**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

| **x**                                                                                                                                                          | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                           |
| **For the  quarterly period ended    July 31, 2007**                                                                                       |
| ** **                                                                                                                                                     | ** ** | ** **                                                                                    |
| **or**                                                                                                                                                         |
|                                                                                                                                                           |       |                                                                                          |
| **o**                                                                                                                                                          | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                           | ** ** | ** **                                                                                    |
| **For the  transition period from                     to** |
| ** **                                                                                                                                                     |
| **Commission  file 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 markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

x Yes      o No

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerate filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.  (Check one):

| o Large  accelerated filer |   | x Accelerated  filer |   | o Non-accelerated  filer |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.  (Check one)

o Yes      x No

As of September 4,2007, there were 52,320,837 shares of the Company’s common stock outstanding.

 

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**TABLE OFCONTENTS**
|                                         | ** ** | ** **                                                                                    | ** ** | **Page** |
|-----------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|----------|
|                                    |       |                                                                                          |       |     |
| **PART I – FINANCIAL INFORMATION** | ** ** | ** **                                                                                    |
|                                    |       |                                                                                          |       |     |
| ITEM 1.                                 |       | FINANCIAL  STATEMENTS.                                                                        |       | 3        |
|                                    |       |                                                                                          |       |     |
| ITEM 2.                                 |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS. |       | 20       |
|                                    |       |                                                                                          |       |     |
| ITEM 3.                                 |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.                                  |       | 34       |
|                                    |       |                                                                                          |       |     |
| ITEM 4.                                 |       | CONTROLS AND  PROCEDURES.                                                                     |       | 35       |
|                                    |       |                                                                                          |       |     |
| **PART II – OTHER  INFORMATION**   | ** ** | ** **                                                                                    |
|                                    |       |                                                                                          |       |     |
| ITEM 1.                                 |       | LEGAL PROCEEDINGS.                                                                            |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM  1A.                               |       | RISK  FACTORS.                                                                                |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM 2.                                 |       | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.                                 |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM 3.                                 |       | DEFAULTS UPON  SENIOR SECURITIES.                                                             |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM 4.                                 |       | SUBMISSION OF MATTERS  TO A VOTE OF SECURITY HOLDERS.                                         |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM 5.                                 |       | OTHER INFORMATION.                                                                            |       | 37       |
|                                    |       |                                                                                          |       |     |
| ITEM  6.                                |       | EXHIBITS.                                                                                     |       | 37       |
|                                         |            |                                                                                               |            |          |  |  |

 

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**PART I – FINANCIAL INFORMATION**

ITEM 1. FINANCIALSTATEMENTS.

**INDEX OFFINANCIAL STATEMENTS**
|                                                                                                             | ** ** | **Page** |
|-------------------------------------------------------------------------------------------------------------|------------|----------|
|                                                                                                        |       |     |
| Consolidated  Balance Sheets as of July 31, 2007 (unaudited) and January 31, 2007.                          |       | 4        |
|                                                                                                        |       |     |
| Consolidated Statements of Income for the three and  six months ended July 31, 2007 and 2006   (unaudited). |       | 6        |
|                                                                                                        |       |     |
| Consolidated Statement of Stockholders’ Equity for the  six months ended July 31, 2007 (unaudited).    |       | 7        |
|                                                                                                        |       |     |
| Consolidated Statements of Cash Flows for the six  months ended July 31, 2007 and 2006 (unaudited).         |       | 8        |
|                                                                                                        |       |     |
| Notes to Consolidated Financial Statements                                                                  |       | 9        |

 

3

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**SOURCE INTERLINK COMPANIES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands)**
| ** **                                      | ** ** | **July 31,  2007** | ** ** | **January 31,  2007** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
| ** **                                      | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **Assets**                                      | ** ** | ** **              | ** ** | ** **                 | ** ** |
| Current assets                                  |       |                    |       |                       |       |
| Cash                                            |       | $                       | 10,490     |                       | $          | — |   |
| Trade  receivables, net                         |       | 61,366                  |       | 102,658                    |       |
| Purchased claims  receivable                    |       | 5,040                   |       | 16,983                     |       |
| Inventories                                     |       | 249,715                 |       | 248,941                    |       |
| Income tax  receivable                          |       | —                  |       | 9,932                      |       |
| Deferred tax  asset                             |       | 29,820                  |       | 29,531                     |       |
| Other                                           |       | 8,784                   |       | 5,440                      |       |
|                                            |       |                    |       |                       |       |
| Total current  assets                           |       | 365,215                 |       | 413,485                    |       |
|                                            |       |                    |       |                       |       |
| Property, plants  and equipment                 |       | 98,838                  |       | 98,812                     |       |
| Less accumulated  depreciation and amortization |       | (32,239                 | )          | (30,897                    | )          |
|                                            |       |                    |       |                       |       |
| Net property,  plants and equipment             |       | 66,599                  |       | 67,915                     |       |
|                                            |       |                    |       |                       |       |
| Other assets                                    |       |                    |       |                       |       |
| Goodwill, net                                   |       | 396,041                 |       | 395,902                    |       |
| Intangibles, net                                |       | 112,555                 |       | 118,971                    |       |
| Other                                           |       | 19,680                  |       | 13,758                     |       |
|                                            |       |                    |       |                       |       |
| Total other assets                              |       | 528,276                 |       | 528,631                    |       |
|                                            |       |                    |       |                       |       |
| Total assets                                    |       | $                       | 960,090    |                       | $          | 1,010,031 |   |

 

*Seeaccompanying notes to Consolidated Financial Statements.*

4

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**SOURCE INTERLINK COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS(CONCLUDED)**

**(in thousands, except per share amounts)**
| ** **                                                                                                                    | ** ** | **July 31,  2007** | ** ** | **January 31,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                    | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
|                                                                                                                          |       |                    |       |                       |       |
| **Liabilities  and Stockholders’ Equity**                                                                                | ** ** | ** **              | ** ** | ** **                 | ** ** |
| Current liabilities                                                                                                           |       |                    |       |                       |       |
| Checks issued against future advances on revolving  credit facility                                                           |       | $                       | —     |                       | $          | 1,465 |   |
| Accounts payable (net of allowance for returns of  $141,654 and $164,069 at July 31, 2007 and January 31, 2007, respectively) |       | 266,764                 |       | 308,184                    |       |
| Accrued expenses                                                                                                              |       | 58,128                  |       | 62,838                     |       |
| Deferred revenue                                                                                                              |       | 1,894                   |       | 2,630                      |       |
| Current portion of obligations under capital leases                                                                           |       | 1,343                   |       | 995                        |       |
| Current maturities of debt                                                                                                    |       | 8,157                   |       | 7,850                      |       |
| Income Tax Payable                                                                                                            |       | 1,884                   |       | —                     |       |
|                                                                                                                          |       |                    |       |                       |       |
| Total current liabilities                                                                                                     |       | 338,170                 |       | 383,962                    |       |
|                                                                                                                          |       |                    |       |                       |       |
| Deferred tax liability                                                                                                        |       | 32,451                  |       | 32,500                     |       |
| Obligations under capital leases                                                                                              |       | 1,046                   |       | 1,069                      |       |
| Debt, less current maturities                                                                                                 |       | 137,322                 |       | 146,534                    |       |
| Other                                                                                                                         |       | 5,267                   |       | 6,519                      |       |
|                                                                                                                          |       |                    |       |                       |       |
| Total liabilities                                                                                                             |       | 514,256                 |       | 570,584                    |       |
|                                                                                                                          |       |                    |       |                       |       |
| Commitments and contingencies                                                                                                 |       |                    |       |                       |       |
|                                                                                                                          |       |                    |       |                       |       |
| Stockholders’ equity                                                                                                     |       |                    |       |                       |       |
| Contributed capital:                                                                                                          |       |                    |       |                       |       |
| Preferred stock, $0.01 par (2,000 shares authorized;  none issued)                                                            |       | —                  |       | —                     |       |
| Common stock, $0.01 par (100,000 shares authorized;  52,321 and 52,064 shares issued)                                         |       | 523                     |       | 521                        |       |
| Additional paid-in-capital                                                                                                    |       | 476,078                 |       | 474,796                    |       |
|                                                                                                                          |       |                    |       |                       |       |
| Total contributed capital                                                                                                     |       | 476,601                 |       | 475,317                    |       |
| Accumulated deficit                                                                                                           |       | (33,721                 | )          | (37,766                    | )          |
| Accumulated other comprehensive income: Foreign  currency translation                                                         |       | 2,954                   |       | 1,896                      |       |
|                                                                                                                          |       |                    |       |                       |       |
| Total stockholders’ equity                                                                                               |       | 445,834                 |       | 439,447                    |       |
|                                                                                                                          |       |                    |       |                       |       |
| Total liabilities and  stockholders’ equity                                                                              |       | $                       | 960,090    |                       | $          | 1,010,031 |   |

 

*Seeaccompanying notes to Consolidated Financial Statements.*

5

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**SOURCE INTERLINK COMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(inthousands, except per share amounts)**

**(unaudited)**
| ** **                                                                                          | ** ** | **Three months ended July 31,** | ** ** | **Six months ended July 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                                                                                            |       | $                                                   | 434,147    |                                              | $          | 433,308 |   | $ | 909,552 |   | $ | 881,202 |   |
| Cost of revenues  (including depreciation of $218, $139, $435 and $294)                             |       | 340,658                                             |       | 339,199                                           |       | 716,569 |   | 698,123 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Gross profit                                                                                        |       | 93,489                                              |       | 94,109                                            |       | 192,983 |   | 183,079 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Selling, general  and administrative expense                                                        |       | 55,266                                              |       | 54,074                                            |       | 113,357 |   | 108,142 |   |
| Fulfillment  freight                                                                                |       | 24,493                                              |       | 25,092                                            |       | 50,248 |   | 47,027 |   |
| Depreciation and  amortization                                                                      |       | 6,985                                               |       | 6,011                                             |       | 13,821 |   | 11,815 |   |
| Relocation,  integration and consolidation expenses                                                 |       | 324                                                 |       | 715                                               |       | 324 |   | 715 |   |
| Gain on sale of  assets                                                                             |       | (173                                                | )          | —                                            |       | (173 | ) | — |   |
| Impairment of  land and building held for sale                                                      |       | —                                              |       | —                                            |       | — |   | 529 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Operating income                                                                                    |       | 6,594                                               |       | 8,217                                             |       | 15,406 |   | 14,851 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Other income  (expense):                                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Interest expense (including amortization of deferred  financing fees of $150, $168, $300, and $300) |       | (2,894                                              | )          | (2,868                                            | )          | (6,461 | ) | (5,135 | ) |
| Interest income                                                                                     |       | 238                                                 |       | 44                                                |       | 279 |   | 112 |   |
| Other                                                                                               |       | 128                                                 |       | 56                                                |       | 199 |   | 75 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Total other expense                                                                                 |       | (2,528                                              | )          | (2,768                                            | )          | (5,983 | ) | (4,948 | ) |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Income from  continuing operations, before income taxes                                             |       | 4,066                                               |       | 5,449                                             |       | 9,423 |   | 9,903 |   |
| Income tax  expense                                                                                 |       | 1,627                                               |       | 2,211                                             |       | 3,770 |   | 3,803 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Income from  continuing operations                                                                  |       | 2,439                                               |       | 3,238                                             |       | 5,653 |   | 6,100 |   |
| Discontinued  operation, net of income taxes                                                        |       | (222                                                | )          | 856                                               |       | (1,608 | ) | 1,253 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                                                                          |       | $                                                   | 2,217      |                                              | $          | 4,094 |   | $ | 4,045 |   | $ | 7,353 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Earnings per  share – basic                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Continuing operations                                                                               |       | $                                                   | 0.04       |                                              | $          | 0.06 |   | $ | 0.11 |   | $ | 0.12 |   |
| Discontinued operation                                                                              |       | —                                              |       | 0.02                                              |       | (0.03 | ) | 0.02 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Total                                                                                               |       | $                                                   | 0.04       |                                              | $          | 0.08 |   | $ | 0.08 |   | $ | 0.14 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Earnings per  share – diluted                                                                  |       |                                                |       |                                              |       |   |   |   |   |
| Continuing operations                                                                               |       | $                                                   | 0.04       |                                              | $          | 0.06 |   | $ | 0.11 |   | $ | 0.12 |   |
| Discontinued operation                                                                              |       | —                                              |       | 0.02                                              |       | (0.03 | ) | 0.02 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Total                                                                                               |       | $                                                   | 0.04       |                                              | $          | 0.08 |   | $ | 0.08 |   | $ | 0.14 |   |
|                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Weighted average  common shares outstanding – basic                                            |       | 52,304                                              |       | 51,811                                            |       | 52,230 |   | 51,760 |   |
| Weighted average common  shares outstanding – diluted                                          |       | 52,441                                              |       | 53,291                                            |       | 52,538 |   | 53,223 |   |

 

*Seeaccompanying notes to Consolidated Financial Statements.*

6

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**SOURCE INTERLINK COMPANIES, INC.**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(inthousands)**

**(unaudited)**
| ** **                                       | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Accumulated**          | ** ** | **Accumulated  Other   Comprehensive ** | ** ** | **Total  Stockholders’ ** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|---------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid-in Capital** | ** ** | **Deficit**                                       | ** ** | **Income**                          | ** ** | **Equity** | ** ** |
|                                             |       |                  |       |           |       |                     |       |                                              |       |                                |       |   |   |
| Balance, January  31, 2007                       |       | 52,064                |       | $              | 521        |                     | $          | 474,796                                           |       | $                                   | (37,766    | ) | $ | 1,896 |   | $ | 439,447 |   |
|                                             |       |                  |       |           |       |                     |       |                                              |       |                                |       |   |   |
| Net income                                       |       | —                |       | —         |       | —                   |       | 4,045                                             |       | —                              |       | 4,045 |   |
| Foreign currency  translation                    |       | —                |       | —         |       | —                   |       | —                                            |       | 1,058                               |       | 1,058 |   |
|                                             |       |                  |       |           |       |                     |       |                                              |       |                                |       |   |   |
| Comprehensive  income                            |       | —                |       | —         |       | —                   |       | —                                            |       | —                              |       | 5,103 |   |
|                                             |       |                  |       |           |       |                     |       |                                              |       |                                |       |   |   |
| Stock  compensation expense                      |       | —                |       | —         |       | 179                      |       | —                                            |       | —                              |       | 179 |   |
| Exercise of  stock options                       |       | 258                   |       | 2              |       | 714                      |       | —                                            |       | —                              |       | 716 |   |
| Excess tax  benefit from stock options exercised |       | —                |       | —         |       | 389                      |       | —                                            |       | —                              |       | 389 |   |
|                                             |       |                  |       |           |       |                     |       |                                              |       |                                |       |   |   |
| Balance, July 31, 2007                           |       | 52,322                |       | $              | 523        |                     | $          | 476,078                                           |       | $                                   | (33,721    | ) | $ | 2,954 |   | $ | 445,834 |   |

 

*Seeaccompanying notes to Consolidated Financial Statements.*

7

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**SOURCE INTERLINK COMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**
| ** **                                                                                   | ** ** | **Six months ended July 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
|                                                                                         |       |                                              |       |   |   |
| **Operating  Activities**                                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net income                                                                                   |       | $                                                 | 4,045      |   | $ | 7,353 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                                |       | 14,674                                            |       | 12,664 |   |
| Provision for losses on accounts receivable                                                  |       | 1,838                                             |       | 2,214 |   |
| Deferred revenue                                                                             |       | (736                                              | )          | (711 | ) |
| Stock compensation expense                                                                   |       | 179                                               |       | 416 |   |
| Loss on sale of discontinued operation                                                       |       | 730                                               |       | — |   |
| Impairment of land and building held for sale                                                |       | —                                            |       | 529 |   |
| Other                                                                                        |       | 686                                               |       | (1,424 | ) |
| Changes in assets and liabilities (excluding  business acquisitions):                        |       |                                              |       |   |   |
| Decrease in accounts receivable                                                              |       | 36,307                                            |       | 7,427 |   |
| (Increase) decrease in inventories                                                           |       | (6,479                                            | )          | 13,713 |   |
| Decrease (increase) in other current and non-current  assets                                 |       | 7,470                                             |       | (3,199 | ) |
| Decrease in accounts payable and other liabilities                                           |       | (49,202                                           | )          | (80,975 | ) |
|                                                                                         |       |                                              |       |   |   |
| Cash provided by  (used in) operating activities                                             |       | 9,512                                             |       | (41,993 | ) |
|                                                                                         |       |                                              |       |   |   |
| **Investment  Activities**                                                                   | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Capital expenditures                                                                         |       | (9,436                                            | )          | (6,460 | ) |
| Purchase of claims                                                                           |       | (47,587                                           | )          | (58,541 | ) |
| Payments received on purchased claims                                                        |       | 59,531                                            |       | 57,840 |   |
| Proceeds from sale of wood manufacturing division,  net of cash transferred                  |       | 9,828                                             |       | — |   |
| Acquisition of Anderson Mid-Atlantic News, LLC, net  of cash acquired                        |       | —                                            |       | (13,652 | ) |
| Acquisition of Anderson SCN Services, LLC, net of  cash acquired                             |       | —                                            |       | (26,081 | ) |
| Proceeds from sale of fixed assets                                                           |       | 54                                                |       | 51 |   |
| Other                                                                                        |       | (2,553                                            | )          | (1,330 | ) |
|                                                                                         |       |                                              |       |   |   |
| Cash provided by  (used in) investing activities                                             |       | 9,837                                             |       | (48,173 | ) |
|                                                                                         |       |                                              |       |   |   |
| **Financing  Activities**                                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Decrease in checks issued against revolving credit  facilities                               |       | (1,383                                            | )          | — |   |
| (Repayments) borrowings under credit facilities                                              |       | (9,079                                            | )          | 71,905 |   |
| Net borrowings (payments) on notes payable and  capital leases                               |       | 498                                               |       | (5,096 | ) |
| Proceeds from the issuance of common stock                                                   |       | 716                                               |       | 1,351 |   |
| Excess tax benefit from exercise of stock options                                            |       | 389                                               |       | 1,164 |   |
|                                                                                         |       |                                              |       |   |   |
| Cash (used in)  provided by financing activities                                             |       | (8,859                                            | )          | 69,324 |   |
|                                                                                         |       |                                              |       |   |   |
| Increase  (decrease) in cash                                                                 |       | 10,490                                            |       | (20,842 | ) |
| Cash, beginning  of period                                                                   |       | —                                            |       | 23,239 |   |
|                                                                                         |       |                                              |       |   |   |
| Cash, end of period                                                                          |       | $                                                 | 10,490     |   | $ | 2,397 |   |

 

*Seeaccompanying notes to Consolidated Financial Statements.*

8

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**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

**1.  Nature of Business and Basis of Presentation**

Source Interlink Companies, Inc. (the “Company”) is a leading marketing, merchandising and fulfillment company of entertainment products including DVDs, music CDs, magazines, books and related items. The Company’s fully integrated businesses include:

·                  Distribution and fulfillment of entertainment products to major retail chains throughout North America and directly to consumers of entertainment products ordered through the Internet;

·                  Import and export of periodicals sold in more than 100 markets worldwide;

·                  Coordination of product selection and placement of impulse items sold at checkout counters at major retail chains throughout North America;

·                  Processing and collection of rebate claims as well as management of sales data obtained at the point-of-purchase; and

·                  Design, manufacture and installation of wire display fixtures in major retail chains throughout North America.

Source Interlink serves approximately 110,000 retail store locations throughout North America. Supply chain relationships include movie studios, record labels, magazine and newspaper publishers, confectionary companies and manufacturers of general merchandise.

The consolidated financial statements includedherein have been prepared by the Company, without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission.  In the opinion of the Company’s management,all adjustments (consisting only of normal recurring adjustments andreclassifications) necessary to present fairly our results of operationsand cash flows for the three and six months ended July 31, 2007 and 2006 and our financial position as of July 31, 2007, respectively have beenmade.  Theresults of operations for such interim periods are not necessarily indicativeof the operating results to be expected for the full year.

Certain information and disclosures normally included in the notes tothe annual consolidated financial statements have been condensed or omittedfrom these interim consolidated financial statements. Accordingly, theseinterim consolidated financial statements should be read in conjunction withthe consolidated financial statements and notes thereto included in our AnnualReport on Form 10-K (the “Annual Report”) for the fiscal year endedJanuary 31, 2007, as filed with the Securities and Exchange Commission (“SEC”)on April 25, 2007, as amended on May 31, 2007.

***Adoption o f FIN-48***

On February 1, 2007, the Company adopted FIN-48 –*Accounting for uncertainty in income taxes – aninterpretation of FASB statement No. 109*.  As a result of the adoption, the Companydetermined that it did not have any material uncertain tax positions which wererequired to be fully or partially de-recognized in its previously issuedfinancial statements.  Accrued interestand penalties on uncertain tax positions are classified as Income tax expensein the Company’s consolidated results of operations and are not material.

9

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

**2. Trade Receivables**

Trade receivables consistof the following:
| **(in thousands)** | ** ** | **July 31,  2007** | ** ** | **January 31,  2007** | ** ** |
|-------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **              | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
|                    |       |                    |       |                       |       |
| Trade  receivables      |       | $                       | 243,750    |                       | $          | 312,116 |   |
| Less allowances  for:   |       |                    |       |                       |       |
| Sales returns and other |       | 164,016                 |       | 192,328                    |       |
| Doubtful accounts       |       | 18,368                  |       | 17,130                     |       |
|                    |       |                    |       |                       |       |
| Total allowances        |       | 182,384                 |       | 209,458                    |       |
|                    |       |                    |       |                       |       |
| Trade receivables, net  |       | $                       | 61,366     |                       | $          | 102,658 |   |

 

**3. Inventories**

Inventories consist ofthe following:
| **(in thousands)**      | ** ** | **July 31,  2007** | ** ** | **January 31,  2007** | ** ** |
|------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
|                         |       |                    |       |                       |       |
| Raw materials                |       | $                       | 575        |                       | $          | 3,048 |   |
| Work-in-process              |       | 1,129                   |       | 2,519                      |       |
| Finished goods:              |       |                    |       |                       |       |
| Pre-recorded music and video |       | 127,016                 |       | 133,193                    |       |
| Magazines and books          |       | 120,603                 |       | 107,449                    |       |
| Display fixtures             |       | 392                     |       | 2,732                      |       |
|                         |       |                    |       |                       |       |
| Inventories                  |       | $                       | 249,715    |                       | $          | 248,941 |   |

 

In the event of non-sale,pre-recorded music and video, magazine and book inventories are generallyreturnable to the suppliers thereof for full credit.

**4. Debt and Revolving CreditFacility**

Debt consists of:
| **(in thousands)**                                | ** ** | **July 31,  2007** | ** ** | **January 31,  2007** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
|                                                   |       |                    |       |                       |       |
| Revolving credit  facility – Wells Fargo Foothill |       | $                       | 107,380    |                       | $          | 116,459 |   |
| Note payable –  Magazine import and export        |       | 2,112                   |       | 3,500                      |       |
| Note payable –  Former owner of Empire            |       | 233                     |       | 233                        |       |
| Note payable –  Arrangements with suppliers       |       | 9,329                   |       | 10,180                     |       |
| Mortgage loan –  Wachovia Bank                    |       | 19,250                  |       | 19,750                     |       |
| Equipment loans                                        |       | 7,175                   |       | 4,262                      |       |
|                                                   |       |                    |       |                       |       |
| Total debt                                             |       | 145,479                 |       | 154,384                    |       |
| Less current  maturities                               |       | 8,157                   |       | 7,850                      |       |
|                                                   |       |                    |       |                       |       |
| Debt, less current  maturities                         |       | $                       | 137,322    |                       | $          | 146,534 |   |

 

10

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

***WellsFargo Foothill Credit Facility***

On February 28, 2005, theCompany modified its existing credit facility with Wells Fargo Foothill (“WFF”)as a result of its acquisition of Alliance. The primary changes from theoriginal line of credit were to (1) increase the maximum allowed advances underthe line of credit from $45.0 million to $250.0 million and (2) extend thematurity date from October 2009 to October 2010. In addition, in conjunctionwith the modification of the existing credit facility, the Company repaid thebalance of its $10.0 million WFF term loan. WFF, as arranger and administrativeagent for each of the parties that may become a participant in such arrangementand their successors (“Lenders”) will make revolving loans to us and oursubsidiaries of up to $250.0 million including the issuance of letters ofcredit. The terms and conditions of the arrangement are governed primarily bythe Amended and Restated Loan Agreement dated February 28, 2005 by and amongus, our subsidiaries, and WFF.

Outstanding borrowingsbear interest at a variable annual rate equal to the prime rate announced byWells Fargo Bank, National Association’s San Francisco office, plus a margin ofbetween 0.0% and 1.00% (applicable margin was 0.25% at July 31, 2007) basedupon a ratio of the Company’s EBITDA to interest expense (“Interest Coverage Ratio”).At July 31, 2007 the prime rate was 8.25%. We also have the option of selectingup to five traunches of at least $1 million each to bear interest at LIBOR plusa margin of between 2.00% and 3.00% based upon our Interest Coverage Ratio. TheCompany had no LIBOR contracts outstanding at July 31, 2007. To securerepayment of the borrowings and other obligations of ours to the Lenders, weand our subsidiaries granted a security interest in all of the personalproperty assets to WFF, for the benefit of the Lenders. These loans mature onOctober 31, 2010.

Under the creditagreement, the Company is limited in its ability to declare dividends or otherdistributions on capital stock or make payments in connection with thepurchase, redemption, retirement or acquisition of capital stock. There arealso limitations on capital expenditures and the Company is required tomaintain certain financial ratios.

Availability under thefacility is limited by the Company’s borrowing base calculation, as defined inthe agreement. The calculation resulted in excess availability, afterconsideration of outstanding letters of credit, of $46.3 million at July 31,2007.

See Note 10 – *Subsequent Event*,for discussion regarding payoff of existing revolving credit facility.

The aggregate amount ofdebt maturing through January 31, 2012 is as follows:
| **(in thousands)** | ** ** | **Amount** | ** ** |
|-------------------------|------------|------------|------------|
|                    |       |       |       |
| Fiscal year:            |       |       |       |
| Remainder of 2008       |       | $          | 4,601      |   |
| 2009                    |       | 6,385      |       |
| 2010                    |       | 3,949      |       |
| 2011                    |       | 109,880    |       |
| 2012                    |       | 2,514      |       |
| Thereafter              |       | 18,150     |       |
|                    |       |       |       |
| Total                   |       | $          | 145,479    |   |

 

11

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

At July 31, 2007 andJanuary 31, 2007, unamortized deferred financing fees were approximately $1.4million and $1.7 million, respectively. See Note 10 – *Subsequent Events*,for a discussion regarding payoff of existing revolving credit facility.

**5. Earnings per Share**

A reconciliation of thedenominators of the basic and diluted earnings per share computations are asfollows:
| ** **                                                                                                     | ** ** | **Three months ended July 31,** | ** ** | **Six months ended July 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Weighted average  common shares outstanding – basic                                                       |       | 52,304                                              |       | 51,811                                            |       | 52,216 |   | 51,760 |   |
| Dilutive effect  of stock options and warrants outstanding                                                     |       | 137                                                 |       | 1,480                                             |       | 322 |   | 1,463 |   |
|                                                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Weighted average  common shares outstanding – diluted                                                     |       | 52,441                                              |       | 53,291                                            |       | 52,538 |   | 53,223 |   |
|                                                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| The following  were not included in weighted average common shares outstanding because they  are antidilutive: |       |                                                |       |                                              |       |   |   |   |   |
|                                                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Stock options                                                                                                  |       | 1,823                                               |       | 221                                               |       | 1,747 |   | 330 |   |
| Warrants                                                                                                       |       | 101                                                 |       | 10                                                |       | 104 |   | 10 |   |
|                                                                                                           |       |                                                |       |                                              |       |   |   |   |   |
| Total                                                                                                          |       | 1,924                                               |       | 231                                               |       | 1,851 |   | 340 |   |

 

**6. Discontinued Operation**

On April 30, 2007, theCompany disposed of substantially all of the assets and liabilities of its WoodManufacturing division.  The Company soldthe assets and liabilities of its Wood Manufacturing division to a purchaser inwhich S. Leslie Flegel, the Company’s former Chairman of the Board and ChiefExecutive Officer, has an interest.  TheWood Manufacturing division was formerly reported as part of our In-StoreServices segment.  The book value of thenet assets sold on the closing date was $11.6 million.  The assets and liabilities of the WoodManufacturing division were sold for $10.0 million cash, and the issuance of anote payable to the Company in the face amount of $3.5 million, which bearsinterest at the 3-month LIBOR plus a margin of 2.00%.  The Company has determined that the note doesnot bear an interest rate equivalent to a market rate for the borrower.  Therefore, the Company has discounted thenote 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 workingcapital, the Company agreed to refund to the buyer $1.9 million in cash duringthe third quarter of fiscal 2008.  Forthe three and six months ended July 31, 2007 and 2006, the summary results forthe Wood Manufacturing division are as follows:
| ** **                                                      | ** ** | **Three months ended July 31,** | ** ** | **Six months ended July 31,** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                      | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                                                        |       | $                                                   | —     |                                              | $          | 8,198 |   | $ | 2,551 |   | $ | 14,904 |   |
| (Loss) income  from discontinued operation, before income taxes |       | —                                              |       | 1,376                                             |       | (1,463 | ) | 2,087 |   |
| Income tax  (benefit) expense                                   |       | —                                              |       | 520                                               |       | (585 | ) | 834 |   |
|                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Loss (income)  from discontinued operation                      |       | —                                              |       | 856                                               |       | (878 | ) | 1,253 |   |
|                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Loss on sale of  discontinued operation, before income taxes    |       | (370                                                | )          | —                                            |       | (1,217 | ) | — |   |
| Income tax  benefit                                             |       | (148                                                | )          | —                                            |       | (487 | ) | — |   |
|                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Loss on sale of  discontinued operation                         |       | (222                                                | )          | —                                            |       | (730 | ) | — |   |
|                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Discontinued operation,  net                                    |       | $                                                   | (222       | )                                                 | $          | 856 |   | $ | (1,608 | ) | $ | 1,253 |   |

 

12

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

**7. Supplemental Cash FlowInformation**

Supplemental informationon interest and income taxes paid is as follows:
| ** **                                         | ** ** | **Six months ended July 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(in thousands)**                            | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
|                                               |       |                                              |       |   |   |
| Interest                                           |       | $                                                 | 6,115      |   | $ | 4,694 |   |
| Income taxes (net of  receipts of $10,206 in 2007) |       | $                                                 | (9,839     | ) | $ | 7,178 |   |

 

As discussed in Note 6,the Company disposed of its Wood Manufacturing division for the totalconsideration of $13.5 million, including $3.5 million in the form of a notereceivable, of which the Company has agreed to refund $1.9 million to the buyerduring the third quarter of fiscal 2008.

**8. Stock-Based Compensation**

On February 1, 2006, theCompany adopted FAS No. 123(R), *Share-Based Payment*,and chose to transition using the modified prospective method.  On February 1, 2007, the Company grantedapproximately 0.1 million options to non-executive members of its board ofdirectors. The Company recognized stock compensation expense of approximately$0.2 million associated with this grant. Also on February 1, 2006, the Company granted approximately 0.1 millionoptions to non-executive members of its board of directors.  The Company recognized stock compensationexpense of approximately $0.3 million associated with this grant.

The fair value of eachoption grant is estimated on the grant date using the Black-Scholes optionpricing model with the following assumptions:
| ** **                                | ** ** | **Six months ended July 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
|                                      |       |                                              |       |   |   |
| Weighted average  dividend yield          |       | 0.0                                               | %          | 0.0 | % |
| Weighted average  expected volatility     |       | 36.9                                              | %          | 41.4 | % |
| Weighted average  expected life           |       | 3.1 years                                         |       | 3.1 years |   |
| Weighted average  risk-free interest rate |       | 4.8                                               | %          | 4.5 | % |

 

**9. Segment Financial Reporting**

The Company’s segmentreporting is based on the reporting of senior management to the chief operatingdecision maker. This reporting combines the Company’s business units in alogical way that identifies business concentrations and synergies.

13

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

The reportable segmentsof the Company are CD and DVD Fulfillment, Magazine Fulfillment, In-StoreServices, and Shared Services. The accounting policies of the segments arematerially the same as those described in the Summary of Accounting Policies.

The CD and DVDFulfillment segment derives revenues from (1) selling and distributingpre-recorded music, videos, video games and related products to retailers, (2)providing product and commerce solutions to “brick-and-mortar” and e-commerceretailers, and (3) providing consumer-direct fulfillment and vendor managedinventory services to its customers.

The Magazine Fulfillmentsegment derives revenues from (1) selling and distributing magazines, includingdomestic and foreign titles, to major specialty and mainstream retailers andwholesalers throughout the United States and Canada, (2) exporting domestictitles internationally to foreign wholesalers or through domestic brokers, (3)providing return processing services for major specialty retail book chains and(4) serving as an outsourced fulfillment agent.

The In-Store Servicessegment derives revenues from (1) providing claim filing services related torebates owed retailers from publishers or their designated agent, (2)designing, manufacturing, shipping, installation and removal of front-end displayfixtures, including high end wire and (3) providing information and managementservices relating to retail magazine sales to U.S. and Canadian retailers andmagazine publishers.

Shared Services consistsof overhead functions not allocated to individual operating segments.

The segment results areas follows:
| **(in thousands)**                            | ** ** | **CD and DVD  Fulfillment** | ** ** | **Magazine  Fulfillment** | ** ** | **In-Store  Services** | ** ** | **Shared Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------|------------|--------------------------|------------|------------------|------------|
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| **Three  months ended July 31, 2007**              | ** ** | ** **                            | ** ** | ** **                | ** ** | ** **             | ** ** | ** **               | ** ** | ** **       | ** ** |
| Revenues                                           |       | $                                     | 195,200    |                      | $          | 228,478                |       | $                        | 10,469     |             | $          | — |   | $ | 434,147 |   |
| Cost of revenues                                   |       | 158,647                               |       | 175,813                   |       | 6,198                  |       | —                   |       | 340,658          |       |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Gross profit                                       |       | 36,553                                |       | 52,665                    |       | 4,271                  |       | —                   |       | 93,489           |       |
| Selling, general and administrative expense        |       | 21,280                                |       | 28,443                    |       | 1,944                  |       | 3,599                    |       | 55,266           |       |
| Fulfillment freight                                |       | 7,232                                 |       | 17,261                    |       | —                 |       | —                   |       | 24,493           |       |
| Depreciation and amortization                      |       | 4,181                                 |       | 2,136                     |       | 122                    |       | 546                      |       | 6,985            |       |
| Relocation, integration and consolidation expenses |       | —                                |       | 324                       |       | —                 |       | —                   |       | 324              |       |
| Gain on sale of assets                             |       | —                                |       | —                    |       | (173                   | )          | —                   |       | (173             | )          |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Operating income                                   |       | $                                     | 3,860      |                      | $          | 4,501                  |       | $                        | 2,378      |             | $          | (4,145 | ) | $ | 6,594 |   |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| **As of  July 31, 2007**                           | ** ** | ** **                            | ** ** | ** **                | ** ** | ** **             | ** ** | ** **               | ** ** | ** **       | ** ** |
| Total assets                                       |       | $                                     | 497,919    |                      | $          | 342,830                |       | $                        | 68,567     |             | $          | 50,774 |   | $ | 960,090 |   |
| Goodwill, net                                      |       | $                                     | 201,532    |                      | $          | 169,875                |       | $                        | 24,634     |             | $          | — |   | $ | 396,041 |   |
| Intangibles, net                                   |       | $                                     | 76,472     |                      | $          | 35,001                 |       | $                        | 1,082      |             | $          | — |   | $ | 112,555 |   |

 

14

----

**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**
| **(in thousands)**                            | ** ** | **CD and DVD  Fulfillment** | ** ** | **Magazine  Fulfillment** | ** ** | **In-Store  Services** | ** ** | **Shared Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------|------------|--------------------------|------------|------------------|------------|
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| **Three  months ended July 31, 2006**              |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Revenues                                           |       | $                                     | 198,182    |                      | $          | 223,240                |       | $                        | 11,886     |             | $          | — |   | $ | 433,308 |   |
| Cost of revenues                                   |       | 160,487                               |       | 172,175                   |       | 6,537                  |       | —                   |       | 339,199          |       |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Gross profit                                       |       | 37,695                                |       | 51,065                    |       | 5,349                  |       | —                   |       | 94,109           |       |
| Selling, general and administrative expense        |       | 19,603                                |       | 26,648                    |       | 2,028                  |       | 5,795                    |       | 54,074           |       |
| Fulfillment freight                                |       | 7,505                                 |       | 17,587                    |       | —                 |       | —                   |       | 25,092           |       |
| Depreciation and amortization                      |       | 3,616                                 |       | 1,728                     |       | 143                    |       | 524                      |       | 6,011            |       |
| Relocation, integration and consolidation expenses |       | —                                |       | 547                       |       | —                 |       | 168                      |       | 715              |       |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Operating income                                   |       | $                                     | 6,971      |                      | $          | 4,555                  |       | $                        | 3,178      |             | $          | (6,487 | ) | $ | 8,217 |   |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| **As of  January 31, 2007**                        |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Total assets                                       |       | $                                     | 541,122    |                      | $          | 342,733                |       | $                        | 89,524     |             | $          | 36,652 |   | $ | 1,010,031 |   |
| Goodwill, net                                      |       | $                                     | 201,532    |                      | $          | 169,600                |       | $                        | 24,770     |             | $          | — |   | $ | 395,902 |   |
| Intangibles, net                                   |       | $                                     | 80,229     |                      | $          | 37,456                 |       | $                        | 1,286      |             | $          | — |   | $ | 118,971 |   |

 

 
| **(in thousands)**                            | ** ** | **CD and DVD  Fulfillment** | ** ** | **Magazine  Fulfillment** | ** ** | **In-Store  Services** | ** ** | **Shared Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------|------------|--------------------------|------------|------------------|------------|
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| **Six  months ended July 31, 2007**                | ** ** | ** **                            | ** ** | ** **                | ** ** | ** **             | ** ** | ** **               | ** ** | ** **       | ** ** |
| Revenues                                           |       | $                                     | 426,016    |                      | $          | 462,413                |       | $                        | 21,123     |             | $          | — |   | $ | 909,552 |   |
| Cost of revenues                                   |       | 349,522                               |       | 354,679                   |       | 12,368                 |       | —                   |       | 716,569          |       |
| Gross profit                                       |       | 76,494                                |       | 107,734                   |       | 8,755                  |       | —                   |       | 192,983          |       |
| Selling, general and administrative expense        |       | 42,893                                |       | 58,758                    |       | 3,924                  |       | 7,782                    |       | 113,357          |       |
| Fulfillment freight                                |       | 14,933                                |       | 35,315                    |       | —                 |       | —                   |       | 50,248           |       |
| Depreciation and amortization                      |       | 8,216                                 |       | 4,239                     |       | 243                    |       | 1,123                    |       | 13,821           |       |
| Relocation, integration and consolidation expenses |       | —                                |       | 324                       |       | —                 |       | —                   |       | 324              |       |
| Gain on sale of assets                             |       | —                                |       | —                    |       | (173                   | )          | —                   |       | (173             | )          |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Operating income                                   |       | $                                     | 10,452     |                      | $          | 9,098                  |       | $                        | 4,761      |             | $          | (8,905 | ) | $ | 15,406 |   |
|                                               |       |                                  |       |                      |       |                   |       |                     |       |             |       |
| Capital Expenditures                               |       | $                                     | 2,966      |                      | $          | 3,687                  |       | $                        | 351        |             | $          | 2,432 |   | $ | 9,436 |   |

 

 
| **(in thousands)**                            | ** ** | **CD and DVD  Fulfillment** | ** ** | **Magazine  Fulfillment** | ** ** | **In-Store   Services** | ** ** | **Shared Services** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|------------------------------|------------|--------------------------|------------|------------------|------------|
|                                               |       |                                  |       |                      |       |                         |       |                     |       |             |       |
| **Six  months ended July 31, 2006**                |       |                                  |       |                      |       |                         |       |                     |       |             |       |
| Revenues                                           |       | $                                     | 438,872    |                      | $          | 418,219                      |       | $                        | 24,111     |             | $          | — |   | $ | 881,202 |   |
| Cost of revenues                                   |       | 359,991                               |       | 324,300                   |       | 13,832                       |       | —                   |       | 698,123          |       |
|                                               |       |                                  |       |                      |       |                         |       |                     |       |             |       |
| Gross profit                                       |       | 78,881                                |       | 93,919                    |       | 10,279                       |       | —                   |       | 183,079          |       |
| Selling, general and administrative expense        |       | 41,408                                |       | 50,754                    |       | 4,012                        |       | 11,968                   |       | 108,142          |       |
| Fulfillment freight                                |       | 16,249                                |       | 30,778                    |       | —                       |       | —                   |       | 47,027           |       |
| Depreciation and amortization                      |       | 7,074                                 |       | 3,379                     |       | 288                          |       | 1,074                    |       | 11,815           |       |
| Relocation, integration and consolidation expenses |       | —                                |       | 547                       |       | —                       |       | 168                      |       | 715              |       |
| Impairment of land and building held for sale      |       | —                                |       | —                    |       | —                       |       | 529                      |       | 529              |       |
|                                               |       |                                  |       |                      |       |                         |       |                     |       |             |       |
| Operating income                                   |       | $                                     | 14,150     |                      | $          | 8,461                        |       | $                        | 5,979      |             | $          | (13,739 | ) | $ | 14,851 |   |
|                                               |       |                                  |       |                      |       |                         |       |                     |       |             |       |
| Capital  Expenditures                              |       | $                                     | 3,026      |                      | $          | 1,127                        |       | $                        | 240        |             | $          | 2,067 |   | $ | 6,460 |   |

 

15

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**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

Approximately $13.2million and $8.6 million of the Company’s total revenues in the MagazineFulfillment segment for the three months ended July 31, 2007 and 2006,respectively, and $25.9 million and $17.5 million of the Company’s totalrevenues in the Magazine Fulfillment segment for the six months ended July 31,2007 and 2006, respectively were derived from the export of U.S. publicationsto overseas markets. At July 31, 2007 and January 31, 2007, identifiable assetsattributable to the export of U.S. publications were $30.1 million and $27.2million.

16

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**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

**(unaudited)**

**10.Subsequent Events**

On August 1, 2007, theCompany completed its acquisition (the “Acquisition”) of PRIMEDIA EnthusiastMedia Inc. (“Enthusiast Media”), one of the largest providers of print anddigital content to the enthusiast community in the United States, from ConsumerSource, Inc. (“Consumer”) for a purchase price of approximately $1.178 billionin cash, subject to post closing adjustments. The Acquisition was effectuated pursuant to a stock purchase agreement(the “Purchase Agreement”) dated as of May 13, 2007, by and between, Consumerand PRIMEDIA, Inc. (“Primedia”).

In connection with theAcquisition, the Company indirectly acquired 80.1% of Automotive.com, Inc. (“Automotive.com”),a subsidiary of Enthusiast Media.  In accordance with the PurchaseAgreement, the Company assumed Primedia’s obligations to make certain paymentsto the minority shareholders of Automotive.com, as provided for in theAutomotive.com, Inc. Stockholders Agreement (the “Automotive.com StockholdersAgreement”), dated as of November 15, 2005, by and among PRIMEDIA Inc.,Automotive.com, and the certain Automotive.com shareholders and optionsholders.  The Company may acquire theremaining 19.9% of Automotive.com’s stock in 2009 or 2010, subject to certainrights held by Automotive.com’s minority shareholders.  The settlement price for the remaining 19.9%interest is based on a measure of Automotive.com’s earnings in the fiscal yearprior to settlement.

Also on August 1, 2007(the “Closing Date”), the Company entered into three new credit facilities: asix-year $300 million senior secured asset-based revolving loan, a seven-year$880 million senior secured term loan, and a one-year $465 million seniorsubordinated bridge loan.  On the Closing Date, the Company used theproceeds of the new facilities (i) to pay off existing revolving creditfacility, (ii) for the purchase price of the Acquisition, (iii) to pay relatedfees and expenses of approximately $50 million and (iv) for generalcorporate purposes.

The terms of the newcredit facilities are set forth in three separate agreements (i) a RevolvingCredit Agreement, dated as of August 1, 2007, by and among the Company, certainsubsidiaries of the Company as guarantors, Citicorp North America, Inc. (“CNAI”)as administrative agent and collateral agent, JP Morgan Chase Bank, N.A. (“JPMC”)as syndication agent, and the lenders from time to time party thereto; (ii) a TermLoan Agreement, dated as of August 1, 2007, by and among the Company, certainsubsidiaries of the Company as guarantors, CNAI as administrative agent andcollateral agent, JPMC as syndication agent, and the lenders from time to timeparty thereto; and (iii) a Senior Subordinated Bridge Loan Agreement, dated asof August 1, 2007, by and among the Company, certain subsidiaries of theCompany as guarantors, CNAI as administrative agent and collateral agent, JPMCas syndication agent, and the lenders from time to time party thereto(collectively, the “Credit Agreements”).

Amounts outstanding underthe Revolving Credit Agreement bear interest at either 0.50 percent per annumabove the base rate as quoted by CNAI (the “Base Rate”) or 1.50 percent perannum above specified Eurodollar rates, at the Company’s option.  There is no mandatory amortization of therevolving loans, which must not exceed a borrowing base.

The term loans bearinterest at either 2.25 percent per annum above the Base Rate or 3.25 percentper annum above specified Eurodollar rates, at the Company’s option.  Termloans must be paid-in quarterly installments of 1.0 percent per annum of theoriginal principal amount, with the balance due at maturity.  The Term Loan Agreement requires the Companyto maintain a consolidated senior secured leverage ratio that declines overtime.

Interest under the SeniorSubordinated Bridge Loan Agreement accrues at either 3.75 percent per annumabove the Base Rate or 4.75 percent per annum above specified Eurodollar rates,at the Company’s option, and increases every three months by 0.50 percent perannum, but cannot exceed 11.25 percent per annum.  If bridge loans remainoutstanding for more than one year, lenders under the Senior SubordinatedBridge Loan Agreement may exchange their loans for senior subordinated notesgoverned by an indenture having generally the same terms as the SeniorSubordinated Bridge Loan Agreement with an interest rate not to exceed 11.25%.

17

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**SOURCE INTERLINK COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (CONCLUDED)**

**(unaudited)**

Obligations under theRevolving Loan Agreement and Term Loan Agreement are secured by substantiallyall of the Company’s and its subsidiaries’ assets, subject to an intercreditoragreement providing generally that inventory and receivables of the Company andit’s subsidiaries are pledged first to support the revolving loan obligations,and the other assets of the Company and its subsidiaries are pledged first tosupport the term loan obligations.  In addition to the obligationsdescribed above, under each of the Credit Agreements, the Company is subject tovarious affirmative and negative covenants and reporting obligations in favorof the lenders, including, among others, restrictions on indebtedness, liens,investments, fundamental changes, asset dispositions, affiliate transactionsand dividends.  The Company also hasagreed to maintain its properties and existence, comply with laws, maintainrecords, allow inspections by lenders and comply with its contractualobligations, subject to specified exceptions.  Events of default includenonpayment of amounts due to the lenders, violation of covenants, change ofcontrol, default under other indebtedness, judgments and specifiedinsolvency-related events, subject, in certain instances, to specifiedthresholds, cure periods and/or exceptions.  If an event of default occursand is continuing the lenders may declare the commitments to be terminated andthe loans to be due, and may exercise all rights and remedies available underlaw, including remedies against the pledged collateral.

The Company’s obligationsunder each of the Credit Agreements are guaranteed by all of the Company’sactive domestic subsidiaries.  TheCompany’s obligations under the Senior Subordinated Bridge Loan Agreement aresubordinated to its obligations under the Revolving Credit Agreement and/or theTerm Loan Agreement.

Some lenders mayparticipate as lenders under more than one of the Company’s three new creditfacilities.  In addition, CNAI is the collateral agent under the RevolvingCredit Agreement and the Term Loan Agreement, and the administrative agentunder each of the Credit Agreements.

18

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**CAUTIONARYSTATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATESECURITIES LITIGATION REFORM ACT OF 1995**

Some of the information contained in this QuarterlyReport on Form 10-Q including, but not limited to, those contained in Item 2 ofPart I “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations,” along with statements in other reports filed with theSecurities and Exchange Commission (the “SEC”), external documents and oralpresentations, which are not historical facts are considered to be“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct of 1934, as amended. The words “believe,” “expect,” “anticipate,”“estimate,” “project,” and similar expressions often characterizeforward-looking statements. These statements may include, but are not limitedto, projections of collections, revenues, income or loss, cash flow, estimatesof capital expenditures, plans for future operations, products or services, andfinancing 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 inthese forward-looking statements as a result of a number of factors, including therisks and uncertainties faced by us described below and those set forth belowunder “Risk Factors” in our Annual Report for the fiscal year ended January 31,2007 on Form 10-K filed with the SEC on April 25, 2007, as amended on May 31,2007:

·                  market acceptanceof and continuing demand for magazines, DVDs, CDs and other home entertainmentproducts;

·                  the impact ofcompetitive products and technologies;

·                  the pricing andpayment policies of magazine publishers, film studios, record labels and otherkey vendors;

·                  changing marketconditions and opportunities;

·                  our ability torealize operating efficiencies, cost savings and other benefits from recentacquisitions; and

·                  retention of keymanagement and employees.

We believe it is important to communicate our expectationsto our investors. However, there may be events in the future that we are notable to predict accurately or over which we have no control. The factors listedabove provide examples of risks, uncertainties and events that may cause ouractual results to differ materially from the expectations we describe in ourforward-looking statements. Before you make an investment decision relating toour common stock, you should be aware that the occurrence of the eventsdescribed in these risk factors and those set forth below under “Risk Factors”in our Annual Report for the fiscal year ended January 31, 2007 filed with theSEC on April 25, 2007, as amended on May 31, 2007 could have a material adverseeffect on our business, operating results and financial condition. You shouldread and interpret any forward-looking statement in conjunction with ourconsolidated financial statements, the notes to our consolidated financialstatements and Item 2 of Part I “Management’s Discussion and Analysis ofFinancial Condition and Results of Operation.” Any forward-looking statementspeaks only as of the date on which that statement is made. Unless required byU.S. federal securities laws, we will not update any forward-looking statementto reflect events or circumstances that occur after the date on which thestatement is made.

19

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ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS.

We are a premier marketing, merchandising andfulfillment company of entertainment products including DVDs, music CDs,magazines, books and related items serving about 110,000 retail store locationsthroughout North America. Our fully integrated businesses include:

·                  Distribution andfulfillment of entertainment products to major retail chains throughout NorthAmerica and direct-to-consumers via the Internet;

·                  Import andexport of periodicals sold in more than 100 markets worldwide;

·                  Coordination ofproduct selection and placement for impulse items sold at checkout counters;

·                  Processing andcollection of rebate claims as well as management of sales data obtained at thepoint-of-purchase; and

·                  Design,manufacture and installation of wire display fixtures in major retail chains.

Our clients include:

·                  Mainstreamretailers, such as Wal-Mart Stores, Inc., The Kroger Company, TargetCorporation, Walgreen Company, Ahold USA, Inc., Sears Holdings Corporation.,and Meijer, Inc.;

·                  Specialtyretailers, such as Barnes & Noble, Inc., Borders Group, Inc., HastingsEntertainment, Inc., Fry’s Electronics, Inc. and Circuit City Stores, Inc.; and

·                  e-commerceretailers, such as amazon.com, barnesandnoble.com, circuitcity.com andbestbuy.com.

Our suppliers include:

·                  Record labels,such as Vivendi Universal S.A., Sony BMG Music Entertainment Company, WEADistribution and Thorn-EMI;

·                  Film studios,such as The Walt Disney Company, Time Warner Inc., Sony Corp., The NewsCorporation, Viacom Inc. and General Electric Company; and

·                  MagazineDistributors, such as COMAG Marketing Group, LLC, Time Warner Retail Sales& Marketing, Inc., Curtis Circulation Company and Kable DistributionServices, Inc.

On February 28, 2005, we completed our merger withAlliance Entertainment Corp, a logistics and supply chain management servicescompany for the home entertainment product market, principally selling CDs andDVDs. Following the merger, we organized the combined company into threeoperating business units:

·                  MagazineFulfillment – The magazine fulfillment segment sells and distributes magazinesto major retailers and wholesalers, imports foreign titles for domesticretailers and wholesalers, exports domestic titles to foreign wholesalers,provides return processing services, serves as an outsource fulfillment agentand provides customer-direct fulfillment.

·                  CD and DVDFulfillment – The CD and DVD fulfillment segment sells and distributespre-recorded music, videos, video games and related products to retailers,provides product and commerce solutions to retailers and providescustomer-direct fulfillment and vendor managed inventory.

20

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·                  In-StoreServices – The in-store services segment designs, manufactures and invoicesparticipants in front-end fixture programs, provides claim filing services forrebates owed retailers from publishers and their agents, designs, manufactures,ships, installs and removes front-end fixtures and provides information andmanagement services relating to retail magazine sales to U.S. and Canadianretailers and magazine publishers.

**Overview**

On August 1, 2007 wecompleted our acquisition of Primedia Enthusiast Media, Inc., one of thelargest providers of print and digital content to the enthusiast community inthe United States, from Consumer Source, Inc. for a purchase price ofapproximately $1.178 billion in cash, subject to post closing adjustments.See Note 10 – *Subsequent Events.*

Significant events thatoccurred during the six months ended July 31, 2007 and 2006 include:

***Sale of Wood ManufacturingDivision***

On April 30, 2007, we soldsubstantially all of the assets of our Wood Manufacturing Division.  This discontinued operation has been excludedfrom current and prior year results as presented herein.  See Note 9 – *DiscontinuedOperation*.

***Acquisition of AndersonMid-Atlantic News, LLC***

On March 30, 2006, we acquired all of the issued and outstandingmembership interests of Anderson Mid-Atlantic News, LLC (“Mid-Atlantic”) fromAnderson News, LLC for a purchase price of approximately $4.0 million, subjectto adjustment based on the negative net worth as of the closing date of thetransaction. In addition, we provided approximately $9.6 million on the date ofacquisition to Mid-Atlantic to repay a portion of their outstandingintercompany debt. The remaining outstanding intercompany debt of Mid-Atlanticwas satisfied by issuance of a promissory note totaling $4.1 million.  The purchase price and the intercompany debtrepayment were funded by borrowings against our revolving line of credit.  Mid-Atlantic’s results of operations havebeen included in our Consolidated Financial Statements since the date ofacquisition

***Acquisition of Anderson-SCN Services, LLC***

On March 30, 2006, we acquired all of the issued and outstandingmembership interests of Anderson-SCN Services, LLC (“SCN”) from Anderson News,LLC for a purchase price of approximately $9.0 million, subject to adjustmentbased on the negative net worth as of the closing date of the transaction. Inaddition, we provided approximately $17.0 million on the date of acquisition toSCN to repay a portion of their outstanding intercompany debt. The remainingoutstanding intercompany debt of SCN was satisfied by issuance of a promissorynote totaling $10.2 million. The purchase price and the intercompany debtrepayment were funded by borrowings against our revolving line of credit.  SCN’s results of operations have been includedin our Consolidated Financial Statements since the date of acquisition.

21

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**Results of operations**

*Please see our Annual Report onForm 10-K for the fiscal year ended January 31, 2007 and filed with the SEC onApril 25, 2007, as amended on May 31, 2007, for more information on the typesof revenues and expenses included within the specific line-items in ourfinancial statements.*

**THREE MONTHS ENDED JULY 31, 2007 AND2006**

***CD and DVD Fulfillment***

The following table setsforth, for the periods presented, information relating to our CD and DVDFulfillment segment:
|                                                                        | ** ** | **Three months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                            | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                   | 195,200    |       | $          | 198,182 |   | $ | (2,982 | ) | (1.5 | )% |
| Cost of revenues                                                       |       | 158,647                                             |       | 160,487    |       | (1,840 | ) | (1.2 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 36,553                                              |       | 37,695     |       | (1,142 | ) | (3.0 | )% |
| Selling, general and administrative expenses                           |       | 21,280                                              |       | 19,603     |       | 1,677 |   | 8.6 | % |
| Fulfillment freight                                                    |       | 7,232                                               |       | 7,505      |       | (273 | ) | (3.6 | )% |
| Depreciation and amortization                                          |       | 4,181                                               |       | 3,616      |       | 565 |   | 15.6 | % |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                   | 3,860      |       | $          | 6,971 |   | $ | (3,111 | ) | (44.6 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| **Key operating measures:**                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit margin                                                    |       | 18.7                                                | %          | 19.0       | %          | (0.3 | )% |   |   |
| Operating income margin                                                |       | 2.0                                                 | %          | 3.5        | %          | (1.5 | )% |   |   |
| Fulfillment freight as a percent of revenues                           |       | 3.7                                                 | %          | 3.8        | %          | (0.1 | )% |   |   |
| Selling, general and administrative expenses  as a percent of revenues |       | 10.9                                                | %          | 9.9        | %          | 1.0 | % |   |   |

 

Revenues decreased primarilydue to negative industry trends within the CD and recorded music industry,gross profit margin decreased primarily due to a shift in product mix towardDVDs and away from CDs which traditionally have higher gross margins and fewervendor rebates and incentives versus the same period of the prior year.

Fulfillment freightdecreased primarily due to decreased shipments. Fulfillment freight as a percent of revenues decreased primarily due toa shift of a larger portion of shipments to certain customers to less expensiveground versus air freight.

Selling, general andadministrative expenses increased primarily due to new vendor managed inventorybusiness, where we provide in-store product merchandising, and other newbusiness ventures.

Depreciation andamortization increased primarily due to capital expenditures in the two finalquarters of fiscal 2007.

Operating income decreasedprimarily due the factors listed above.

22

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***Magazine Fulfillment***

The following table setsforth, for the periods presented, information relating to our MagazineFulfillment segment:
|                                                                        | ** ** | **Three months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                            | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                   | 228,478    |       | $          | 223,240 |   | $ | 5,238 |   | 2.4 | % |
| Cost of revenues                                                       |       | 175,813                                             |       | 172,175    |       | 3,638 |   | 2.1 | % |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 52,665                                              |       | 51,065     |       | 1,600 |   | 3.1 | % |
| Selling, general and administrative expenses                           |       | 28,443                                              |       | 26,648     |       | 1,795 |   | 6.7 | % |
| Fulfillment freight                                                    |       | 17,261                                              |       | 17,587     |       | (326 | ) | (1.9 | )% |
| Depreciation and amortization                                          |       | 2,136                                               |       | 1,728      |       | 408 |   | 23.6 | % |
| Relocation expense                                                     |       | 324                                                 |       | 547        |       | (223 | ) | (40.8 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                   | 4,501      |       | $          | 4,555 |   | $ | (54 | ) | (1.2 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| **Key operating measures:**                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit margin                                                    |       | 23.1                                                | %          | 22.9       | %          | 0.2 | % |   |   |
| Operating income margin                                                |       | 2.0                                                 | %          | 2.0        | %          | (0.0 | )% |   |   |
| Fulfillment freight as a percent of revenues                           |       | 7.6                                                 | %          | 7.9        | %          | (0.3 | )% |   |   |
| Selling, general and administrative expenses  as a percent of revenues |       | 12.5                                                | %          | 11.9       | %          | 0.6 | % |   |   |
| **Revenues from:**                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Domestic distribution                                                  |       | $                                                   | 215,234    |       | $          | 214,687 |   | $ | 547 |   | 0.3 | % |
| International distribution                                             |       | $                                                   | 13,244     |       | $          | 8,553 |   | $ | 4,691 |   | 54.8 | % |

 

Revenues increased primarilydue to increased export distribution as a result of a new exclusive exportcontract with a major domestic national distributor.

Gross profit marginincreased primarily due to improved pricing from vendors.

Fulfillment freight as apercent of revenues decreased primarily due to synergies achieved related toour acquisition of Anderson Mid-Atlantic News, LLC and Anderson SCN Services,LLC.

Selling, general andadministrative expenses as a percent of revenues increased due in part toincreased expenses as a result of the addition of new customers and a change inthe method of allocation of costs formerly accumulated in the Shared Servicessegment, partially offset by synergies achieved related to our acquisition ofAnderson Mid-Atlantic News, LLC and Anderson SCN Services, LLC.  Under the current methodology, approximately$1.0 million of additional Selling, general and administrative expenses wouldhave been recorded in the same period of the prior year.

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***In-Store Services***

The following table setsforth, for the periods presented, information relating to our In-Store Servicessegment (results for fiscal 2007 have been revised to eliminate the results ofour Wood Manufacturing Division which was sold in April 2007):

|                                                                        | ** ** | **Three months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                            | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                   | 10,469     |       | $          | 11,886 |   | $ | (1,417 | ) | (11.9 | )% |
| Cost of revenues                                                       |       | 6,198                                               |       | 6,537      |       | (339 | ) | (5.2 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 4,271                                               |       | 5,349      |       | (1,078 | ) | (20.2 | )% |
| Selling, general and administrative expenses                           |       | 1,944                                               |       | 2,028      |       | (84 | ) | (4.1 | )% |
| Depreciation and amortization                                          |       | 122                                                 |       | 143        |       | (21 | ) | (14.7 | )% |
| Gain on sale of assets                                                 |       | (173                                                | )          | —     |       | (173 | ) | (100.0 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                   | 2,378      |       | $          | 3,178 |   | $ | (800 | ) | (25.7 | )% |
|                                                                   |       |                                                |       |       |       |   |   |   |   |
| **Key operating measures:**                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit margin                                                    |       | 40.8                                                | %          | 45.0       | %          | (4.2 | )% |   |   |
| Operating income margin                                                |       | 22.7                                                | %          | 26.7       | %          | (4.0 | )% |   |   |
| Selling, general and administrative expenses  as a percent of revenues |       | 18.6                                                | %          | 17.1       | %          | 1.5 | % |   |   |
| **Revenues from:**                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Claim filing and information                                           |       | $                                                   | 3,614      |       | $          | 4,091 |   | $ | (477 | ) | (11.7 | )% |
| Wire manufacturing                                                     |       | $                                                   | 6,855      |       | $          | 7,795 |   | $ | (940 | ) | (12.1 | )% |

 

Revenues from Claim filingand information decreased primarily due to the timing of payments received onclaims filed.  Revenues from Wiremanufacturing decreased primarily due to fewer jobs in the current quarterversus the same period of the prior year.

Gross profit decreasedprimarily due to lower revenue, while gross profit margin decreased primarilydue to lower margin jobs within the wire manufacturing, there was also anon-recurring higher cost of goods sold related to the recognition ofpreviously deferred revenue and related costs on specific foreign claimscollected that yield a lower gross profit margin than the traditional clientbase.

Selling, general and administrativeexpenses decreased in part due to cost cutting initiatives.  In addition, we changed the method ofallocating costs formerly accumulated in the Shared Services segment.  Under the current methodology, approximately$0.2 million of additional Selling, general and administrative expenses wouldhave been recorded in the same period of the prior year.

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***Shared Services***

The following table setsforth, for the periods presented, information relating to our Shared servicessegment:
|                                                                              | ** ** | **Three months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                                                                   | ** ** | **2007**                                            | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                         |       |                                                |       |       |       |   |   |   |   |
| Selling, general and  administrative expenses                                |       | $                                                   | 3,599      |       | $          | 5,795 |   | $ | (2,196 | ) | (37.9 | )% |
| Depreciation and  amortization                                               |       | 546                                                 |       | 524        |       | 22 |   | 4.2 | % |
| Relocation expense                                                           |       | —                                              |       | 168        |       | (168 | ) | (100.0 | )% |
|                                                                         |       |                                                |       |       |       |   |   |   |   |
| Operating loss                                                               |       | $                                                   | (4,145     | )          | $          | (6,487 | ) | $ | 2,342 |   | (36.1 | )% |
|                                                                         |       |                                                |       |       |       |   |   |   |   |
| **Key operating measures:**                                                  | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Selling, general and administrative expenses as a  percent of total revenues |       | 0.8                                                 | %          | 1.3        | %          | (0.5 | )% |   |   |

 

Selling, general andadministrative expenses decreased due in part to a change in the method ofallocation of costs formerly accumulated in the Shared Services segment.  Under the current methodology, approximately$1.2 million more Selling, general and administrative expenses would have beenallocated to the operating segments in the same period of the prior year.  Selling, general and administrative expensesalso decreased $0.6 million due in part to the elimination of the corporateaircraft lease.

***Interest Expense***

Interest expense includesthe interest and fees on our significant debt instruments and outstandingletters of credit.  Interest expense wascomparable at approximately $2.9 million for the three months ended July 31,2007 and 2006.

***Other Income (Expense)***

Other income (expense)consists of items outside the normal course of operations.  Due to its nature, comparability betweenperiods is not generally meaningful.

***Income Tax Expense***

The effective tax rates were 40.0% for the current quarter and the samequarter of the prior year.  Weanticipate our effective tax rate to approximate 40% for the remainder of theyear.

25

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**SIX MONTHS ENDED JULY 31, 2007 AND2006**

***CD and DVD Fulfillment***

The following table setsforth, for the periods presented, information relating to our CD and DVDFulfillment segment:
|                                                                        | ** ** | **Six months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                          | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                 | 426,016    |       | $          | 438,872 |   | $ | (12,856 | ) | (2.9 | )% |
| Cost of revenues                                                       |       | 349,522                                           |       | 359,991    |       | (10,469 | ) | (2.9 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 76,494                                            |       | 78,881     |       | (2,387 | ) | (3.0 | )% |
| Selling, general and  administrative expenses                          |       | 42,893                                            |       | 41,408     |       | 1,485 |   | (3.6 | )% |
| Fulfillment freight                                                    |       | 14,933                                            |       | 16,249     |       | (1,316 | ) | (8.1 | )% |
| Depreciation and  amortization                                         |       | 8,216                                             |       | 7,074      |       | 1,142 |   | 16.1 | % |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                 | 10,452     |       | $          | 14,150 |   | $ | (3,698 | ) | (26.1 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| **Key operating measures:**                                            | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit  margin                                                   |       | 18.0                                              | %          | 18.0       | %          | (0.0 | )% |   |   |
| Operating income  margin                                               |       | 2.5                                               | %          | 3.2        | %          | (0.7 | )% |   |   |
| Fulfillment  freight as a percent of revenues                          |       | 3.5                                               | %          | 3.7        | %          | (0.2 | )% |   |   |
| Selling, general and  administrative expenses as a percent of revenues |       | 10.1                                              | %          | 9.4        | %          | 0.7 | % |   |   |

 

Revenues decreased primarilydue to negative industry trends within the CD and recorded music industry.

Fulfillment freightdecreased primarily due to decreased shipments. Fulfillment freight as a percent of revenues decreased primarily due toa shift of a larger portion of shipments to certain customers to ground versusair.

Selling, general andadministrative expenses increased primarily due to new vendor managedinventory, where we provide in-store product merchandising, business and othernew business ventures.

Depreciation andamortization increased primarily due to capital expenditures in the two finalquarters of fiscal 2007.

Operating income decreasedprimarily due the factors listed above.

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***Magazine Fulfillment***

The following table setsforth, for the periods presented, information relating to our MagazineFulfillment segment:
|                                                                        | ** ** | **Six months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                          | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                 | 462,413    |       | $          | 418,219 |   | $ | 44,194 |   | 10.6 | % |
| Cost of revenues                                                       |       | 354,679                                           |       | 324,300    |       | 30,379 |   | 9.4 | % |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 107,734                                           |       | 93,919     |       | 13,815 |   | 14.7 | % |
| Selling, general  and administrative expenses                          |       | 58,758                                            |       | 50,754     |       | 8,004 |   | 15.8 | % |
| Fulfillment  freight                                                   |       | 35,315                                            |       | 30,778     |       | 4,537 |   | 14.7 | % |
| Depreciation and  amortization                                         |       | 4,239                                             |       | 3,379      |       | 860 |   | 25.5 | % |
| Relocation  expense                                                    |       | 324                                               |       | 547        |       | (223 | ) | (40.8 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                 | 9,098      |       | $          | 8,461 |   | $ | 637 |   | 7.5 | % |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| **Key  operating measures:**                                           | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit margin                                                    |       | 23.3                                              | %          | 22.5       | %          | 0.8 | % |   |   |
| Operating income margin                                                |       | 2.0                                               | %          | 2.0        | %          | (0.0 | )% |   |   |
| Fulfillment freight as a percent of revenues                           |       | 7.6                                               | %          | 7.4        | %          | 0.2 | % |   |   |
| Selling, general and administrative expenses as a  percent of revenues |       | 12.7                                              | %          | 12.1       | %          | 0.6 | % |   |   |
| **Revenues  from:**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Domestic distribution                                                  |       | $                                                 | 436,475    |       | $          | 400,763 |   | $ | 35,712 |   | 8.9 | % |
| International  distribution                                            |       | $                                                 | 25,938     |       | $          | 17,456 |   | $ | 8,482 |   | 48.6 | % |

 

On March 30, 2006 weacquired Mid-Atlantic and SCN.  Increasesin individual income statement line items within our Magazine Fulfillment groupare primarily related to the impact of the inclusion of six months of resultsin the current year period versus four in the same period of fiscal 2007.

Gross profit marginincreased primarily due to improved pricing from vendors.

Fulfillment freight as apercent of revenues increased primarily due to decreased sell-through efficiencieswithin the mainstream market.

Selling, general andadministrative expenses as a percent of revenues increased in part due toincreased overhead related to the acquisition of Mid-Atlantic and SCN,increased expenses as a result of the addition of new customers and a change inthe method of allocation of costs formerly accumulated in the Shared Servicessegment.  Under the current methodology,approximately $2.8 million of additional Selling, general and administrativeexpenses would have been recorded in the same period of the prior year.

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***In-Store Services***

The following table setsforth, for the periods presented, information relating to our In-Store Servicessegment (results for fiscal 2007 have been revised to eliminate the results ofour Wood Manufacturing Division which was sold in April 2007):
|                                                                        | ** ** | **Six months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| ** **                                                             | ** ** | **2007**                                          | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Revenues                                                               |       | $                                                 | 21,123     |       | $          | 24,111 |   | $ | (2,988 | ) | (12.4 | )% |
| Cost of revenues                                                       |       | 12,368                                            |       | 13,832     |       | (1,464 | ) | (10.6 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Gross profit                                                           |       | 8,755                                             |       | 10,279     |       | (1,524 | ) | (14.8 | )% |
| Selling, general  and administrative expenses                          |       | 3,924                                             |       | 4,012      |       | (88 | ) | (2.2 | )% |
| Depreciation and  amortization                                         |       | 243                                               |       | 288        |       | (45 | ) | (15.6 | )% |
| Gain on sale of  assets                                                |       | (173                                              | )          | —     |       | (173 | ) | (100.0 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| Operating income                                                       |       | $                                                 | 4,761      |       | $          | 5,979 |   | $ | (1,218 | ) | (20.4 | )% |
|                                                                   |       |                                              |       |       |       |   |   |   |   |
| **Key  operating measures:**                                           | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross profit margin                                                    |       | 41.5                                              | %          | 42.6       | %          | (1.1 | )% |   |   |
| Operating income margin                                                |       | 22.5                                              | %          | 24.8       | %          | (2.3 | )% |   |   |
| Selling, general and administrative expenses as a  percent of revenues |       | 18.6                                              | %          | 16.7       | %          | 1.9 | % |   |   |
| **Revenues  from:**                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Claim filing and information                                           |       | $                                                 | 7,114      |       | $          | 8,639 |   | $ | (1,525 | ) | (17.7 | )% |
| Wire  manufacturing                                                    |       | $                                                 | 14,009     |       | $          | 15,472 |   | $ | (1,463 | ) | (9.5 | )% |

 

Revenues from Claim filingand information decreased primarily due to the timing of payments received onclaims filed.  Revenues from Wiremanufacturing decreased primarily due to fewer jobs in the current periodversus the same period of the prior year.

Gross profit decreasedprimarily due to lower revenue, while gross profit margin increased primarilydue to higher profit margin jobs within the wire manufacturing, therewas also a non-recurring higher cost of goods sold related to the recognitionof previously deferred revenue and related costs on specific foreign claimscollected that yield a lower gross profit margin than the traditional clientbase.

Selling, general andadministrative expenses decreased in part due to cost cutting initiatives.  In addition, we changed the method ofallocating costs formerly accumulated in the Shared Services segment.  Under the current methodology, approximately$0.2 million of additional Selling, general and administrative expenses wouldhave been recorded in the same period of the prior year.

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***Shared Services***

The following table setsforth, for the periods presented, information relating to our Shared servicessegment:
|                                                                              | ** ** | **Six months ended July 31,** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| ** **                                                                   | ** ** | **2007**                                          | ** ** | **2006**   | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                         |       |                                              |       |       |       |   |   |   |   |
| Selling, general and  administrative expenses                                |       | $                                                 | 7,782      |       | $          | 11,968 |   | $ | (4,186 | ) | (35.0 | )% |
| Depreciation and  amortization                                               |       | 1,123                                             |       | 1,074      |       | 49 |   | 4.6 | % |
| Relocation expense                                                           |       | —                                            |       | 168        |       | (168 | ) | (100.0 | )% |
| Impairment of land and  building held for sale                               |       | —                                            |       | 529        |       | (529 | ) | (100.0 | )% |
|                                                                         |       |                                              |       |       |       |   |   |   |   |
| Operating loss                                                               |       | $                                                 | (8,905     | )          | $          | (13,739 | ) | $ | 4,834 |   | (35.2 | )% |
|                                                                         |       |                                              |       |       |       |   |   |   |   |
| **Key operating measures:**                                                  | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Selling, general and  administrative expenses as a percent of total revenues |       | 0.9                                               | %          | 1.3        | %          | (0.4 | )% |   |   |

 

Selling, general andadministrative expenses decreased primarily due to a change in the method ofallocation of costs formerly accumulated in the Shared Services segment.  Under the current methodology, approximately$2.8 million more Selling, general and administrative expenses would have beenallocated to the operating segments in the same period of the prior year.  Selling, general and administrative expensesalso decreased $1.0 million due in part to the elimination of the corporateaircraft lease.

In the first quarter offiscal 2007, we recorded an impairment related to land and building held forsale that was sold after the balance sheet date to record the assets at theirsales price.

***Interest Expense***

Interest expense includesthe interest and fees on our significant debt instruments and outstandingletters of credit.  The increase of $1.3million relates primarily to significantly higher borrowings during the currentperiod due primarily to the acquisition of Mid-Atlantic and SCN and increasedinterest rates on debt.

***Other Income (Expense)***

Other income (expense)consists of items outside the normal course of operations.  Due to its nature, comparability betweenperiods is not generally meaningful.

***Income Tax Expense***

Theeffective tax rates were 40.0% and 38.4% for the current period and the same periodof the prior year, respectively.  Theincrease in effective tax rates relates primarily to the treatment of certaintaxable differences that occurred in the first quarter of fiscal 2007.  We anticipate our effective tax rateto approximate 40% for the remainder of the year.

**Liquidity and Capital Resources**

Our primary sources of cashinclude receipts from our customers and borrowings under our credit facilitiesand from time to time the proceeds from the sale of common stock.

Our primary cash requirementsfor the Magazine Fulfillment and CD and DVD Fulfillment groups consist of thecost of home entertainment products and the cost of freight, labor and facilityexpense associated with our distribution centers.

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Our primary cashrequirements for the In-Store Services group consist of the cost of rawmaterials, labor, and factory overhead incurred in the production of front-end wiredisplays, the cost of labor incurred in providing our claiming, design andinformation services and cash advances funding our Advance Pay program.  Our Advance Pay program allows retailers toaccelerate collections of their rebate claims through payments from us inexchange for the transfer to us of the right to collect the claim.  We then collect the claims when paid bypublishers for our own account.

Our primary cashrequirements for the Shared Services group consist of salaries, professionalfees and insurance not allocated to the operation groups.

The following table presentsa summary of our significant obligations and commitments to make futurepayments under debt obligations and lease agreements due by period as of July31, 2007:
| ** **                         | ** ** | **Payments due during the year ending January 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------|------------|
| ** **                         | ** ** | **Remainder  of 2008**                                                            | ** ** | **2009**   | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
|                               |       |                                                                                   |       |       |       |   |   |   |   |   |   |   |   |
| Debt obligations                   |       | $                                                                                      | 4,601      |       | $          | 6,385 |   | $ | 3,949 |   | $ | 109,880 |   | $ | 20,664 |   | $ | 145,479 |   |
| Interest payments(a)               |       | 8,577                                                                                  |       | 11,106     |       | 10,772 |   | 5,997 |   | 4,688 |   | 41,140 |   |
| Capital leases                     |       | 808                                                                                    |       | 1,027      |       | 504 |   | 50 |   | — |   | 2,389 |   |
| Operating leases                   |       | 7,934                                                                                  |       | 14,272     |       | 12,355 |   | 8,613 |   | 21,150 |   | 64,324 |   |
|                               |       |                                                                                   |       |       |       |   |   |   |   |   |   |   |   |
| Total contractual cash obligations |       | $                                                                                      | 21,920     |       | $          | 32,790 |   | $ | 27,580 |   | $ | 124,540 |   | $ | 46,502 |   | $ | 253,332 |   |

 

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| (a) |   | Interest is calculated using the prevailing weighted  average rate on our outstanding debt at July 31, 2007, using the required  payment schedule. |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|

 

The following table presentsa summary of our commercial commitments and the notional amount expiration byperiod:
| ** **                          | ** ** | **Notional amounts expiring during the year ending January 31,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **(in thousands)**             | ** ** | **Remainder   of 2008**                                                                        | ** ** | **2009**   | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
|                                |       |                                                                                                     |       |       |       |   |   |   |   |   |   |   |   |
| Financial standby letters of credit |       | $                                                                                                        | 4,825      |       | $          | 2,317 |   | $ | — |   | $ | — |   | $ | — |   | $ | 7,142 |   |
|                                     |            |                                                                                                          |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Operating Cash Flow***

Net cash provided byoperating activities was $9.5 million for the six months ended July 31, 2007versus cash used in operating activities of $42.0 million for the six monthsended July 31, 2006.

Operating cash flows for thesix months ended July 31, 2007 were comprised of:

·                  Net income of $4.0 million,

·                  Plus non-cash charges and positive changes in operating assets andliabilities including:

·      Depreciationand amortization of $14.7 million,

·      Provisionsfor losses on accounts receivable of $1.8 million,

·      Losson sale of discontinued operation of $0.7 million,

·      Decreasesin accounts receivable of $36.3 million, and

·      Decreases in other current and non-currentassets of $7.5 million.

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·                  Cash was used for:

·                  Increases in inventories of $6.5 million and

·                  Decrases in accounts payable and other liabilities of $49.2 million.

The decrease in accountsreceivable relates primarily to a decrease in accounts receivable within our CDand DVD Fulfillment group of $30.0 million related to the timing of customerpayments and a decrease in accounts receivable within our In-Store Servicesgroup of $6.6 million related to the timing of collections.

The decrease in othercurrent and non-current assets relates primarily to a decrease in income taxesreceivable due to $10.0 million in income tax refunds received during thequarter ended July 31, 2007, partially offset by an increase in other currentand non-current assets of $2.2 million within our CD and DVD Fulfillment group.

The decrease in accountspayable and other liabilities relates primarily to a decrease in accountspayable within our CD and DVD Fulfillment group of $53.7 million primarilyrelated to a shift in product mix away from CDs and toward DVDs, which havetraditionally shorter payment terms than CDs, and a decrease in accruedexpenses of $7.8 million within our Shared Services group related to payment ofseverance and other amounts due to our former Chairman of the Board and CEO,partially offset by an increase in accounts payable of $10.3 within ourIn-Store Services group related to the timing of payments to retailers.

The increase in inventoriesrelates primarily to an increase in inventories of $13.2 million within ourMagazine Fulfillment group related primarily to the timing of shipments andincreased consignment inventory, partially offset by a decrease in inventorywithin our CD and DVD Fulfillment group of $6.2 million related primarily tothe timing of purchases and shipments and seasonality.

Operating cash flows for thesix months ended July 31, 2006 were comprised of:

·      Netincome of $7.4 million,

·      Plusnon-cash charges including:

·                  depreciation and amortization of $12.7million,

·                  provisions for losses on accounts receivable of $2.2 million, and

·                  Cash was used for:

·                  a decrease in accounts receivable of $7.4million,

·                  a decrease in inventories of $13.7 million,

·                  an increase in other current and non-currentassets of $3.2 million, and

·                  a decrease in accounts payable and other liabilities of $81.0 million.

The decrease in accounts receivable was primarily due to a $39.2 million decrease in accounts receivable within our CD and DVD Fulfillment group, primarily related to the timing of receipts from major customers within the first quarter of fiscal 2007 related to the holiday season.  This decrease was partially offset by a $26.1 million increase in accounts receivable in our Magazine Fulfillment group. $15.2 million of the increase within the Magazine Fulfillment group results from the timing of the acquisition of Mid-Atlantic and SCN, approximately $7.9 million in new receivables as a result of bringing in new customers and locations, coupled with the timing of receipts from major customers. Additionally, increased production within our In-Store Services group during the first quarter of fiscal 2007, versus fourth quarter fiscal 2006 resulted in $4.8 million in additional receivables.

The decrease in inventorywas due to a decrease in inventories within our Magazine Fulfillment group of$6.6 million and a decrease in inventory within our CD and DVD Fulfillmentgroup of $8.2 million.  $4.7 million ofthe decrease in our Magazine Fulfillment group resulted from the reduction ininventory associated with aligning and streamlining the operations ofMid-Atlantic and SCN following their acquisition.  The decrease in inventories within our CD andDVD Fulfillment group relates to the seasonal nature of the CD and DVDdistribution business.

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The decrease in accounts payable was primarily due to a decrease in accounts payable within our Magazine Fulfillment group of $43.1 million. $15.0 million of this decrease results from the timing of the acquisition of Mid-Atlantic and SCN, with the remainder attributable to the timing of vendor payments within the first six months of fiscal 2007. Additionally, our CD and DVD Fulfillment group had a decrease in accounts payable of $39.0 million associated with payments on accounts payable originated under extended holiday season payment terms in the fourth quarter of fiscal 2006.

***Investing Cash Flow***

Net cash provided byinvesting activities was $9.8 million for the six months ended July 31, 2007versus cash used in investing activities of $48.2 million for the six monthsended July 31, 2006.

For the six months endedJuly 31, 2007, cash provided by investing activities consisted primarily of$9.8 million received from the sale of our Wood Manufacturing group and $11.9million received from net collections of advance pay claims, offset by $9.4million in capital expenditures and $2.6 million of other investingexpenditures primarily related to the payment of acquisition costs related tothe acquisition of Primedia Enthusiast Media, Inc.

For the six months endedJuly 31, 2006, cash used in investing activities included capital expendituresof $6.5 million.  Additionally, $39.7million was used to acquire Mid-Atlantic and SCN during the six months endedJuly 31, 2006.

***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 CD and DVD and magazine distribution businesses. Because the magazine distribution business and Advance Pay program cash requirement usually peaks at our fiscal quarter ends, the reported bank debt levels usually are the maximum level outstanding during the quarter. Alliance has historically generated approximately 33% of its total net sales in the fourth calendar quarter coinciding with the holiday shopping season and therefore should have 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 wire 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 used in financing activities was $8.9 million for the six months ended July 31, 2007 versus cash provided by financing activities of $69.3 million for the six months ended July 31, 2006.

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 borrowings under notes payable of $0.5 million, and cash provided by the exercise of stock options of $1.1 million.

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Financing activities in the six months ended July 31, 2006 consisted primarily of borrowings under our revolving credit facility of $71.9 million, cash provided by the exercise of stock options of $2.5 million, partially offset by net payments on notes payable and capital leases of $5.1 million.  The significant borrowings under the revolving credit facility were primarily for the purpose of acquiring Mid-Atlantic and SCN.

***Debt***

For a detailed descriptionof the terms of our significant debt instruments, please see Note 4 to ourConsolidated Financial Statements.

In connection with ouracquisition of Primedia Enthusiast Media, Inc., we issued three new creditfacilities on August 1, 2007.  Thesefacilities consist of a $300 million asset-based revolving facility that wasundrawn at close of the transaction, a $880 million term loan facility thatamortizes 1.0% per year, and a $465 million bridge loan that will convert tolong-term financing if it is not refinanced within one year.  See Note 10 – Subsequent Events.  We expect to pay interest on these facilitieswith cash flow generated from operations.

Significant debttransactions during the six months ended July 31, 2007 and 2006 are as follows:

·                   In connection with the acquisition ofMid-Atlantic on March 30, 2006, we issued a promissory note to its former ownerin the amount of $4.1 million.  It wasrepaid during the remainder of fiscal 2007. The remainder of the purchase price, $13.6 million, was funded byborrowings on our revolving credit facility.

·                   In connection with the acquisition of SCN onMarch 30, 2006, we issued a promissory note to its former owner in the amountof $10.2 million.  It was repaid duringthe remainder of fiscal 2007.  Theremainder of the purchase price, $26.0 million, was funded by borrowings on ourrevolving credit facility.

***Off-Balance Sheet Arrangements***

We do not engage intransactions or arrangements with unconsolidated or other special purposeentities.

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ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

Our primary market risksinclude fluctuations in interest rates and exchange rate variability.

Our debt primarily relatesto credit facilities with Wells Fargo Foothill. See Note 4 to our Consolidated Financial Statements.

The revolving creditfacility with Wells Fargo Foothill had an outstanding principal balance of$107.4 million at July 31, 2007. Interest on the outstanding balance is charge based on a variableinterest rate related to the prime rate (8.25% at July 31, 2007) plus a marginspecified in the credit agreement based on an availability calculation (0.25%at July 31, 2007).

A 1.0% increase in theprevailing interest rate on our debt at July 31, 2007 is estimated to cause anincrease of $1.0 million in the interest expense for the remainder of the yearending January 31, 2008.

We do not perform anyinterest rate hedging activities related to this facility.

On August 1, 2007, werefinanced this facility in connection with our acquisition of PrimediaEnthusiast Media, Inc.  See Note 10 – *Subsequent Event*.

We have exposure to foreigncurrency fluctuation through our exporting of foreign magazines and thepurchase of foreign magazines for domestic distribution.

Revenues derivedfrom the export of domestic titles (or sales to domestic brokers who facilitatethe export) totaled $13.2 million for the quarter ended July 31, 2007 or 3.0% of total revenues.  For the most part, our export revenues aredenominated in dollars, and the foreign wholesaler is subject to foreigncurrency risks.  We have the availabilityto control foreign currency risk via increasing or decreasing the local coverprice paid in the foreign markets.  Thereis a risk that a substantial increase in local cover price, due to a decline inthe local currency relative to the dollar, could decrease demand for thesemagazines at retail and negatively impact our results of operations.

Domesticdistribution (gross) of imported titles totaled approximately $25.8 million (ofa total $581.1 million or 4.4%).  Foreignpublications are purchased in both dollars and the local currency of theforeign publisher, primarily Euros and British pounds sterling.  In the instances where we buy product in theforeign currency, we generally have the ability to set the domestic coverprice, which allows us to control the foreign currency risk.  Foreign titles generally have significantlyhigher cover prices than comparable domestic titles, are considered somewhat ofa luxury item, are sold only at select retail locations, and sales do not appearto be highly impacted by cover price increases. However, a significant negative change in the relative strength of thedollar to these foreign currencies could result in higher domestic cover pricesand result in lower sales of these titles at retail, which would negativelyimpact our results of operations.

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ITEM4. 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.

***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.

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***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***

Except as setforth in this paragraph, there were no changes in the Company’s internalcontrols over financial reporting (as defined in Rule 13a-15f of the ExchangeAct that occurred during the fiscal quarter ended July 31, 2007 that havematerially affected, or are reasonably likely to materially affect thosecontrols.

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**PART II – OTHER INFORMATION**

ITEM1. LEGAL PROCEEDINGS.

We are party to routinelegal proceedings arising out of the normal course of business.  Although it is not possible to predict withcertainty the outcome of these unresolved legal actions of the range ofpossible loss, we believe that none of these actions, individually or in theaggregate, will have a material adverse effect on our financial condition orresults of operations.

ITEM1A. RISK FACTORS.

In addition to our riskfactors as presented in the section entitled “Risk Factors” in our AnnualReport on Form 10-K for the year ended January 31, 2007 as filed with the SECon April 25, 2007, as amended May 31, 2007, the following risk anduncertainties could cause actual results to differ materially from the resultscontemplated by the forward looking statements contained in this QuarterlyReport on form 10-Q:

**TRENDSIN ADVERTISING SPENDING MAY REDUCE OUR REVENUES.**

Our advertising revenuesare subject to the risks arising from possible shifting of advertising spendingamongst media. A decline in the level of business activity of certain of ouradvertisers, particularly U.S. and non-U.S. automobile manufacturers, couldhave an adverse effect on our revenues and profit margins.

**WEHAVE SUBSTANTIAL INDEBTEDNESS, WHICH WILL CONSUME A SIGNIFICANT PORTION OF THECASH FLOW THAT WE GENERATE.**

A significant portion ofour cash flow will be dedicated to the payment of interest on indebtednesswhich will reduce funds available for capital expenditures and businessopportunities and may limit our ability to respond to adverse developments inour business or in the economy.

**OURDEBT INSTRUMENTS LIMIT OUR BUSINESS FLEXIBILITY BY IMPOSING OPERATING ANDFINANCIAL RESTRICTIONS ON OUR OPERATIONS.**

The agreements governingour indebtedness impose specific operating and financial restrictions on us.These restrictions impose conditions or limitations on our ability to, amongother things:

· change the nature of our business;

· incur additional indebtedness;

· create liens on our assets;

· sell assets;

·issue stock;

· engage in mergers, consolidations ortransactions with our affiliates;

· make investments in or loans tospecific subsidiaries; and

· declare or make dividend payments onour common stock.

Our failure to complywith the terms and covenants in our indebtedness could lead to a default underthe terms of those documents, which would entitle the lenders to accelerate theindebtedness and declare all amounts owed due and payable. Moreover, theinstruments governing almost all of our indebtedness contain cross-defaultprovisions so that a default under any of our indebtedness may result in adefault under our other indebtedness. If a cross-default occurs, the maturityof almost all of our indebtedness could be accelerated and become immediatelydue and payable. If that happens, we might not be able to satisfy our debtobligations, which could have a substantial adverse effect on our ability tocontinue as a going concern. We may not be able to comply with theserestrictions in the future or, in order to comply with these restrictions, wemay have to forego opportunities that might otherwise be beneficial to us.

ITEM2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

Not Applicable.

ITEM3. DEFAULTS UPON SENIOR SECURITIES.

Not Applicable.

ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not Applicable.

ITEM5. OTHER INFORMATION.

Not Applicable.

ITEM6. EXHIBITS.

See Exhibit Index.

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**SIGNATURES**

Pusuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.
|                     | **SOURCE  INTERLINK COMPANIES, INC.** |
|---------------------|---------------------------------------|
|                |                                  |
| September 10,  2007 | By:                                   | /s/ Marc Fierman |
|                | * *                              | Marc Fierman |
|                | * *                              | *Chief  Financial Officer* |
|                | * *                              | *(principal  financial officer)* |

 

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**EXHIBITINDEX**
| Exhibit No. | ** ** | **Description**                                                                             |
|-------------|------------|---------------------------------------------------------------------------------------------|
|        |       |                                                                                        |
| 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. |

 

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