a
result of our first quarter fiscal 2009 impairment test, we reassessed the
estimated remaining useful lives of our indefinite-lived tradenames and
shortened such as lives as required.As a result of our fourth fiscal 2008
quarter impairment test, we reassessed the estimate remaining useful lives of
our customer lists within our DVD and CD Fulfillment group and shortened such
lives as required.
 
 Amortization
of intangible assets was $10.7 million and $3.4 million for the three months
ended July 31, 2008 and 2007, respectively. Amortization of intangible assets
was $23.3 million and $6.8 million for the six months ended July 31, 2008 and
2007, respectively.
 
 Changes
in the carrying amount of goodwill for the six months ended July 31, 2008 are as
follows:
 
 (in
      thousands)
                
                Media
                
                
                Periodical
      Fulfillment Services
                
                
                DVD
      and CD Fulfillment
                
                
                ConsolidatedBalance,
      January 31, 2008
                
                $
                673,654
                
                
                $
                194,649
                
                
                $
                201,532
                
                
                $
                1,069,835Additions
                
                
                1,937
                
                
                
                —
                
                
                
                —
                
                
                
                1,937Foreign
      currency translation adjustments
                
                
                —
                
                
                
                (55
                )
                
                
                —
                
                
                
                (55
                )Impairment
                
                
                (196,547
                )
                
                
                —
                
                
                
                —
                
                
                
                (196,547
                )Balance,
      July 31, 2008
                
                $
                479,044
                
                
                $
                194,594
                
                
                $
                201,532
                
                
                $
                875,170
  As
discussed above, our fiscal year 2009 FAS 142 annual first quarter impairment
analysis determined that the goodwill attributable to four reporting units
within our Media reportable segment was impaired and consequently we recorded a
charge of approximately $196.5 million. See Note 1 – Nature of Business and
Basis of Presentation.
  13
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 6.
Debt and Revolving Credit Facility
  Debt
consists of:
 
 July
      31,
                
                
                January 31,(in thousands)
                
                2008
                
                
                2008(unaudited)Revolving
      credit facility – Citicorp North America
                
                $
                49,600
                
                
                $
                -Term
      Loan B – Citicorp North America
                
                
                871,200
                
                
                
                875,600Bridge
      Facility – Citicorp North America
                
                
                -
                
                
                
                465,00011.25%
      Senior Unsecured Notes due 2015
                
                
                465,000
                
                
                
                -Note
      payable – Magazine import and export
                
                
                -
                
                
                
                708Note
      payable – Arrangements with suppliers
                
                
                7,568
                
                
                
                8,461Mortgage
      loan – Wachovia Bank
                
                
                18,250
                
                
                
                18,750Equipment
      loans
                
                
                4,515
                
                
                
                6,060Total
      debt
                
                
                1,416,133
                
                
                
                1,374,579Less
      current maturities
                
                
                14,161
                
                
                
                15,369Debt,
      less current maturities
                
                $
                1,401,972
                
                
                $
                1,359,210
 
 
 Citicorp
North America Credit Facilities
  Revolving Credit
Facility
  On August
1, 2007, the Company entered into a $300.0 million asset-based revolving credit
facility as a result of its acquisition of SIM. Citicorp North America, Inc., as
administrative agent for each of the parties that may become a participant in
such arrangement and their successors (“Lenders”) will make revolving loans to
the Company and its subsidiaries of up to $300.0 million including the issuance
of letters of credit. The terms and conditions of the arrangement are governed
primarily by the Revolving Credit Agreement dated August 1, 2007 by and among
the Company, its subsidiaries, and Citigroup Global Markets, Inc. and J.P.
Morgan Securities, Inc. as Joint Lead Arrangers and Joint Book Runners, Citicorp
North America, Inc. as Administrative Agent and Collateral Agent, JPMorgan Chase
Bank, N.A. as Syndication Agent, and Wachovia Bank, National Association and
Wells Fargo Foothill, LLC as Co-Documentation Agents.
  Outstanding
borrowings bear interest at a variable annual rate equal to the prime rate
announced by Citicorp North America, Inc., plus a margin of 0.50%. At July 31,
2008, the prime rate was 5.00%. The Company also has the option of selecting up
to five tranches of at least $1.0 million each to bear interest at LIBOR plus a
margin of 1.50%. The Company had no LIBOR contracts outstanding at July 31,
2008. To secure repayment of the borrowings and other obligations of ours to the
Lenders, the Company and its subsidiaries granted a security interest in
substantially all of our assets to Citicorp North America, Inc., for the benefit
of the Lenders. These loans mature on August 1, 2013. As of July 31, 2008 and
January 31, 2008, the Company had borrowings of $49.6 million and $0,
respectively, under this facility.
  Under the
credit agreement, the Company is limited in its ability to declare dividends or
other distributions on capital stock or make payments in connection with the
purchase, redemption, retirement or acquisition of capital stock.The Company is
and has been in compliance with this provision over the life of the
facility.
  Availability
under the facility is limited by the Company’s borrowing base calculation, as
defined in the agreement. The calculation resulted in excess availability, after
consideration of outstanding letters of credit, of $189.5 million at July 31,
2008.
   14
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 
 Term Loan
B
  On August
1, 2007, the Company entered into an $880.0 million Term Loan B as a result of
its acquisition of SIM. Citicorp North America, Inc., as administrative agent
for each of the parties that may become a participant in such arrangement and
their successors (“Lenders”) made loans to the Company and its subsidiaries of
$880.0 million. The terms and conditions of the arrangement are governed
primarily by the Term Loan Agreement dated August 1, 2007 by and among the
Company, its subsidiaries, and Citigroup Global Markets, Inc. and J.P. Morgan
Securities, Inc. as Joint Lead Arrangers and Joint Book Runners, Citicorp North
America, Inc. as Administrative Agent and Collateral Agent and J.P. Morgan Chase
Bank, N.A. as Syndication Agent.
  Outstanding
borrowings bear interest at a variable annual rate equal to the prime rate
announced by Citicorp North America, Inc., plus a margin of 2.25%. At July 31,
2008, the prime rate was 5.00%. The Company also has the option of selecting up
to five tranches of at least $1.0 million each to bear interest at LIBOR plus a
margin of 3.25%. The Company had one LIBOR contract outstanding at July 31, 2008
in the amount of $871.2 million, maturing in August 2008 and bearing interest at
a rate of 5.713%.The Term Loan B requires the Company to make principal payments
of $2.2 million on the last day of each fiscal quarter.The Company made
principal payments totaling $4.4 million during the six months ended July 31,
2008.To secure repayment of the borrowings and other obligations of ours to the
Lenders, the Company and its subsidiaries granted a security interest in
substantially all of our assets to Citicorp North America, Inc., for the benefit
of the Lenders. These loans mature on August 1, 2014.At that time, a final
principal payment of $820.6 million is due.
  Under the
credit agreement, the Company is limited in its ability to declare dividends or
other distributions on capital stock or make payments in connection with the
purchase, redemption, retirement or acquisition of capital stock. The Company is
also required to maintain a certain financial ratio. The Company was in
compliance with this requirement at July 31, 2008.
  Refinancing of Bridge
Facility
  In June,
2008, the Company consummated the refinancing and permanent retirement of all of
its indebtedness under the certain Senior Subordinated Bridge Loan Agreement
(the “Bridge Facility”), dated as of August 1, 2007.This refinancing and
permanent retirement was effected through the exchange of the Company’s 11.25%
Senior Unsecured Notes due 2015 (the “Senior Notes”) for the termination of the
Company’s indebtedness under the Bridge Facility.The Senior Notes were issued to
the former Bridge Facility lenders and were offered in conformance with the
exemptions for non-public offerings provided by Rule 506 and Section 4(2) of the
Securities Act of 1933.These notes constitute “restricted securities” under Rule
144A of the aforementioned Act.Furthermore, in connection therewith,the Company entered into
a Registration Rights Agreement, dated as of June 26, 2008 by and between
the Company, certain subsidiaries of the Company as guarantors and the Senior
Note holders, Citigroup Global Markets Inc., JPMorgan Securities Inc., Citigroup
North America Inc. and JPMorgan Chase Bank N.A.The Senior Notes were issued
under an Indenture, dated as of June 23, 2008, by and between the Company,
certain of the Company’s subsidiaries and HSBC Bank USA, National Association,
as Trustee.
 
 As part
of the aforementioned refinancing, the Company paid a conversion fee of $11.6
million and other deferred financing fees of approximately $0.8 million, which
will be amortized over the term of the Senior Notes.As a result of the
refinancing, the Company wrote off the remaining $1.0 million of deferred
financing fees related to the Bridge Facility.
  15
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 
 The
aggregate amount of debt maturing in each of the next five fiscal years is as
follows:
 
 (in thousands)
              
              AmountFiscal
      Year:Remainder
      of 2009
              
              $
              7,3222010
              
              
              12,9442011
              
              
              11,4022012
              
              
              11,3152013
              
              
              60,538Thereafter
              
              
              1,312,612Total
              
              $
              1,416,133
 
 
 At July
31, 2008 and January 31, 2008, unamortized deferred financing fees were
approximately $34.6 million and $29.0 million, respectively.
   7.
Earnings per Share
  A
reconciliation of the denominators of the basic and diluted earnings per share
computations is shown below:
  Three months ended July
      31,
              
              Six months ended July
      31,2008
              
              2007
              
              2008
              
              2007Weighted
      average common shares outstanding – basic
              
              52,321
              
              52,304
              
              52,321
              
              52,216Dilutive
      effect of stock options and warrants outstanding
              
              -
              
              137
              
              -
              
              322Weighted
      average common shares outstanding – diluted
              
              52,321
              
              52,441
              
              52,321
              
              52,538The
      following were not included in weighted average common shares
                outstanding
      because they are antidilutive:Unvested
      restricted stock units
              
              234
              
              -
              
              239
              
              -Stock
      options
              
              2,544
              
              1,823
              
              2,561
              
              1,747Warrants
              
              101
              
              101
              
              101
              
              104Total
              
              2,879
              
              1,924
              
              2,901
              
              1,851
 
  16
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 8.
Discontinued Operation
 On April
30, 2007, the Company disposed of substantially all of the assets and
liabilities of its Wood Manufacturing division.The Company sold the assets and
liabilities of its Wood Manufacturing division to a purchaser in which the
Company’s former Chairman of the Board and Chief Executive Officer, has an
interest.The Wood Manufacturing division was formerly reported as part of our
Periodical Fulfillment Services segment.The book value of the net assets sold on
the closing date was $11.6 million.The assets and liabilities of the Wood
Manufacturing division were sold for $10.0 million in cash, and the issuance of
a note payable to the Company in the face amount of $3.5 million, which bears
interest at the 3-month LIBOR plus a margin of 2.00%.The Company has determined
that the note does not bear an interest rate equivalent to a market rate for the
borrower.Therefore, the Company has discounted the note to fair value using its
estimation of a market rate for the note.This discount was approximately $1.0
million.Based upon the final determination of working capital, the Company
refunded to the buyer $1.9 million in cash during the third quarter of fiscal
2008.For the three and six months ended July 31, 2007, the summary results for
the Wood Manufacturing division are as follows:
  (in thousands)
              
              Three months ended
                July
      31, 2007
              
              
              Six months ended
                July
      31, 2007Revenues
              
              $
              -
              
              
              $
              2,551Loss
      from discontinued operation, before income taxes
              
              $
              -
              
              
              $
              (1,463
              )Income
      tax benefit
              
              
              -
              
              
              
              585Loss
      from discontinued operation
              
              
              -
              
              
              
              (878
              )Loss
      on sale of discontinued operation, before income taxes
              
              
              (370
              )
              
              
              (847
              )Income
      tax benefit
              
              
              148
              
              
              
              339Loss
      on sale of discontinued operation
              
              
              (222
              )
              
              
              (730
              )Discontinued
      operation, net
              
              $
              (222
              )
              
              $
              (1,608
              )
 
  9.
Supplemental Cash Flow Information
  Supplemental
information on interest and income taxes paid (received) is as
follows:
  Six months ended July
      31,(in thousands)
              
              2008
              
              
              2007Interest
              
              $
              53,206
              
              
              $
              6,115Income
      taxes (net of receipts of $276 in 2008)
              
              $
              338
              
              
              $
              (9,839
              )
 
  As
discussed in Note 8, the Company disposed of its Wood Manufacturing division on
April 30, 2007 for the total consideration of $13.5 million, including $3.5
million in the form of a note receivable, of which the Company refunded $1.9
million to the buyer during the third quarter of fiscal 2008, based on a working
capital adjustment.
   17
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 10.
Stock-Based Compensation
  On
February 1, 2008, the Company authorized the issuance of 243,472 restricted
stock units (“the units”) to its Board of Directors as compensation for services
rendered (or 30,434 units per Director).The units vest in one-third increments,
annually beginning one year from the grant date.
  11.
Derivative Financial Instruments and Hedging Activities
 
 The
aggregate fair value of derivative instruments in asset positions on July 31,
2008, is $2.4 million, and represents the maximum loss that would be recognized
at the reporting date if the counterparty failed to perform as
contracted.
 
 We have
applied hedge accounting to the interest rate swap and designated it as a cash
flow hedge in accordance with the provisions of FAS 133.The Company uses this
derivative to reduce the risk of changes in cash interest payments related to
its long-term debt.The notional balance for this interest rate swap is $210.0
million at July 31, 2008.The agreement was perfectly effective throughout the
six months ended July 31, 2008 and is expected to be effective throughout its
life.
 
 12.
Segment Financial Reporting
 
 The
Company’s segment reporting is based on the reporting of senior management to
the chief operating decision maker. This reporting combines the Company’s
business units in a logical way that identifies business concentrations and
synergies.Accordingly, beginning in fiscal 2009, management has restructured the
presentation of the Company’s segments to better reflect the change in
management and financial reporting of the applicable units.The Company’s
segments are heretofore presented as follows: Media, Periodical Fulfillment
Services, DVD and CD Fulfillment and Shared Services.Prior reporting periods
have been reclassified to conform to current presentation to make prior period
comparisons meaningful.
  The
Company conducts business through four reportable segments; Media, Periodical
Fulfillment Services, DVD and CD Fulfillment and Shared Services. The accounting
policies of the segments are materially the same as those described in the
Summary of Accounting Policies found in our Annual Report on Form 10-K for the
year ended January 31, 2008 filed with the SEC on April 15, 2008, as amended on
May 30, 2008.
  The Media
segment derives revenues primarily from (1) selling print advertising space in
its enthusiast publications, (2) selling enthusiast publications via newsstand
and subscription, (3) selling online advertising and lead generation services,
and (4) other revenues including licensing, barter and events.
  The
Periodical Fulfillment Services segment derives revenues from (1) selling and
distributing magazines, including domestic and foreign titles, to major
specialty and mainstream retailers and wholesalers throughout the United States
and Canada, (2) exporting domestic titles internationally to foreign wholesalers
or through domestic brokers, (3) providing return processing services for major
specialty retailers, (4) providing claim filing services related to rebates owed
retailers from publishers or their designated agent, (5) designing,
manufacturing, shipping, installation and removal of front-end display fixtures,
and (6) providing information and management services relating to retail
magazine sales to U.S. and Canadian retailers and magazine publishers and
national distributors.
  The DVD
and CD Fulfillment segment derives revenues from (1) selling and distributing
pre-recorded music, videos, video games and related products to retailers, (2)
providing product and commerce solutions to “brick-and-mortar” and e-commerce
retailers, and (3) providing consumer-direct fulfillment and vendor managed
inventory services to its customers.
  Shared
Services consist of overhead functions not allocable to the individual operating
segments.
   18
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  The
segment results are as follows:
 
 Three
      months ended July 31, 2008 (in thousands)
              
              Media
              
              
              Periodical
      Fulfillment
              
              
              DVD
      and CD Fulfillment
              
              
              Shared
      Services
              
              
              Eliminations
              
              
              ConsolidatedRevenues,
      net:Distribution
              
              $
              2,266
              
              
              $
              232,672
              
              
              $
              207,796
              
              
              $
              -
              
              
              $
              -
              
              
              $
              442,734Advertising
              
              
              63,178
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              63,178Circulation
              
              
              38,589
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (7,361
              )
              
              
              31,228Manufacturing
              
              
              -
              
              
              
              11,135
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              11,135Claiming
      and information
              
              
              -
              
              
              
              2,937
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,937Other
              
              
              20,506
              
              
              
              4,956
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              25,462Total
      revenues, net
              
              
              124,539
              
              
              
              251,700
              
              
              
              207,796
              
              
              
              -
              
              
              
              (7,361
              )
              
              
              576,674Cost
      of goods sold
              
              
              34,260
              
              
              
              192,680
              
              
              
              171,712
              
              
              
              -
              
              
              
              (7,361
              )
              
              
              391,291Gross
      profit
              
              
              90,279
              
              
              
              59,020
              
              
              
              36,084
              
              
              
              -
              
              
              
              -
              
              
              
              185,383Distribution,
      circulation and fulfillment
              
              
              12,048
              
              
              
              27,864
              
              
              
              14,966
              
              
              
              -
              
              
              
              -
              
              
              
              54,878Selling,
      general and administrative expenses
              
              
              51,158
              
              
              
              22,291
              
              
              
              14,594
              
              
              
              4,017
              
              
              
              -
              
              
              
              92,060Depreciation
      and amortization
              
              
              12,064
              
              
              
              2,087
              
              
              
              2,869
              
              
              
              858
              
              
              
              -
              
              
              
              17,878Integration,
      consolidation and relocation expenses
              
              
              15
              
              
              
              1
              
              
              
              1,230
              
              
              
              94
              
              
              
              -
              
              
              
              1,340Write
      off of acquisition related assets
              
              
              -
              
              
              
              4,603
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,603Operating
      income (loss)
              
              $
              14,994
              
              
              $
              2,174
              
              
              $
              2,425
              
              
              $
              (4,969
              )
              
              $
              -
              
              
              $
              14,624As
      of July 31, 2008Total
      assets
              
              $
              1,074,219
              
              
              $
              314,974
              
              
              $
              469,405
              
              
              $
              1,450,496
              
              
              $
              (1,226,930
              )
              
              $
              2,082,164Goodwill,
      net
              
              $
              479,044
              
              
              $
              194,594
              
              
              $
              201,532
              
              
              $
              -
              
              
              $
              -
              
              
              $
              875,170Intangibles,
      net
              
              $
              470,533
              
              
              $
              34,438
              
              
              $
              35,164
              
              
              $
              -
              
              
              $
              -
              
              
              $
              540,135
 
 
 Three
      months ended July 31, 2007 (in thousands)
              
              Media
              
              
              Periodical
      Fulfillment
              
              
              DVD
      and CD Fulfillment
              
              
              Shared
      Services
              
              
              Eliminations
              
              
              ConsolidatedRevenues,
      net:Distribution
              
              $
              -
              
              
              $
              224,579
              
              
              $
              195,199
              
              
              $
              -
              
              
              $
              -
              
              
              $
              419,778Manufacturing
              
              
              -
              
              
              
              6,855
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              6,855Claiming
      and information
              
              
              -
              
              
              
              3,254
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              3,254Other
              
              
              -
              
              
              
              4,259
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              4,259Total
      revenues, net
              
              
              -
              
              
              
              238,947
              
              
              
              195,199
              
              
              
              -
              
              
              
              -
              
              
              
              434,146Cost
      of goods sold
              
              
              -
              
              
              
              182,011
              
              
              
              158,646
              
              
              
              -
              
              
              
              -
              
              
              
              340,657Gross
      profit
              
              
              -
              
              
              
              56,936
              
              
              
              36,553
              
              
              
              -
              
              
              
              -
              
              
              
              93,489Distribution,
      circulation and fulfillment
              
              
              -
              
              
              
              27,225
              
              
              
              13,248
              
              
              
              -
              
              
              
              -
              
              
              
              40,473Selling,
      general and administrative expenses
              
              
              -
              
              
              
              20,423
              
              
              
              15,263
              
              
              
              3,599
              
              
              
              -
              
              
              
              39,285Depreciation
      and amortization
              
              
              -
              
              
              
              2,258
              
              
              
              4,182
              
              
              
              546
              
              
              
              -
              
              
              
              6,986Integration,
      consolidation and relocation expenses
              
              
              -
              
              
              
              151
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              151Operating
      income (loss)
              
              $
              -
              
              
              $
              6,879
              
              
              $
              3,860
              
              
              $
              (4,145
              )
              
              $
              -
              
              
              $
              6,594As
      of January 31, 2008Total
      assets
              
              $
              1,378,489
              
              
              $
              433,508
              
              
              $
              538,867
              
              
              $
              89,208
              
              
              $
              (4,067
              )
              
              $
              2,436,005Goodwill,
      net
              
              $
              673,654
              
              
              $
              194,649
              
              
              $
              201,532
              
              
              $
              -
              
              
              $
              -
              
              
              $
              1,069,835Intangibles,
      net
              
              $
              561,808
              
              
              $
              37,868
              
              
              $
              37,406
              
              
              $
              -
              
              
              $
              -
              
              
              $
              637,082
 
 
  19
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED)
 (unaudited)
  
 Six
      months ended July 31, 2008 (in thousands)
              
              Media
              
              
              Periodical
      Fulfillment
              
              
              DVD
      and CD Fulfillment
              
              
              Shared
      Services
              
              
              Eliminations
              
              
              ConsolidatedRevenues,
      net:Distribution
              
              $
              4,326
              
              
              $
              489,823
              
              
              $
              436,379
              
              
              $
              -
              
              
              $
              -
              
              
              $
              930,528Advertising
              
              
              124,636
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              124,636Circulation
              
              
              75,830
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (14,441
              )
              
              
              61,389Manufacturing
              
              
              -
              
              
              
              19,764
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              19,764Claiming
      and information
              
              
              -
              
              
              
              6,699
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              6,699Other
              
              
              43,063
              
              
              
              4,956
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              48,019Total
      revenues, net
              
              
              247,855
              
              
              
              521,242
              
              
              
              436,379
              
              
              
              -
              
              
              
              (14,441
              )
              
              
              1,191,035Cost
      of goods sold
              
              
              67,651
              
              
              
              397,019
              
              
              
              361,284
              
              
              
              -
              
              
              
              (14,441
              )
              
              
              811,513Gross
      profit
              
              
              180,204
              
              
              
              124,223
              
              
              
              75,095
              
              
              
              -
              
              
              
              -
              
              
              
              379,522Distribution,
      circulation and fulfillment
              
              
              23,352
              
              
              
              56,751
              
              
              
              29,778
              
              
              
              -
              
              
              
              -
              
              
              
              109,881Selling,
      general and administrative expenses
              
              
              104,838
              
              
              
              46,047
              
              
              
              29,922
              
              
              
              7,884
              
              
              
              -
              
              
              
              188,691Depreciation
      and amortization
              
              
              24,207
              
              
              
              4,358
              
              
              
              5,815
              
              
              
              1,722
              
              
              
              -
              
              
              
              36,102Integration,
      consolidation and relocation expenses
              
              
              2,017
              
              
              
              489
              
              
              
              1,393
              
              
              
              149
              
              
              
              
              
              
              
              4,048Impairment
      of goodwill and intangible assets
              
              
              270,847
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              270,847Write
      off of acquisition related assets
              
              
              -
              
              
              
              4,603
              
              
              
              -
              
              
              
              1,900
              
              
              
              -
              
              
              
              6,503Operating
      (loss) income
              
              $
              (245,057
              )
              
              $
              11,975
              
              
              $
              8,187
              
              
              $
              (11,655
              )
              
              $
              -
              
              
              $
              (236,550
              )Capital
      expenditures:
              
              $
              4,460
              
              
              $
              4,864
              
              
              $
              5,916
              
              
              $
              3,713
              
              
              $
              -
              
              
              $
              18,953
 
 
 
 Six
      months ended July 31, 2007 (in thousands)
              
              Media
              
              
              Periodical
      Fulfillment
              
              
              DVD
      and CD Fulfillment
              
              
              Shared
      Services
              
              
              Eliminations
              
              
              ConsolidatedRevenues,
      net:Distribution
              
              $
              -
              
              
              $
              454,463
              
              
              $
              426,016
              
              
              $
              -
              
              
              $
              -
              
              
              $
              880,479Manufacturing
              
              
              -
              
              
              
              14,009
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              14,009Claiming
      and information
              
              
              -
              
              
              
              6,280
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              6,280Other
              
              
              -
              
              
              
              8,784
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              8,784Total
      revenues, net
              
              
              -
              
              
              
              483,536
              
              
              
              426,016
              
              
              
              -
              
              
              
              -
              
              
              
              909,552Cost
      of goods sold
              
              
              -
              
              
              
              367,047
              
              
              
              349,522
              
              
              
              -
              
              
              
              -
              
              
              
              716,569Gross
      profit
              
              
              -
              
              
              
              116,489
              
              
              
              76,494
              
              
              
              -
              
              
              
              -
              
              
              
              192,983Distribution,
      circulation and fulfillment
              
              
              -
              
              
              
              56,013
              
              
              
              27,018
              
              
              
              -
              
              
              
              -
              
              
              
              83,031Selling,
      general and administrative expenses
              
              
              -
              
              
              
              41,970
              
              
              
              30,808
              
              
              
              7,782
              
              
              
              -
              
              
              
              80,560Depreciation
      and amortization
              
              
              -
              
              
              
              4,483
              
              
              
              8,216
              
              
              
              1,123
              
              
              
              -
              
              
              
              13,822Integration,
      consolidation and relocation expenses
              
              
              -
              
              
              
              163
              
              
              
              -
              
              
              
              
              
              
              
              -
              
              
              
              163Operating
      income (loss)
              
              $
              -
              
              
              $
              13,860
              
              
              $
              10,452
              
              
              $
              (8,905
              )
              
              $
              -
              
              
              $
              15,407Capital
      expenditures:
              
              $
              -
              
              
              $
              4,038
              
              
              $
              2,966
              
              
              $
              2,432
              
              
              $
              -
              
              
              $
              9,436
 
 
 
 
 
  
  20
  
 CAUTIONARY
STATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
  Some of
the information contained in this Quarterly Report on Form 10-Q including, but
not limited to, those contained in Item 2 of Part I “Management’s Discussion and
Analysis of Financial Condition and Results of Operations,” along with
statements in other reports filed with the Securities and Exchange Commission
(the “SEC”), external documents and oral presentations, which are not historical
facts are considered to be “forward-looking statements” within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. The words “believe,” “expect,”
“anticipate,” “estimate,” “project,” and similar expressions often characterize
forward-looking statements. These statements may include, but are not limited
to, projections of collections, revenues, income or loss, cash flow, estimates
of capital expenditures, plans for future operations, products or services, and
financing needs or plans, as well as assumptions relating to these matters.
These statements are only predictions and you should not unduly rely on them.
Our actual results will differ, perhaps materially, from those anticipated in
these forward-looking statements as a result of a number of factors, including
the risks and uncertainties faced by us described below and those set forth
below under “Risk Factors” in our Annual Report for the fiscal year ended
January 31, 2008 on Form 10-K filed with the SEC on April 15, 2008, as amended
on May 30, 2008:
  ·              
changes in the retail market for CDs and DVDs;
  ·              
changes in the retail market for magazines, books and other
publications;
  ·              
changes in the market for advertising expenditures;
  ·              
adverse effects to our customer base, upon whom our business
depends;
  ·              
disruptions in the operations of our key shipper and/or increased costs for
shipping services;
  ·              
the departure from the Company of key personnel;
  ·              
changes in print, ink, paper and fuel costs; and
  ·              
changes in consumer discretionary spending.
  The
factors listed above should not be construed as exhaustive.We believe it is
important to communicate our expectations to our investors. However, there may
be events in the future that we are not able to predict accurately or over which
we have no control. The factors listed above provide examples of risks,
uncertainties and events that may cause our actual results to differ materially
from the expectations we describe in our forward-looking statements. Before you
make an investment decision relating to our common stock, you should be aware
that the occurrence of the events described in these risk factors and those set
forth below under “Risk Factors” in our Annual Report for the fiscal year ended
January 31, 2008 filed with the SEC on April 15, 2008, as amended on May 30,
2008 could have a material adverse effect on our business, operating results and
financial condition. You should read and interpret any forward-looking statement
in conjunction with our consolidated financial statements, the notes to our
consolidated financial statements and Item 2 of Part I “Management’s Discussion
and Analysis of Financial Condition and Results of Operation.” Any
forward-looking statement speaks only as of the date on which that statement is
made. Unless required by U.S. federal securities laws, we undertake no
obligation to release publicly the results of any future revisions we may make
to forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
 
  21
  
 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
 
 We are a
premier publishing, marketing, merchandising and fulfillment company of
entertainment products including magazines, DVDs, music CDs, books and related
items, serving over 100,000 retail locations throughout North America. We
produce print and digital content for consumers in North America through our
enthusiast media division, Source Interlink Media (“SIM”), which was acquired on
August 1, 2007.We also sell and distribute entertainment products to leading
mass merchandise retailers, grocery stores, bookstore chains, music stores, drug
stores and other specialty retailers, as well as e-commerce retailers. We offer
customers an array of value-added content and services including enthusiast
media publications and online content, category management, product procurement,
fulfillment services, claims submission, information services and in-store
fixturing.We believe no other competitor can provide this scope of content and
services across this range of home entertainment products.
 
 We
directly produce and deliver magazine, Internet and home entertainment content
to consumers. With the addition of SIM, we transformed from a leading home
entertainment distributor into a significant content owner. This array of
products and services, in combination with our value added services and
geographic reach, positions us to service the needs of America’s leading
retailers and to capitalize on the rapidly changing distribution and fulfillment
landscape.
 
 We are
one of the largest independent wholesalers of DVDs and CDs in North America. We
effectively operate as an extension of our customers’ operations. Between our
fulfillment, category management and e-commerce solutions, we provide our
customers with a complete solution to maximize the sales and profitability of
their home entertainment content products.
 
 We are a
dynamic organization composed of three synergistic operating divisions. Together
they form a leading integrated media company with distinguished content and a
national distribution and merchandising platform.
   Our
Divisions
 
 Source
Interlink Media
 Our SIM
division is one of the largest providers of enthusiast print and digital content
in North America. SIM sells print advertising space in its publications, sells
publications through newsstands and subscriptions, sells online advertising and
lead generation services, and sells sponsorships and tickets for events. Its
properties consist of 80 publications, 94 websites and over 100 events as of
July 31, 2008. Well known print titles include Motor Trend, Hot Rod, Lowrider,
Power & Motoryacht, Surfer, Home Theater, Motorcyclist, 4 Wheel &
Offroad, and Soap Opera
Digest. SIM’s web properties include Automotive.com, Motortrend.com and
Equine.com as well as corresponding properties for most of its print
publications. SIM’s magazines have a combined circulation of approximately 9.0
million print copies per month, and its websites reach a total of over 19
million unique users who generate over 145 million page views per month. The
estimated total reach of our audience is over 75 million consumers each month.
Additionally, the reader base of our automotive portfolio is approximately 90%
male, and approximately 81% are between 18 and 54 years old.
 
 SIM is a
leading provider of content to enthusiast communities interested in automotive,
action sports, marine, equine and home technology. SIM has the largest portfolio
of magazines in the automotive category, including six of the top ten titles by
paid circulation. These print publications are supplemented by branded websites,
consumer events, and licensed products. Automotive.com has proven expertise in
car sales lead generation, search engine marketing and search engine
optimization. This expertise coupled with a technology platform that is
increasing traffic can be monetized through advertising and lead generation. As
automakers divert marketing dollars to the Internet and as auto dealers seek
increased car sale leads, the combination of Automotive.com and our portfolio of
branded Internet sites provides a platform for strong growth in online
advertising and lead generation revenues.
 
 SIM’s
strategy of differentiated, specialized and authoritative content has
effectively positioned it to take advantage of the industry shift towards more
targeted advertising. SIM is an important source of information for readers on
their avocations. Given its niche content, SIM is less exposed to the pressures
faced by sports, news and other general interest magazines. SIM’s readers tend
to spend a significant amount of time and money on their avocations, therefore
these titles are less reliant on rate base guarantees than general interest
publications. Only six of SIM’s 80 titles have rate base guarantees. SIM’s
15,000+ endemic advertisers rely on its titles as virtual storefronts to
directly connect with buyers and generate sales. Endemic sources comprise
approximately 85% of SIM’s print advertising revenue and provide a highly
desirable and, historically, a relatively less volatile revenue stream that
differentiates it from other content providers.
   22
  
 Periodical
Fulfillment Services
 Our
Periodical Fulfillment Services division provides an array of value-added
services including category management, product procurement, fulfillment and
returns processing services to approximately 18,600 mainstream retail locations
and 3,100 specialty retail locations. Its customers include most of the nation’s
leading magazine retailers including Barnes & Noble, Borders, Wal-Mart,
Target, Kroger, Safeway, Costco, Walgreens and Rite Aid, many of which have been
customers for more than 10 years. The division has approximately 30% share of
the single-copy magazine distribution market and is the leading distributor in
five of the nation’s top ten advertising markets. The division also imports and
exports periodicals sold in more than 100 markets worldwide and designs,
manufactures and implements display fixture programs, manages rebates and other
incentive payments and accumulates data from more than 100,000 retail locations.
These services are critical to both mainstream and specialty retailers alike as
they enable clients to make more informed decisions regarding product placement
and marketing strategies.
 
 DVD
/ CD Fulfillment
 Our DVD /
CD Fulfillment division is the leading independent distributor of DVDs and CDs
in the home entertainment products marketplace, offering the most extensive
selection of products in the United States. It provides category management
(vendor managed inventory), procurement, fulfillment and e-commerce services to
leading DVD and CD retailers and Internet retailers, including Barnes &
Noble, Amazon.com, Meijer, K Mart, Toys “R” Us, Circuit City and Walgreens. The
DVD / CD Fulfillment division utilizes its industry leading Stock Keeping Unit
(“SKU”) availability of approximately 360,000 CD titles and approximately
100,000 DVD titles, approximately two-thirds of which are physically in stock in
our warehouses, as well as video games and other related products to supply a
tailored merchandise offering for its customers. Through its Consumer Direct
Fulfillment segment, the division also provides fulfillment for the majority of
domestic e-commerce sites that sell music or videos.
 
 
 Operating
Environment
 The
Company’s business is affected by economic factors that impact the level of
disposable income available to our customers.The continuing economic downturn
has affected the level of consumer spending on discretionary items such as
magazines, DVDs and CDs.This reduction in discretionary spending has had a
related effect on the amount of advertising spend in our
publications.Advertising is a significant source of revenue for the Company and
is traditionally negatively affected by economic downturns in any of the
Company’s markets.Historically, our cost of sales has been made up of raw
material and packing costs with paper being the Company’s most substantial raw
material.Operating results could be adversely affected to the extent that
current economic conditions bring about significant increases in raw material
prices.In addition, related expenses have increased and will continue to do so
resulting from the impact of unprecedented rising fuel prices on our freight
costs.
 
 Overview
  Significant
events that occurred during the six months ended July 31, 2008 and 2007
include:
 
 Refinancing
of Bridge Facility and Issuance of Senior Notes
 
 On
June 26, 2008, the Company consummated the refinancing and permanent
retirement of all of its indebtedness under the certain Senior Subordinated
Bridge Loan Agreement (the “Bridge Facility”), dated as of August 1,
2007.This refinancing and permanent retirement was effected through the exchange
of the Company’s 11.25% Senior Unsecured Notes due 2015 (the “Senior Notes”) for
the termination of the Company’s indebtedness under the Bridge Facility.The
Senior Notes were issued to the former Bridge Facility lenders and were offered
in conformance with the exemptions for non-public offerings provided by Rule 506
and Section 4(2) of the Securities Act of 1933.These notes constitute
“restricted securities” under Rule 144A of the aforementioned Act.Furthermore,
in connection therewith,the Company entered into
a Registration Rights Agreement, dated as of June 26, 2008 by and between
the Company, certain subsidiaries of the Company as guarantors and the Senior
Note holders, Citigroup Global Markets Inc., JPMorgan Securities Inc., Citigroup
North America Inc. and JPMorgan Chase Bank N.A.The Senior Notes were issued
under an Indenture, dated as of June 23, 2008, by and between the Company,
certain of the Company’s subsidiaries and HSBC Bank USA, National Association,
as Trustee.
 
 As part
of the aforementioned refinancing, the Company paid a conversion fee of $11.6
million and other deferred financing fees of approximately $0.8 million, which
will be amortized over the term of the Senior Notes.As a result of the
refinancing, the Company wrote off the remaining $1.0 million of deferred
financing fees related to the Bridge Facility.
 
  23
 SOURCE
INTERLINK COMPANIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 (unaudited)
  
 Business
Combinations
 
 On July
18, 2008, the Company purchased the remaining 19.9% of Automotive.com, Inc. for
$42.0 million in cash.The Company expects to realize numerous benefits as a
result of attaining total management control of the Autodigital business,
including operating synergies, cross-selling opportunities, improved customer
management and cost savings through rationalization and integration
strategies.This acquisition resulted in the retirement of $40.7 million,
including minority interests, of obligations to the prior minority interest
holders and a $0.7 million increase in amortizable intangible assets.The
purchase price was funded by additional borrowings under the Company’s Revolving
Credit Facility.
  Impairment
Charge
  As a
result of our fiscal year 2009 FAS 142 first quarter impairment analysis,
we determined that certain tradenames of our Media reportable segment were
impaired and consequently recorded a charge of approximately $74.3 million
during the first quarter. This determination was based largely on management’s
projections regarding the revenues from and profitability of tradenames acquired
on August 1, 2007. The combination of the analysis and other factors
discussed below, had an adverse impact on the anticipated future cash flows used
in the impairment analysis performed during the first quarter of fiscal year
2009.The net carrying amount of the tradenames was $280.6 million at the end of
the first quarter of fiscal year 2009, after the impairment charge was
recorded.
 
 As a
result of our fiscal year 2009 FAS 142 annual first quarter impairment analysis,
we determined that the goodwill of four of our reporting units of our Media
reportable segment was impaired and consequently recorded an impairment charge
of $196.5 million during the first quarter. However, the results of the Phase I
analysis indicated significant clearance on three of the reporting units within
our Media reportable segment.This determination was based largely on
management’s projections regarding the revenues and profitability of the Media
reportable segment as well as the effects of the recent credit market changes,
the continued economic downturn and the related effects on customer
discretionary spending and print advertising. The charge was measured on the
basis of comparison of estimated fair values with corresponding book values and
relates primarily to goodwill recorded in connection with our acquisition of EM.
These fair values were determined in accordance with Company policy discussed
above as well as FAS 142 and other relevant guidance.
 
 Valuation
Allowance
  Statement
of Financial Accounting Standards No. 109 "Accounting for Income Taxes"
("FAS 109") requires that a valuation allowance be establishedwhen it is more likely
than not that all or a portion of deferred tax assetswill not be realized. A
review of all available positive and negative evidenceneeds to be considered,
including a company's performance, the marketenvironment in which
the company operates, the utilization of past tax credits,length of carryback and
carryforward periods, existing contracts or salesbacklog that will
result in future profits, etc.It further states that
forming a conclusion that a valuation allowance is notneeded is difficult
when there is negative evidence such as cumulative losses inrecent years.
Therefore, cumulative losses weigh heavily in the overall assessment. We
identified several significant developments which we considered in determining
the need to record a full valuation allowance in the current quarter, including
the continuing economic downturn and our projections regarding the near-term
revenues and profitability of our segments. As a result of our assessment, we
recorded a valuation allowance on deferred tax assets of approximately $108.7
million during the first quarter and increased that allowance to $115.1 million
in the second quarter of fiscal 2009.
  Sale
of Wood Manufacturing Division
  On April
30, 2007, we sold substantially all of the assets of our Wood Manufacturing
Division.This discontinued operation has been excluded from current and prior
year results as presented herein.See Note 8 – Discontinued
Operation.
  
  24
  
 Results
of operations
  Please
see our Annual Report on Form 10-K for the fiscal year ended January 31, 2008
and filed with the SEC on April 15, 2008, as amended on May 30, 2008, for more
information on the types of revenues and expenses included within the specific
line-items in our financial statements.
  The
Company’s segment reporting is based on the reporting of senior management to
the chief operating decision maker. This reporting combines the Company’s
business units in a logical way that identifies business concentrations and
synergies.Accordingly, beginning in fiscal 2009, management has restructured the
presentation of the Company’s segments to better reflect the change in
management and financial reporting of the applicable units.The Company’s
segments are heretofore presented as follows: Media, Periodical Fulfillment
Services, DVD and CD Fulfillment and Shared Services.Prior reporting periods
have been reclassified to conform to current presentation to make prior period
comparisons meaningful.
  THREE
MONTHS ENDED JULY 31, 2008 AND 2007
  Media
  The
following table sets forth, for the periods presented, information relating to
our Media segment:
 
  Three months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              PercentRevenues,
      netDistribution
              
              $
              2,266
              
              
              $
              -
              
              
              $
              2,266
              
              NMAdvertising
              
              
              63,178
              
              
              
              -
              
              
              
              63,178
              
              NMCirculation
              
              
              38,589
              
              
              
              -
              
              
              
              38,589
              
              NMOther
              
              
              20,506
              
              
              
              -
              
              
              
              20,506
              
              NMTotal
      revenues, net
              
              
              124,539
              
              
              
              -
              
              
              
              124,539
              
              NMCost
      of goods sold
              
              
              34,260
              
              
              
              -
              
              
              
              34,260
              
              NMGross
      profit
              
              
              90,279
              
              
              
              -
              
              
              
              90,279
              
              NMDistribution,
      circulation and fulfillment
              
              
              12,048
              
              
              
              -
              
              
              
              12,048
              
              NMSelling,
      general and administrative expenses
              
              
              51,158
              
              
              
              -
              
              
              
              51,158
              
              NMDepreciation
      and amortization
              
              
              12,064
              
              
              
              -
              
              
              
              12,064
              
              NMIntegration,
      consolidation and relocation expenses
              
              
              15
              
              
              
              -
              
              
              
              15
              
              NMOperating
      income
              
              $
              14,994
              
              
              $
              -
              
              
              $
              14,994
              
              NM
 
 
  On August
1, 2007, we acquired SIM, which created our Media operating segment.All changes
in income statement line items result from this acquisition.
  
  25
  
 Periodical
Fulfillment Services
  The
following table sets forth, for the periods presented, information relating to
our Periodical Fulfillment Services segment:
  Three months ended July
      31,
                
                
                Change2008
                
                
                2007
                
                
                Amount
                
                
                PercentRevenues,
      netDistribution
                
                $
                232,672
                
                
                $
                224,579
                
                
                $
                8,093
                
                
                
                3.6
                %Manufacturing
                
                
                11,135
                
                
                
                6,855
                
                
                
                4,280
                
                
                
                62.4
                %Claiming
      and information
                
                
                2,937
                
                
                
                3,254
                
                
                
                (317
                )
                
                
                (9.7
                %)Other
                
                
                4,956
                
                
                
                4,259
                
                
                
                697
                
                
                
                16.4
                %Total
      revenues, net
                
                
                251,700
                
                
                
                238,947
                
                
                
                12,753
                
                
                
                5.3
                %Cost
      of goods sold
                
                
                192,680
                
                
                
                182,011
                
                
                
                10,669
                
                
                
                5.9
                %Gross
      profit
                
                
                59,020
                
                
                
                56,936
                
                
                
                2,084
                
                
                
                3.7
                %Distribution,
      circulation and fulfillment
                
                
                27,864
                
                
                
                27,225
                
                
                
                639
                
                
                
                2.3
                %Selling,
      general and administrative expenses
                
                
                22,291
                
                
                
                20,423
                
                
                
                1,868
                
                
                
                9.1
                %Depreciation
      and amortization
                
                
                2,087
                
                
                
                2,258
                
                
                
                (171
                )
                
                
                (7.6
                %)Write
      off of acquisition related assets
                
                
                4,603
                
                
                
                -
                
                
                
                4,603
                
                
                NMIntegration
      and relocation expense
                
                
                1
                
                
                
                151
                
                
                
                (150
                )
                
                NMOperating
      income
                
                $
                2,174
                
                
                $
                6,879
                
                
                $
                (4,705
                )
                
                
                (68.4
                %)Key
      operating measures:Gross
      profit margin
                
                
                23.4
                %
                
                
                23.8
                %
                
                
                (0.4
                %)Operating
      income margin
                
                
                0.9
                %
                
                
                2.9
                %
                
                
                (2.0
                %)Distribution,
      circulation andfulfillment as a percent of revenues11.1
                %
                
                
                11.4
                %
                
                
                (0.3
                %)Selling,
      general and administrative expensesas
      a percent of revenues
                
                
                8.9
                %
                
                
                8.5
                %
                
                
                0.4
                %NM
      - percentage change not meaningful
 
  Revenues
have increased due to the impact of a new exclusive contract with a major
bookstore, new business to traditional retailers and higher volume in the
manufacturing lines.This has been offset by some customer attrition in the
claiming business.
 
 Gross
margin is slightly lower than the prior year period due to a higher
concentration of sales from low margin titles.
  Distribution,
circulation and fulfillment as a percent of revenues decreased as a result of
our distribution center consolidation project as well as increased revenue from
our export distribution business that does not carry freight costs.
  Selling,
general and administrative expenses have increased over the same period last
year due in part to additional Information Technology expense associated with
our continued integration of the operating platforms of our prior
acquisitions.
  Operating
margin is significantly lower than last year due to the one-off noncash purchase
price adjustment to correctly state the opening balance sheet of the 2007
Anderson acquisition.
 
  26
  
 DVD
and CD Fulfillment
  The
following table sets forth, for the periods presented, information relating to
our DVD and CD Fulfillment segment:
  Three months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              
              PercentRevenues,
      netDistribution
              
              $
              207,796
              
              
              $
              195,199
              
              
              $
              12,597
              
              
              
              6.5
              %Total
      revenues, net
              
              
              207,796
              
              
              
              195,199
              
              
              
              12,597
              
              
              
              6.5
              %Cost
      of goods sold
              
              
              171,712
              
              
              
              158,646
              
              
              
              13,066
              
              
              
              8.2
              %Gross
      profit
              
              
              36,084
              
              
              
              36,553
              
              
              
              (469
              )
              
              
              (1.3
              %)Distribution,
      circulation and fulfillment
              
              
              14,966
              
              
              
              13,248
              
              
              
              1,718
              
              
              
              13.0
              %Selling,
      general and administrative expenses
              
              
              14,594
              
              
              
              15,263
              
              
              
              (669
              )
              
              
              (4.4
              %)Depreciation
      and amortization
              
              
              2,869
              
              
              
              4,182
              
              
              
              (1,313
              )
              
              
              (31.4
              %)Integration
      and relocation expense
              
              
              1,230
              
              
              
              -
              
              
              
              1,230
              
              
              NMOperating
      income
              
              $
              2,425
              
              
              $
              3,860
              
              
              $
              (1,435
              )
              
              
              (37.2
              %)Key
      operating measures:Gross
      profit margin
              
              
              17.4
              %
              
              
              18.7
              %
              
              
              (1.3
              %)Operating
      income margin
              
              
              1.2
              %
              
              
              2.0
              %
              
              
              (0.8
              %)Distribution,
      circulation and fulfillment as a percent of revenues
              
              
              7.2
              %
              
              
              6.8
              %
              
              
              0.4
              %Selling,
      general and administrative expensesas
      a percent of revenues
              
              
              7.0
              %
              
              
              7.8
              %
              
              
              (0.8
              %)NM
      - percentage change not meaningful
 
  Revenues
increased compared to the prior year period due in part to the addition of a
significant new customer which offset declining sales from existing
customers.
  Gross
profit margin decreased slightly as the significant new customer carries lower
gross margins.
  Distribution,
circulation and fulfillment as a percent of revenues increased due to increased
fuel surcharges in the current year period compared to the prior year
period.
  Selling,
general and administrative expenses in total and as a percent of revenues
deceased primarily due to reduced headcount and successful implementation of
cost reductions.
  Depreciation
and amortization decreased primarily due to decreased intangible assets as a
result of the fourth quarter prior year impairment.
  Operating
income decreased primarily due the combined effects of the factors listed
above.
  
  27
  
 Shared
Services
  The
following table sets forth, for the periods presented, information relating to
our Shared Services segment:
  Three months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              
              PercentSelling,
      general and administrative expenses
              
              $
              4,017
              
              
              $
              3,599
              
              
              $
              418
              
              
              
              11.6
              %Depreciation
      and amortization
              
              
              858
              
              
              
              546
              
              
              
              312
              
              
              
              57.1
              %Integration,
      consolidation and relocation expenses
              
              
              94
              
              
              
              -
              
              
              
              94
              
              
              NMOperating
      loss
              
              $
              (4,969
              )
              
              $
              (4,145
              )
              
              $
              (824
              )
              
              
              (19.9
              %)Key
      operating measures:Selling,
      general and administrative expensesas
      a percent of total company revenues
              
              
              0.7
              %
              
              
              0.8
              %
              
              
              (0.1
              %)NM
      - percentage change not meaningful
 
  Selling,
general and administrative expenses remained consistent with the same period of
the prior year.
  
 SIX
MONTHS ENDED JULY 31, 2008 AND 2007
  Media
  The
following table sets forth, for the periods presented, information relating to
our Media segment:
  Six months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              PercentRevenues,
      netDistribution
              
              $
              4,326
              
              
              $
              -
              
              
              $
              4,326
              
              NMAdvertising
              
              
              124,636
              
              
              
              -
              
              
              
              124,636
              
              NMCirculation
              
              
              75,830
              
              
              
              -
              
              
              
              75,830
              
              NMOther
              
              
              43,063
              
              
              
              -
              
              
              
              43,063
              
              NMTotal
      revenues, net
              
              
              247,855
              
              
              
              -
              
              
              
              247,855
              
              NMCost
      of goods sold
              
              
              67,651
              
              
              
              -
              
              
              
              67,651
              
              NMGross
      profit
              
              
              180,204
              
              
              
              -
              
              
              
              180,204
              
              NMDistribution,
      circulation and fulfillment
              
              
              23,352
              
              
              
              -
              
              
              
              23,352
              
              NMSelling,
      general and administrative expenses
              
              
              104,838
              
              
              
              -
              
              
              
              104,838
              
              NMDepreciation
      and amortization
              
              
              24,207
              
              
              
              -
              
              
              
              24,207
              
              NMIntegration,
      consolidation and relocation expenses
              
              
              2,017
              
              
              
              -
              
              
              
              2,017
              
              NMImpairment
      of goodwill and intangible assets
              
              
              270,847
              
              
              
              -
              
              
              
              270,847
              
              NMOperating
      loss
              
              $
              (245,057
              )
              
              $
              -
              
              
              $
              (245,057
              )
              NMNM
      - percentage change not meaningful
 
  On August
1, 2007, we acquired SIM, which created our Media operating segment.All changes
in income statement line items result from this acquisition.
   28
  
 Periodical
Fulfillment Services
  The
following table sets forth, for the periods presented, information relating to
our Periodical Fulfillment Services segment:
  Six months ended July
      31,
                
                
                Change2008
                
                
                2007
                
                
                Amount
                
                
                PercentRevenues,
      netDistribution
                
                $
                489,823
                
                
                $
                454,463
                
                
                $
                35,360
                
                
                
                7.8
                %Manufacturing
                
                
                19,764
                
                
                
                14,009
                
                
                
                5,755
                
                
                
                41.1
                %Rebate/information
                
                
                6,699
                
                
                
                6,280
                
                
                
                419
                
                
                
                6.7
                %Other
                
                
                4,956
                
                
                
                8,784
                
                
                
                (3,828
                )
                
                
                (43.6
                %)Total
      revenues, net
                
                
                521,242
                
                
                
                483,536
                
                
                
                37,706
                
                
                
                7.8
                %Cost
      of goods sold
                
                
                397,019
                
                
                
                367,047
                
                
                
                29,972
                
                
                
                8.2
                %Gross
      profit
                
                
                124,223
                
                
                
                116,489
                
                
                
                7,734
                
                
                
                6.6
                %Distribution,
      circulation and fulfillment
                
                
                56,751
                
                
                
                56,013
                
                
                
                738
                
                
                
                1.3
                %Selling,
      general and administrative expenses
                
                
                46,047
                
                
                
                41,970
                
                
                
                4,077
                
                
                
                9.7
                %Depreciation
      and amortization
                
                
                4,358
                
                
                
                4,483
                
                
                
                (125
                )
                
                
                (2.8
                %)Write
      off of acquisition related assets
                
                
                4,603
                
                
                
                -
                
                
                
                4,603
                
                
                NMIntegration
      and relocation expense
                
                
                489
                
                
                
                163
                
                
                
                326
                
                
                NMOperating
      income
                
                $
                11,975
                
                
                $
                13,860
                
                
                $
                (1,885
                )
                
                
                (13.6
                %)Key
      operating measures:Gross
      profit margin
                
                
                23.8
                %
                
                
                24.1
                %
                
                
                (0.3
                %)Operating
      income margin
                
                
                2.3
                %
                
                
                2.9
                %
                
                
                (0.6
                %)Distribution,
      circulation andfulfillment as a percent of revenues10.9
                %
                
                
                11.6
                %
                
                
                (0.7
                %)Selling,
      general and administrative expensesas
      a percent of revenues
                
                
                8.8
                %
                
                
                8.7
                %
                
                
                0.1
                %NM
      - percentage change not meaningful
 
  Revenues
have increased due to the impact of a new exclusive contract with a major
bookstore, new business to traditional retailers and higher volume in the
manufacturing lines.This has been offset by some customer attrition in the
rebate/information business.
 
 Gross
margin is slightly lower than the prior year period due to a higher
concentration of sales from low margin titles.
  Distribution,
circulation and fulfillment as a percent of revenues decreased due to the
combination of our operational initiatives and increased international business
that does not carry freight costs.
  Selling,
general and administrative expenses have increased over the same period last
year due in part to additional Information Technology expense associated with
our continued integration of the operating platforms of our prior
acquisitions.
  In fiscal
2008, we incurred expenses associated with the integration of our Brainerd, MN
distribution center into our new McCook, IL distribution center.
  Operating
margin is lower than last year due to the one-off purchase price adjustment
to correctly state the opening balance sheet of the 2007 Anderson
acquisition.
 
  29
  
 DVD
and CD Fulfillment
  The
following table sets forth, for the periods presented, information relating to
our DVD and CD Fulfillment segment:
  Six months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              
              PercentRevenues,
      netDistribution
              
              $
              436,379
              
              
              $
              426,016
              
              
              $
              10,363
              
              
              
              2.4
              %Total
      revenues, net
              
              
              436,379
              
              
              
              426,016
              
              
              
              10,363
              
              
              
              2.4
              %Cost
      of goods sold
              
              
              361,284
              
              
              
              349,522
              
              
              
              11,762
              
              
              
              3.4
              %Gross
      profit
              
              
              75,095
              
              
              
              76,494
              
              
              
              (1,399
              )
              
              
              (1.8
              %)Distribution,
      circulation and fulfillment
              
              
              29,778
              
              
              
              27,018
              
              
              
              2,760
              
              
              
              10.2
              %Selling,
      general and administrative expenses
              
              
              29,922
              
              
              
              30,808
              
              
              
              (886
              )
              
              
              (2.9
              %)Depreciation
      and amortization
              
              
              5,815
              
              
              
              8,216
              
              
              
              (2,401
              )
              
              
              (29.2
              %)Integration
      and relocation expense
              
              
              1,393
              
              
              
              -
              
              
              
              1,393
              
              
              NMOperating
      income
              
              $
              8,187
              
              
              $
              10,452
              
              
              $
              (2,265
              )
              
              
              (21.7
              %)Key
      operating measures:Gross
      profit margin
              
              
              17.2
              %
              
              
              18.0
              %
              
              
              (0.8
              %)Operating
      income margin
              
              
              1.9
              %
              
              
              2.5
              %
              
              
              (0.6
              %)Distribution,
      circulation and fulfillment as a percent of revenues
              
              
              6.8
              %
              
              
              6.3
              %
              
              
              0.5
              %Selling,
      general and administrative expensesas
      a percent of revenues
              
              
              6.9
              %
              
              
              7.2
              %
              
              
              (0.3
              %)NM
      - percentage change not meaningful
 
  Revenues
increased over the prior year period due in part to the addition of a
significant new customer which offset declining sales from existing
customers.
  Gross
profit margin decreased slightly as the significant new customer carries lower
gross margins, the penalties for vendor returns increased and rebate income
decreased.
  Distribution,
circulation and fulfillment as a percent of revenues increased due to increased
fuel surcharges over the same period of the prior year.
  Selling,
general and administrative expenses in total and as a percent of revenues
deceased due to reduced headcount and successful implementation of cost
reductions.
  Depreciation
and amortization decreased primarily due to decreased intangible assets as a
result of the fourth quarter prior year impairment.
  In the
six months ended July 31, 2008, we incurred relocation and integration expenses
related to our project to relocate our Coral Springs, FL distribution facility
to Shepherdsville, KY.
 
 Operating
income decreased primarily due the combined effects of the factors listed
above.
  
  30
  
 Shared
Services
  The
following table sets forth, for the periods presented, information relating to
our Shared Services segment:
  Six months ended July
      31,
              
              
              Change2008
              
              
              2007
              
              
              Amount
              
              
              PercentSelling,
      general and administrative expenses
              
              $
              7,884
              
              
              $
              7,782
              
              
              $
              102
              
              
              
              1.3
              %Depreciation
      and amortization
              
              
              1,722
              
              
              
              1,123
              
              
              
              599
              
              
              
              53.3
              %Integration,
      consolidation and relocation expenses
              
              
              149
              
              
              
              -
              
              
              
              149
              
              
              NMWrite
      off of acquisition related assets
              
              
              1,900
              
              
              
              -
              
              
              
              1,900
              
              
              NMOperating
      loss
              
              $
              (11,655
              )
              
              $
              (8,905
              )
              
              $
              (2,750
              )
              
              
              (30.9
              %)Key
      operating measures:Selling,
      general and administrative expensesas
      a percent of total company revenues
              
              
              0.7
              %
              
              
              0.9
              %
              
              
              (0.2
              %)NM
      - percentage change not meaningful
 
  Selling,
general and administrative expenses remained consistent with the same period of
the prior year.
  During
the six months ended July 31, 2008, we wrote off $1.9 million in previously
capitalized acquisition related costs.The write-off occurred as a direct result
of management’s determination that continued capitalization of these costs was
no longer appropriate given the status of a potential
acquisition.
  Interest
Expense
  Interest
expense includes the interest and fees on our significant debt instruments and
outstanding letters of credit. Net interest expense increased to $57.7 million
from $6.2 million for the six months ended July 31, 2008 and 2007,
respectively.The increase relates to the significant increase in borrowings as a
result of our acquisition of SIM and the issuance of the Senior
Notes.
  Other
Income (Expense)
  Other
income (expense) consists of items outside the normal course of operations.Due
to its nature, comparability between periods is not generally
meaningful.
  Income
Tax Expense
  The
effective tax rate for the current quarter was 0.0% versus an effective tax rate
of 40.0% in the same period of the prior year. The change in effective tax rates
is due to the valuation allowance discussed above.Our effective tax rate differs
from that disclosed in our Annual Report on Form 10-K due to the full valuation
of current period tax benefits.
 
  31
  
 Liquidity
and Capital Resources
   The
primary sources of the Company’s cash are receipts from customers, borrowings
under our credit facilities.
 
 Our
primary cash requirements for the Media group consist of raw materials and
salaries.Our primary cash requirements for the Periodical Fulfillment Services
group consist of the cost of home entertainment products, the cost of freight
and facility expense associated with our distribution centers and the cost of
raw materials, labor, and factory overhead incurred in the production of
front-end wire displays, the cost of labor incurred in providing our claiming,
design and information services and cash advances funding our Advance Pay
program.Our Advance Pay program allows retailers to accelerate collections of
their rebate claims through payments from us in exchange for the transfer to us
of the right to collect the claim.We then collect the claims when paid by
publishers for our own account.Our primary cash requirements for the DVD and CD
Fulfillment group consist of the cost of home entertainment products and the
cost of freight, labor and facility expense associated with our distribution
centers.Our primary cash requirements for the Shared Services group consist of
salaries and professional fees not allocated to the operating groups, repayments
of principal on our term loan and interest payments on our debt.
 
 The
Company has a $300.0 million revolving credit facility dated as of
August 1, 2007. Availability under the facility is limited by the Company’s
borrowing base calculation, as defined in the agreement. The calculation
resulted in excess availability, after consideration of outstanding letters of
credit, of $189.5 million at July 31, 2008 and borrowings at this date amount to
$49.6 million compared with $0 at January 31, 2008.Proceeds from the revolving
credit facility are used for general corporate purposes, including seasonal
working capital needs, for the acquisition of the minority interest of our Media
reportable segment’s Autodigital reporting unit on July 18, 2008 and payment of
the related financing fees of $12.4 million.
  The
Company has an $880.0 million term loan dated as of August 1, 2007 under
which it had one LIBOR contract outstanding at July 31, 2008 in the amount of
$871.2 million, maturing in August 2008 bearing interest at 5.713%.During the
six months ended July 31, 2008, the Company made principal repayments totaling
$4.4 million on this loan.
  In
addition, the Company retired the Bridge Facility of $465.0 million by issuing
the Senior Notes in the same principal amount.As noted above, the payment of
$12.4 million in fees is included in the Company’s financing activities for the
period.
  The
Company had $1,416.2 million in borrowings on July 31, 2008.The Company had
$145.5 million in outstanding debt at July 31, 2007.
  Based
upon the Company’s current operating levels, management believes cash on hand,
net cash flows from operating activities and the capacity under the credit
facilities will be sufficient to meet the Company’s normal working capital and
debt service requirements for at least the next twelve months.
   32
   Operating
Cash Flow
  Net cash
provided by operating activities was $12.2 million for the six months ended July
31, 2008 compared with cash provided by operating activities of $9.5 million for
the six months ended July 31, 2007.
  Operating
cash flows for the six months ended July 31, 2008 were comprised
of:
  ·
              Net
      loss of $296.7 million,
  ·
              Plus
      non-cash charges and positive changes in operating assets and liabilities
      including:
  ·Impairment of
goodwill and intangibles of $270.8 million,
 ·Depreciation and
amortization of $44.7 million
 ·Provisions for
losses on accounts receivable of $3.4 million
 ·Decreases in
accounts receivable of $35.8 million and
 ·Decreases in
inventories of $6.3 million.
 
 ·
              Cash
      was used for:
  ·
              Decreases
      in accounts payable and other liabilities of $55.6
  million.
  The
decrease in accounts receivable of $35.8 million relates primarily to a decrease
in accounts receivable within our DVD and CD Fulfillment group of $43.4 million
related primarily to the timing of payments received from major customers.This
decrease was partially offset by an increase in accounts receivable within our
Periodical Fulfillment Services group of approximately $13.7 million related
primarily to the timing of payments received from major customers.
  The
decrease in inventories of $6.3 million is primarily made up of the $7.1 million
decrease attributable to the seasonality of our DVD and CD Fulfillment group’s
products.
  The
decrease in accounts payable and other liabilities of $60.2 million relates
primarily to a decrease in accounts payable within our DVD and CD Fulfillment
group of $54.4 million related to the timing of vendor payments.We currently do
not receive as favorable payment terms from DVD vendors as from CD
vendors.Therefore, as the mix shifts we experience negative working capital
consequences.Also contributing to the decrease in accounts payable and other
liabilities were our Media and Periodical Fulfillment Services groups which
experienced decreases of $13.6 million and $11.1 million,
respectively.
   33
  
 Operating
cash flows for the six months ended July 31, 2007 were comprised
of:
  ·
              Net
      income of $4.0 million,
  ·
              Plus
      non-cash charges and positive changes in operating assets and liabilities
      including:
  ·
              depreciation
      and amortization of $14.7 million,
 ·
              provisions
      for losses on accounts receivable of $1.8
  million
 ·
              decreases
      in accounts receivable of $36.3 million,
and
 ·
              decreases
      in other current and non-current assets of $7.5
  million.
  ·
              Cash
      was used for:
  ·
              increases
      in inventories of $6.5 million, and
 ·
              decreases
      in accounts payable and other liabilities of $49.2
  million.
 
 The
decrease in accounts receivable relates primarily to a decrease in accounts
receivable within our DVD and CD Fulfillment group of $30.0 million related to
the timing of customer payments and a decrease in accounts receivable within our
Periodical Fulfillment Services group of $6.6 million related to the timing of
collections.
  The
decrease in other current and non-current assets relates primarily to a decrease
in income taxes receivable due to $10.0 million in income tax refunds received
during the quarter ended July 31, 2007, partially offset by an increase in other
current and non-current assets of $2.2 million within our DVD and CD Fulfillment
group.
  The
decrease in accounts payable and other liabilities relates primarily to a
decrease in accounts payable within our DVD and CD Fulfillment group of $53.7
million primarily related to a shift in product mix away from CDs and toward
DVDs, which have traditionally shorter payment terms than CDs, and a decrease in
accrued expenses of $7.8 million within our Shared Services group related to
payment of severance and other amounts due to our former Chairman of the Board
and CEO, partially offset by an increase in accounts payable of $10.3 million
within our Periodical Fulfillment Services group related to the timing of
payments to retailers.
  The
increase in inventories relates primarily to an increase in inventories of $13.2
million within our Periodical Fulfillment Services group related primarily to
the timing of shipments and increased consignment inventory, partially offset by
a decrease in inventory within our DVD and CD Fulfillment group of $6.2 million
related primarily to the timing of purchases and shipments and
seasonality.
  
 Investing
Cash Flow
  Net cash
used by investing activities was $62.6 million for the six months ended July 31,
2008 compared with cash provided by investing activities of $9.8 million for
same period last year.
  For the
six months ended July 31, 2008, cash used by investing activities consisted
primarily of the $42.0 million in cash paid to purchase the remaining minority
interest in Automotive.com, Inc.Capital expenditures of $19.0 million made up
the majority of the remaining net cash used.
  For the
six months ended July 31, 2007, cash provided by investing activities consisted
primarily of $9.8 million received from the sale of our Wood Manufacturing group
and $11.9 million received from net collections of advance pay claims, offset by
$9.4 million in capital expenditures and $2.6 million of other investing
expenditures primarily related to the payment of acquisition costs related to
the acquisition of SIM.
   34
  
 Financing
Cash Flow
  Outstanding
balances on our credit facility fluctuate partially due to the timing of the
retailer rebate claiming process and our Advance Pay program, the seasonality of
our front end wire and services business and the payment cycles of the DVD and
CD and magazine fulfillment businesses. Because the magazine distribution
business and Advance Pay program cash requirement usually peaks during the
middle of the fiscal quarter, the reported bank debt levels usually are the
minimum level outstanding during that quarter. Our DVD and CD Fulfillment group
has historically generated approximately 33% of its total net sales in the
fourth calendar quarter coinciding with the holiday shopping season and
therefore requires greater borrowings in the third quarter to finance the
buildup of inventory.
 
 Payments
under our Advance Pay program generally occur just prior to our fiscal quarter
end. The related claims are not generally collected by us until 30-60 days after
the advance is made. As a result, our funding requirements peak at the time of
the initial advances and decrease over this period as the cash is collected on
the related claims.
  The front
end display fixture manufacturing and services business is seasonal because most
retailers prefer initiating new programs before the holiday shopping season
begins, which concentrates revenues in the second and third quarter. Receivables
from these programs are generally collected from all participants within 180
days. We are usually required to tender payment on the costs of these programs
(raw material and labor) within a shorter period. As a result, our funding
requirements peak in the second and third fiscal quarters when we manufacture
the fixtures, and decrease significantly in the fourth and first fiscal quarters
as the related receivable are collected and significantly less manufacturing
activity is occurring.
  Net cash
provided by financing activities was $21.1 million for the six months ended July
31, 2008 versus cash used in financing activities of $8.9 million for the same
period last year.
  Financing
activities in the six months ended July 31, 2008 consisted primarily of $49.6
million in borrowings on our revolving credit facility and $0.7 million from the
excess tax benefit from the exercise of stock options.These amounts were offset
by payments of financing fees, notes payable and capital leases, and deferred
purchase price liabilities of $12.4 million, $9.5 million and $7.3 million,
respectively.
  Financing
activities in the six months ended July 31, 2007 consisted primarily of
repayments under our revolving credit facility of $9.1 million and a decrease in
checks issued against future borrowings under the revolving credit facility of
$1.4 million, offset by net borrowings under notes payable and capital leases of
$0.5 million, and cash provided by the exercise of stock options of $1.1
million.
  
 Debt
  For a
detailed description of the terms of our significant debt instruments, please
refer to Note 6 to our Consolidated Financial Statements.
  In
connection with our acquisition of SIM, we issued three new credit facilities on
August 1, 2007.These facilities consist of a $300.0 million asset-based
revolving facility that had a balance of $49.6 million at July 31, 2008, an
$880.0 million term loan facility that amortizes 1.0% per year, and a $465.0
million bridge loan which we refinanced on June 26, 2008.We expect to pay
interest on these facilities with cash flow generated from
operations.
  Off-Balance
Sheet Arrangements
  We do not
engage in transactions or arrangements with unconsolidated or other special
purpose entities as defined by Item 303(a) (4) of Regulation S-K.
  
  35
  
 ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
  Our
primary market risks include fluctuations in interest rates and exchange rate
variability.
  Our debt
primarily relates to credit facilities with Citicorp North America, Inc and
long-term financing in the form of Senior Notes.See Note 6 to our Consolidated
Financial Statements.
  The
revolving credit facility with Citicorp North America had an outstanding
principal balance of $49.6 million at July 31, 2008. There were outstanding
balances of $871.2 million and $465.0 million as of July 31, 2008 on our Term
Loan B and Senior Notes, respectively.Interest on the outstanding balance of the
revolver is charged at Prime plus a margin of 0.50%.Interest on the outstanding
balance of the Term Loan B is charged based on LIBOR (2.463% at July 31, 2008)
plus a margin of 3.25%.Interest on the Senior Notes is charged at 11.25%,
fixed.
  As a
result of the above, our primary market risks relate to fluctuations in interest
rates.On April 11, 2008, the Company entered into an interest rate swap
agreement with Wachovia Bank, N.A. to hedge the Company’s exposure to
fluctuations in LIBOR.The notional amount of this swap is $210.0 million.A 1.0%
increase in the prevailing interest rate on our debt at July 31, 2008 is
estimated to cause an increase of $4.7 million in interest expense for the
remainder of the year ending January 31, 2009.The swap would provide protection
against approximately $1.1 million of the above increase.
  ITEM 4.
CONTROLS AND PROCEDURES
  Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, we conducted an
evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report (the
“Evaluation Date”).
  Attached
as exhibits to this Quarterly Report are certifications of our principal
executive officer and chief financial officer, which are required in accordance
with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (“Exchange
Act”). The information appearing below should be read in conjunction with the
certifications for a more complete understanding of the topics
presented.
  About
Disclosure Controls
  Disclosure
controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) of the
Exchange Act) are designed to provide assurance that the information concerning
us and our consolidated subsidiaries, which is required to be included in our
reports and statements filed or submitted under the Exchange Act, as amended,
(i) is accumulated and communicated to our management, including our principal
executive officer and principal financial officer, as appropriate to allow
timely decisions required disclosure and (ii) is recorded, processed, summarized
and reported within the time periods specified in rules and forms of the
SEC.
  Limitations
on the Effectiveness of Controls
  Our
management, including our principal executive officer and chief financial
officer, do not expect that our disclosure controls and procedures will prevent
all error and all fraud. A control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the control
system’s objectives will be met. Further, the design of a control system must
reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty and that breakdowns
can occur because of simple error or mistake. Controls can also be circumvented
by the individual acts of some persons, by collusion of two or more people, or
by management override of the controls. The design of any system of controls is
based in part on certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions. Over time, controls may become
inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.
  36
  
  Scope
of the Controls Evaluation
  The
evaluation of our disclosure controls and procedures included a review of the
controls’ objectives and design, the Company’s implementation of the controls
and the effect of the controls on the information generated for use in this
Quarterly Report. In the course of the controls evaluation, we sought to
identify data errors, control problems or acts of fraud and confirm that
appropriate corrective action, including process improvements, were being
undertaken. This type of evaluation is performed on a quarterly basis so that
the conclusions of management, including the chief executive officer and the
chief financial officer, concerning the effectiveness of the controls can be
reported in our Quarterly Reports on Form 10-Q and to supplement our disclosures
made in our Annual Report on Form 10-K. Many of the components of our disclosure
controls and procedures are also evaluated on an ongoing basis by our Internal
Audit Department and by other personnel in our finance organization. The overall
goals of these various evaluation activities are to monitor our disclosure
controls and procedures, and to modify them as necessary. Our intent is to
maintain the disclosure controls and procedures as dynamic systems that change
as conditions warrant.
  Conclusions
  Based on
this evaluation, our principal executive officer and our chief financial
officer, have concluded that, subject to the limitations noted above, as of the
end of the period covered by this report, our disclosure controls and procedures
were effective to ensure that information we are required to disclose in reports
that we file or submit under the Exchange Act is recorded, processed, summarized
and reported within the time periods specified in SEC rules and forms and
include controls and procedures designed to ensure that information required to
be disclosed by the Company in such reports is accumulated and communicated to
the Company’s management, including the principal executive officer and the
chief financial officer, as appropriate to allow timely decisions regarding
required disclosure.
  Changes
in Internal Controls over Financial Reporting
  There
were no changes in the Company’s internal controls over financial reporting (as
defined in Rule 13a-15f of the Exchange Act) that occurred during the fiscal
quarter ended July 31, 2008 that have materially affected, or are reasonably
likely to materially affect those controls.
  
  37
  
 PART
II – OTHER INFORMATION
  ITEM 1.
LEGAL PROCEEDINGS.
  We are
party to routine legal proceedings arising out of the normal course of
business.Although it is not possible to predict with certainty the outcome of
these unresolved legal actions of the range of possible loss, we believe that
none of these actions, individually or in the aggregate, will have a material
adverse effect on our financial condition or results of operations.
  ITEM 1A.
RISK FACTORS.
  Refer to
our Annual Report on Form 10-K filed April 15, 2008 as amended May 30,
2008.
  ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
  Not
Applicable.
  ITEM 3.
DEFAULTS UPON SENIOR SECURITIES.
  Not
Applicable.
  ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
  Not
Applicable.
  ITEM 5.
OTHER INFORMATION.
  Not
Applicable.
  ITEM 6.
EXHIBITS.
  See
Exhibit Index.
  
  38
  
 SIGNATURES
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
  SOURCE
      INTERLINK COMPANIES, INC.September
      5, 2008
              By:
              /s/
      Marc FiermanMarc
      FiermanChief
      Financial Officer(Principal
      Financial Officer)
 
  
  39
  
 EXHIBIT
INDEX
  Exhibit
      No.
              
              Description3.10.3
              
              Amendment
      No. 3 to the Amended and Restated Bylaws of Source Interlink Companies,
      Inc. incorporated by reference to exhibit 3.10.3 to Current Report on Form
      8-K, as filed with the SEC on September 3, 2008 (File No.
      001-13437).4.1
              
              Registration
      Rights Agreement, dated as of June 26, 2008, by and between Source
      Interlink Companies, Inc., certain subsidiaries of Source Interlink
      Companies, Inc., Citigroup Global Markets Inc., J.P. Morgan
      Securities Inc., Citicorp North America Inc., JPMorgan Chase Bank N.A.,
      incorporated by reference to exhibit 4.1 to Current Report on Form 8-K, as
      filed with the SEC on July 1, 2008 (File No. 001-13437).4.2
              
              Indenture,
      dated as of June 23, 2008, by and between Source Interlink
      Companies, Inc., certain subsidiaries of Source Interlink
      Companies, Inc. and HSBC Bank USA, National Association relating to
      Source Interlink Companies, Inc. 11.25% Senior Notes due 2015,
      incorporated by reference to exhibit 4.2 to Current Report on Form 8-K, as
      filed with the SEC on July 1, 2008 (File No. 001-13437).4.3
              
              Specimen
      of Source Interlink Companies, Inc. 11.25% Senior Note due 2015,
      incorporated by reference to exhibit 4.3 to Current Report on Form 8-K, as
      filed with the SEC on July 1, 2008 (File No. 001-13437).14.1
              
              Code
      of Business Conduct and Ethics of Source Interlink Companies, Inc., a
      Delaware corporation, incorporated by reference to exhibit 14.1 to Current
      Report on Form 8-K, as filed with the SEC on June 4, 2008 (File No.
      001-13437).31.1*
              
              Rule
      13a-14(a)/15d-14(a) Certification of Principal Executive
      Officer.31.2*
              
              Rule
      13a-14(a)/15d-14(a) Certification of Principal Financial
      Officer.32.1*
              
              Section
      1350 Certification of Principal Executive Officer and Principal Financial
      Officer.
 
 * Filed
Herewith