##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10-K (Mark One) þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended March 31, 2005
or
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 Commission File Number 0-22982   NAVARRE CORPORATION  Minnesota
(State or other jurisdiction of
incorporation or organization)
    
    41-1704319
(IRS Employer
Identification No.)
 7400 49thAvenue North, New Hope, MN 55428
(Address of principal executive offices) (763) 535-8333
(Registrants telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class
    
    Name of each exchange on which registeredCommon Stock, No par value
    
    NASDAQ National Market
 Securities registered pursuant to Section 12(g) of the Act:None Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
(ü) No ( ) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. ( ) Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act
Rule 12b of the Act). Yes (ü) No ( ) The aggregate market value of the voting stock held by non-affiliates of the Registrant at
September 30, 2004 was $347,525,175 based on the closing sale price on such date of $14.49 per
share. The Registrant had 29,752,166 shares of Common Stock, no par value, outstanding at June 9, 2005. DOCUMENTS INCORPORATED BY REFERENCE Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K incorporate certain
information by reference from the Registrants definitive Proxy Statement to be filed with the
Securities and Exchange Commission not later than 120 days after the conclusion of the registrants
last fiscal year, which ended March 31, 2005.




---








NAVARRE CORPORATION
FORM 10-K

TABLE OF CONTENTS

PART I

PageItem 1.
    
    Business
    
    
    3Item 2.
    
    Properties
    
    
    25Item 3.
    
    Legal Proceedings
    
    
    26Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    27PART IIItem 5.
    
    Market for
Registrants Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities
    
    
    28Item 6.
    
    Selected Financial Data
    
    
    29Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    30Item 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    40Item 8.
    
    Financial Statements and Supplementary Data
    
    
    41Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    41Item 9A.
    
    Controls and Procedures
    
    
    41Item 9B.
    
    Other Information
    
    
    42PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    43Item 11.
    
    Executive Compensation
    
    
    43Item 12.
    
    Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    43Item 13.
    
    Certain Relationships and Related Transactions
    
    
    43Item 14.
    
    Principal Accountant Fees and Services
    
    
    43PART IVItem 15.
    
    Exhibits and Financial Statement Schedules
    
    
    43Signatures
    
    
    53Form of 2004 Stock Plan Incentive Stock Option AgreementForm of 2004 Stock Plan Non-Employee Director Stock Option AgreementOffice LeaseLetterSubsidiariesConsent of Independent Registered Public Accounting Firm - Grant Thornton LLPConsent of Independent Registered Public Accounting Firm - Ernst & Young LLPCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906




2



---



##### Table of Contents



PART I 
 Item 1  Business Overview We are a distributor and publisher of a broad range of home entertainment and multimedia
products, including PC software, CD audio, DVD and VHS video, video games and accessories. Since
our founding in 1983, we have established distribution relationships with major retailers including
Best Buy, Wal-Mart/Sams Club and CompUSA, and we currently distribute to over 18,000 retail and
distribution center locations throughout the United States and Canada. We believe that our
established relationships throughout the supply chain, our broad product offering and our
state-of-the-art distribution facility permit us to offer industry-leading home entertainment and
multimedia products to our retail customers and to provide access to attractive retail channels for
the publishers of such products. Historically, our business has focused on providing distribution services for third party
vendors. Over the past three years, we have expanded our business to include the licensing and
publishing of home entertainment and multimedia content, primarily through our acquisitions of
publishers in select markets. By expanding our product offerings through such acquisitions, we
believe that we can leverage both our sales experience and distribution capabilities to drive
increased retail penetration and more effective distribution of such products, and enable content
developers and publishers that we acquire to focus more on their core competencies. Our business is divided into two segmentsDistribution and Publishing. Distribution.Through our distribution business, we distribute and provide fulfillment
services in connection with a variety of finished goods that are provided by our vendors, which
include PC software and video game publishers and developers, independent and major music labels,
and major motion picture studios. These vendors provide us with PC software, CD audio, DVD and VHS
video, and video games and accessories which we, in turn, distribute to our retail customers. Our
distribution business focuses on providing vendors and retailers with a range of value-added
services including: vendor-managed inventory, Internet-based ordering, electronic data interchange
services, fulfillment services and retailer-oriented marketing services. Our vendors include
Symantec Corporation, Adobe Systems, Inc., Microsoft, McAfee, Inc., Dreamcatcher Interactive, Inc.
and Sony/BMG Music Entertainment. Publishing. Through our publishing business, which generally has higher gross margins than
our distribution business, we own or license various PC software, CD audio and DVD and VHS video
titles, and we package, brand, market and sell directly to retailers, third party distributors and
our distribution business. Our publishing business currently consists of Encore Software, Inc.
(Encore), BCI Eclipse Company, LLC (BCI), FUNimation Productions, Ltd. and The FUNimation
Store, Ltd. (together, FUNimation). Encore, which we acquired in July 2002, licenses and
publishes personal productivity, genealogy, education and interactive gaming PC products, including
titles such as Print Shop, Mavis Beacon, Zone Alarmand Reader Rabbit. BCI, which we acquired in
November 2003, is a provider of niche DVD and video products and in-house produced CDs and DVDs.
FUNimation, acquired on May 11, 2005, is a leading animeand childrens entertainment content
provider in the United States. Strategy We seek to continue to grow our distribution and publishing businesses, through a combination
of organic growth and targeted acquisitions, intended to leverage the complementary strengths of
our businesses. We intend to execute this strategy as follows:  
    Acquisitions of Attractive Content.We seek to continue to expand our publishing
business through the acquisition or licensing of well-established titles or other
attractive content. We believe these acquisitions and/or licenses will help position
us to increase our net sales in our
publishing business, which historically has had higher margins than our distribution
business, and will allow us to distribute additional home entertainment and multimedia
content through our distribution business. In addition, we believe that by allowing
the management of these publishing companies to focus on content 3




---



##### Table of Contents



licensing and
marketing rather than on distribution operations, they will be able to devote more time
and greater resources to their core competency, publishing. We believe that leveraging
the core assets and strengths of our distribution business will provide broader retail
penetration, distribution expertise and other services for our content and increase
sales of our publishing products. We may also seek selective acquisitions of
distribution businesses.  
    Distribute a Broader Range and Larger Volume of Products.We seek to distribute a
broader range and larger volume of home entertainment and multimedia products to our
retail customers by providing a broad selection of products and capitalizing on our
customer relationships. We seek to capture additional business from new and existing
retail customers by providing them with a lower all-in cost of procuring merchandise
and getting product to retailers shelves through efficient distribution. We expect
that providing additional products to retailers will enable us to gain category
management opportunities and enhance our reputation for product distribution
expertise. We believe our approximately 60 strategic account associates located
throughout the United States and Canada will help position us to improve the retail
penetration of our published products to new and existing retail customers.  
    Integrating Our Technology and Systems with Retailers.We seek to enhance the link
in the supply chain between us and our publishers and retail customers through the
integration of our respective information and technology systems, including inventory
management tools, replenishment systems and point-of-sale information. We believe
this integration will lead to better in-stock levels of product, improved on-time
arrivals of product to the customer, enhanced inventory management and lower return
rates for our customers, thereby strengthening customer relationships.  
    Providing Value-Added Services.We believe that due to increasing retailer
logistic needs and demands, including demands for new technology standards such as
GTIN® (global trade item number) and RFID (radio frequency identification
devices), many publishers will be required to decide whether to spend additional
resources to update their distribution capabilities or to select a distributor such as
us that intends to offer such services. We believe that implementing and offering
these and other technologies should position us well to capture additional business
from existing and new publishers. Our overall goal is to create a structure that leverages the complementary strengths of our
businesses: publishing, which provides brand management and marketing, licensing, and home video
sales; and distribution, which provides enhanced distribution, logistics and customer relations. Competitive Strengths We believe that we possess the following competitive strengths:  
    Value-Added Services.We offer a wide range of distribution services and
procurement solutions intended to capitalize on our broad understanding of the
products that we distribute, the procurement process and the supply chain, as well as
our logistics expertise and systems capabilities. We believe that our advanced
distribution infrastructure enables us to provide customized procurement programs for
our retail customers at a lower overall cost than many of our competitors. In
addition, we believe that our information technology systems provide cost-effective
interfacing with our customers information technology systems, supporting integration
of the procurement process. We believe that our focus on providing customer-specific
and cost-effective solutions is a key benefit that we provide to our retail customers.  
    Broad Product Offering.We provide our retail customers with a broad selection of
home entertainment and multimedia products that we believe allows us to better serve
their home entertainment and multimedia product requirements. In addition, we
regularly survey the markets we serve for new products with significant retail
potential, that come from publishers we currently have relationships with as well as
those we have not distributed for in the past.  
    Established Content in our Publishing Business.We currently license a number of
well-known home entertainment and multimedia titles. Encore, whose
published brands when combined, rank it as the sixth largest PC
software publisher in North America by dollar sales (according to
The NPD Group), 4




---



##### Table of Contents



publishes leading titles in the education, productivity, kids and
games software categories, including Print Shop, Print Master, Mavis Beacon, Zone
Alarm, Reader Rabbitand Hoyle Casino.According to The NPD Group, as of January
2005, Hoyle Casinoheld the #1 rank in the PC Games/Family Entertainment category and
the Hoylebrand held a 14% share of this category based on dollar sales. According to
The NPD Group, Mavis Beacon isthe #1 ranking typing title with a 54% market share, as
of January 2005. In addition, our BCI subsidiary currently publishes home video for
the television shows Ridesand Overhaulin,both featured on The Learning Channel, and
PRIDE Fighting Championships,featured on Pay-Per-View. Through our FUNimation
business we also license and distribute a portfolio of established animeand
childrens entertainment titles in the United States, including Dragon Ball Z,
Fullmetal Alchemist, Yu-Gi-Oh!, Code Lyoko, Teenage Mutant Ninja Turtles, Arthur,
Noddy, Case Closed, Yu Yu Hakusho, Beyblade, Fruits Basketand Cabbage Patch Kids.  
    Established Relationships with Publishers and Retailers.Since our founding in
1983, we have established distribution relationships with major retailers including
Best Buy, Wal-Mart/Sams Club and CompUSA, and we currently distribute to over 18,000
retail and distribution center locations throughout the United States and Canada. We
believe our strong relationships throughout the supply chain, broad product offering
and state-of-the-art distribution facility permit us to offer industry-leading home
entertainment and multimedia products to our retail customers and provide access to
attractive retail channels for publishers of these products. We believe our
relationships with leading publishers and our efficient distribution of their products
should provide opportunities for us to secure distribution rights to leading products
in the future. We believe that these relationships give us a competitive advantage in
the markets in which we operate and provide us with attractive channels to distribute
current and future products offered by our publishing business.  
    Efficient Operations and Operating Leverage.We believe that our competitive
position is enhanced by our efficient operations, which are based on extensive use of
automation and technology in our state-of-the-art distribution facility;
centralization of functions such as purchasing, accounting and information systems;
and economies of scale. We recently completed a state-of-the-art warehouse facility
adjacent to our corporate headquarters. We believe that this facility provides us
with an industry-leading fulfillment infrastructure, the ability to efficiently
service our vendors and retail customers, and the capacity to increase the number of
products that we distribute. Distribution Markets PC Software According to The NPD Group, the PC software industry achieved $3.8 billion on a trailing 12
month basis ending January 31, 2005. Categories that experienced
an increase during this time period were
system utilities, business, finance and personal productivity products. We presently have relationships with PC software publishers such as Symantec Corporation,
Roxio, Inc., Adobe Systems Inc., McAfee, Inc., Dreamcatcher Interactive, Inc., Sony Online
Entertainment,
Inc., Delorme and THQ. These relationships are important to our distribution business and
during the fiscal year ended March 31, 2005 each of these publishers accounted for more than $5.0
million in revenues. In the case of Symantec, sales accounted for approximately $51.0 million in
net sales in the fiscal year ended March 31, 2004 and approximately $91.0 in net sales for the
fiscal year ended March 31, 2005. During the past fiscal year, we added several publishers to our
distribution roster. While we have agreements in place with our major suppliers, they are generally short-term
agreements with terms of one to three years, they generally cover the right to distribute in the
United States and Canada, they do not restrict the publisher from distributing their products
through other distributors or directly to retailers and they do not guarantee product availability
to us for distribution. Our agreements with these publishers provide us with the ability to
purchase products at a reduced wholesale price and for us to provide a variety of distribution and
fulfillment services in connection with the products. We intend to continue seeking to add
publishers that will increase our market share in the PC software industry. 5




---



##### Table of Contents



Video Games Software and Accessories According to The NPD Group, the video games software and accessories industry was $10.2
billion in 2004 compared to $10.0 billion in 2003. According to industry sources, the installed
base of video game consoles in North America is expected to grow to approximately 58.2 million
users in 2008 compared to 32.0 million users in June 2004. We continued to expand our distribution of console-based video games in fiscal 2005. Our
relationships with video game vendors such as Square Enix USA, Inc., Midway, THQ and Vivendi are
important to this category of our distribution business. Major Label Music According to the Recording Industry Association of America (RIAA), the dollar value of audio
and music video product shipped to domestic markets was $11.4 billion in 2004 versus $11.0 billion
in 2003. Industry sources indicate that approximately 83% of the unit shipments are derived from
major recording labels which are controlled by four companies. Those companies are Warner Music
Group, Sony/BMG Music Entertainment, EMI Music Marketing, and Universal Music & Video Distribution
Corp. Generally, these companies control distribution of their products through major music retail
chains and other channels. We have established a relationship with certain of these companies, which allows us to
distribute certain major label music to wholesale clubs and mass merchant retailers on a
non-exclusive basis through our distribution business. Independent Label Music The independent segment of the music industry currently represents approximately 17% of total
music product for 2004 according to the RIAA. We are one of a limited number of large, independent distribution companies that represent
independent labels exclusively on a regional or national basis. These companies provide products
and services to the nations leading music specialty stores and wholesalers. We seek to increase
our market share in the independent music distribution business by continuing to seek quality music
labels and to provide greater service to our customers, in addition to providing content ownership
and licensing opportunities. Relationships with independent music labels such as CMH Records,
Inc., Studio Distribution, Inc. and Cleopatra Records, Inc. are also important to our independent
music distribution business. We have exclusive distribution agreements in place with certain of
these labels that allow us to retain a percentage of amounts received in connection with the sale
of the products provided by these labels. Among other customary provisions, these agreements
generally provide us with the ability to return products to our
independent music labels, the right for us to retain a reserve against potential returns of products, and
requirements that the label provide discounts, rebates and price protections. Major Studio Home Video According to industry sources, U.S. home video industry sales totaled $24.5 billion in 2004
compared to $22.5 billion in 2003. Our relationships with Universal Distribution Corp., Twentieth Century Fox Home Entertainment
and Buena Vista Home Video are important to our major studio home video distribution business. Customers Since our founding in 1983, we have established relationships with retailers across mass
merchant, specialty and wholesale club channels, including Best Buy, Wal-Mart/Sams Club, CompUSA
and Costco. We currently sell and distribute products to over 18,000 retail and distribution
center locations throughout the United States and Canada. While a major portion of our revenues
are generated from these major retailers, we also supply products to smaller independent retailers
through telephone sales and our business-to-business site located at 6




---



##### Table of Contents



www.navarre.com. See our
discussion of E-Commerce below. Through these sales channels, we seek to ensure a broad reach of
product throughout the country in a cost-efficient manner. In each of the past several years, we have had one or more customers that accounted for 10% or
more of our net sales. During the fiscal year ended March 31, 2005, sales to two customers,
Wal-Mart/Sams Club and Best Buy accounted for approximately 20%, and 19%, respectively, of our
total net sales. During the fiscal year ended March 31, 2004, sales to three customers, Best Buy,
CompUSA and Sams Club, represented approximately 18%, 13% and 11%, respectively, of our total net
sales. Navarres Distribution Business Model Vendor Relationships We view our vendors as customers and work to manage retail relationships to make their
business easier and more productive. By doing so, we believe that our reputation as a
service-oriented organization has helped us expand our vendor roster. We believe that major
companies like Microsoft, Adobe Systems, Symantec Corporation, Buena Vista, Universal, Sony/BMG
Music Entertainment, Lucas Arts, Take-Two Interactive, Konami and Square Enix have been added to
our vendor roster because of our reputation as a service-driven organization. Furthermore, our dedication to smaller, second-tier vendors has helped to complement our
vendor roster. Many of these vendors do not have the leverage necessary to manage their business
effectively with major retailers. We provide these vendors the opportunity to access shelf space
and assist in the solicitation, logistics, promotion and management of products. We also conduct
one-on-one meetings with smaller vendors to give them the opportunity to establish crucial business
relationships with our retail customers. Examples of these vendors are as follows: Dreamcatcher
Interactive, Inc., Webroot, Punch Software, First Look Home Entertainment, Hart Sharp Video, Tokyo
Pop, Bay, Intec Inc. and Majesco. Retail Services Along with the value added sales functions that we provide to vendors, we also have the
ability to customize shipments to each individual customer. In the case of the warehouse club
channel, we may pre-sticker multiple different labels, based on the vendor/customer preference.
We assemble creative marketing programs, which include pallet programs, product bundles and
specialized packaging. We also create multi-vendor assortments for the club channel, providing the
retailer with a broad assortment of
products. Our marketing and creative services department designs and
produces a variety of advertising vehicles including in-store flyers,
direct mail pieces and magazine/newspaper ads, as well as free standing displayers for retail. We are committed to offering first-rate information flow for all vendors. We understand the
importance of sharing sell-through, inventory, sales forecasts, promotional forecasts, SKU status
and all SKU data with the respective vendor. We provide the aforementioned information via a
secure online portal, for all vendors. Furthermore, each individual account manager has
account-specific information that is shared on a regular basis with appropriate vendors. We also
accommodate specialized reporting requests for our vendors, which we believe helps in the
management of their business. Warehouse Systems A primary focus of our distribution business is logistics and supply chain management. As
customer demands become more sophisticated, we have continued to update our technology. Our most
recent significant investment involves a new, highly-automated material handling facility which we
believe will improve our overall long-term efficiency and assist in reducing costs for both vendors
and customers. With our state-of-the-art, highly automated returns processing system, we generally
are able to process returns and issue both credit and vendor deductions within 48 hours of receipt.
We believe that our inventory system offers better in-stock levels of product, improved on-time
arrivals of product to the customer, enhanced inventory management and lower return rates for our
customers, thereby strengthening our customer relationships. E-Commerce During fiscal year 2005, we continued to expand the number of electronic commerce (e-commerce)
customers for whom we perform fulfillment and distribution. These services include sales of PC
software, prerecorded music and DVD/VHS videos and video games. Our business-to-business web-site
www.navarre.com integrates on-line ordering and deployment of text and visual product information,
and has been enhanced to allow for easier user navigation and ordering. 7




---



##### Table of Contents



Publishing Markets In July 2002 and November 2003, we acquired Encore and BCI, respectively. Encore is a
publisher of entertainment and education PC products and BCI is a provider of niche DVD/video
products. Both of these businesses exclusively own or license and produce PC/DVD/video products.
In April 2004, we entered into an exclusive co-publishing agreement with Riverdeep, Inc. for the
sales and marketing of Riverdeeps interactive products in the educational and productivity
markets, which includes products published under the Broderbund and The Learning Company labels.
In December 2004, we entered into exclusive licensing agreements with Vivendi and The United States
Playing Card Company, Inc. for the sales and marketing of the Hoylebrand of family entertainment
software products. FUNimation, acquired on May 11, 2005, is a leading animeand childrens
entertainment content provider in the United States. Encore Encore,
whose published brands when combined, rank it as the sixth largest PC
software publisher in North America by dollar sales (according to The
NPD Group), publishes leading titles in the education,
productivity, kids and games software categories, including Print Shop, Print Master, Mavis Beacon,
Zone Alarm, Reader Rabbitand Hoyle Casino.According to The NPD Group, as of January 2005, the
Hoylebrand held a 14% share of the PC Games/Family Entertainment category based on dollar sales,
and Hoyle Casinoheld the #1 rank in this category. According to The NPD Group, Mavis Beaconwas
the #1 ranked typing title with a 54% market share, as of January 2005. Encores corporate headquarters are located in Los Angeles, California. Encores
distribution, assembly and fulfillment operations relocated from Los Angeles, California, to
Minneapolis, Minnesota, in January 2005. Encore focuses on retail sales and marketing of its licensed content, without the distraction
and financial risk of content development. The benefit to our licensed vendors is they can focus
on their core competencies of content development and delivery. Encore continues to evaluate emerging PC software brands that have the potential to
become successful franchises. Encore continues to focus on establishing relationships with
developed brands that are seeking to change their business models. Encores strategy is to continue to license quality branded PC software titles. It has
experience in signing single-brand products as well as taking on multiple titles in single
agreements, as demonstrated by the signing of the Riverdeep and Hoylepublishing agreements. BCI BCI is a developer, licensor, packager and marketer of entertainment video and audio products.
Since 1988, BCI has sought to redefine the standards and concepts in the budget DVD category. We
believe that BCI was among one of the first vendors to introduce five-pack, ten-pack and 20-pack
DVDs to the marketplace. We also believe that BCI was also one of the first to introduce dollar
DVDs to the dollar store marketplace. 8




---



##### Table of Contents



BCIs portfolio of titles represents both licensed titles, in-house produced CDs and DVDs from
production groups, and specialty television programming on Discovery, A&E, HBO, Fox and
Pay-Per-View. BCIs home video titles include Ridesand Overhaulin, featured on The Learning
Channel, and PRIDE Fighting Championships,featured on Pay-Per-View. FUNimation Business On May 11, 2005, we completed the acquisition of 100% of the general and limited partnership
interests of FUNimation Productions, Ltd. and The FUNimation Store, Ltd., which are based in Fort
Worth, Texas (together, FUNimation). We operate FUNimation as a part of our Publishing business.
FUNimation is a leading content provider in the United States market
for anime which it licenses from Japanese rights holders and translates and adopts the content for television
programming and home videos, primarily targeting audiences between the ages of 6 and 17. In
addition, FUNimation licenses other childrens entertainment content. FUNimation leverages its
licensed content into various revenue streams, including television broadcast, VHS and DVD home
video distribution, and licensing of merchandising rights for toys, video games and trading cards.
FUNimations licensed titles include Dragon Ball Z, Fullmetal Alchemist, Yu-Gi-Oh!, Code Lyoko,
Teenage Mutant Ninja Turtles, Noddy, Arthur, Case Closed, Yu Yu Hakusho, Beyblade, Fruits Basket
and Cabbage Patch Kids. A number of these titles are currently airing on various television
networks including The Cartoon Network, ABC Family and Fox. FUNimation identifies, based on its own market research, properties that it believes can be
successfully adapted to the U.S. animeand childrens content market. This market research
generally involves analyzing television ratings, merchandise sales trends, home video sales, anime
magazines and popularity polls in both the U.S. and Japanese markets. After identifying a property
that has the potential for success in the United States, FUNimation seeks to capitalize on its
relationships with Japanese rights holders and its reputation as a content provider of animein the
United States to obtain the commercial rights to such property, primarily for television
programming, home video distribution and merchandising. Broadcast For television programming, FUNimation translates and adapts its licensed animetitles to
conform to U.S. television programming standards. FUNimation performs most of its production work
in-house at its production facility in Fort Worth, Texas. As of June 8, 2005, the primary
television broadcast outlets for FUNimations licensed properties were as follows: Titles
    
    Broadcast OutletDragon Ball Z
    
    Cartoon NetworkYu-Gi-Oh!*
    
    Cartoon Network and WBTeenage Mutant Ninja Turtles*
    
    Cartoon Network and FoxFullmetal Alchemist
    
    Cartoon NetworkBeyblade*
    
    ABC Family and Toon DisneyBraceface*
    
    DisneyArthur*
    
    PBSConnie the Cow*
    
    NogginDragon Booster*
    
    ABC Family and Toon DisneyCode Lyoko*
    
    Cartoon NetworkSonic X*
    
    FoxShaman King*
    
    FoxTimothy Goes to School*
    
    Discovery Kids and TLCNever Ending Story*
    
    HBO FamilyDegrassi: The Next Generation*
    
    The NMy Dad the Rockstar*
    
    NickelodeonRedwall*
    
    PBSWinx*
    
    Cartoon Network and FoxCase Closed
    
    Cartoon Network
   
    
    FUNimation currently licenses the U.S. home video distribution rights for such titles.*
    
    Broadcast and certain other rights for such property are owned or licensed by third parties. 9




---



##### Table of Contents



Home Video Distribution FUNimation seeks to increase the revenue derived from its licensed properties through home
video distribution. FUNimation also currently provides home video distribution services for other
childrens content providers, including 4Kids Entertainment, Nelvana and Alliance Atlantis. A
majority of its home videos are sold directly to major retail chains. According to Nielsen
VideoScan, in 2004, FUNimation was ranked as one of the leading distributors of animehome video in
the United States. Licensing and Merchandising For properties which FUNimation controls the merchandise rights, it seeks to further leverage
its licensed content by sub-licensing these rights to manufacturers of childrens and other
products. FUNimation has developed a network of over 80 license partners, including JAKKS Pacific,
Atari, ODM, SCORE Entertainment and Scholastic for the merchandising of toys, video games, apparel,
trading and collectible card games and books. FUNimation manages its properties for consistent and
accurate portrayal throughout the marketplace. FUNimation receives royalties from its sublicensees
based on a predetermined royalty rate, subject to guaranteed minimums in certain cases. Retail Sales and Web Sites FUNimation operates websites devoted to the animefan base. Typically, as part of its brand
management strategy, FUNimation will develop an interactive site for each licensed property. The
sites provide information about upcoming episodes and the characters associated with the show. In
addition, FUNimations properties are supported by its in-house Internet store, the Z-Store,which
sells home videos and licensed merchandise. Competition All aspects of our business are highly competitive. Our competitors include other national
and regional businesses, as well as some suppliers that sell directly to retailers. Some of these
competitors have substantially greater financial and other resources than we do. Our ability to
effectively compete in the future depends upon a number of factors, including our ability to:  
    obtain exclusive national distribution contracts and licenses with independent
music labels and manufacturers; 
    obtain proprietary publishing rights with various rights holders and brand owners; 
    maintain our margins and volume; 
    expand our sales through a varied range of products and personalized services; 
    anticipate changes in the marketplace including technological developments and
consumer interest in our proprietary products; and 
    maintain operating expenses at an appropriate level. 10




---



##### Table of Contents



In the PC software industry, we face competition from a number of distributors including
Ingram Micro, Inc., Tech Data Corporation and Atari, Inc., as well as from manufacturers and
publishers that sell directly to retailers. In the pre-recorded music industry, we face
competition from the five major label distribution companies, as well as other national independent
distributors, such as Koch Entertainment, RED Music Distribution, Alternative Distribution
Alliance, Ryko Distribution, and Caroline Distribution, as well as from other entities that sell
directly to retailers. FUNimations competitors include: 4Kids, ADV Films, Geneon Entertainment,
Bandai, Ventura, Anchor Bay, Media Blasters and Buena Vista. We believe that competition in all of our businesses will remain intense. The keys to our
growth and profitability will include: (i) customer service, (ii) continued focus on improvements
and operating efficiencies, (iii) the ability to develop proprietary products, and (iv) the ability
to attract new content, quality labels, studios and software publishers. We also believe that over
the next several years, both the PC software distribution industry and pre-recorded music
distribution industry, particularly on the independent side, will continue to further consolidate. Backlog Because a substantial portion of our products are shipped in response to orders, we do not
maintain any significant backlog. Environmental Matters We do not anticipate any material effect on our capital expenditures, earnings or competitive
position due to compliance with government regulations involving environmental matters. Employees As of March 31, 2005, we had 618 employees, including 179 in administration, finance and
merchandising, 97 in sales and marketing and 342 in distribution. As of March 31, 2005, FUNimation
had 112 employees, including 29 in administration, finance and licensing, and 83 in sales,
marketing, production and distribution. These employees are not subject to collective
bargaining agreements and are not represented by unions. We consider our relations with our employees
to be good. 11




---



##### Table of Contents



RECENT DEVELOPMENTS Restatements In June 2005, our management, after consultation with the Audit Committee of the Board of
Directors, determined that our consolidated financial statements for the third fiscal quarter ended
December 31, 2003, year ended March 31, 2004, first fiscal quarter ended June 30, 2004, second
fiscal quarter ended September 30, 2004, and third fiscal quarter ended December 31, 2004 should no
longer be relied upon. As a result of the fiscal year 2005 audit, it was determined that expenses
related to the incentive-based deferred compensation of our Chief Executive Officer should have
been recorded in the third fiscal quarter of 2004 and first fiscal quarter of 2005. As a result,
additional expenses and accrued liabilities of $1.5 million and
$2.2 million have been recorded in these
quarters, respectively. These expenses were determined in accordance with the provisions of the
Chief Executive Officers 2001 employment agreement. It was also determined that our deferred tax benefit recorded in the third fiscal quarter of
2005 was improperly included in income and should have increased common stock. Consequently,
the tax benefit of $2.4 million recognized during the third fiscal quarter of 2005 was reduced and
common stock increased by the same amount. The consolidated financial statements for our third fiscal quarter ended December 31, 2003,
year ended March 31, 2004, first fiscal quarter ended June 30, 2004, second fiscal quarter ended
September 30, 2004, and third fiscal quarter ended December 31, 2004 and notes thereto included in
this annual report on Form 10-K have been restated to include the effects of the expenses related
to the incentive-based deferred compensation of our Chief Executive Officer and the deferred tax
benefit recorded in income that should have been applied to common stock. Capital Resources  Financing Our credit agreement with GE Commercial Finance was amended and restated in its entirety on
May 11, 2005 in order to provide us with the funds necessary to complete funding for the FUNimation
acquisition and was again amended and restated in its entirety on June 1, 2005. The credit
agreement currently provides a six-year $115.0 million Term Loan B sub-facility, a $25.0 million
five and one-half year Term Loan C sub-facility, and a five-year revolving sub-facility for up to
$25.0 million. The entire $115.0 million of the Term Loan B sub-facility has been drawn since May
11, 2005 and the entire $25.0 million of the Term Loan C sub-facility was drawn at June 1, 2005.
The revolving sub-facility of up to $25.0 million is available to us for our working capital and
general corporate needs. The loans under our senior credit facilities are variable rate obligations and are guaranteed
by our subsidiaries and are secured by a first priority security interest in all of our assets and
in all of the assets of our subsidiary companies, as well as the capital stock of our subsidiary
companies. Under the credit agreement we are required to meet certain financial and non-financial
covenants. The financial covenants include a variety of financial metrics that are used to
determine our overall financial stability and include limitations on our capital expenditures, a
minimum ratio of EBITDA to fixed charges, and a minimum of indebtedness to EBITDA. However, the
revolving sub-facility has no borrowing base availability requirement. FUNimation Acquisition On May 11, 2005 we acquired 100% of the general and limited partnership interests of
FUNimation Productions, Ltd. and The FUNimation Store, Ltd. As consideration for the acquisition
of FUNimation, the sellers of FUNimation received $100.4 million in cash, subject to post-closing
adjustments not to exceed $5.0 million and excess cash as defined in the purchase agreement, and
1,827,486 shares of Navarre common stock. In addition, during the five-year period following the
closing of the transaction, we may pay up to an additional $17.0 million in cash to the FUNimation
sellers if they
achieve certain agreed-upon financial targets relating to the FUNimation business. The
FUNimation business is described in more detail at Business-FUNimation Business. AVAILABLE INFORMATION We
also make available, free of charge through our website,
www.navarre.com, annual, quarterly
and current reports (and amendments thereto) as soon as reasonably practicable after our electronic
filing. 12




---



##### Table of Contents



FORWARD-LOOKING STATEMENTS / IMPORTANT RISK FACTORS We make written and oral statements from time to time regarding our business and prospects,
such as projections of future performance, statements of managements plans and objectives,
forecasts of market trends, and other matters that are forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. Statements containing the words or phrases will likely result, are expected to, will
continue, is anticipated, estimates, projects, believes, expects, anticipates,
intends, target, goal, plans, objective, should or similar expressions identify
forward-looking statements, which may appear in documents, reports, filings with the Securities and
Exchange Commission, including this Annual Report on Form 10-K, news releases, written or oral
presentations made by officers or other representatives made by us to analysts, shareholders,
investors, news organizations and others and discussions with management and other representatives
of us. For such statements, we claim the protection of the safe harbor for forward-looking
statements contained in the Private Securities Litigation Reform Act of 1995. Our future results, including results related to forward-looking statements, involve a number
of risks and uncertainties. No assurance can be given that the results reflected in any
forward-looking statements will be achieved. Any forward-looking statement made by or on behalf of
us speaks only as of the date on which such statement is made. Our forward-looking statements are
based on assumptions that are sometimes based upon estimates, data, communications and other
information from suppliers, government agencies and other sources that may be subject to revision.
Except as required by law, we do not undertake any obligation to update or keep current either (i)
any forward-looking statement to reflect events or circumstances arising after the date of such
statement, or (ii) the important factors that could cause our future results to differ materially
from historical results or trends, results anticipated or planned by us, or which are reflected
from time to time in any forward-looking statement which may be made by or on behalf of us. In addition to other matters identified or described by us from time to time in filings with
the SEC, there are several important factors that could cause our future results to differ
materially from historical results or trends, results anticipated or planned by us, or results that
are reflected from time to time in any forward-looking statement that may be made by or on behalf
of us. Some of these important factors, but not necessarily all important factors, include the
following: Risks Relating To Our Business And Industry We derive a substantial portion of our total net sales from a small group of customers. A
reduction in sales to any of these customers could have a material adverse effect on our net sales
and profitability. For the fiscal year ended March 31, 2005, net sales to two customers, Wal-Mart/Sams Club and
Best Buy accounted for approximately 20% and 19%, respectively, of our total net sales, and, in the
aggregate, approximately 39% of our total net sales. For the fiscal year ended March 31, 2004, net
sales to three customers, Best Buy, CompUSA and Sams Club, represented approximately 18%, 13% and
11%, respectively, of our total net sales, and, in the aggregate, approximately 42% of our total
net sales. For the fiscal year ended March 31, 2003, these three customers accounted for
approximately 19%, 15% and 15%, respectively, of our total net sales, and, in the aggregate,
approximately 49% of our total net sales. We believe that sales to a small group of customers will
continue to represent a significant percentage of our total sales. Substantially all of the
products we distribute to these customers are supplied on a non-exclusive basis under arrangements
that may be cancelled without cause and upon short notice, and our retail customers generally are
not required to make minimum purchases. If we are unable to continue to sell our products to all
or any of these customers or are unable to maintain our sales to these customers at current levels
and cannot find other customers to replace these sales, there would be an adverse impact on our
revenues and profitability. There can be no assurance that we will continue to recognize a
significant amount of revenue from sales to any specific customer. The loss of a significant vendor or manufacturer or a decline in the popularity of its products
could negatively affect our product offerings and reduce our net sales and profitability. A significant portion of our increase in net sales over the past two fiscal years has been due
to increased sales of PC software provided by software publishers such as Symantec Corporation,
Roxio, Inc., Adobe Systems Inc., McAfee, Inc., Dreamcatcher Interactive, Inc. and Sony Online
Entertainment, Inc. During the fiscal year ended 13




---



##### Table of Contents



March 31, 2005 and for the fiscal year ended
March 31, 2004, each of these publishers accounted for more than $5.0 million in net sales. Sales
under our agreement with Symantec accounted for approximately $91.0 million in net sales for the
fiscal year ended March 31, 2005 and approximately $51.0 million in net sales for the fiscal year
ended March 31, 2004. While we have agreements in place with each of these parties, such
agreements generally are short-term agreements that may be cancelled without cause and upon short
notice; they generally cover the right to distribute in the United States and Canada; they do not
restrict the publishers from distributing their products through other distributors or directly to
retailers; and they do not guarantee product availability to us for distribution. These agreements
allow us to purchase the publishers products at a reduced wholesale price and to provide various
distribution and fulfillment services in connection with the publishers products. If we were to
lose our right to distribute products of any of the above PC software publishers, our net sales and
profitability would be adversely impacted. Our relationships with independent music labels, such as CMH Records, Inc., Studio
Distribution, Inc. and Cleopatra Records, Inc., also are important to our distribution business.
Our future growth and success depends partly upon our ability to procure and renew PC software and
music distribution agreements and to sell the underlying products. There can be no assurance that
we will enter into new distribution agreements or that we will be able to sell products under
existing distribution agreements. Further, our current distribution agreements may be terminated
on short notice. The loss of a software developer, manufacturer or independent music label could
negatively affect our product offerings and, accordingly, our net sales. Similarly, a decrease in
customer demand for such products could negatively affect our net sales. The continued growth and breadth of our exclusive distribution business could be negatively
affected if we fail to sign or renew distribution agreements with independent music labels. Our distribution business derives a portion of its sales from exclusive distribution
agreements with independent music labels. Our future growth and success depend partly upon our
ability to procure and renew these agreements and to sell the underlying recordings. In addition,
we depend upon artists and labels to generate additional quality recordings. In order to procure
future distribution agreements, we regularly evaluate new distribution opportunities with music
labels. There can be no assurance that we will sign such music labels to distribution agreements
or that we will be able to sell recordings under existing distribution agreements. Further, there
can be no assurance that any current distribution agreements will be renewed. Similarly, a
decrease in customer demand for such recordings could negatively affect our sales. The loss of our founder could affect the depth, quality and effectiveness of our management team.
In addition, if we fail to attract and retain qualified personnel, the depth, quality and
effectiveness of our management team and employees could be negatively affected. Eric H. Paulson, our President, Chief Executive Officer and founder, has been with us since
our inception in 1983. Mr. Paulsons employment agreement extends through March 31, 2007, and the
loss of or change in Mr. Paulsons services to us could affect managements ability to continue to
effectively operate our business. Our ability to enhance and develop markets for our current products and to introduce new
products to the marketplace also depends on our ability to attract and retain qualified management
personnel. We compete for such personnel with other companies and organizations, many of which
have substantially greater capital resources and name recognition than we do. If we are not
successful in recruiting or retaining such personnel, it could have a material adverse effect on
our business. We may not be able to sustain the recent growth in our publishing segment. Our publishing business has grown significantly over the past three fiscal years. Our
discussions of changes in financial position and results of operations of this business may not be
indicative of future performance, and this segments financial results may significantly vary in
future quarters as we integrate these new lines of business. As these new lines of business
represent new opportunities and challenges, we may encounter difficulties in the operation of this
segment that could negatively affect its financial condition and results of operation.
Accordingly, there is no assurance that we will be able to continue to grow this segment of our
business. Investors should not rely on the past performance of our publishing segment as an
indicator of our future growth, and there can be no assurance that we will be able to successfully
implement our publishing growth strategy. 14




---



##### Table of Contents



We may not be successful in implementing our acquisition strategy, and future acquisitions could
result in disruptions to our business by, among other things, distracting management time and
diverting financial resources. Further, if we are unsuccessful in integrating FUNimation or other
acquired companies into our business, it could materially and adversely affect our financial
condition and operating results. One of our growth strategies is the acquisition of complementary businesses. We may not be
able to identify suitable acquisition candidates or, if we do, we may not be able to make such
acquisitions on commercially acceptable terms or at all. If we make acquisitions, a significant
amount of our managements time and financial resources may be required to complete the acquisition
and integrate the acquired business, such as FUNimation, into our existing operations. Even with
this investment of management time and financial resources, an acquisition may not produce the
revenue, earnings or business synergies that we anticipated. Acquisitions involve numerous other
risks, including assumption of unanticipated operating problems or legal liabilities, problems
integrating the purchased operations, technologies or products, diversion of managements attention
from our core businesses, adverse effects on existing business relationships with suppliers and
customers, incorrect estimates made in the accounting for
acquisitions and amortization of acquired
intangible assets that would reduce future reported earnings
(goodwill impairments), ensuring acquired companies compliance with the
requirements of the Sarbanes-Oxley Act of 2002 and potential
loss of customers or key employees of acquired businesses. We cannot assure you that if we make
any future acquisitions, investments, strategic alliances or joint ventures they will be completed
in a timely manner or achieve anticipated synergies, that they will be structured or financed in a
way that will enhance our creditworthiness or that they will meet our strategic objectives or
otherwise be successful. In addition, we may not be able to secure the financing necessary to
consummate future acquisitions, and future acquisitions and investments could involve the issuance
of additional equity securities or the incurrence of additional debt, which could harm our
financial condition or creditworthiness. Our business is seasonal and variable in nature and, as a result, the level of sales and payment
terms during our peak season could adversely affect our results of operations and liquidity. Traditionally, our third quarter (October 1-December 31) has accounted for our largest
quarterly revenue figures and a substantial portion of our earnings. Our third quarter accounted
for approximately 30.6%, 32.1% and 32.5% of our net sales for the fiscal years ended March 31,
2005, 2004 and 2003, respectively, and approximately 63.5%, 28.7%
and 69.5% of our
net income for the fiscal years ended March 31, 2005, 2004 (as
Restated) and
2003, respectively. As a
distributor of products ultimately sold to consumers, our business is affected by the pattern of
seasonality common to other suppliers of retailers, particularly during the holiday season.
Because of this seasonality, if we or our customers experience a weak holiday season or if we
provide extended payment terms for sales during the holiday season or determine to increase our
inventory levels to meet anticipated retail customer demand, our financial results and liquidity or
could be negatively affected. In addition, our borrowing levels and inventory levels can increase
substantially during this time. For example, during the 2004 holiday season, we increased our
inventory of certain PC software products to satisfy potential retail customer demand for such
products, which temporarily caused our inventory and borrowing levels to be higher than usual for
us. In addition to seasonality issues, other factors contribute to the variability of our revenues
and cash flows in both of our business segments on a quarterly basis. These factors include:  
    the popularity of the pre-recorded music, DVD and PC software titles released
during the quarter; 
    product marketing and promotional activities; 
    the opening and closing of retail stores by our major customers; 
    payment terms offered to certain of our retail customers during the holiday season; 
    fluctuations of inventory levels; 
    the extension, termination or non-renewal of existing distribution agreements and
licenses; and 
    general economic changes affecting the buying pattern of retailers, particularly
those changes affecting consumer demand for home entertainment products and PC
software. 15




---



##### Table of Contents



If we fail to meet our significant working capital requirements or if our working capital
requirements increase substantially, our business and prospects could be adversely affected. As a distributor and publisher, we purchase and license products directly from manufacturers
and content developers for resale to retailers. As a result, we have significant working capital
requirements, principally to acquire inventory, procure licenses and finance accounts receivable.
Our working capital needs will increase as our inventory, licensing activities and accounts
receivable increase in response to our growth. In addition, license advances, prepayments to
enhance margins, investments, and inventory increases to meet customer requirements could increase
our working capital needs. The failure to obtain additional financing or maintain working capital
credit facilities on reasonable terms in the future could adversely affect our business. In
addition, if the cost of financing is too expensive or not available, it could require a reduction
in our distribution or publishing activities. We rely upon bank borrowings to fund our general working capital needs and it may be necessary
for us to secure additional financing in the future depending upon the growth of our business and
the possible financing of additional acquisitions. If we were unable to borrow under our credit
facility or otherwise unable to secure sufficient financing on acceptable terms or at all, our
future growth and profitability could be adversely affected. Product returns or inventory obsolescence could reduce our sales and profitability or could
negatively impact our liquidity. We maintain a significant investment in product inventory. Like other distribution companies
operating in our industry, product returns from our retail customers are significant when expressed
as a percentage of revenues. Adverse financial or other developments with respect to a particular
supplier could cause a significant decline in the value and marketability of our products and could
make it difficult for us to return products to a supplier and recover our initial product
acquisition costs. Under such circumstances, our sales and profitability, including our liquidity,
could be adversely affected. We maintain a sales return reserve based on our trailing twelve month
sales returns by product line. There can be no assurance that our reserves will be adequate to
cover potential returns. We are subject to the risk that our inventory values may decline due to, among other things,
changes in demand and that protective terms under our supplier agreements may not adequately cover
the decline in values, which could result in lower gross margins or inventory write-downs. The demand for products that we sell and distribute is subject to rapid technological change,
new and enhanced product specification requirements, consumer preferences and evolving industry
standards. These changes may cause our inventory to decline substantially in value or to become
obsolete which may occur in a short period of time. We generally are entitled to receive a credit from certain suppliers
for products returned to us based upon the terms and conditions with those suppliers, including
maintaining a minimum level of inventory of their products and limitations on the amount of product
that can be returned and/or restocking fees. If major suppliers decrease or eliminate the
availability of price protection or inventory returnability to us, such a change in policy could
lower our gross margins or cause us to record inventory write-downs. We are also exposed to
inventory risk to the extent that supplier protections are not available on all products or
quantities and are subject to time restrictions. In addition, suppliers may become insolvent and
unable to fulfill their protection obligations to us. As a result, these policies do not protect
us in all cases from declines in inventory value or product demand. We offer no assurance that
price protection or inventory returnability terms may not change or be eliminated in the future,
that unforeseen new product developments will not materially adversely affect our revenues or
profitability or that we will successfully manage our existing and future inventories. In our publishing business, prices could decline due to decreased demand and, therefore, there
may be greater risk of declines in inventory value. To the extent that our publishing business has
not properly reserved for inventory exposure or price reductions needed to sell remaining
inventory, our profitability may suffer. We have significant credit exposure and negative trends or other factors could cause us significant
credit loss. We provide credit to our customers for a significant portion of our net sales. During the
holiday season, certain of our retail customers may request and we may grant extended payment
terms, which may require us to borrow additional amounts under our credit facilities. We are
subject to the risk that our customers will not pay for the products they have purchased. This
risk may increase if our customers experience decreases in demand for their 16




---



##### Table of Contents



products and services
or become less financially stable due to adverse economic conditions or otherwise. If there is a
substantial deterioration in the collectibility of our receivables,
our earnings and cash flows could be adversely affected. In addition, from time to time, we may make loans to or invest in complementary businesses,
such as our $2.5 million loan commitment to Mix & Burn, Inc., a start-up company developing a music
listening and CD burning station. These business or investment opportunities may not be
successful, which could result in the loss of our invested capital. We may not be able to adequately adjust our cost structure in a timely fashion in response to a
decrease in net sales, which may cause our profitability to suffer. A significant portion of selling, general and administrative expense is comprised of
personnel, facilities and costs of invested capital. In the event of a significant downturn in net
sales, we may not be able to exit facilities, reduce personnel, improve business processes, reduce
inventory or make other significant changes to our cost structure without significant disruption to
our operations or without significant termination and exit costs. Additionally, if management is
not be able to implement such actions in a timely manner or at all to offset a shortfall in net
sales and gross profit, our profitability would suffer. Our distribution and publishing businesses operate in highly competitive industries and compete
with large national firms. Further competition, among other things, could reduce our sales volume
and margins. The business of distributing home entertainment and multimedia products is highly competitive.
Our competitors in the distribution business include other national and regional distributors as
well as suppliers that sell directly to retailers. These competitors include the distribution
affiliates of Time-Warner, Sony/BMG Music Entertainment, EMI, Ingram Micro and Tech Data
Corporation. Our competitors in the publishing business include both independent national
publishers as well as large international firms. These competitors include Ventura, Madacy, Direct
Source, Platinum Image, Topics,
Vivendi and Disney. Many of our competitors have substantially greater financial and other
resources than we have. Our ability to compete effectively in the future depends upon a number of
factors, including our ability to:  
    obtain exclusive national distribution contracts and licenses with independent
music labels and manufacturers; 
    obtain proprietary publishing rights with various rights holders and brand owners; 
    maintain our margins and volume; 
    expand our sales through a varied range of products and personalized services; 
    anticipate changes in the marketplace including technological developments and
consumer interest in our proprietary products; and 
    maintain operating expenses at an appropriate level. Our failure to perform adequately one or more of these tasks may materially harm our business. In addition, competition in the home entertainment and multimedia products industries is
intense and is often based on price. Distributors generally experience low gross profit margins
and operating margins. Consequently, our distribution profitability is highly dependent upon
achieving effective cost and management controls and maintaining sales volumes. A material
decrease in our gross profit margins or sales volumes would harm our financial results. 17




---



##### Table of Contents



We depend on third party shipping and fulfillment companies for the delivery of our products. We
rely almost entirely on arrangements with third party shipping and fulfillment companies,
principally UPS and Federal Express, for the delivery of our products. The termination of our
arrangements with one or more of these third party shipping companies, or the failure or inability
of one or more of these third party shipping companies to deliver products on a timely basis from
suppliers to us, or products from us to our reseller customers or their end-user customers, could
disrupt our business and harm our reputation and net sales. Furthermore, an increase in amounts
charged by these shipping companies could negatively affect our gross margins and earnings. We depend on a variety of systems for our operations, and a failure of these systems could disrupt
our business and harm our reputation and net sales and negatively impact our results of operations. We depend on a variety of systems for our operations. These systems support our operating
functions, including inventory management, order processing, shipping, receiving and accounting.
Our recently implemented, new picking and shipping system, currently supports a portion of our
business and we anticipate that all other product lines will be moved to this system. Any failures
or significant downtime in our systems could prevent us from taking customer orders, printing
product pick-lists, and/or shipping product. It could also prevent customers from accessing our
price and product availability information. From time to time we may acquire other businesses having information systems and records,
which may be converted and integrated into our information systems. This can be a lengthy and
expensive process that results in a material diversion of resources from other operations. In
addition, because our information systems are comprised of a number of legacy, internally-developed
applications, they can be harder to upgrade and may not be adaptable to commercially available
software. As our needs for technology evolve, we may experience
difficulty or significant cost in upgrading or significant
replacing our systems. We also rely on the Internet for a portion of our orders and information exchanges with our
customers. The Internet and individual websites can experience disruptions and slowdowns. In
addition, some websites have experienced security breakdowns. Our website could experience
material breakdowns, disruptions or breaches in security. If we were to experience a security
breakdown, disruption or breach that compromised sensitive information, this could harm our
relationship with our customers or suppliers. Disruption of our website or the Internet in general
could impair our order processing or more generally prevent our customers and suppliers from
accessing information. This could cause us to lose business. We believe that customer information systems and product ordering and delivery systems,
including Internet-based systems, are becoming increasingly important in the distribution of
technology products and services. Although we seek to enhance our customer information systems by
adding new features, we offer no assurance that competitors will not develop superior customer
information systems or that we will be able to meet evolving market requirements by upgrading our
current systems at a reasonable cost, or at all. Our inability to develop competitive customer
information systems or upgrade our current systems could cause our business and market share to
suffer. Technology developments, particularly in the electronic downloading arena, may adversely affect our
net sales, margins and results of operations. Home entertainment products have traditionally been marketed and delivered on a physical
delivery basis. If, in the future, these products are increasingly marketed and delivered through
technology transfers, such as electronic downloading through the Internet or similar delivery
methods, then our retail and wholesale distribution business could be negatively impacted. As
electronic downloading grows through Internet retailers, competition between suppliers to
electronic retailers in traditional ways will intensify and likely negatively impact our net sales
and margins. Furthermore, we may be required to spend significant capital to enter or participate
in this delivery channel. If we are unable to develop necessary supplier relationships with
electronic retailers or are unable to develop relationships to facilitate electronic downloading of
home entertainment products, our business may be materially harmed. 18




---



##### Table of Contents



Increased counterfeiting or piracy may negatively affect the demand for our home entertainment
products. The recorded music and motion picture industries have been adversely affected by
counterfeiting of audiocassettes, CDs and DVDs, piracy and parallel imports, and also by websites
and technologies that allow consumers to illegally download and access music and video. Increased
proliferation of these alternative access methods to these products could impair our ability to
generate net sales and could cause our business to suffer. We may not be able to successfully protect our intellectual property rights. We rely on a combination of copyright, trademark and other proprietary rights laws to protect
the intellectual property we license. Third parties may try to challenge the ownership by us or
our licensors of such intellectual property. In addition, our business is subject to the risk of
third parties infringing on our intellectual property rights or those of our licensors and
producing counterfeit products. We may need to resort to litigation in the future to protect our
intellectual property rights or those of our licensors, which could result in substantial costs and
diversion of resources and could have a material adverse effect on our business and competitive
position. Interruption of our business or catastrophic loss at any of our facilities could lead to a
curtailment or shutdown of our business, which would reduce our net sales and earnings. We receive, manage and distribute our inventory from a centralized warehouse and distribution
facility that is located adjacent to our corporate headquarters. An interruption in the operation
of or in the service capabilities at this facility or our separate returns processing center as a
result of equipment failure or other reasons could result in our inability to distribute products,
which would reduce our net sales and
earnings for the affected period. In the event of a stoppage at such facilities, even if only
temporary, or if we experience delays as a result of events that are beyond our control, delivery
times to our customers and our relationship with such customers could be severely affected. Any
significant delay in deliveries to our customers could lead to increased returns or cancellations
and cause us to lose future sales. Our facilities are also subject to the risk of catastrophic
loss due to unanticipated events such as fires, explosions, violent weather conditions or other
natural disasters. We may experience a shutdown of our facilities or periods of reduced production
as a result of equipment failure, delays in deliveries or catastrophic loss, which could have a
material adverse effect on our business, results of operations or financial condition. Future terrorist or military actions could result in disruption to our operations or loss of
assets, in certain markets or globally. Future terrorist or military actions, in the U.S. or abroad, could result in destruction or
seizure of assets or suspension or disruption of our operations. Additionally, such actions could
affect the operations of our suppliers or customers, resulting in loss of access to products,
potential losses on supplier programs, loss of business, higher losses on receivables or inventory,
or other disruptions in our business, which could negatively affect our operating results. We do
not carry insurance covering such terrorist or military actions, and even if we were to seek such
coverage and such coverage were available, the cost likely would not be commercially reasonable. Legislative actions, higher director and officer insurance costs and potential new accounting
pronouncements are likely to cause our general and administrative expenses to increase and impact
our future financial condition and results of operations. In order to comply with the Sarbanes-Oxley Act of 2002, as well as changes to the NASDAQ
listing standards and rules adopted by the Securities and Exchange Commission, we have been
required to strengthen our internal controls, hire additional personnel and retain additional
legal, accounting and advisory services, all of which have caused and will continue to cause our
general and administrative costs to increase. Although we have not experienced any claims,
insurers have increased and are likely to continue to increase premiums as a result of the high
claims rates they have incurred with other companies over the past year, and so our premiums for
our directors and officers insurance policies are likely to increase. Changes in the accounting
rules and auditing standards, including legislative and other proposals to account for employee
stock options as a compensation expense among others, could materially increase the expenses that
we incur and report under generally accepted accounting principles and adversely affect our
operating results. 19




---



##### Table of Contents



Any material weakness or significant deficiency in our internal controls may adversely affect our
ability to report our financial results on a timely and accurate basis. Section 404 of the Sarbanes-Oxley Act of 2002 requires that companies evaluate and report on
their internal control structure and procedures over financial reporting. In addition, our
independent accountants must report on managements evaluation as well as evaluate our internal
control structure and procedures. As a result of this process we have
identified certain material weaknesses in our internal controls over financial reporting and we have taken steps to address these material weaknesses. However, if we are unable to successfully address these material weaknesses, or if any
other material weaknesses are identified in the future which we are unable to successfully address, our ability
to report our financial results on a timely and accurate basis may be adversely affected. Risks Relating to the FUNimation Business A substantial portion of FUNimations revenues typically derive from a small number of licensed
properties and a small number of licensors and FUNimations content is highly concentrated in the
animegenre. FUNimation derives a substantial portion of its revenues from a small number of properties and
such properties usually generate revenues only for a limited period of time. Additionally,
FUNimations content is concentrated in the animesector and its revenues are highly subject to the
changing trends in the toy, game and entertainment businesses. In particular, the Dragon Ball
properties accounted for $57.3 million, $61.9 million and $47.1 million, or 90%, 76%, and 65%, of
FUNimations net sales for the years ended December 31, 2002, 2003 and 2004, respectively.
FUNimations revenues may fluctuate significantly from year to year due to, among other reasons,
the popularity of its licensed properties and the timing of entering into new licensing contracts. During the years ended December 31, 2002, 2003 and 2004, 95%, 92% and 82% of FUNimations
revenues, respectively, were derived from sales of products under multiple licensing arrangements
with two licensors. The loss of any of these licensing relationships could have a material
negative effect on FUNimations revenues. FUNimations success depends upon retaining the services of key FUNimation personnel. For the foreseeable future, we will place substantial reliance upon the personal efforts and
abilities of Gen Fukunaga, the President and one of the founders of FUNimation. Mr. Fukunaga has
entered into a five-year 20




---



##### Table of Contents



employment agreement with FUNimation Productions, Ltd. However, the loss
of his services could materially and adversely affect FUNimations business, and could affect our
financial condition and operating results. We cannot assure you that we would be able to find an
appropriate replacement for Mr. Fukunaga if the need should arise. FUNimations ability to enhance and develop its markets for its current products and to
introduce new products to the marketplace also depends on its ability to attract and retain
qualified management personnel. FUNimation competes for such personnel with other companies and
organizations, some of which have substantially greater capital resources and name recognition than
FUNimation. If FUNimation is not successful in recruiting or retaining such personnel, it could
have a material adverse effect on its business. FUNimations business is dependent on a few customers, and a loss of any of these customers could
have a material adverse effect on its revenues and profitability. During the year ended December 31, 2004, sales to four customers, Anderson Merchandisers, The
Musicland Group, Goldhil Home Media International and Best Buy, represented approximately 28%, 16%,
16% and 12% of FUNimations gross wholesale and retail sales, respectively, and in the aggregate,
approximately 72% of FUNimations gross wholesale and retail sales. In addition, one licensor made
up approximately 80% of FUNimations license and royalty revenue for such year. Revenue from this
licensor included $10.0 million relating to a contract effective as of December 2004 and that is
reflected in accounts and royalties receivable at December 31, 2004 in accordance with SOP 00-2
American Institute of Certified Public Accountants Statement of Position (SOP) 00-2, Accounting
by Producers or Distributors of Films.During the year ended December 31, 2003, sales to three
customers, Anderson Merchandisers, The Musicland Group and Goldhil Home Media International,
accounted for approximately 28%, 23% and 21% of FUNimations gross wholesale and retail sales,
respectively, and, in the aggregate, approximately 72% of FUNimations gross wholesale and retail
sales. If FUNimation is unable to continue to sell its products to all or any of these customers
or is unable to maintain its sales to these customers at current levels and cannot find other
customers to replace these sales, there would be an adverse impact on its revenues and
profitability. FUNimations revenues are dependent on consumer preferences and demand. FUNimations business and operating results substantially depend upon the appeal of its
properties, product concepts and programming to consumers, including the popularity of animein the
United States market and trends in the toy, game and entertainment businesses. A decline in the
popularity of its existing properties or the failure of new properties and product concepts to
achieve and sustain market acceptance could result in reduced overall revenues, which could have a
material adverse effect on FUNimations business, financial condition and results of operations.
Consumer preferences with respect to entertainment are continuously changing and are difficult to
predict and can vary from months to years and entertainment properties often have short life
cycles. There can be no assurances that:  
    any of FUNimations current properties, product concepts or programming will
continue to be popular for any significant period of time; 
    any new properties, product concepts or programming FUNimation represents or
produces will achieve an adequate degree of popularity; or 
    any propertys life cycle will be sufficient to permit FUNimation to profitably
recover advance payments, guarantees, development, marketing, royalties and other
costs. FUNimations failure to successfully anticipate, identify and react to consumer preferences
could have a material adverse effect on FUNimations revenues, profitability and results of
operations. In addition, changes in consumer preferences may cause its revenues and net income to
vary significantly between comparable periods. FUNimation has significant credit exposure. Negative trends and other factors could cause it
significant credit loss. As of December 31, 2003 and 2004, two and four customers made up 81% and 80% of FUNimations
gross accounts receivable, respectively. FUNimation is subject to the risk that its customers will
not pay for the products 21




---



##### Table of Contents



they have purchased or licensed. This risk may increase if FUNimations
customers experience decreases in demand for their products and services or become less financially
stable due to adverse economic conditions or otherwise. If there is a substantial deterioration in
the collectibility of FUNimations receivables, FUNimations earnings and cash flows could be
adversely affected. FUNimations revenues are substantially dependent on television exposure for its licensed
properties. The ability for certain animeand childrens entertainment content to gain television exposure
is an important promotional vehicle for home video sales and licensing opportunities. To the
extent that FUNimations content is not able to gain television exposure, sales of these products
could be limited. Similarly, demand for properties broadcast on television generally is based on
television ratings. In addition, FUNimation does not own the broadcast rights for some of its
properties, so it depends on third parties to secure or renew broadcast rights for such content. A
decline in television ratings or programming time of FUNimations licensed properties could
adversely affect FUNimations revenues. Excessive product returns or inventory obsolescence could significantly reduce FUNimations
revenues or profitability. FUNimation maintains a significant investment in product inventory. FUNimations product
returns are significant when expressed as a percentage of revenues. FUNimation maintains a sales
return reserve, which is determined in part based on historical returns. Actual sales returns
could be higher or lower than FUNimations estimated sales returns due to, among other reasons,
changes in consumer preferences and demand. If actual returns are significantly higher than
FUNimations estimates for potential returns, FUNimations sales return reserve may be inadequate
and, as a result, its operating results and financial condition could be affected adversely. In FUNimations home video distribution business, it is possible that prices will decline due
to decreased demand and, therefore, there may be greater risk of declines in inventory value. To
the extent that FUNimation, as a result of changes in consumer preferences, technological advances,
or other factors, has not properly reserved for inventory exposure or price reductions needed to
sell remaining inventory, its profitability may suffer. FUNimation may experience significant fluctuations in operating results resulting from management
judgments. FUNimation recognizes revenue upon meeting the recognition requirements of SOP 00-2. Revenues
from home video distribution are recognized, net of an allowance for estimated returns, in the
period in which the product is available for sale by FUNimations customers (generally upon
shipment to the customer and in the case of new releases, after street date restrictions lapse).
Revenues from broadcast licensing and home video sublicensing are recognized when the programming
is available to the licensee and other recognition requirements of SOP 00-2 are met. Fees received
in advance of availability are deferred until revenue recognition requirements have been satisfied.
Royalties on sales of licensed products are recognized in the period earned. In all instances,
provisions for uncollectible amounts are provided at the time of sale. Significant management judgments must be made and used in connection with the revenue
recognized in any FUNimation accounting period. Material differences may result in the amount and
timing of revenue recognized or deferred for any period if management made different judgments. FUNimations business operates in a highly competitive industry and its business could be
negatively affected if it fails to sign or renew licenses of attractive content. FUNimations business depends upon its ability to procure and renew agreements to license
certain rights for attractive titles on favorable terms. Competition for attractive childrens
animeand childrens entertainment content and television broadcasting slots is intense.
FUNimations principal competitors in the animesector are media companies such as AD Vision, 4Kids
Entertainment, VIZ and Geneon and Japanese rights holders operating in the United States.
FUNimation also competes with various toy companies, other licensing companies, numerous others
acting as licensing representatives and large media companies such as Disney and Time Warner. Many
of FUNimations competitors have substantially greater resources than FUNimation and own or license
properties 22




---



##### Table of Contents



which are more commercially successful than FUNimations properties. There are low barriers to enter the
licensing and brand management business and therefore there is potential for new competitors to
enter the market. If FUNimation fails to meet its significant working capital requirements, its ability to license
and distribute future content or finance accounts receivable could be negatively affected. As a licensor and distributor, FUNimation acquires certain rights to properties directly from
Japanese rights holders of animeand other childrens entertainment content providers. As a
result, FUNimation has significant working capital requirements, principally to finance inventory,
accounts receivable and licensing acquisitions. FUNimations working capital needs will increase
as its inventory, licensing activities and accounts receivable increase in response to its growth.
The failure to obtain financing on acceptable terms or at all in the future could adversely affect
FUNimations business. FUNimation may not be able to successfully protect its intellectual property rights. FUNimation relies on a combination of copyright, trademark and other proprietary rights laws
to protect its rights to the intellectual property it licenses. Third parties may try to challenge
the ownership by FUNimation or its licensors of such intellectual property. In addition,
FUNimations business is subject to the risk of third parties producing counterfeit products or
infringing upon its intellectual property rights or those of its licensors. FUNimation may need to
resort to litigation in the future to protect the intellectual property rights or those of its
licensors, which could result in substantial costs and diversion of resources and could have a
material adverse effect on FUNimations business and competitive position. FUNimations business depends in part on the Internet, and a failure of this system could disrupt
and harm FUNimations business. FUNimation relies on the Internet for a portion of its orders and information exchanges with
customers and the general public. The Internet and individual websites can experience disruptions
and slowdowns. In addition, some websites have experienced security breakdowns. To date,
FUNimations websites have not experienced any material breakdowns, disruptions or breaches in
security, but it cannot assure that this will not occur in the future. If FUNimation were to
experience a security breakdown, disruption or breach that compromised sensitive information, this
could harm FUNimations relationship with its customers or suppliers. Disruption of the websites
or the Internet in general could impair FUNimations order processing or, more generally, prevent
customers and suppliers from accessing information. This could cause FUNimation to lose business. Interruption of FUNimations business or catastrophic loss at any of its facilities or its
production masters could lead to a curtailment or shutdown of its business. An interruption in FUNimations operations could result in its inability to produce its
content, which would reduce its revenues and earnings. In the event of a stoppage, even if only
temporary, or if FUNimation experiences a delay as a result of events that are beyond its control,
its business could be severely affected. FUNimations facilities are also subject to the risk of
catastrophic loss due to unanticipated events such as fires, explosions, violent weather conditions
or other natural disasters. FUNimation may experience a shutdown of its facilities or periods of
reduced production as a result of equipment failure or catastrophic loss, which could have a
material adverse effect on FUNimations business, results of operations or financial condition. FUNimation depends on
third party shipping and fulfillment companies for the delivery of its
products. FUNimation
relies almost entirely on arrangements with third party shipping and fulfillment
companies, principally UPS and Federal Express, for the delivery of its products. The termination
of arrangements with one or more of these third party shipping companies, or the failure or
inability of one or more of these third party shipping companies to deliver products on a timely
basis from suppliers to
FUNimation, or products from it to its reseller customers or their end-user customers, could
disrupt FUNimations business and harm its reputation and net sales. 23




---



##### Table of Contents



Increased counterfeiting or piracy may negatively affect the demand for FUNimations home
entertainment products. The home entertainment industry has been adversely affected by counterfeiting of home videos,
piracy and parallel imports, as well as by websites and technologies that allow consumers to
illegally download and access music and video content. Increased proliferation of these
alternative access methods to these products could impair FUNimations ability to generate revenues
and could cause its business to suffer. Future terrorist or military actions could result in disruption to FUNimations operations or loss
of assets, in certain markets or globally. Future terrorist or military actions, in the U.S. or abroad, could result in the destruction
or seizure of assets or suspension or disruption of FUNimations operations. Additionally, such
actions could affect the operations of FUNimations suppliers or customers, resulting in a loss of
access to products, potential losses on supplier programs, loss of business, higher losses on
receivables or inventory, or other disruptions in FUNimations business, which could negatively
affect its operating results. FUNimation does not carry insurance covering such terrorist or
military actions, and even if it were to seek such coverage and such coverage were available, the
cost likely would not be commercially reasonable. Risks Relating to Indebtedness The level of our indebtedness could adversely affect our financial condition. Following completion of the FUNimation acquisition, we have significant debt service
obligations. As of May 31, 2005, our total indebtedness under our credit agreement is $140.0
million. We also have the ability to borrow an additional $25.0 million under this credit
agreement. The level of our indebtedness could have important consequences. For example, it could:  
    make it more difficult for us to satisfy our obligations with respect to other indebtedness; 
    increase our vulnerability to adverse economic and industry conditions; 
    require us to dedicate a substantial portion of our cash flow from operations to
the payment of our indebtedness, thereby reducing the availability of cash to fund
working capital and capital expenditures and for other general corporate purposes; 
    restrict us from making strategic acquisitions, acquiring new content or exploring
other business opportunities; 
    limit our ability to obtain financing for working capital, capital expenditures,
general corporate purposes or acquisitions; 
    place us at a disadvantage compared to our competitors that have less indebtedness; and 
    limit our flexibility in planning for, or reacting to, changes in our business and industry. We may be unable to generate sufficient cash flow to service our debt obligations. Our ability to make payments on and to refinance our indebtedness and to fund our operations,
working capital and capital expenditures, depends on our ability to generate cash in the future,
which is subject to general economic, industry, financial, competitive, operating, legislative,
regulatory and other factors that are beyond our control. 24




---



##### Table of Contents



We cannot assure you that our business will generate sufficient cash flow from operations
or that future borrowings will be available to us under our credit agreement in an amount
sufficient to enable us to pay amounts due on our indebtedness or to fund our other liquidity
needs. We may need to refinance all or a portion of our indebtedness on or before maturity. Our
ability to refinance our indebtedness or obtain additional financing will depend on, among other
things:  
    our financial condition at the time;
    restrictions in our credit agreement or other outstanding indebtedness; and
    other factors, including the condition of the financial markets or the distribution
and publishing markets. As a result, we may not be able to refinance any of our indebtedness on commercially
reasonable terms, or at all. If we do not generate sufficient cash flow from operations, and
additional borrowings or refinancings or proceeds of asset sales are not available to us, we may
not have sufficient cash to enable us to meet all of our obligations. We may be able to incur additional indebtedness, which could further exacerbate the risks
associated with our current indebtedness level. We and our subsidiaries may be able to incur substantial additional indebtedness in the
future. Although our credit facility contains restrictions on the incurrence of additional
indebtedness, debt incurred in compliance with these restrictions could be substantial. Our
revolving working capital credit facility provided pursuant to a credit agreement, permits total
borrowings of up to an additional $25.0 million. In addition, our credit agreement will not prevent
us from incurring certain other obligations. If we and our subsidiaries incur additional
indebtedness or other obligations, the related risks that we and they face could be magnified. Our credit agreement contains significant restrictions that limit our operating and financial
flexibility. Our credit agreement requires us to maintain specified financial ratios, and we may be unable
to meet such ratios. All of these restrictions may limit our ability to execute our business
strategy. Moreover, if operating results fall below current levels, we may be unable to comply
with these covenants. If that occurs, our lenders could accelerate our indebtedness, in which case
we may not be able to repay all of our indebtedness. Most of our outstanding indebtedness bears interest at variable rates. Any increase in interest
rates will reduce funds available to us for our operations and future business opportunities and
will adversely affect our leveraged capital structure. Our debt service requirements will be impacted by changing interest rates as we have, as of
May 31, 2005, $140.0 million of variable interest rate debt. A 100-basis point change in LIBOR
would cause our projected annual interest expense to change by approximately $1.4 million. The
fluctuation in our debt service requirements, in addition to interest rate changes, may be impacted
by future borrowings under our credit facility or other alternative financing arrangements. Other Risks The foregoing is not a complete description of all risks relevant to our future performance, and the foregoing should be read and understood together with and in the context of similar discussions which may be contained in the documents that we file with the SEC in the future. We undertake no obligation to release publicly any revision to the foregoing or any update to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. 
 Item 2. Properties Our corporate headquarters are located in the Minneapolis suburb of New Hope, Minnesota. We
operate our corporate offices, the offices for our distribution business, a significant portion of
our warehousing and shipping and the majority of our manufacturing and assembly functions from this
location. Our headquarters consist of 281,625 square feet of combined office and warehouse space
situated on three contiguous properties. These properties include approximately 35,000 square feet
of office space; approximately 40,000 square feet of space utilized in the manufacturing and
assembly of new products; and approximately 205,000 square feet of space devoted to warehousing,
product picking and shipping. Approximately 80,000 square feet of our corporate headquarters is
leased through 2010 and the remaining space is leased through 2019. 25




---



##### Table of Contents



Our product returns processing facility is located in the Minneapolis suburb of Brooklyn
Center which consists of approximately 65,000 square feet of warehouse space that is leased through
November 2005. We also operate a satellite sales office in Bentonville, Arkansas which resides in
2,000 square feet of office space that is leased through February 2007. The present aggregate
monthly rent for our headquarters facility and these additional two additional locations is
$146,701. Our publishing business operates its offices in several locations. Encore operates its offices
out of approximately 13,000 square feet of leased office space located in Los Angeles, California.
Encores lease to this facility expires in May 2010 and its monthly rent is currently $25,771. BCI
operates its offices out of 6,534 square feet of leased office space located in Newbury Park,
California. BCIs lease to this facility expires in March 2007 and its monthly rent is currently
$7,373. FUNimation currently operates its offices and certain of its operations out of two locations.
The first consists of 15,681 square feet of office space in Fort Worth, Texas that is leased for
$11,107 per month through July of 2009. The second facility consists of 20 acres of real property
located in Decatur, Texas that is owned by The FUNimation Store, Ltd. This Decatur, Texas property
includes two warehouse buildings and one combined warehouse/office/retail building that are owned
by The FUNimation Store, Ltd. Approximately 3,000 square feet of office/retail space located at
this facility is leased to a third party. We believe that our facilities are adequate for our present operations as well as for the
incorporation of growth. We continually explore alternatives to certain of these facilities that
could expand our capacities and enhance efficiencies, and we believe we can renew or obtain
replacement or additional space, if required, on commercially reasonable terms. 
 Item 3. Legal Proceedings In the normal course of our business, we are involved in a number of litigation matters that,
other than the matters described immediately below, are incidental to the operation of our
business. These matters generally include, among other things, collection matters with regard to
products distributed by us and accounts receivable owed to us. We currently believe that the
resolution of any of these pending matters will not have a material adverse effect on our financial
position or liquidity, but an adverse decision in more than one of the matters could be material to
our consolidated results of operations. ValueVision Media, Inc. v. Navarre Corporation On July 7, 2004, ValueVision Media, Inc. (ValueVision) commenced an action against the
Navarre Corporation in Hennepin County District Court for the State of Minnesota, alleging among
other things that the Navarre breached a 1997 Stock Purchase Agreement and Conversion Agreement
between the parties and NetRadio Corporation (NetRadio). ValueVisions Complaint (Complaint)
seeks damages in excess of $50,000, restitution and an order of specific performance requiring
Navarre to convert ValueVisions shares of NetRadio stock into Navarre common stock based upon a
January 30, 2002 notice of default and the conversion formula set forth in the Conversion Agreement
that is filed as exhibit 10.19 to our Form 10-K for the year ended March 31, 1997. On August 9, 2004, Navarre answered the Complaint, denied liability and asserted defenses.
Among other defenses, we believe that ValueVisions alleged rights under the Stock Purchase
Agreement and Conversion Agreement terminated pursuant to the express terms and conditions of the
Stock Purchase Agreement and the Conversion Agreement upon the occurrence of the initial public
offering of NetRadio. This position is supported by, among other things, certain statements that
appear in the prospectus that is on file in connection with NetRadios initial public offering. In
addition, at the time the NetRadio registration statement was filed, a representative of
ValueVision sat on the board of directors of NetRadio and consented to the filing of the NetRadio
registration statement. On December 17, 2004, Navarre commenced a third-party action against Gene McCaffrey. Navarre
alleges that, if ValueVisions claims are correct, then McCaffrey, as a Director of NetRadio,
breached his fiduciary duties to Navarre, a shareholder of NetRadio. McCaffrey responded to the
Third-Party Complaint and denied liability. In 26




---



##### Table of Contents



addition, Navarre and ValueVision stipulated that Navarre could assert a counterclaim against
ValueVision, but ValueVision did not waive any defenses or rights by so stipulating. On or about January 21, 2005, the Court approved the parties stipulation for Navarre to
assert its counterclaim against ValueVision, and on January 26, 2005, Navarre served and filed its
counterclaim. ValueVisions reply to the counterclaim is due on or about February 15, 2005. The parties are in the process of conducting discovery. All parties have scheduled hearings
for summary judgment. The case is currently scheduled for trial during the courts November 2005
trial block. We intend to vigorously defend against the claims asserted by ValueVision and pursue
our claims. Because of the status of the proceeding and the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to predict a result in this
proceeding. Sybersound Records, Inc. v. BCI Eclipse, LLC, et al. On May 12, 2005, Sybersound Records, Inc. (Sybersound) filed this action against BCI
Eclipse, LLC (BCI) and others in the Superior Court of California, County of Los Angeles, West
District, Case Number SC085498. Plaintiff alleges that BCI and others sold unlicensed records in
connection with their karaoke related business or otherwise failed to account for or pay licensing
fees and/or royalties. Sybersound alleges that this conduct gives BCI and others an illegal,
competitive advantage in the marketplace. Based on this and related conduct, Sybersound asserts the
following causes of action: tortious interference with business relations, unfair competition under
the California Business and Professions Code, and unfair trade practices under Californias Unfair
Practices Act. Sybersound seeks damages, including punitive damages, of not less than $195 million
dollars plus trebled actual damages, injunctive relief, pre- and post- judgment interest, costs,
attorneys fees and expert fees. BCI intends to deny the allegations of the Complaint and assert all available and appropriate
affirmative defenses. Because of the status of the proceeding and the contingencies and
uncertainties associated with litigation, it is difficult, if not impossible to predict a result in
this proceeding. Sybersound Records, Inc. v. Navarre Corporation, BCI Eclipse, LLC, et al. Sybersound Records, Inc. filed this action on or about May 12, 2005 in the Superior Court of
Justice, Toronto, Ontario, Canada, Court File Number 05-CV-289397Pd2. The factual basis for
Sybersounds claims in this case are essentially the same as those in the case described above.
However, Sybersound has named Navarre Corporation in this case in addition to BCI Eclipse, LLC. Sybersound claims that the alleged misconduct constitutes tortious interference with economic
interests, and seeks damages of not less than $5,745,000, plus punitive damages in the amount of
$800,000, plus injunctive relief against certain of the defendants other than Navarre and BCI. Navarre and BCI Eclipse Company, LLC intend to deny liability and damages and to vigorously
defend against Sybersounds claims. Because of the status of the proceeding and the contingencies
and uncertainties associated with litigation, it is difficult, if not impossible to predict a
result in this proceeding. Faulconer Productions Music Corp. v. FUNimation Productions, Inc. et al. Faulconer Productions
Music Corporation (FPMC) filed a lawsuit in the U.S. District Court
for the Eastern District of Texas on September 24, 2003 alleging that FUNimation Productions, Ltd. and certain other
defendants fraudulently induced it to enter into contracts pursuant to which FUNimation had
commissioned it to compose music for certain television episodes. FPMC also claims that it owns
all copyrights in the music and that FUNimation has infringed upon its music copyrights. FPMC is
asserting state law claims for fraudulent inducement, fraudulent misrepresentation, negligent
misrepresentation, negligence, breach of contract, unjust enrichment, breach of the duty of good
faith and fair dealing, conspiracy to commit fraud, and a host of similar claims related to a
proposed settlement agreement related to this case. FPMC seeks
damages of approximately $13.0 million. FUNimation instituted an action against FPMC and Bruce Faulconer, a principle of FPMC, in the
U.S. District Court for the Northern District of Texas. These two cases were consolidated in the
Eastern District of Texas. FUNimation asserts claims for trademark and copyright infringement,
passing off, and breach of contract. Actual damages have not yet been calculated. FUNimation also
seeks attorneys fees on the copyright infringement and contract claims and in connection with the
defense of FPMCs copyright infringement claims. FUNimation has filed a motion to dismiss all fraud-based, breach of the duty of good faith and
fair dealing, negligent misrepresentation, and negligence claims. Additionally, this motion to
dismiss seeks the dismissal of all claims relating to the individual defendants. FPMCs response
to this motion to dismiss is due on June 28, 2005. We intend to vigorously defend against the claims asserted against FUNimation and to pursue
our claims. Because of the status of the proceeding and the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to predict a result in this
proceeding. Aviva Partners LLC, individually on behalf of all other similarly
situated, v. Navarre Corporation, Eric H. Paulsen and James
Gilbertson Aviva Partners LLC individually and on behalf of all others similarly
situated (Plaintiffs) filed this putative class action lawsuit on June 13,
2005 in the United States District Court for the District of Minnesota, as Case
Number 05-1151 (PAM/RLE). Plaintiffs allege that this is a federal class
action lawsuit on behalf of all those who purchased or otherwise acquired
securities in the Company between July 23, 2003 and May 31, 2005. Plaintiffs
allege among other things, that the Company, its chief executive officer, and
its chief financial officer violated federal securities laws and regulations
because the Companys financial results were materially inflated and not
prepared in accordance with generally accepted accounting principles, which
benefited Company insiders, including the individual defendants. Plaintiffs
further allege the company failed to properly recognize executive deferred
compensation and improperly recognized a deferred tax benefit as income.
Plaintiffs allege violation of Sec. 10(b) of the Securities Exchange Act of
1934 (the Act) and Rule 10(b)5 promulgated under the Act, and as to the
individual defendants only, violation of Sec. 20(a) of the Act. Plaintiffs seek certification of the action as a class action lawsuit,
compensatory but unspecified damages allegedly sustained as a result of the
alleged wrongdoing, plus costs, counsel fees and expert fees. Neither the Company nor the individual defendants have yet been served
with the Complaint, so the date for a response has not yet been determined.
The Company intends to vigorously defend against Plaintiffs claims. Because of
the status of the proceedings as well as the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to
predict a result in this matter. 
 Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of shareholders, through the solicitation of proxies
or otherwise, during the fourth quarter of the fiscal year covered by this report. 27




---



##### Table of Contents



PART II 
 Item 5. Market for Registrants Common Equity, and Related Stockholder Matters and Issuer Purchase
of Equity Securities Price Range of Common Stock Our common stock, no par value, is traded on The NASDAQ Stock Market under the symbol NAVR.
The following table presents the range of high and low closing sale prices for our stock for each
period indicated as reported on The NASDAQ Stock Market. Such prices reflect inter-dealer prices,
do not include adjustments for retail mark-ups, markdowns or commissions and may not necessarily
represent actual transactions. Quarter
    
    
    High
    
    
    LowFiscal 2005
    
    First
    
    $
    14.39
    
    
    $
    5.84Second
    
    
    16.37
    
    
    
    12.65Third
    
    
    18.13
    
    
    
    14.27Fourth
    
    
    19.02
    
    
    
    6.68Fiscal 2004
    
    First
    
    $
    2.37
    
    
    $
    1.67Second
    
    
    3.00
    
    
    
    1.96Third
    
    
    7.13
    
    
    
    2.74Fourth
    
    
    7.44
    
    
    
    5.85
 Holders and Dividends At June 15, 2005, we had an estimated 700 common shareholders of record and an estimated 9,975
beneficial owners whose shares were held by nominees or broker dealers. We have never declared or
paid cash dividends on our common stock. We currently intend to retain all earnings for use in our
business and do not intend to pay any dividends on our common stock in the foreseeable future. Equity Compensation Plan Information We adopted our 1992 Stock Option Plan and 2004 Stock Option Plan (together, the Plans) to
attract and retain persons to perform services for us by providing an incentive to these persons
through equity participation in the Company and by rewarding such persons who contribute to the
achievement of our economic objectives. Eligible recipients are all employees including, without
limitation, officers and directors who are also our employees as well as our non-employee
directors, consultants and independent contractors or employees of any of our subsidiaries. A maximum number
of 5,224,000 shares and 1,000,000 shares, respectively, of common stock have been authorized and
reserved for issuance under the Plans. The number of shares authorized may also be increased from
time to time by approval of the Board and the shareholders. These Plans terminate in 2006 and
2014. We are authorized to grant stock options and restricted stock grants under the Plans. Options
generally vest in increments of 20% of the original option grant beginning one year from the date
of grant and expire six to ten years from the date of grant, subject to early termination upon
death, disability or termination of employment. Performance-based options are subject to variable
accounting and will be recognized when, and if, the criteria are met for vesting. On April 1 of each year, each director who is not an employee of Navarre is granted an option
to purchase 6,000 shares of common stock under the Plans, at a price equal to fair market value.
These options are designated as non-qualified stock options and are subject to the same terms and
provisions as are then in effect with respect to granting of non-qualified stock options to
salaried officers and key employees of Navarre. These options vest in increments of 20% of the
original option grant beginning one year from the date of grant and expire six years from the date
of grant. We are entitled to (a) withhold and deduct from future wages of the participant (or from other
amounts that may be due and owing to the participant from us), or make other arrangements for the
collection of, all legally required amounts necessary to satisfy any and all federal, state and
local withholding and employment-related tax 28




---



##### Table of Contents



requirements (i) attributable to the grant or exercise of an option or a restricted stock
award or to a disqualifying disposition of stock received upon exercise of an incentive stock
option, or (ii) otherwise incurred with respect to an option or a restricted stock award, or (iii)
require the participant promptly to remit the amount of such withholding to us before taking any
action with respect to an option or a restricted stock award. The following table below presents our Equity Compensation Plan information: Plan Category
    
    Number of securities to be
    
    
    Weighted-average exercise
    
    
Number of securitiesissued upon exercise of
    
    
    price of outstanding options,
    
    
    remaining available foroutstanding options,
    
    
    warrants and rights
    
    
    future issuance under equitywarrants and rights
    
    
    
    
    
    
    compensation plans(excluding securitiesreflected in column (a))(a)
    
    
    
    (b)
    
    
    
    (c)Equity compensation
plans approved by
security holders
    
    

2,787,800
    
    
    $
    7.24
    
    
    
    771,854Equity compensation
plans not approved
by security holders
    
    
    -0-
    
    
    
    -0-
    
    
    
    -0-Total
    
    
    2,787,800
    
    
    $
    7.24
    
    
    
    771,854
 
 Item 6. Selected Financial Data The following selected financial data should be read in conjunction with our consolidated
financial statements and related notes, Managements Discussion and Analysis of Financial
Condition and Results of Operations, and other financial information appearing elsewhere in this
annual report on Form 10-K. We derived the following historical financial information from our
consolidated financial statements for the fiscal years ended March 31, 2005, 2004, 2003, 2002 and
2001 which have been audited by Grant Thornton LLP (year ended March 31, 2005) and Ernst & Young
LLP (for the remaining periods). (In thousands, except per share data) Fiscal Years ended March 31,2005
    
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001(Restated)Statement of operations data:Net sales
    
    $
    596,263
    
    
    $
    470,877
    
    
    $
    356,816
    
    
    $
    303,817
    
    
    $
    314,199Gross profit, exclusive of
depreciation and amortization
    
    
    91,112
    
    
    
    58,021
    
    
    
    45,475
    
    
    
    32,893
    
    
    
    37,421Income (loss) from operations
    
    
    12,334
    
    
    
    7,697
    
    
    
    4,005
    
    
    
    521
    
    
    
    (2,364
    )Interest expense
    
    
    (778
    )
    
    
    (378
    )
    
    
    (194
    )
    
    
    (173
    )
    
    
    (223
    )Other income (expense)
    
    
    500
    
    
    
    (456
    )
    
    
    447
    
    
    
    884
    
    
    
    2,000Net income (loss) before tax
    
    
    12,056
    
    
    
    6,863
    
    
    
    4,321
    
    
    
    2,712
    
    
    
    (10,925
    )Tax benefit
    
    
    492
    
    
    
    583
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    12,548
    
    
    $
    7,446
    
    
    $
    4,321
    
    
    $
    2,712
    
    
    $
    (10,925
    )Earnings (loss) per common share:Basic
    
    $
    .47
    
    
    $
    .33
    
    
    $
    .20
    
    
    $
    .12
    
    
    $
    (.47
    )Diluted
    
    $
    .44
    
    
    $
    .31
    
    
    $
    .20
    
    
    $
    .12
    
    
    $
    (.47
    )Weighted average shares outstanding:Basic
    
    
    26,830
    
    
    
    22,780
    
    
    
    21,616
    
    
    
    22,553
    
    
    
    25,137Diluted
    
    
    28,782
    
    
    
    24,112
    
    
    
    21,841
    
    
    
    22,575
    
    
    
    25,137Balance sheet data:Total assets
    
    $
    197,802
    
    
    $
    154,837
    
    
    $
    109,665
    
    
    $
    87,368
    
    
    $
    93,918Short-term borrowings
    
    
    
    
    
    
    651
    
    
    
    805
    
    
    
    
    
    
    
    Long-term debt
    
    
    237
    
    
    
    
    
    
    
    268
    
    
    
    
    
    
    
    Shareholders equity
    
    
    80,706
    
    
    
    54,118
    
    
    
    28,671
    
    
    
    24,350
    
    
    
    24,350
 29




---



##### Table of Contents



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview Navarre Corporation, a Minnesota corporation formed in 1983, publishes and distributes a broad
range of home entertainment and multimedia products, including PC software, CD audio, DVD and VHS
video, video games and accessories. Our business is divided into two business segments 
Distribution and Publishing. Through these business segments we maintain and leverage strong
relationships throughout the publishing and distribution chain. Our broad base of customers includes: (i) wholesale clubs, (ii) mass merchandisers, (iii)
other third-party distributors, (iv) computer specialty stores, (v) music specialty stores, (vi)
book stores, (vii) office superstores, and (viii) electronic superstores. Our customer base
includes over 500 individual customers with over 18,000 locations, certain of which are
international locations. Through our distribution business we distribute and provide fulfillment services in connection
with a variety of finished goods that are provided by our vendors, which include PC software and
video game publishers and developers, independent and major music labels, and major motion picture
studios. These vendors provide us with PC software, CD audio, DVD and VHS video, and video games
and accessories, which we in turn distribute to our retail customers. Our distribution business
focuses on providing vendors and retailers with a range of value-added services, including
vendor-managed inventory, Internet-based ordering, electronic data interchange services,
fulfillment services, and retailer-oriented marketing services. Through our publishing business we own or license various PC software, CD audio, and DVD and
VHS video titles. Our publishing business packages, brands, markets and sells directly to
retailers, third-party distributors, and our distribution business. Our publishing business
currently consists of Encore, BCI and FUNimation. Encore,
which we acquired in July 2002, licenses and publishes personal productivity, genealogy, education
and interactive gaming PC products. BCI, which we acquired in November 2003, is a provider of
niche DVD and video products and in-house produced CDs and DVDs. FUNimation, acquired on May 11,
2005, is a leading animeand childrens animation content provider in the United States. Restatements In June 2005, our management, after consultation with the Audit Committee of the Board of
Directors, determined that our consolidated financial statements for the third fiscal quarter ended
December 31, 2003, year ended March 31, 2004, first fiscal quarter ended June 30, 2004, second
fiscal quarter ended September 30, 2004, and third fiscal quarter ended December 31, 2004 should no
longer be relied upon. As a result of the fiscal year 2005 audit, it was determined that expenses
related to the incentive-based deferred compensation of our Chief Executive Officer should have
been recorded in the third fiscal quarter of 2004 and first fiscal quarter of 2005. As a result,
additional expenses and accrued liabilities of $1.5 million and $2.2 million were recorded in these
quarters, respectively. These expenses were determined in accordance with the provisions of the
Chief Executive Officers 2001 employment agreement. It was also determined that our deferred tax benefit recorded in the third fiscal quarter of
2005 was improperly included in income and should have increased common stock. Consequently,
the tax benefit of 30




---



##### Table of Contents



$2.4 million recognized during the third fiscal quarter of 2005 was reduced and
common stock increased by the same amount. The consolidated financial statements for our third fiscal quarter ended December 31, 2003,
year ended March 31, 2004, first fiscal quarter ended June 30, 2004, second fiscal quarter ended
September 30, 2004, and third fiscal quarter ended December 31, 2004 and notes thereto included in
this annual report on Form 10-K have been restated to include the effects of the expenses related
to the incentive-based deferred compensation of our Chief Executive Officer and the deferred tax
benefit recorded in income that should have increased common stock. Executive Summary Fiscal 2005 was another year of growth for Navarre Corporation. Our consolidated net sales
for fiscal 2005 increased 26.6% to $596.3 million compared to $470.9 million in fiscal 2004. This
growth was achieved through increases in all of our product groups. Our gross profit increased to
$91.1 million or 15.3% of net sales for fiscal 2005 compared with $58.0 million or 12.3% of net
sales for fiscal 2004. The increase in gross margin percent for 2005 was primarily due to the
continued expansion of our higher margin publishing segment. Total operating expenses for fiscal 2005 were $78.8 million or 13.2% of net sales, compared
with $50.3 million or 10.7% of net sales for fiscal 2004. We incurred an increase in expenses
during fiscal 2005 due to compensation expense of $5.8 million
that resulted from our acquisition of the remaining twenty
percent ownership position in Encore, incentive-based deferred compensation expense of $2.5 million
related to our CEOs employment agreement, expense of $1.2 million related to Sarbanes-Oxley Act of
2002 compliance, and FUNimation transaction expenses of $578,000. Additionally, certain operating
expenses (information technologies, warehouse expenses and freight charges) were approximately 0.6%
above our prior year percent of net sales. This increase was primarily due to the building of a
new warehouse and certain improvements to our warehouse operating systems during fiscal 2005. We
expect these certain operating expenses to trend to our historical averages and management intends
to focus on obtaining further efficiencies in fiscal 2006. Net income for fiscal 2005 increased to $12.5
million or $0.44 per diluted share compared to $7.4 million or $0.31 per diluted share for last
year. We acquired the general and limited partnership interests of FUNimation in May 2005. This
acquisition resulted in a substantial increase in our debt level, but has the potential to add
substantial revenues and profits to our publishing business in fiscal 2006. We expect this segment
to grow during fiscal 2006 with the addition of business generated through this acquisition. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based
upon our consolidated financial statements, which have been prepared in conformity with accounting
principles generally accepted in the United States of America. The preparation of these
consolidated financial statements requires us to make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we review and evaluate our estimates,
including those related to customer programs and incentives, product returns, bad debt,
inventories, long-lived assets including intangible assets, goodwill, income taxes, contingencies
and litigation. We base our estimates on historical experience and various other assumptions that
are believed to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are not readily apparent
from other sources. Actual results could differ from these estimates under different assumptions
or conditions. We believe the following critical accounting policies are affected by our judgment, estimates
and/or assumptions used in the preparation of our consolidated financial statements. Revenue Recognition We recognize revenue on products shipped when title and risk of loss transfers, delivery has
occurred, the price to the buyer is determinable and collectibility is reasonably assured. We
recognize service revenues upon delivery of the services. Service revenues have represented less
than 10% of total net sales for fiscal 2005, 2004 and 2003. Under specific conditions, we permit
our customers to return products. We record a general reserve for sales returns and allowances
against amounts due to reduce the net recognized receivables to the amounts we reasonably 31




---



##### Table of Contents



believe
will be collected. These reserves are based on the application of the our average historical gross
profit percent against averages sales returns, sales discounts percent against average gross sales
and specific reserves for marketing programs. Our actual sales return rates have averaged between
13% to 17% over the past three years. Although our past experience has been a good indicator of
future reserve levels, there can be no assurance that our current reserve levels will be adequate
in the future. Our distribution customers at times qualify for certain price protection benefits from our
vendors. We serve as an intermediary to settle these amounts between vendors and customers. We
account for these amounts as reductions of revenues with
corresponding reductions in cost of sales. Our publishing business at times provides certain price protection, promotional monies, volume
rebates and other incentives to customers. We record these amounts as reductions in revenue. Allowance for Doubtful Accounts We perform periodic credit evaluations of our customers financial condition and generally do
not require collateral. We make estimates of the uncollectibility of our accounts receivable,
including advances and balances with independent labels. In determining the adequacy of our
allowances, we analyze customer financial statements, historical collection experience, aging of
receivables, substantial down-grading of credit scores, bankruptcy filings, and other economic and
industry factors. Although we utilize risk management practices and methodologies to determine the
adequacy of the allowance, it is possible that the accuracy of the estimation process could be
materially impacted by different judgments as to collectibility based on the information considered
and further deterioration of accounts. Our largest collection risks exist for retail customers
that are in bankruptcy, or at risk of bankruptcy. The occurrence of these events is infrequent and
has diminished slightly over the last few years, but can be material
when they occur. Although
credit losses relating to customers consistently have been within managements expectations, if
circumstances change (i.e., higher than expected defaults or an unexpected material
adverse change in a major customers ability to meet its financial obligations to us), our
estimates of the recoverability of amounts due could be reduced by a material amount. Goodwill Impairment We review goodwill for potential impairment annually for each reporting unit or when events or
changes in circumstances indicate the carrying value of the goodwill might exceed its current fair
value. We have no goodwill associated with our distribution segment, while our publishing segment
has goodwill. We determine fair value using widely accepted valuation techniques, including
discounted cash flow and market multiple analysis. These types of analyses require us to make
certain assumptions and estimates regarding industry economic factors and the profitability of
future business strategies. We conduct impairment testing at least once annually based on our most
current business strategy in light of present industry and economic conditions, as well as future
expectations. Our goodwill consisted of $ 9.8 million and $10.4 million as of March 31, 2005 and
2004, respectively. If the operating results for our publishing segment deteriorate considerably
and are not consistent with our assumptions and estimates, we may be exposed to a goodwill
impairment charge that could be material. Impairment of Long-Lived Assets In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets, long-lived assets, such as property and equipment
and amortizable intangible assets, are evaluated for impairment whenever events or changes in
circumstances indicate the carrying value of an asset may not be recoverable. An impairment loss
is recognized when estimated undiscounted cash flows expected to result from the use of the asset
plus net proceeds expected from disposition of the asset (if any) are less than the carrying value
of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced
to its estimated fair value. If our results from operations deteriorate considerably and are not
consistent with our assumptions, we may be exposed to a material impairment charge. Inventory Valuation Our
inventories are recorded at the lower of cost or market. We use certain
estimates and judgments to properly value inventory. We monitor our inventory to ensure that we
properly identify inventory items that are slow-moving and non-returnable, on a timely basis. The
primary risk in our distribution business is 32




---



##### Table of Contents



product that has been purchased from vendors that
cannot be sold at full distribution prices and is not returnable to the vendors. The primary risk
in our publishing business is that certain products may run out of shelf life and be returned.
Generally, these products can be sold in bulk to a variety of liquidators. We establish reserves
for the difference between carrying value and estimated realizable value in the periods when we
first identify the lower of cost or market issue. If future demand or market conditions are less
favorable than current analyses, additional inventory write-downs or reserves may be required and
would be reflected in cost of sales in the period the determination is made. Income Taxes Income taxes are recorded under the liability method. Deferred income taxes are provided for
temporary differences between the financial reporting and tax basis of assets and liabilities. In
the preparation of our consolidated financial statements, management is required to estimate income
taxes in each of the jurisdictions in which we operate. This process involves estimating actual
current tax exposures together with assessing temporary differences resulting from differing
treatment of items for tax and accounting purposes. These differences result in deferred tax
assets and liabilities, which are included in our consolidated balance sheet. Management reviews
its deferred tax assets for recoverability on a quarterly basis and assesses the need for valuation
allowances. These deferred tax assets are evaluated by considering historical levels of income,
estimates of future taxable income streams and the impact of tax planning strategies. A valuation
allowance is recorded to reduce deferred tax assets when it is determined that it is more likely
than not that we would not be able to realize all or part of our deferred tax assets. We carried
no valuation allowance against our net deferred tax assets at March 31, 2005 and a valuation
allowance of $7.2 million at March 31, 2004. We expect to
operate on a fully taxable basis for
fiscal 2006. Contingencies and Litigation There are various claims, lawsuits and pending actions against us incidental to our
operations. If a loss arising from these actions is probable and can be reasonably estimated, we
record the amount of the estimated loss. If the loss is estimated using a range within which no
point is more probable than another, the minimum estimated liability is recorded. Based on current
available information, we believe that the ultimate resolution of these actions will not have a
material adverse effect on our consolidated financial statements (see Note 16 to our consolidated
financial statements). As additional information becomes available, we assess any potential
liability related to these actions and may need to revise our estimates. Future revisions of our
estimates could materially impact our consolidated results of operations, cash flows or financial
position. Results of Operations The following table sets forth for the periods indicated, the percentage of net sales
represented by certain items included in our Consolidated Statements of Operations. Fiscal Years Ended March 31,2005
    
    

2004(Restated)
    
    
    2003Net sales:Distribution
    
    
    93.4
    %
    
    
    94.4
    %
    
    
    99.0
    %Publishing
    
    
    16.1
    
    
    
    9.8
    
    
    
    4.1Elimination of sales
    
    
    (9.5
    )
    
    
    (4.2
    )
    
    
    (3.1
    )Total net sales
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Cost of sales  exclusive of depreciation
and amortization
    
    
    84.7
    
    
    
    87.7
    
    
    
    87.3Gross profit
    
    
    15.3
    
    
    
    12.3
    
    
    
    12.7Selling and marketing
    
    
    3.7
    
    
    
    3.6
    
    
    
    3.9Distribution and warehousing
    
    
    1.5
    
    
    
    1.3
    
    
    
    1.5General and administrative
    
    
    7.5
    
    
    
    5.4
    
    
    
    5.6Depreciation and amortization
    
    
    0.6
    
    
    
    0.4
    
    
    
    0.6Total operating expenses
    
    
    13.3
    
    
    
    10.7
    
    
    
    11.6
 33




---



##### Table of Contents



Fiscal Years Ended March 31,2005
    
    

2004(Restated)
    
    
    2003Income from operations
    
    
    2.0
    
    
    
    1.6
    
    
    
    1.1Interest expense
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    (0.1
    )Interest income
    
    
    0.1
    
    
    
    0.1
    
    
    
    Debt extinguishment
    
    
    
    
    
    
    (0.2
    )
    
    
    Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    0.2Tax benefit
    
    
    0.1
    
    
    
    0.1
    
    
    
    Net income
    
    
    2.1
    %
    
    
    1.5
    %
    
    
    1.2
    %
 Certain information in this section contains forward-looking statements. Our actual
results could differ materially from the statements contained in the forward-looking statements as
a result of a number of factors, including risks and uncertainties inherent in our business,
dependency upon key employees, the seasonality of our business, dependency upon significant
customers and vendors, erosions in our gross profit margins, dependency upon bank borrowings,
obtaining additional financing when required, dependency upon software developers and
manufacturers, dependency upon recording artists, risks of returns and inventory obsolescence,
effect of technology developments, effect of free music downloads, change in retailers methods of
distribution and the possible volatility of our stock price. See Business  Forward-Looking
Statements / Important Risk Factors in Item 1 of this Form 10-K. Distribution Segment The distribution segment distributes PC software, video games, accessories, major label music,
and DVD video, as well as independent music. Fiscal 2005 Results Compared With Fiscal 2004 (Restated) Net Sales Net sales for the distribution segment were $556.9 million (before intercompany eliminations)
for fiscal 2005 compared to $444.7 million (before intercompany eliminations) for fiscal 2004. The
25.2% increase in net sales for fiscal 2005 was primarily due to increases in the software and
video games product groups. Sales increased in the software product group to $399.3 million for
fiscal 2005 compared to $311.9 million for fiscal 2004. The
increase in net sales in this product group was primarily due to continued increases in a
variety of software categories, including internet security utility products where sales remained
strong due to continued demand. Major label music and DVD video increased to $62.8 in fiscal 2005
compared to $49.3 in fiscal 2004. The increase in net sales in this product group was primarily
due to the addition of new customers and store openings of existing customers. Video games
increased to $30.1 million in fiscal 2005 compared to $21.8 million in fiscal 2004 due to an
increase in penetration of our existing customer base. Independent music increased to $64.7
million in fiscal 2005 compared to $61.7 million in fiscal 2004 due to additional growth from
catalog product sales as well as sales resulting from new label relationships. Future sales
increases will be dependent upon our ability to continue to add new, appealing products. Gross Profit Gross profit for the distribution segment was $59.8 million or 10.7% of net sales for fiscal
2005 compared to $48.7 million or 11.0% of net sales for fiscal 2004. The slight decrease in gross
profit as a percent of net sales for fiscal 2005 was due to higher sales of products with lower
gross margins, such as video games. We typically incur lower operating costs as a result of the
one-way terms of sales related to the video games category. As sales in the video games product
category increase, as a portion of our total net sales, we anticipate a continued reduction in our
overall gross margin. We expect gross profit to fluctuate depending upon the make-up of product
sold in each quarter. To the extent we continue to grow the distribution segments share of legacy
products from large vendors at 34




---



##### Table of Contents



a rate faster than certain entertainment products from the smaller
vendors, we would expect an overall margin decrease. Operating Expenses Total operating expenses for the distribution segment were $61.4 million or 11.0% of net sales
for fiscal 2005 compared to $39.2 million or 8.8% of net sales for fiscal 2004. Overall, certain operating expenses increased in fiscal 2005; particularly, information
technology, freight and warehouse expenses related to the new warehouse and certain warehouse
operating systems. The increased expense incurred in these areas was due to movement of product
between warehouses, expedited freight to customers in connection with
the transition to the new warehouse and
information technology systems, warehouse labor costs related to
additional movement of product,
information technology programming labor and programming costs,
and the building of racks. These
operating expenses were approximately 0.6% higher during fiscal 2005 than during the prior fiscal
year. We expect these costs to trend down as a percentage of net sales as we focus on creating
overall efficiencies during fiscal 2006. Selling and marketing expenses for the distribution segment were $14.4 million or 2.6% of net
sales for fiscal 2005 compared to $10.4 million or 2.3% of net sales for fiscal 2004. The increase
in selling and marketing expenses for fiscal 2005 is primarily a result of costs increasing in
relation to increased net sales and higher freight costs incurred during the transition to the new
warehouse. Distribution and warehousing expenses for the distribution segment were $8.8 million or 1.6%
of net sales for fiscal 2005 compared to $6.0 million or 1.3% of net sales for fiscal 2004. The
increase in distribution and warehousing expense was primarily due to the new warehouse and
implementation of the new warehouse operating system. We expect to generate overall efficiencies
for fiscal 2006 as the new systems become further integrated into our operations. General and administration expenses for the distribution segment consist principally of
executive, accounting and administrative personnel and related expenses, including professional
fees. General and administration expenses for the distribution segment were $36.4 million or 6.5%
of net sales for fiscal 2005 compared to $21.4 million or 4.8% of net sales for fiscal 2004. The
increase in general and administration expenses was primarily due to compensation expense of $5.8
million to acquire the remaining twenty percent ownership position in Encore, incentive-based
deferred compensation expense of $2.5 million related to the CEOs employment agreement, expense of
$1.2 million related to Sarbanes-Oxley Act of 2002 compliance, and FUNimation transaction expenses
of $578,000. Depreciation and amortization for the distribution segment was $1.8 million for fiscal 2005
compared to $1.3 million for fiscal 2004. This increase is due to the new warehouse and warehouse
systems. We had a net operating loss for the distribution segment of $1.7 million for fiscal 2005
compared to net income of $9.6 million for fiscal 2004. Fiscal 2004 (Restated) Results Compared With Fiscal 2003 Net Sales Net sales for the distribution segment were $444.7 million (before intercompany eliminations)
for fiscal 2004 compared to $353.3 million (before intercompany eliminations) for fiscal 2003. The
25.9% increase in net sales for fiscal 2004 was principally due to strong increases in sales across
all of our distribution product groups. In particular, software sales continued to expand its
market share presence across all categories. Internet security and anti-virus products remained
strong in light of continued virus outbreaks. Sales increased in this product group to $311.9
million during fiscal 2004 from $260.6 million in fiscal 2003. Major label music, DVD video and
video games grew to $71.1 million in fiscal 2004 from $35.1 million in fiscal 2003, due to the
combinations of increased publisher and customer rosters and from strong releases throughout the
year. Independent music grew to 35




---



##### Table of Contents



$61.7 million in fiscal 2004 from $57.6 million in fiscal 2003,
due to its increased label and artist roster and its continued focus on catalog sales. Gross Profit Gross profit for the distribution segment was $48.7 million or 11.0% as a percent of net sales
for fiscal 2004 compared to $39.7 million or 11.2% as a percent of net sales for fiscal 2003. The
decrease in gross profit as a percent of net sales for fiscal 2004 was due to lower margins from
the growth of our video game distribution segment. Video game distribution generally has a lower
margin throughout the industry, however, video games are sold on a one-way basis with no returns
permitted; therefore, the lower handling costs of the product offset some of the lower margins as
it relates to overall profitability. In addition, we experienced lower margins with the
continuation of the expansion of our market share in software categories such as business and
productivity which generally have lower gross margins as much of the product is considered legacy
product; however, these product categories tend to sell at higher dollar price points and generally
have fewer returns. We experienced higher margins from sales of independent music in fiscal 2004
due to our continuing efforts to sign new labels at higher distribution rates. Operating Expenses Total operating expenses for the distribution segment were $39.2 million or 8.8% as a percent
of net sales for fiscal 2004 compared to $35.7 million or 10.1% as a percent of net sales for
fiscal 2003. Selling and marketing expenses for the distribution segment were $10.4 million or 2.3% as a
percent of net sales for fiscal 2004 compared to $11.1 million or 3.2% as a percent of net sales
for fiscal 2003. The decrease for fiscal 2004 resulted from our improved efforts to reduce freight
costs. Freight cost, as a percent of sales, decreased to 1.4% in fiscal 2004 compared to 1.8% in
fiscal 2003. Additionally, we recorded an expense of $680,000 in fiscal 2003 in connection with
the write-off of specialty product display sales racks. Distribution and warehousing expenses for the distribution segment were $6.0 million or 1.3%
as a percent of net sales for fiscal 2004 compared to $5.5 million or 1.6% as a percent of net
sales for fiscal 2003. The decrease as a percentage of net sales resulted from overall improved
efficiency of warehousing expenses such as one-way video game business, higher priced software
categories such as business and productivity, and in part, efficiencies associated with a higher
level of sales. General and administrative expenses for the distribution segment consist principally of
executive, accounting and administrative personnel and related expenses, including professional
fees. General and administrative expenses for the distribution segment were $21.4 million or 4.8%
as a percent of net sales for fiscal 2004 compared to $17.8 million or 5.0% as a percent of net
sales for fiscal 2003. The increase in general and
administrative expenses for fiscal 2004 resulted from incentive-based deferred compensation
expense of $1.5 million related to the CEOs employment agreement, a non cash charge of $705,000
for stock-based compensation relating to the vesting of option shares exercisable under option
agreements for certain key employees, an increase in information technology expense of $476,000
which is allocated based on sales volume, and $891,000 for executive, accounting and administrative
personnel required as our segment grows. The decrease as a percent of net sales for general and
administrative expenses for fiscal 2004 was attributable to our continued increased efforts to
control expenses as a percent of net sales. Depreciation and amortization for the distribution segment remained flat at $1.3 million for
fiscal 2004 and for fiscal 2003. The net operating income for the distribution segment was $9.6 million for fiscal 2004
compared to $4.0 million for fiscal 2003. Publishing Segment The publishing segment includes Encore and BCI. We acquired the assets of BCI on November 3,
2003 and the assets of Encore on July 31, 2002. 36




---



##### Table of Contents



Fiscal 2005 Results Compared With Fiscal 2004 (Restated) Net sales for the publishing segment were $95.8 million (before intercompany eliminations) for
fiscal 2005 and $46.2 million (before intercompany eliminations) for fiscal 2004.
Fiscal 2005 included a full year of Encore and BCI revenues, whereas fiscal 2004
only included a full year of Encore revenues and five months of BCI revenues.
Additionally, on April 1, 2004 Encore signed a multi-year, multi-license agreement with
Riverdeep Inc. The Riverdeep license significantly
increased its revenue during fiscal 2005. A significant portion of the net sales increase was
due to increased sales in our Encore business. Gross profit for the publishing segment was $31.4 million or 32.7% as a percent of net sales
for fiscal 2005 and $9.3 million or 20.1% as a percent of net sales for fiscal 2004. The lower
gross profit in fiscal year 2004 was primarily due to an impairment charge for $5.6 million related
to software development costs. Operating expenses for the publishing segment were $17.3 million, or 18.1% of net sales, for
fiscal 2005, including $7.1 million for sales and marketing expenses, $8.5 million for general and
administration expenses and $1.7 million for depreciation and amortization expense. For fiscal
2004, operating expenses were $11.2 million, or 24.2% of net sales, including $6.5 million for
sales and marketing expenses, $4.0 million for general and administration expenses and $673,000 for
depreciation and amortization expense. The 6.1% of net sales decrease is a result of operating
efficiencies. The publishing segment had operating income of $14.0 million for fiscal 2005 and operating
loss of $1.9 million for fiscal 2004. We expect this segments net sales and gross profit to
increase during fiscal 2006 as a result of the inclusion of FUNimations operations for
approximately 10 months. Fiscal 2004 (Restated) Results Compared With Fiscal 2003 Net sales for the publishing segment were
$46.2 million (before intercompany eliminations) for
fiscal 2004 and $14.7 million (before intercompany eliminations) for fiscal 2003. The addition of
BCI in November 2003 contributed $8.0 million of the
growth. Fiscal 2004 included  a full year of Encore revenues and approximately five
months of BCI revenues, compared to fiscal 2003 that included only
eight months of Encore revenues. Gross profit for the publishing segment was $9.3 million or 20.1% as a percent of net sales
for fiscal 2004 and $5.8 million or 39.4% as a percent of net sales for fiscal 2003. The gross
margin decrease was primarily due to a $5.6 million impairment charge for the capitalized product
development costs. Operating expenses for the publishing segment were $11.2 million, or 24.2% of net sales for
fiscal 2004, including $6.5 million for sales and marketing expenses, $4.0 million for general and
administration expenses and $673,000 for depreciation and amortization expense. For fiscal 2003,
operating expenses were $5.8 million or 39.1% of net sales, including $2.7 million for sales and
marketing expenses, $2.3 million for general and administration expenses and $822,000 for
depreciation and amortization expense, which included a charge of
$501,000 for certain intangible assets that were deemed impaired subsequent to the acquisition
of Encore. The expense increase in fiscal 2004 was due to the addition of BCIs operations in
November 2003. The publishing segment had an operating loss of $1.9 million for fiscal 2004 and operating
income of $41,000 for fiscal 2003. Market Risk The Companys exposure to market risk is primarily due to the fluctuating interest rate
associated with variable rate indebtedness. See Item 7a  Quantitative and Qualitative Disclosure
About Market Risk. Seasonality and Inflation Quarterly operating results are affected by the seasonality of our business. Specifically,
our third quarter (October 1December 31) typically accounts for our largest quarterly revenue
figures and a substantial portion of our earnings, although the percentage of net sales and
earnings has declined over the past fiscal years. As a distributor of products ultimately sold to retailers,
our business is affected by the pattern of seasonality common to other suppliers of retailers,
particularly during the holiday selling season. Inflation is not expected to have a significant
impact on our business, financial condition or results of operations since we can generally offset
the impact of inflation through a combination of productivity gains and price increases. 37




---



##### Table of Contents



Liquidity and Capital Resources Cash Flow Analysis Operating Activities Cash used in operating activities for fiscal 2005 totaled $168,000. Cash provided from
operating activities totaled $9.2 million and $1.3 million in fiscal 2004 and fiscal 2003,
respectively. The net
    cash used in fiscal 2005 mainly reflected our net earnings, combined with
    various non-cash charges, including depreciation and amortization of $3.9 million
    and executive, stock compensation expense of $8.6 million, deferred
    taxes of $4.3 million, and tax benefit from employee stock plans of $2.4 million,
    offset by our working capital demands. Accounts receivable increased by $13.6 million,
    reflecting the growth in sales for fiscal 2005. Inventories increased by $10.5 million,
    reflecting the higher inventories required by the Companys increased
    sales activities. Prepaid expenses increased by $6.8 million, primarily
    reflecting royalty advances in the publishing business. Accounts payable increased
    $4.3 million, primarily as a result of increased inventory. Accrued expenses
    increased $5.6 million as a result of increased bonuses and royalties
    payable resulting from increased profitability and sales. The net
    cash provided in fiscal 2004 reflected our net earnings, combined with various
    non-cash charges, including depreciation and amortization of $2.1 million,
    executive and stock compensation expense of $2.2 million and impairment
    of capitalized software development costs of $5.6 million, partially offset
    by our working capital demands. Accounts receivable increased by $11.3 million,
    inventories increased by $4.3 million, and prepaids
increased by $4.2 million, which were offset by the increase
    in accounts payable of $13.0 million, which were a result of the Companys
    increased profitability and sales. The net
    cash provided in fiscal 2003 reflected our net earnings, combined with various
    non-cash charges, including depreciation and amortization of $2.2 million
    partially offset by our working capital demands. Accounts receivable increased
    by $10.4 million, inventories increased by $5.5 million, prepaid expenses
    and other assets increased by $5.9 million which were partially offset
    by the increase in accounts payable and accrued expenses of $16.4 million,
    which were a result of the Companys increased profitability and sales. Investing Activities Cash flows used in investing activities totaled $5.8 million, $17.0 million and $9.2 million
in fiscal 2005, 2004 and 2003, respectively. Loans to related parties totaled $2.2 million and $278,000 and $711,000 for fiscal 2005, 2004
and 2003, respectively. Acquisition of property and equipment totaled $9.3 million, $5.0 million and $1.0 million in
fiscal 2005, 2004 and 2003 respectively. Purchases of 2005 fixed assets were offset by $6.4
million in proceeds from the sale and leaseback of our new building. Purchase of intangible assets totaled $608,000 and $1.2 million for fiscal 2005 and 2004,
respectively. Acquisition of businesses totaled $10.5 million and $7.5 million for fiscal 2004 and 2003
respectively. In August, 2002 the Company completed the acquisition of the assets of Encore, an
interactive publisher in the video game and PC CD-ROM markets. This transaction was made to enable
the Company to more actively participate in the high growth video game industry and to extend our
direct distribution relationships with large retailers. In November, 2003 the Company completed
the acquisition of the assets of BCI, a provider of niche DVD/video and audio products. This
transaction was made to enhance the line of products and services to the Companys customers. Financing Activities Cash flows provided from financing activities totaled $7.0 million and $11.8 million for
fiscal 2005 and 2004, respectively. Cash flows used in financing activities for fiscal 2003
totaled $536,000 for repayment of notes payable. 38




---



##### Table of Contents



The Company recorded proceeds from the exercise of common stock options and warrants of $8.2
million and $814,000 in fiscal 2005 and 2004, respectively and $11.7 million from the proceeds of the sale of common stock in fiscal 2004. Capital Resources In October 2001, we entered into a credit agreement with General Electric Capital Corporation
as administrative agent, agent and lender, and GECC Capital Markets Group, Inc. as Lead Arranger,
for a three year, $30.0 million revolving credit facility for use in connection with our working
capital needs. In June 2004, this credit agreement was amended and restated to, among other things,
provide for two senior secured revolving sub-facilities: a $10.0 million revolving acquisition
sub-facility, and a $40.0 million revolving working capital sub-facility. The revolving working
capital sub-facility allowed for borrowing up to $40.0 million, subject to a borrowing base
requirement, and required that we maintain a minimum excess availability of at least $10.0 million.
In addition to the provision for the two senior secured revolving sub-facilities, this credit
agreement allowed for up to $10.0 million of the revolving working capital facility to be used for
acquisitions, providing us with an aggregate revolving acquisition availability of up to $20.0
million, subject to a borrowing base requirement. The working capital revolving credit facility
included borrowing capacity available for letters of credit and for borrowings on same-day notice,
referred to as swing line loans. Under the amended and restated credit agreement, the maturity date
of the revolving working capital facility was December 2007 and the maturity date of the revolving
acquisition facility was June 2006. We were in compliance with the covenants related to our $40.0
million credit facility on March 31, 2005. The credit agreement was amended and restated in its entirety on May 11, 2005 in order to
provide the Company with funding to complete the FUNimation acquisition and was again amended and
restated in its entirety on June 1, 2005. The credit agreement currently provides a six-year
$115.0 million Term Loan B sub-facility, a $25.0 million five and one-half year Term Loan C
sub-facility, and a five-year revolving sub-facility for up to $25.0 million. The entire $115.0
million of the Term Loan B sub-facility has been drawn since May 11, 2005 and the entire $25.0
million of the Term Loan C sub-facility was drawn at June 1, 2005. The revolving sub-facility of up
to $25.0 million is available to the Company for its working capital and general corporate needs. The revolving sub-facility has no borrowing base requirement. The loans under our senior credit facilities are variable rate obligations and are guaranteed by our subsidiaries and are
secured by a first priority security interest in all of our assets and in all of the assets of our
subsidiary companies, as well as the capital stock of our subsidiary companies. Under the credit agreement we are required to meet certain financial and non-financial
covenants. The financial covenants include a variety of financial metrics that are used to
determine our overall financial stability and include limitations on our capital expenditures, a
minimum ratio of EBITDA to fixed charges, and a minimum of indebtedness to EBITDA. Liquidity On May 11, 2005 we acquired 100% of the general and limited partnership interests of
FUNimation Productions, Ltd. and The FUNimation Store, Ltd.
(together,FUNimation). As consideration for the acquisition
of FUNimation, the sellers of FUNimation received $100.4 million in cash, subject to post-closing
adjustments not to exceed $5.0 million and excess cash as defined in the purchase agreement, and
1,827,486 shares of Navarre common stock. In addition, during the five-year period following the
closing of the transaction, we may pay up to an additional $17.0 million in cash to the FUNimation
sellers if they achieve certain agreed-upon financial targets relating to the FUNimation business.
The FUNimation business is described in more detail at Business-FUNimation Business. During the last fiscal quarter of fiscal year 2005 we made a strategic decision to increase
our inventory levels of certain products that we sell to service a new major mass merchant retailer
customer. We determined that it was in our best interest to take extra precautions that would
allow us to provide a high level of service to this important new customer during the first holiday
season, which occurs during our fiscal 2005 third quarter. As a result, a higher than normal level
of inventory was purchased and maintained in order to ensure that we had the capacity to quickly
fill large orders of these products during the holiday sales season.



Additionally, as payment terms with the vendors that provide certain of
these products require us to pay for our inventory purchases more quickly than
we were able to collect our accounts receivable in connection with a sale of
these products to our customers, a significant amount of cash was utilized in
these purchases.



Now that we have greater
experience with this customers buying patterns, we do not currently anticipate that it will be
necessary to maintain an increased inventory level during future fiscal third quarter periods to
such a significant degree. 39




---



##### Table of Contents



From time to time we are required to invest a significant amount of cash
in our publishing business in order to license content from third parties and
in our distribution business in order to sign exclusive distribution
agreements. Typically, these amounts are paid to third parties in connection
with the signing of the applicable agreement and are recouped from the proceeds
that we receive from the sale of products that result from these agreements.
During the third quarter of the fiscal year 2005 we invested approximately $5.0
million in connection with the licensing of new content in our publishing
business. In our publishing
business we must estimate the likely demand for the
products that we sell in order to ensure that we have enough of these products
ready for shipment to our customers. During the third and fourth quarters of
fiscal year 2005 we invested cash into our inventory in the publishing business
in order to ensure that we had sufficient products to meet expected demand for
the foreseeable future. The
cumulative effect of these events was that, at the end of our fiscal 2005 third quarter, we had
significantly higher inventory levels, reduced cash, and a significant amount of borrowings under
our working capital credit facility. Through the course of the fiscal 2005 fourth quarter these
increased inventory levels were reduced as a result of the sale of these products and by returning
certain inventories. The result at the end of the fiscal 2005 fourth quarter was that we had
reduced our inventory and accounts receivable by $21.6 million
and $24.0 million, respectively.
Cash at March 31, 2005 was $15.5 million and we had no borrowings under our credit agreement. While this strategy affected our liquidity and capital resources during the later portions of
the 2005 fiscal year, we believe that certain recent events have considerably enhanced our outlook
in these areas. Specifically, the acquisition of FUNimation is currently expected to provide
positive cash flow during the approximate ten months that its operations will be included in fiscal
2006. In addition, our historical business is expected to continue to generate positive cash flow.
Furthermore, the recent changes to our credit agreement with GE Commercial Finance have provided
us with approximately $35.0 million of additional cash as well as the ability to make borrowings
under a $25.0 million working capital revolving credit facility without reference to a borrowing
base availability requirement. We currently believe funds generated from the expected results of operations and available
cash and cash equivalents and borrowings under our existing credit facility will be sufficient to
satisfy our working capital requirements and to finance expansion plans and strategic initiatives
for this fiscal year and otherwise in the long-term absent significant acquisitions. We have
stated our plans to grow through acquisitions; however, such opportunities will likely require the
use of additional equity or debt capital, some combination thereof, or other financing. Contractual Obligations The following table presents information regarding contractual obligations that exist as of
March 31, 2005 by fiscal year (in thousands). Total
    
    
    Lessthan 1Year
    
    
    1  3Years
    
    
    4  5Years
    
    
    More than 5YearsOperating leases
    
    $
    22,988
    
    
    $
    2,234
    
    
    $
    3,916
    
    
    $
    3,825
    
    
    $
    13,013Capital leases
    
    
    430
    
    
    
    129
    
    
    
    229
    
    
    
    72
    
    
    
    License and distribution agreement
    
    
    7,287
    
    
    
    7,287
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    30,705
    
    
    $
    9,650
    
    
    $
    4,145
    
    
    $
    3,897
    
    
    $
    13,013
 
 Item 7a  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk.Market risk refers to the risk that a change in the level of one or more market
prices, interest rates, indices, volatilities, correlations or other market factors such as
liquidity will result in losses for a certain financial instrument or group of financial
instruments. We do not hold or issue financial instruments for trading purposes, and do not enter
into forward financial instruments to manage and reduce the impact of changes in foreign currency
rates because we have few foreign relationships and substantially all of our foreign transactions
are negotiated, invoiced and paid in U.S. dollars. Based on the controls in place and the relative
size of the financial instruments entered into, we believe the risks associated with not using
these instruments will not have a material adverse effect on our consolidated financial position or
results of operations. Interest
    Rate Risk.As of March 31, 2005, fluctuations in interest rates,
    exchange rates and price changes did not have a material effect on our financial
    position or operating results. However, our exposure to market risk during
    fiscal 2006 will be primarily dependent upon fluctuating interest rates associated
    with variable rate indebtedness. As of June 14, 2005 we had $140.0 million
    of variable rate indebtedness, representing 100% of our total debt
    outstanding at that time. Based on the 40




---



##### Table of Contents



borrowings
outstanding on June 14, 2005, a 100-basis point change in LIBOR would cause the Companys annual
interest expense to change by $1.4 million. FOREIGN CURRENCY RISK We have a limited number of foreign transactions. Substantially all of our foreign
transactions are negotiated, invoiced and paid in U.S. dollars. Therefore, fluctuations in the
value of the dollar as compared to other foreign currencies have not had an effect on us. 
 Item 8. Financial Statements and Supplementary Data See the consolidated financial statements and notes, supplementary data of Navarre and the
Report of Independent Auditors included at the end of this document. 
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. 
 Item 9A. Controls and Procedures Managements Report on Internal Control over Financial Reporting Management of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting (Internal control) as defined in Rules 13a-15(f) and 15d-15(f)
under the Securities Exchange Act of 1934, as amended (the Exchange Act). A material weakness is
a significant deficiency (within the meaning of Public Company Accounting Oversight Board Auditing
Standard No. 2), or a combination of significant deficiencies, that results in there being more
than a remote likelihood that a material misstatement of the Companys annual or interim
consolidated financial statements will not be prevented or detected. Management assessed the effectiveness of the Companys internal control over financial
reporting as of March 31, 2005, using the criteria published in the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on
this assessment, management concluded the Company did not maintain effective control over financial
reporting as of March 31, 2005, because of the following material weaknesses in the Companys
internal control over financial reporting:  
    The Company did not maintain effective controls over the accounting for certain
compensation arrangements. Specifically, the Company had a deficiency in the design of
controls to identify the proper accounting treatment for compensation arrangements for key
employees. Adjustments related to a deferred compensation arrangement with a key employee
were included in the restatement of the Companys consolidated financial statements for the
third quarter in the year ended March 31, 2004 and the first quarter of the year ended
March 31, 2005.
    The Company did not maintain effective controls over the accounting for income taxes.
Specifically, the Companys established internal controls surrounding the preparation of
its income tax provision for the third quarter ended December 31, 2004 were not effective.
During the year end financial reporting process, the Company identified an error in the
preparation of the third quarter tax provision. This material weakness resulted in
adjustments that were included in the restatement of the Companys consolidated financial
statements for the third quarter in the year ended March 31, 2005. 41




---



##### Table of Contents



Grant Thornton LLP, the Companys independent registered public accounting firm, has issued an
attestation report on managements assessment of the Companys internal control over financial
reporting, which appears on page . Evaluation of Disclosure Controls and Procedures We maintain disclosure controls and procedures (Disclosure Controls), as such term is
defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, that are designed to ensure that
information required to be disclosed in our Exchange Act reports, including the Companys Annual
Report on Form 10-K, is recorded, processed, summarized and reported within the time periods
specified in the SECs rules and forms, and that such information is accumulated and communicated
to our management, including our Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the Disclosure Controls, our management recognized that any
controls and procedures, no matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and our management necessarily was required
to apply its judgment in evaluating the cost-benefit relationship of possible controls and
procedures. As required by Rule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried our an
evaluation, under the supervision and with the participation of our management, including our Chief
Executive Officer and our Chief Financial Officer, 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. As
described in Managements Report on Internal Control over Financial Reporting set forth above, we
have identified certain material weaknesses in the Companys internal control over financial
reporting as of March 31, 2005. The Companys Chief Executive Officer and Chief Financial Officer
have concluded that, as a result of these material weaknesses, the Companys disclosure controls
and procedures, as of March 31, 2005 were not effective. Changes in Internal Control over Financial Reporting There were no changes in the Companys internal control over financial reporting that
occurred during the Companys last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, the Companys internal control over financial reporting. Remediation Efforts Related to Deficiencies Noted in Managements Report on Internal Control over
Financial Reporting Management has implemented additional procedures to enhance the identification of the proper
accounting treatment for compensation arrangements. An additional person has been added to the
Companys Human Resources department with compensation experience. Approval by the Compensation
Committee for all compensation arrangements will be made in conjunction with the Finance
Department, once the Finance Department has confirmed the effects of
a compensation agreement on its consolidated financial statements and
that finding has been further verified with the appropriate outside
parties. Management has implemented additional procedures to enhance the controls surrounding the
preparation of its income tax provision. An experienced tax manager has been hired to oversee
the tax provision process, among other tax related responsibilities. The Company has also
purchased a tax software package to maintain the tax information for provision purposes and
further implemented detail checklists to supplement the existing controls. Item 9B. Other Information Not applicable. 42




---



##### Table of Contents



PART III 
 Item 10. Directors and Executive Officers of the Registrant The information concerning the Executive Officers of the Registrant required under this item
will be included under the captions Election of Directors and Information Concerning Directors,
Nominees and Executive Officers in our Proxy Statement for the Annual Meeting of Shareholders to
be held on September 15, 2005 (the 2005 Proxy Statement), a definitive copy of which will be
filed with the Securities and Exchange Commission within 120 days of the close of the fiscal year
ended March 31, 2005, and is incorporated herein by reference. Information concerning the
compliance of the Companys officers, directors and 10% shareholders with Section 16(a) of the
Securities Exchange Act of 1934 is incorporated by reference to the information to be contained in
the Proxy Statement under the caption Compliance with Section 16(a). The information regarding
Audit Committee members and audit committee financial experts is incorporated by reference to the
information to be contained in the 2005 Proxy Statement under the caption Board Committees. The
information regarding the Companys Code of Business Ethics is incorporated by reference to the
information to be contained in the Proxy Statement under the heading Code of Business Conduct and
Ethics. A copy of the Companys Code of Business Ethics was filed as an exhibit to our Annual
Report on Form 10-K filed for the for the fiscal year ended March 31, 2004. 
 Item 11. Executive Compensation Information required under this item will be contained in our 2005 Proxy Statement and is
incorporated herein by reference. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters Information required under this item will be contained in our 2005 Proxy Statement and is
incorporated herein by reference. 
 Item 13. Certain Relationships and Related Transactions Information required under this item will be contained in our 2005 Proxy Statement and is
incorporated herein by reference. 
 Item 14. Principal Accountant Fees and Services Information required under this item will be contained in our 2005 Proxy Statement and is
incorporated herein by reference. PART IV 
 Item 15. Exhibits and Financial Statements Schedules  (a)
    Documents filed as part of this report -  (1)
    Financial Statements. Our following consolidated financial statements
and the Reports of Independent Registered Public Accounting Firms thereon are set forth at the end of this
document:  (i)
    Reports of Independent Registered Public Accounting Firms.(ii)
    Consolidated Balance Sheets as of March 31, 2005 and
2004 (Restated).(iii)
    Consolidated Statements of Operations for the years ended
March 31, 2005, 2004 (Restated) and 2003.(iv)
    Consolidated Statements of Shareholders Equity for the years
ended March 31, 2005, 2004 (Restated) and 2003. 43




---



##### Table of Contents







| | (v)  | Consolidated Statements of Cash Flows for the years ended March
31, 2005, 2004 (Restated) and 2003.
| | ---- | ---------------------------------------------------------------------------------------------------
|
| | (vi) | Notes to Consolidated Financial Statements                                                         



| | (2) | Financial Statement Schedules
| | --- | -----------------------------



| | (i) | Schedule II  Valuation and Qualifying Accounts and Reserves
| | --- | ------------------------------------------------------------



| |  | Schedules other than those listed above have been omitted because they are
inapplicable or the required information is either immaterial or shown in the
Consolidated Financial Statements or the notes thereto.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | Exhibits
| | --- | --------

ItemNo.
    
    Description2.1
    
    Asset Purchase Agreement dated November 3, 2003 between BCI
Eclipse Company, LLC and the Company (incorporated by reference
to Exhibit 2.1 to the Companys Form 10-Q for the quarter ended
September 30, 2003 (File No. 0-22982)).3.1
    
    Articles of Incorporation (incorporated by reference to Exhibit
3.1 to the Companys Annual Report on Form 10-K for the year
ended March 31, 2000 (File No. 0-22982)).3.2
    
    Bylaws of the Company (incorporated by reference to Exhibit 4.2
to the Companys Registration Statement on Form S-3 (File No.
333-111733)).3.3
    
    Certificate of Rights and Preferences of Series B Convertible
Preferred Stock (incorporated by reference to Exhibit 2 to the
Companys Form 8-K dated August 20, 1999 (File No. 0-22982)).3.4
    
    Form of Warrant Agreement (incorporated by reference to Exhibit
10.3 to the Companys Form 8-K dated December 16, 2003 (File No.
0-22982)).10.1 *
    
    Employment Agreement dated November 1, 2001 between the Company
and Eric H. Paulson (incorporated by reference to Exhibit 10.1 to
the Companys Form 10-Q for the quarter ended December 31, 2001
(File No. 0-22982)).10.2 *
    
    Amendment to Employment Agreement between the Company and Eric H.
Paulson (incorporated by reference to Exhibit 10.1.1 to the
Companys Form 10-Q for the quarter ended December 31, 2003 (File
No. 0-22982)).10.3 *
    
    Employment Agreement dated January 2, 2002 between the Company
and Charles E. Cheney (incorporated by reference to Exhibit 10.2
to the Companys Annual Report on Form 10-K for the year ended
March 31, 2002 (File No. 0-22982)).10.4 *
    
    Employment Agreement between Encore Software, Inc. and Michael
Bell (incorporated by reference to Exhibit 10.3 to the Companys
Annual Report on Form 10-K for the year ended March 31, 2003
(File No. 0-22982)).10.5 *
    
    Employment Agreement dated November 5, 2003, between BCI Eclipse
Company, LLC and Edward D. Goetz (incorporated by reference to
Exhibit 10.16 to the Companys Form 10-Q for the quarter ended
September 30, 2003 (File No. 0-22982)).


44



---



##### Table of Contents





10.6 *
    
    1992 Stock Option Plan, amended and restated (incorporated by
reference to Exhibit 10.3 to the Companys Annual Report on Form
10-K for the year ended March 31, 2002 (File No. 0-22982)).10.7 *
    
    2003 Amendment to the Companys 1992 Stock Option Plan
(incorporated by reference to Exhibit 99.1 to the Companys
Registration Statement on Form S-8 (File No. 333-109056)).10.8 *
    
    Form of Individual Stock Option Agreement under 1992 Stock Option
Plan (incorporated by reference to Exhibit 10.4 to the Companys
Registration Statement on Form S-1 (No. 333-68392)).10.9 *
    
    Form of Termination Agreement for certain of the Companys
Executives (incorporated by reference to Exhibit 10.2 to the
Companys Form 10-Q for the quarter ended December 31, 2001 (File
No. 0-22982)).10.10
    
    Lease dated March 12, 1998 between the Company and Cambridge
Apartments, Inc. with respect to the corporate headquarters in
New Hope, MN (incorporated by reference to Exhibit 10.6 to the
Companys Annual Report on Form 10-K for the year ended March 31,
1999 (File No. 0-22982)).10.11
    
    Amendment No. 1 to Lease Agreement between the Company and
Cambridge Apartments, Inc. dated April 1, 1998 (incorporated by
reference to Exhibit 10.9.1 to the Companys Form 10-Q for the
quarter ended June 30, 2003 (File No. 0-22982)).10.12
    
    Amendment No. 2 to Lease Agreement between the Company and
Cambridge Apartments, Inc. dated July 14, 2003 (incorporated by
reference to Exhibit 10.9.2 to the Companys Form 10-Q for the
quarter ended June 30, 2003 (File No. 0-22982)).10.13
    
    Lease dated May 1, 1999 between the Company and Sunlite III, LLP
with respect to a second facility in Brooklyn Park, MN
(incorporated by reference to Exhibit 10.7 to the Companys
Annual Report on Form 10-K for the year ended March 31, 1999
(File No. 0-22982)).10.14
    
    Amendment Nos. 1, 2 and 3 to Lease Agreement (incorporated by
reference to Exhibit 10.10.1 to the Companys Annual Report on
Form 10-K for the year ended March 31, 2003 (File No. 0-22982)).10.15
    
    Lease dated December 17, 1999 between Encore and EastGroup
Properties L.P., with respect to a third facility in Gardena,
California (incorporated by reference to Exhibit 10.11 to the
Companys Annual Report on Form 10-K for the year ended March 31,
2003 (File No. 0-22982)).10.16
    
    First Amendment to Lease dated June 27, 2002 between Encore and
Eastgroup Properties L.P. (incorporated by reference to Exhibit
10.11.1 to the Companys Annual Report on Form 10-K for the year
ended March 31, 2003 (File No. 0-22982)).


45



---



##### Table of Contents



10.17
    
    Credit Agreement dated October 3, 2001 between General Electric
Capital Corporation and the Company (incorporated by reference to
Exhibit 10.1 to the Companys Form 10-Q for the quarter ended
September 30, 2001 (File No. 0-22982)).10.18
    
    Amendment No. 1 and Limited Waiver with Respect to Credit
Agreement dated March 4, 2002 (incorporated by reference to
Exhibit 10.8.1 to the Companys Annual Report on Form 10-K for
the year ended March 31, 2002 (File No. 0-22982)).10.19
    
    Amendment No. 2 to Credit Agreement dated August 1, 2002
(incorporated by reference to Exhibit 10.1 to the Companys Form
10-Q for the quarter ended September 30, 2002 (File No.
0-22982)).10.20
    
    Amendment No. 3 to Credit Agreement dated March 30, 2003
(incorporated by reference to Exhibit 10.12.3 to the Companys
Annual Report on Form 10-K for the year ended March 31, 2003
(File No. 0-22982)).10.21
    
    Amendment No. 4 to Credit Agreement dated June 24, 2003
(incorporated by reference to Exhibit 10.12.4 to the Companys
Annual Report on Form 10-K for the year ended March 31, 2003
(File No. 0-22982)).10.22
    
    Amendment No. 5 to Credit Agreement dated October 23, 2003
(incorporated by reference to Exhibit 10.12.5 to the Companys
Form 10-Q for the quarter ended September 30, 2003 (File No.
0-22982)).10.23
    
    Amendment No. 6 to Credit Agreement dated November 5, 2003
(incorporated by reference to Exhibit 10.12.6 to the Companys
Form 10-Q for the quarter ended September 30, 2003 (File No.
0-22982)).10.24
    
    Separation Agreement dated as of March 1, 1999 between the
Company and NetRadio Corporation (incorporated by reference to
Exhibit 10.16 to NetRadio Corporations Form S-1/A Registration
Statement (File No. 333-73261)).10.25
    
    Term Note dated October 14, 1999, between the Company and
NetRadio Corporation (incorporated by reference to Exhibit 10.11
to the Companys Annual Report on Form 10-K for the year ended
March 31, 2000 (File No. 0-22982)).10.26
    
    Amendment No. 1 to Term Note dated March 26, 2001, between the
Company and NetRadio Corporation (incorporated by reference to
Exhibit 10.1 to NetRadio Corporations Form 10-Q for the quarter
ended March 31, 2001 (File No. 0-27575)).10.27
    
    Amendment No. 2 to Term Note dated March 30, 2001, between the
Company and NetRadio Corporation (incorporated by reference to
Exhibit 10.2 to NetRadio Corporations Form 10-Q for the quarter
ended March 31, 2001 (File No. 0-27575)).
 46




---



##### Table of Contents



10.28
    
    Form of Warrant dated May 1, 1998 issued to investors in
connection with the Companys May 1, 1998 private placement of
Class A Convertible Preferred Stock (incorporated by reference to
Exhibit 4 to the Companys Form 8-K dated May 1, 1998 (File No.
0-22982)).10.29
    
    Amended and Restated Asset Purchase Agreement effective as of
July 10, 2002 by and between the Company and Encore Software,
Inc. (incorporated by reference to Exhibit 10.1 to the Companys
Form 8-K dated August 14, 2002 (File No. 0-22982)).10.30
    
    Amendment No. 1 to Asset Purchase Agreement effective as of July
31, 2002, by and among the Company, Encore Software, Inc. and
Encore Acquisition Corporation (incorporated by reference to
Exhibit 10.2 to the Companys Form 8-K dated August 14, 2002
(File No. 0-22982)).10.31
    
    Agreement of Reciprocal Easements, Covenants, Conditions and
Restrictions dated June 16, 2003 (incorporated by reference to
Exhibit 10.9.3 to the Companys Form 10-Q for the quarter ended
June 30, 2003 (File No. 0-22982)).10.32
    
    Incentive Stock Option Agreement dated September 6, 2002 between
Cary Deacon and the Company (incorporated by reference to Exhibit
10.17 to the Companys Form 10-Q for the quarter ended September
30, 2003 (File No. 0-22982)).10.33
    
    Addendum to Incentive Stock Option Agreement dated November 13,
2003 (incorporated by reference to Exhibit 10.17.1 to the
Companys Form 10-Q for the quarter ended September 30, 2003
(File No. 0-22982)).10.34
    
    Form of Securities Purchase Agreement dated as of December 15,
2003 among the Corporation and the various purchasers
(incorporated by reference to Exhibit 10.1 to the Companys Form
8-K dated December 16, 2003 (File No. 0-22982)).10.35
    
    Form of Registration Rights Agreement dated as of December 15,
2003 among the Corporation and the various purchasers
(incorporated by reference to Exhibit 10.2 to the Companys Form
8-K dated December 16, 2003 (File No. 0-22982)).10.36
    
    Form of Separation Agreement with Charles E. Cheney dated April
30, 2004 (incorporated by reference to Exhibit 10.41 to the
Companys Form 10-K for the year ended March 31, 2004 (File No.
0-22982)).10.37
    
    Form of Assignment of Lease between BCI Eclipse LLC and BCI
Eclipse Company, LLC dated November 3, 2003 (incorporated by
reference to Exhibit 10.42 to the Companys Form 10-K for the
year ended March 31, 2004 (File No. 0-22982)).
 47




---



##### Table of Contents



10.38
    
    Form of Amendment No. 7 to Credit Agreement dated January 26,
2004 (incorporated by reference to Exhibit 10.43 to the Companys
Form 10-K for the year ended March 31, 2004 (File No. 0-22982)).10.39
    
    Form of Amendment No. 8 to Credit Agreement dated March 9,
2004 (incorporated by reference to Exhibit 10.44 to
the Companys Form 10-K for the year ended March 31, 2004 (File
No. 0-22982)).10.40
    
    Form of Amendment No. 9 to Credit Agreement dated March 30,
2004 (incorporated by reference to Exhibit 10.45
to the Companys Form 10-K for the year ended March 31, 2004
(File No. 0-22982)).10.41
    
    Form of Amended and Restated Credit Agreement with General
Electric Capital Corporation dated June 18, 2004
(incorporated by reference to Exhibit 10.46 to the Companys Form
10-K for the year ended March 31, 2004 (File No. 0-22982)).10.42
    
    Form of Lease Agreement between the Company and NL Ventures IV
New Hope, L.P. dated May 27, 2004 (incorporated by reference to
Exhibit 10.47 to the Companys Form 10-K for the year ended March
31, 2004 (File No. 0-22982)).10.43
    
    Form of Third Amendment to Office/Warehouse Lease between
Cambridge Apartments, Inc. and the Company dated February 23,
2004 (incorporated by reference to Exhibit 10.48 to the Companys
Form 10-K for the year ended March 31, 2004 (File No. 0-22982)).10.44
    
    Form of Fourth Amendment to Office/Warehouse Lease between
Cambridge Apartments, Inc. and the Company dated
June 2004 (incorporated by reference to Exhibit 10.49 to the
Companys Form 10-K for the year ended March 31, 2004 (File No.
0-22982)).10.45
    
    Amendment No. 2 to Lease Agreement between Airport One Limited
Partnership and the Company dated March 21, 2004 (incorporated by
reference to Exhibit 10.50 to the Companys Form 10-K for the
year ended March 31, 2004 (File No. 0-22982)).10.46
    
    Addendum to Lease Agreement between Cambridge Apartments, Inc.
and the Company dated May 27, 2004 (incorporated by reference to
Exhibit 10.51 to the Companys Form 10-K for the year ended March
31, 2004 (File No. 0-22982)).10.47
    
    Form of BCI Eclipse Lease Agreement effective October 1, 1999
(incorporated by reference to Exhibit 10.52 to the Companys Form
10-K for the year ended March 31, 2004 (File No. 0-22982)).10.48
    
    First Amendment to BCI Eclipse Lease Agreement made as of January
5, 2000 (incorporated by reference to Exhibit 10.53 to the
Companys Form 10-K for the year ended March 31, 2004 (File No.
0-22982)).
 48




---



##### Table of Contents



10.49
    
    Amended and Restated Credit Agreement dated June 18, 2004 between
the Company and General Electric Capital Corporation
(incorporated by reference to Exhibit 10.54 to the Companys Form
10-Q for the quarter ended September 30, 2004 (File No.
0-22982)).10.50
    
    Amendment No. 1 and Limited Waiver with Respect to Amended and
Restated Credit Agreement dated August 25, 2004 (incorporated by
reference to Exhibit 10.55 to the Companys Form 10-Q for the
quarter ended September 30, 2004 (File No. 0-22982)).10.51
    
    Amendment No. 2 and Limited Waiver with Respect to Amended and
Restated Credit Agreement dated October 18, 2004 (incorporated by
reference to Exhibit 10.56 to the Companys Form 10-Q for the
quarter ended September 30, 2004 (File No. 0-22982)).10.52
    
    Lease dated October 8, 2004, between Encore Software, Inc. and
Kilroy Realty, L.P., with respect to a a office facility in El
Segundo, California (incorporated by reference to Exhibit 10.57
to the Companys Form 10-Q for the quarter ended September 30,
2004 (File No. 0-22982)).10.53
    
    Form of License and Distribution Agreement (Manufacturing Rights)
(2004-2005) between Riverdeep Inc. and Encore Software, Inc.
dated as of March 29, 2004 (incorporated by reference to Exhibit
10.1 to the Companys Form 10-Q/A for the quarter ended September
30, 2004 (File No. 0-22982)).10.54
    
    Form of License and Distribution Agreement (Manufacturing Rights)
(2005-2007) between Riverdeep Inc. and Encore Software, Inc.
dated as of March 29, 2004 (incorporated by reference to Exhibit
10.2 to the Companys Form 10-Q/A for the quarter ended September
30, 2004 (File No. 0-22982)).10.55
    
    Form of Addendum #1 to Licensing and Distribution Agreements
(2004-2005 and 2005-2007) between Riverdeep, Inc. and Encore
Software, Inc. dated as of April 13, 2004 (incorporated by
reference to Exhibit 10.3 to the Companys Form 10-Q/A for the
quarter ended September 30, 2004 (File No. 0-22982)).10.56
    
    Form of Addendum #2 to Licensing and Distribution agreements
(2004-2005 and 2005-2007) between Riverdeep, Inc. and Encore
Software, Inc. dated October 2004 (incorporated by reference to
Exhibit 10.4 to the Companys Form 10-Q/A for the quarter ended
September 30, 2004 (File No. 0-22982)).10.57 *
    
    Navarre Corporation 2004 Stock Plan (incorporated by reference to
Exhibit D to the Companys Proxy Statement filed July 27, 2004
(File No. 0-22982)).10.58*Ö
    
    Form of 2004 Stock Plan Incentive Stock Option Agreement.10.59*Ö
    
    Form of 2004 Stock Plan Non-Employee Director Stock Option
Agreement.
 49




---



##### Table of Contents



10.60
    
    Form of Senior Debt Indenture (incorporated by reference to
Exhibit 4(a) to the Companys Registration Statement on Form S-3
filed September 28, 2004 (File No. 333-119260)).10.61
    
    Form of Senior Debt Indenture (incorporated by reference to
Exhibit 4(c) to the Companys Registration Statement on Form S-3
filed September 28, 2004 (File No. 333-119260)).10.62
    
    FUNimation Partnership Interest Purchase Agreement, dated January
10, 2005 (incorporated by reference to Exhibit 10.1 to the
Companys Form 8-K filed January 14, 2005 (File No. 0-22982)).10.63
    
    Form of Assignment and Assumption Agreement (incorporated by
reference to Exhibit 10.1(a) to the Companys Form 8-K filed
January 14, 2005 (File No. 0-22982)).10.64*
    
    Form of Gen Fukanaga Employment Agreement (incorporated by
reference to Exhibit 10.1(b) to the Companys Form 8-K filed
January 14, 2005 (File No. 0-22982)).10.65
    
    Form of Escrow Agreement (incorporated by reference to Exhibit
10.1(c) to the Companys Form 8-K filed January 14, 2005 (File
No. 0-22982)).10.66
    
    Form of Non-Competition Agreement (incorporated by reference to
Exhibit 10.1(d) to the Companys Form 8-K filed January 14, 2005
(File No. 0-22982)).10.67
    
    Form of Registration Rights Agreement (incorporated by reference
to Exhibit 10.1(e) to the Companys Form 8-K filed January 14,
2005 (File No. 0-22982)).10.68
    
    Form of Release (incorporated by reference to Exhibit 10.1(f) to
the Companys Form 8-K filed January 14, 2005 (File No.
0-22982)).10.69
    
    Limited Waiver and Third Amendment to Amended and Restated Credit
Agreement, filed January 14, 2005 (incorporated by reference to
Exhibit 10.1 to the Companys Form 8-K filed January 14, 2005
(File No. 0-22982)).10.70
    
    Amendment No. 3 to Lease Agreement between Airport One
Limited Partnership and the Company dated November 23,
2004 (incorporated by reference to Exhibit 10.1 to the Companys
Form 10-Q for the quarter ended December 31, 2005 (File No.
0-22982)).10.71
    
    Form of Addendum #3 to Licensing and Distribution Agreements
(2004-2005 and 2005-2007) between Riverdeep, Inc. and Encore
Software, Inc. dated November 2004 (incorporated by reference to
Exhibit 10.2 to the Companys Form 10-Q for the quarter ended
December 31, 2005 (File No. 0-22982)).
 50




---



##### Table of Contents



10.72
    
    Amendment No. 1 to Lease Agreement between Encore Software, Inc.
and Kilroy Realty, L.P. dated December 29, 2004 (incorporated by
reference to Exhibit 10.3 to the Companys Form 10-Q for the
quarter ended December 31, 2005 (File No. 0-22982)).10.73
    
    Limited Waiver With Respect To Amended and Restated Credit
Agreement dated March 15, 2005 (incorporated by reference to
Exhibit 10.1 to the Companys Form 8-K filed March 17, 2005 (File
No. 0-22982)).10.74
    
    Stock Purchase Agreement between the Company and Michael Bell
dated March 14, 2005 (incorporated by reference to Exhibit 10.2
to the Companys Form 8-K filed March 17, 2005 (File No.
0-22982)).10.75
    
    Registration Rights Agreement between the Company and Michael
Bell dated March 14, 2005 (incorporated by reference to Exhibit
10.3 to the Companys Form 8-K filed March 17, 2005 (File No.
0-22982)).10.76
    
    Amendment to Stock Purchase Agreement between the Company and
Michael Bell dated March 31, 2005 (incorporated by reference to
Exhibit 10.1 to the Companys Form 8-K filed April 14, 2005 (File
No. 0-22982)).10.77
    
    Amendment to Registration Rights Agreement between the Company
and Michael Bell dated March 31, 2005 (incorporated by reference
to Exhibit 10.2 to the Companys Form 8-K filed April 14, 2005
(File No. 0-22982)).10.78
    
    Limited Waiver with Respect to Amended and Restated General
Electric Capital Corporation Credit Agreement dated March 31,
2005 (incorporated by reference to Exhibit 10.3 to the Companys
Form 8-K filed April 14, 2005 (File No. 0-22982)).10.79
    
    Pledge Agreement between the Company and General Electric Capital
Corporation related to Encore shares dated March 31, 2005
(incorporated by reference to Exhibit 10.4 to the Companys Form
8-K filed April 14, 2005 (File No. 0-22982)).10.80
    
    Amendment No. 1 to Partnership Interest Purchase Agreement dated
May 11, 2005 (incorporated by reference to Exhibit 10.1 to the
Companys Form 8-K filed May 17, 2005 (File No. 0-22982)).10.81
    
    Second Amended and Restated Credit Agreement dated as of May 11,
2005 between the Company and General Electric Capital Corporation
(incorporated by reference to Exhibit 10.2 to the Companys Form
8-K filed May 17, 2005 (File No. 0-22982)).10.82
    
    Form of Third Amended and Restated Credit Agreement with Lenders
and General Electric Capital Corporation dated June 1, 2005
(incorporated by reference to Exhibit 10.1 to the Companys Form
8-K filed June 3, 2005 (File No. 0-22982)).
 51




---



##### Table of Contents



10.83
    
    Form of Limited Waiver to General Electric Capital Corporation
Second Amended and Restated Credit Agreement dated June 1, 2005
(incorporated by reference to Exhibit 10.2 to the Companys Form
8-K filed June 3, 2005 (File No. 0-22982)).10.84Ö
    
    Office Lease dated August 1, 2004 between Cocanaugher Asset #1,
Ltd. and FUNimation Productions, Ltd.10.85Ö
    
    Letter dated June 14, 2005 regarding Companys policy to use
straight-line method of depreciation from Grant Thorton LLP.14.1
    
    The Companys Code of Business Conduct and Ethics (incorporated
by reference to Exhibit 14.1 to the Companys Form 10-K for the
year ended March 31, 2004 (File No. 0-22982)).21.1Ö
    
    Subsidiaries of the Registrant.23.1Ö
    
    Consent of Independent Registered
Public Accounting Firm  Grant Thornton LLP23.2Ö
    
    Consent of Independent Registered
Public Accounting Firm  Ernst & Young LLP24.1Ö
    
    Power of Attorney, contained on signature page31.01Ö
    
    Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of
the Exchange Act)31.02Ö
    
    Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of
the Exchange Act)32.01Ö
    
    Certifications of the Chief Executive Officer pursuant Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.
Section 1350)32.02Ö
    
    Certifications of the Chief Financial Officer pursuant Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.
Section 1350)
 * Indicates management contract or compensatory plan or agreement.Öfiled herewith 52




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized. Navarre Corporation
(Registrant)June 14, 2005
    By    /s/ Eric H. PaulsonEric H. PaulsonChairman of the Board, President
and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated. POWER OF ATTORNEY Each person whose signature appears below constitutes and appoints Eric H. Paulson and James
Gilbertson as his true and lawful attorneys-in-fact and agents, each acting alone, with full power
of substitution and resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any of all amendments to this Annual Report on Form 10-K and to file the same,
with all exhibits thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power
and authority to do and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or could do in person,
hereby ratifying and confirming all said attorneys-in-fact and agents, each acting alone, or his
substitute or substitutes, may lawfully do or cause to be done by virtue thereof. Signature
    
    Title
    
    Date/s/ Eric H. Paulson

Eric H. Paulson
    
    Chairman of the Board, President
and Chief Executive Officer
(principal executive officer)
    
    June 14, 2005/s/ James Gilbertson

James Gilbertson
    
    Vice President, Chief Financial Officer
and Director
(principal financial and accounting
officer)
    
    June 14, 2005/s/ Charles E. Cheney

Charles E. Cheney
    
    Director
    
    June 14, 2005/s/ Timothy R. Gentz

Timothy R. Gentz
    
    Director
    
    June 14, 2005/s/ James G. Sippl

James G. Sippl
    
    Director
    
    June 14, 2005/s/ Michael L. Snow

Michael L. Snow
    
    Director
    
    June 14, 2005/s/ Tom Weyl

Tom Weyl
    
    Director
    
    June 14, 2005/s/ Dickinson G. Wiltz

Dickinson G. Wiltz
    
    Director
    
    June 14, 2005/s/ Keith A. Benson

Keith A. Benson
    
    Director
    
    June 14, 2005
 53




---



##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders
Navarre Corporation We have audited the accompanying consolidated balance sheet of Navarre Corporation and
subsidiaries as of March 31, 2005, and the related consolidated statements of operations,
shareholders equity, and cash flows for the year then ended. These financial statements are the
responsibility of the Companys management. Our responsibility is to express an opinion on these
financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a reasonable basis for our
opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Navarre Corporation and subsidiaries as of March 31,
2005, and the results of their operations and their cash flows for the year then ended, in
conformity with accounting principles generally accepted in the United States of America. Our audit was conducted for the purpose of forming an opinion on the basic consolidated
financial statements taken as a whole. The accompanying Schedule II of Navarre Corporation and
subsidiaries is presented for purposes of additional analysis and is not a required part of the
basic consolidated financial statements. This schedule has been subjected to the auditing
procedures applied in the 2005 audit of the basic consolidated financial statements and, in our
opinion, is fairly stated in all material respects in relation to the 2005 basic consolidated
financial statements taken as a whole. We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of the Companys internal control over financial
reporting as of March 31, 2005, based on criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO),
and our report dated June 13, 2005 expressed an unqualified opinion on managements assessment of
the effectiveness of the Companys internal control over financial reporting and an adverse opinion
on the effectiveness of the Companys internal control over financial reporting. /s/ Grant Thornton LLP 
 54




---



##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders
Navarre Corporation We have audited managements assessment, included in Managements Report on Internal Control
over Financial Reporting appearing under Item 9A, that Navarre Corporation and subsidiaries (the
Company) did not maintain effective internal control over financial reporting as of March 31, 2005,
because the Company did not maintain effective controls over the accounting for certain
compensation arrangements and income taxes, based on the criteria
established in Internal Control 
Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). The Companys management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on managements assessment and an opinion
on the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinions. A companys internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting
principles. A companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys assets that could have
a material effect on the financial statements. 55




---



##### Table of Contents



Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness to future periods
are subject to the risk that controls may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a control deficiency, or combination of control deficiencies, that
results in more than a remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The following material weaknesses have
been identified and included in managements assessment: Accounting for Certain Compensation Arrangements As of March 31, 2005, the Company did not maintain effective controls over the accounting for
certain compensation arrangements. Specifically, the Company had a deficiency in the design of
controls to identify the proper accounting treatment for compensation arrangements for key
employees. Adjustments related to a deferred compensation arrangement with a key employee were
included in the restatement of the Companys consolidated financial statements for the third
quarter in the year ended March 31, 2004 and for the first
quarter in the year ending March 31, 2005. Accounting for Income Taxes As of March 31, 2005, the Company did not maintain effective controls over the accounting for
income taxes. Specifically, the Companys established internal controls surrounding the
preparation of its income tax provision for the quarter ending December 31, 2004 were not
effective. During the March 31, 2005 year end financial reporting process, the Company identified an error in the
preparation of the third quarter tax provision. This material weakness resulted in adjustments
that were included in the restatement of the Companys consolidated financial statements for the
third quarter in the year ended March 31, 2005. These material weaknesses were considered in determining the nature, timing, and extent of audit
tests applied in our audit of the 2005 consolidated financial statements, and our opinion regarding
the effectiveness of the Companys internal control over financial reporting does not affect our
report dated June 13, 2005 on those financial statements. In our opinion, managements assessment that Navarre Corporation and subsidiaries did not
maintain effective internal control over financial reporting as of March 31, 2005, is fairly
stated, in all material respects, based on the criteria established
in Internal Control 
Integrated Frameworkissued by COSO. Also, in our opinion, because of the effect of the material
weaknesses described above on the achievement of the objectives of the control criteria, Navarre
Corporation and subsidiaries had not maintained effective internal control over financial reporting
as of March 31, 2005, based on the criteria established in
Internal Control  Integrated Framework
issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board, (United States), the consolidated balance sheet of Navarre Corporation and
subsidiaries as of March 31, 2005, and the related consolidated statements of operations,
shareholders equity, and cash flows for the year then ended and our report dated June 13, 2005
expressed an unqualified opinion on those financial statements. /s/ Grant Thornton LLP Minneapolis, Minnesota
June 13, 2005 56




---



##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders
Navarre Corporation We have audited the accompanying consolidated balance sheets of Navarre Corporation as of March 31,
2004 and 2003, and the related consolidated statements of operations, shareholders equity, and
cash flows for each of the two years in the period ended March 31, 2004. Our audits also
included the financial statement schedule listed in the Index at Item 15(a). These financial
statements and schedule are the responsibility of the Companys management. Our responsibility is
to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Navarre Corporation at March 31, 2004 and
2003, and the consolidated results of its operations and its cash
flows for each of the two years
in the period ended March 31, 2004, in conformity with accounting principles generally accepted in
the United States. Also in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein. As discussed in Note 3, the Company has restated its consolidated financial statements for the year
ended March 31, 2004. /s/ Ernst & Young LLP
Minneapolis, Minnesota
May 13, 2004, except for Note 5, as to which the date is
June 21, 2004 and Note 3, as to which the date is June 1, 2005. 57




---



##### Table of Contents



NAVARRE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts) March 31,2005
    
    

2004(Restated)AssetsCurrent assets:Cash and cash equivalents
    
    $
    15,519
    
    
    $
    14,495Note receivable, related parties
    
    
    2,700
    
    
    
    478Accounts receivable, less allowance for doubtful accounts, vendor
advances and sales returns of $13,815 and $11,159, respectively
    
    
    94,003
    
    
    
    79,948Inventories
    
    
    40,593
    
    
    
    30,151Prepaid expenses and other current assets
    
    
    10,028
    
    
    
    4,139Deferred tax assets
    
    
    7,250
    
    
    
    1,036Total current assets
    
    
    170,093
    
    
    
    130,247Property and equipment, net of accumulated depreciation of
$7,247 and $6,650, respectively
    
    
    8,081
    
    
    
    6,914Other assets:Notes receivable, related parties
    
    
    200
    
    
    
    400Goodwill
    
    
    9,832
    
    
    
    10,371Intangible assets, net of amortization of $2,369 and
$812, respectively
    
    
    5,174
    
    
    
    6,123Other assets
    
    
    4,422
    
    
    
    782Total assets
    
    $
    197,802
    
    
    $
    154,837Liabilities and shareholders equityCurrent liabilities:Note payable
    
    $
    
    
    
    $
    651Capital lease obligation  short term
    
    
    84
    
    
    
    Accounts payable
    
    
    96,146
    
    
    
    92,120Income taxes payable
    
    
    8
    
    
    
    121Accrued expenses
    
    
    14,664
    
    
    
    6,377Total current liabilities
    
    
    110,902
    
    
    
    99,269Capital lease obligation  long-term
    
    
    237
    
    
    
    Deferred compensation
    
    
    4,000
    
    
    
    1,450Deferred tax liabilities
    
    
    1,957
    
    
    
    Total liabilities
    
    
    117,096
    
    
    
    100,719Commitments and contingencies (Note 16)Shareholders equity:Common stock, no par value:Authorized shares  100,000,000Issued and outstanding shares  27,896,080 and 25,817,965, respectively
    
    
    123,445
    
    
    
    109,405Accumulated deficit
    
    
    (42,739
    )
    
    
    (55,287
    )Total shareholders equity
    
    
    80,706
    
    
    
    54,118Total liabilities and shareholders equity
    
    $
    197,802
    
    
    $
    154,837
 See accompanying notes to consolidated financial statements. 58




---



##### Table of Contents



NAVARRE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts) Fiscal Years ended March 31,2005
    
    
    2004(Restated)
    
    
    2003Net sales
    
    $
    596,263
    
    
    $
    470,877
    
    
    $
    356,816Cost of sales (exclusive of depreciation and amortization)
    
    
    505,151
    
    
    
    412,856
    
    
    
    311,341Gross profit
    
    
    91,112
    
    
    
    58,021
    
    
    
    45,475Operating expenses:Selling and marketing
    
    
    21,483
    
    
    
    16,895
    
    
    
    13,792Distribution and warehousing
    
    
    8,840
    
    
    
    6,000
    
    
    
    5,514General and administrative
    
    
    44,934
    
    
    
    25,429
    
    
    
    20,047Depreciation and amortization
    
    
    3,521
    
    
    
    2,000
    
    
    
    2,11778,778
    
    
    
    50,324
    
    
    
    41,470Income from operations
    
    
    12,334
    
    
    
    7,697
    
    
    
    4,005Other income (expense):Interest expense
    
    
    (778
    )
    
    
    (378
    )
    
    
    (194
    )Interest income
    
    
    565
    
    
    
    446
    
    
    
    Debt extinguishment
    
    
    
    
    
    
    (908
    )
    
    
    Other income (expense)
    
    
    (65
    )
    
    
    6
    
    
    
    447Income before equity in income of NetRadio Corp.
    
    
    12,056
    
    
    
    6,863
    
    
    
    4,258Equity in income of NetRadio Corp.
    
    
    
    
    
    
    
    
    
    
    63Net income before tax
    
    
    12,056
    
    
    
    6,863
    
    
    
    4,321Tax benefit
    
    
    492
    
    
    
    583
    
    
    
    Net income
    
    $
    12,548
    
    
    $
    7,446
    
    
    $
    4,321Earnings per common share:Basic
    
    $
    .47
    
    
    $
    .33
    
    
    $
    .20Diluted
    
    $
    .44
    
    
    $
    .31
    
    
    $
    .20Weighted average shares outstanding:Basic
    
    
    26,830
    
    
    
    22,780
    
    
    
    21,616Diluted
    
    
    28,782
    
    
    
    24,112
    
    
    
    21,841
 See accompanying notes to consolidated financial statements. 59




---



##### Table of Contents



NAVARRE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands, except share amounts) Common StockAccumulatedShares
    
    
    Amount
    
    
    Deficit
    
    
    TotalBalance at March 31, 2002
    
    
    21,616,187
    
    
    $
    91,404
    
    
    $
    (67,054
    )
    
    $
    24,350Net income
    
    
    
    
    
    
    
    
    
    
    4,321
    
    
    
    4,321Balance at March 31, 2003
    
    
    21,616,187
    
    
    $
    91,404
    
    
    $
    (62,733
    )
    
    $
    28,671Shares issued upon exercise of stock options
    
    
    570,231
    
    
    
    814
    
    
    
    
    
    
    
    814Shares issued with private placement
    
    
    2,631,547
    
    
    
    11,735
    
    
    
    
    
    
    
    11,735Shares issued with acquisition of BCI
    
    
    1,000,000
    
    
    
    5,080
    
    
    
    
    
    
    
    5,080Value of warrants issued to Hilco
    
    
    
    
    
    
    372
    
    
    
    
    
    
    
    372Net income
    
    
    
    
    
    
    
    
    
    
    7,446
    
    
    
    7,446Balance at March 31, 2004 (Restated)
    
    
    25,817,965
    
    
    $
    109,405
    
    
    $
    (55,287
    )
    
    $
    54,118Shares
issued upon exercise of stock options and warrants
    
    
    1,778,115
    
    
    
    8,238
    
    
    
    
    
    
    
    8,238Shares issued upon repurchase of Encore
stock
    
    
    300,000
    
    
    
    2,400
    
    
    
    
    
    
    
    2,400Tax benefit
from employee stock option plans
    
    
    
    
    
    
    2,428
    
    
    
    
    
    
    
    2,428Stock-based compensation expense
    
    
    
    
    
    
    269
    
    
    
    
    
    
    
    269Reclassification of stock- based compensation
accrual
    
    
    
    
    
    
    705
    
    
    
    
    
    
    
    705Net income
    
    
    
    
    
    
    
    
    
    
    12,548
    
    
    
    12,548Balance at March 31, 2005
    
    
    27,896,080
    
    
    $
    123,445
    
    
    $
    (42,739
    )
    
    $
    80,706
 See accompanying notes to consolidated financial statements. 60




---



##### Table of Contents



NAVARRE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Fiscal Years ended March 31,2005
    
    
    2004(Restated)
    
    
    2003Operating activities:Net income
    
    $
    12,548
    
    
    $
    7,446
    
    
    $
    4,321Adjustments
to reconcile net income to net cash (used in)
provided by operating activities:Depreciation and amortization
    
    
    3,661
    
    
    
    2,000
    
    
    
    2,117Amortization of deferred financing costs
    
    
    240
    
    
    
    87
    
    
    
    108Equity in income of NetRadio Corp.
    
    
    
    
    
    
    
    
    
    
    (63
    )Stock-based compensation expense
    
    
    269
    
    
    
    705
    
    
    
    Deferred compensation expense
    
    
    2,550
    
    
    
    1,450
    
    
    
    Compensation expense incurred with repurchase of Encore
Stock
    
    
    5,800
    
    
    
    
    
    
    
    Expense related to warrant exercise
    
    
    
    
    
    
    372
    
    
    
    Write-off of notes receivable
    
    
    200
    
    
    
    200
    
    
    
    200Impairment
of capitalized software development costs
    
    
    465
    
    
    
    5,588
    
    
    
    Tax benefit
from employee stock option plans
    
    
    2,428
    
    
    
    
    
    
    
    Loss on disposal of property and equipment
    
    
    82
    
    
    
    
    
    
    
    Deferred income taxes
    
    
    (4,257
    )
    
    
    (1,036
    )
    
    
    Changes in
operating assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    (13,641
    )
    
    
    (11,301
    )
    
    
    (10,370
    )Inventories
    
    
    (10,536
    )
    
    
    (4,252
    )
    
    
    (5,495
    )Prepaid expenses
    
    
    (6,754
    )
    
    
    (4,180
    )
    
    
    (4,580
    )Other assets
    
    
    (2,985
    )
    
    
    (2
    )
    
    
    (1,359
    )Accounts payable
    
    
    4,276
    
    
    
    13,029
    
    
    
    15,165Income taxes payable
    
    
    (113
    )
    
    
    121
    
    
    
    Accrued expenses
    
    
    5,599
    
    
    
    (992
    )
    
    
    1,244Net cash (used in) provided by operating activities
    
    
    (168
    )
    
    
    9,235
    
    
    
    1,288Investing activities:Acquisitions, net of cash acquired
    
    
    
    
    
    
    (10,465
    )
    
    
    (7,546
    )Purchases of property and equipment
    
    
    (9,292
    )
    
    
    (5,048
    )
    
    
    (1,039
    )Proceeds from sale of property and equipment
    
    
    
    
    
    
    60
    
    
    
    Net proceeds from sale leaseback
    
    
    6,401
    
    
    
    
    
    
    
    Purchases of intangible assets
    
    
    (608
    )
    
    
    (1,246
    )
    
    
    Payment of earn-out related to an acquisition
    
    
    (88
    )
    
    
    
    
    
    
    Notes receivable, related parties
    
    
    (2,222
    )
    
    
    (278
    )
    
    
    (711
    )Payments on NetRadio note
    
    
    
    
    
    
    
    
    
    
    63Net cash used in investing activities
    
    
    (5,809
    )
    
    
    (16,977
    )
    
    
    (9,233
    )Financing activities:Proceeds from note payable, bank
    
    
    117,197
    
    
    
    75,930
    
    
    
    42,067Payments on note payable, bank
    
    
    (117,197
    )
    
    
    (75,930
    )
    
    
    (42,067
    )Repayment of note payable
    
    
    (651
    )
    
    
    (1,073
    )
    
    
    (536
    )Proceeds of note payable
    
    
    
    
    
    
    651
    
    
    
    Debt acquisition costs
    
    
    (527
    )
    
    
    (375
    )
    
    
    Repayments of capital lease obligations
    
    
    (59
    )
    
    
    
    
    
    
    Proceeds from sale of common stock
    
    
    
    
    
    
    11,735
    
    
    
    Proceeds from exercise of common stock options and warrants
    
    
    8,238
    
    
    
    814
    
    
    
    Net cash provided by (used in) financing activities
    
    
    7,001
    
    
    
    11,752
    
    
    
    (536
    )Net increase (decrease) in cash
    
    
    1,024
    
    
    
    4,010
    
    
    
    (8,481
    )Cash at beginning of year
    
    
    14,495
    
    
    
    10,485
    
    
    
    18,966Cash at end of year
    
    $
    15,519
    
    
    $
    14,495
    
    
    $
    10,485
 61




---



##### Table of Contents



NAVARRE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS  (Continued) Fiscal Years ended March 31,2005
    
    
    2004(Restated)
    
    
    2003Supplemental cash flow information:Cash paid for:Interest
    
    $
    771
    
    
    $
    353
    
    
    $
    194Income taxes
    
    
    1,449
    
    
    
    324
    
    
    
    Supplemental schedule of non-cash investing and financing
activities:Reclassification of stock compensation accrual to
shareholders equity
    
    $
    705
    
    
    
    
    
    
    
    Purchase price adjustments affecting: accounts receivable,
prepaid expenses, goodwill and accounts payable
    
    
    627
    
    
    
    
    
    
    
    Capital lease obligations incurred for the purchase of
computer equipment
    
    
    380
    
    
    
    
    
    
    
    Reclassification of prepaid rent to long-term rent
    
    
    450
    
    
    
    
    
    
    
    
 See accompanying notes to consolidated financial statements. 62




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 Note 1 Business Description Navarre Corporation, a Minnesota corporation formed in 1983, publishes and distributes a broad
range of home entertainment and multimedia products, including PC software, CD audio, DVD and VHS
video, video games and accessories. The business is divided into two business segments 
Distribution and Publishing. Through these business segments, the Company maintains and leverages
strong relationships throughout the publishing and distribution chain. The broad base of customers
includes: (i) wholesale clubs, (ii) mass merchandisers, (iii) other third party distributors, (iv)
computer specialty stores, (v) music specialty stores, (vi) book stores, (vii) office superstores,
and (viii) electronic superstores. The Companys customer base includes over 500 individual
customers with over 18,000 locations, certain of which are international locations. Through the Distribution business, the Company distributes and provides fulfillment services
in connection with a variety of finished goods that are provided by our vendors, which include PC
software and video game publishers and developers, independent and major music labels, and major
motion picture studios. These vendors provide the Company with PC software, CD audio, DVD and VHS
video, and video games and accessories, which are in turn distributed to retail customers. The
Distribution business focuses on providing vendors and retailers with a range of value-added
services, including vendor-managed inventory, Internet-based ordering, electronic data interchange
services, fulfillment services, and retailer-oriented marketing services. Through the Publishing business the Company owns or licenses various PC software, CD audio,
and DVD and VHS video titles. The Publishing business packages, brands, markets and sells directly
to retailers, third-party distributors, and our Distribution business. The Publishing business
currently consists of Encore Software, Inc. and BCI Eclipse Company, LLC. Encore, which was
acquired in July 2002, licenses and publishes personal productivity, genealogy, education and
interactive gaming PC products. BCI, which was acquired in November 2003, is a provider of niche
DVD and video products and in-house produced CDs and DVDs. The Company acquired FUNimation
Productions, Ltd. and The FUNimation Store, Ltd. (together,
FUNimation) in May of 2005, which is a publisher and licensor
of Japanese animation and entertainment video products for children and young adults. Note 2 Summary of Significant Accounting Policies Basis of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned
subsidiaries, BCI Eclipse Company, LLC (BCI) and Encore Software, Inc. (Encore) (collectively
referred to herein as the Company). Prior to March 2005, Encore was a majority-owned subsidiary.
All significant intercompany accounts and transactions have been eliminated in consolidation. Fiscal Year References in these footnotes to fiscal 2005, 2004 and 2003 represent the twelve months ended
March 31, 2005, March 31, 2004 and March 31, 2003. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. Significant estimates include the realizability
of accounts receivable, vendor advances, inventories, goodwill, intangible assets, 63




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) prepaid royalties, income taxes and the adequacy of certain accrued liabilities and reserves.
Actual results could differ from these estimates. Reclassifications Certain amounts included in the consolidated financial statements have been reclassified in
prior years to conform with the current year presentation. These amounts had no effect on
previously reported shareholders equity or net income, except as disclosed in the consolidated
statements of shareholders equity. Fair Value of Financial Instruments The carrying value of the Companys current financial assets and liabilities, because of their
short-term nature, approximates fair value. Cash and Cash Equivalents The Company considers short-term investments with a maturity of three months or less when
purchased to be cash equivalents. Cash equivalents are carried at cost, which approximates fair
value. Inventories Inventories are stated at the lower of cost or market with cost determined on the first-in,
first-out (FIFO) method. The Company monitors its inventory to ensure that it properly identifies,
on a timely basis, inventory items that are slow-moving and non-returnable. The primary risk in
the Companys distribution business is product that has been purchased from vendors that cannot be
sold at full distribution prices and is not returnable to the vendors. The primary risk in the
Companys publishing business is that certain products may run out of shelf life and be returned.
Generally, these products can be sold in bulk to a variety of liquidators. The Company establishes
reserves for the difference between carrying value and estimated realizable value in the periods
when the Company first identifies the lower of cost or market issue. The Companys accounting
policy is to record inventory acquired in a purchase business combination at fair value, defined as
the estimated selling price less the costs of disposal and a reasonable selling margin. Property and Equipment Property and equipment are recorded at cost. Depreciation is recorded over estimated useful
lives, ranging from three to ten years. Depreciation is computed using the straight-line method
for leasehold improvements over the shorter of the lease term or the estimated useful life. The
straight-line method of depreciation was adopted for all property and equipment placed into service
after March 31, 2004. For property and equipment placed into service prior to April 1, 2004,
except leasehold improvements, depreciation is provided using accelerated methods. The change in
accounting principle to the use of straight-line depreciation was made to reflect a better matching
of expense to the use of the equipment and the new method is prevalent in the industry in which the
Company operates. Under the accelerated method, depreciation expense would have been higher by
$559,000 in fiscal 2005 for new additions. Estimated useful lives by major asset categories are as
follows: Asset
    
    Life in YearsFurniture and fixtures
    
    7Office equipment
    
    5Computer equipment
    
    3Warehouse equipment
    
    5Leasehold improvements
    
    5-10
 Maintenance, repairs and minor renewals are charged to expense as incurred. Additions, major
renewals and betterments to property and equipment are capitalized. 64




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Impairment of Long-Lived Assets In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets, long-lived assets, such as property and equipment
and amortizable intangible assets, are evaluated for impairment whenever events or changes in
circumstances indicate the carrying value of an asset may not be recoverable. An impairment loss
is recognized when estimated undiscounted cash flows expected to result from the use of the asset
plus net proceeds expected from disposition of the asset (if any) are less than the carrying value
of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced
to its estimated fair value. Goodwill Goodwill represents the excess of the purchase price over the fair value of identifiable net
assets acquired in business combinations accounted for under the purchase method. Effective April
1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and
Other Intangible Assets, which eliminated the systematic amortization of goodwill. The Company
reviews goodwill for potential impairment annually for each reporting unit or when events or
changes in circumstances indicate the carrying value of the goodwill might exceed its current fair
value. The Company has no goodwill associated with its distribution segment. The publishing
segment has two reporting units that have goodwill  Encore and BCI. The Company
determines fair value using widely accepted valuation techniques. These types of analyses require the Company to make certain assumptions
and estimates regarding industry economic factors and the profitability of future business
strategies. In the fourth quarter of fiscal 2005 and 2004, the Company completed its annual impairment
testing of goodwill related to the acquisitions of Encore and BCI and determined there were
no impairments. Intangible Assets Intangible assets include masters acquired during the acquisition of BCI, masters acquired
from independent parties and other intangibles. Intangible assets are amortized on a straight-line
basis with estimated useful lives ranging from three to seven years. The straight-line method of
amortization of these assets reflects an appropriate allocation of the costs of the intangible
assets to its useful life. Intangible assets are tested for impairment whenever events or
circumstances indicate that a carrying amount of an asset may not be recoverable. An impairment
loss is generally recognized when the carrying amount of an asset exceeds the estimated fair value
of the asset. Fair value is generally determined using a discounted cash flow analysis. Debt Issuance costs Debt issuance costs are amortized over the life of the related debt. Accumulated amortization
amounted to approximately $502,000 and $262,000 at March 31, 2005 and 2004, respectively.
Amortization expense is included in interest expense in the accompanying consolidated statements of
operations. Revenue Recognition Revenue on products shipped is recognized when title and risk of loss transfers, delivery has
occurred, the price to the buyer is determinable and collectibility is reasonably assured. Service
revenues are recognized upon delivery of the services. Service revenues have represented less than
10% of total net sales for fiscal 2005, 2004 and 2003. The Company, under specific conditions,
permits its customers to return products. The Company records a general reserve for sales returns
and allowances against amounts due to reduce the net recognized receivables to the amounts the
Company reasonably believes will be collected. These reserves are based on the application of the
Companys average historical gross profit percent against averages sales returns, sales discounts
percent against average gross sales and specific reserves for marketing programs. Although its
past experience has been a good indicator of future reserve levels, there can be no assurance that
its current reserve levels will be adequate in the future. The Companys distribution customers at times qualify for certain price protection benefits
from the Companys vendors. The Company serves as an intermediary to settle these amounts between
vendors and 65




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) customers. The Company accounts for these amounts as reductions of revenues with
corresponding reductions in cost of sales. The Companys publishing business at times provides certain price protection, promotional
monies, volume rebates and other incentives to customers. The Company records these amounts as
reductions in revenue. Vendor Allowances The Company receives allowances from certain vendors as a result of purchasing their products.
In accordance with Emerging Issues Task Force (EITF) 02-16, Accounting by a Customer (Including a
Reseller) for Certain Consideration Received from a Vendor, vendor allowances are initially
deferred. The deferred amounts are then recorded as a reduction of cost of sales when the
related product is sold. Allowance for Doubtful Accounts The Company performs periodic credit evaluations of its customers financial condition and
generally does not require collateral. The Company makes estimates of the uncollectibility of its
accounts receivable, including advances and balances with independent labels. In determining the
adequacy of its allowances, the Company analyzes customer financial statements, historical
collection experience, aging of receivables, substantial down-grading of credit scores, bankruptcy
filings, and other economic and industry factors. Although risk management practices and
methodologies are utilized to determine the adequacy of the allowance, it is possible that the
accuracy of the estimation process could be materially impacted by different judgments as to
collectibility based on the information considered and further deterioration of accounts. The
Companys largest collection risks exist for retail customers that are in bankruptcy, or at risk of
bankruptcy. The occurrence of these events is infrequent, but can be material when it does occur. Classification of Shipping Costs Costs incurred with the shipment of product between the Company and its vendors are classified
in cost of sales. These costs were $4,778,000, $2,103,000, and $1,660,000 for the years ended
March 31, 2005, 2004, and 2003, respectively. Costs incurred with the shipment of product from the Company to its customers are
classified in selling expenses. These costs were $9,489,000,
$6,984,000, and $6,626,000 for the
years ended March 31, 2005, 2004, and 2003, respectively. Foreign Currency Transactions Transaction gains and losses that arise from exchange rate fluctuations on transactions
denominated in a currency other than the functional currency are included in the results of
operations when settled or at the most balance sheet date if the transaction has not settled.
Historically, the Company has had minimal foreign currency transactions. Income Taxes Income taxes are recorded under the asset and liability method. Deferred tax assets and
liabilities are recognized for the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply
to taxable income in the years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized
in income in the period that includes the enactment date. Stock-Based Compensation The Company has two stock option plans for officers, non-employee directors and key employees.
The Company accounts for these plans under the recognition and measurement principles of
Accounting Principles 66




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB 25), and related
interpretations. Therefore, when the exercise price of stock options equals the market price of
the underlying stock on the date of grant, no compensation expense is recognized. The Company
adopted the disclosure-only provisions of Financial Accounting Standards Board Statement No. 123,
Accounting for Stock-Based Compensation(SFAS 123). The intrinsic value method is used to
account for stock-based compensation plans. The following table illustrates the effect on net
income and net income per share if the Company had applied the fair value recognition provision of
SFAS 123, to stock-based employee compensation. (In thousands, except for per share data) Fiscal years ended March 31,2005
    
    
    2004(Restated)
    
    
    2003Net income, as reported
    
    $
    12,548
    
    
    $
    7,446
    
    
    $
    4,321Deduct: Stock-based compensation determined under
fair value method for all awards, net of tax
    
    
    (936
    )
    
    
    (319
    )
    
    
    (694
    )Net income, pro forma
    
    $
    11,612
    
    
    $
    7,127
    
    
    $
    3,627Income per share:Basic  as reported
    
    $
    .47
    
    
    $
    .33
    
    
    $
    .20Basic  pro forma
    
    $
    .43
    
    
    $
    .31
    
    
    $
    .17Diluted  as reported
    
    $
    .44
    
    
    $
    .31
    
    
    $
    .20Diluted  pro forma
    
    $
    .40
    
    
    $
    .30
    
    
    $
    .17
 Pro forma information regarding net income and income per share is required by SFAS 123, and
has been determined as if the Company had accounted for its employee stock options under the fair
value method of SFAS 123. The fair value of options granted were estimated at the date of grant
using the Black-Scholes option pricing model with the following assumptions used for grants in
fiscal 2005, 2004 and 2003: Weighted Average
    
    
    Dividend
    
    
    Expected
    
    
    ExpectedRisk Free Rate
    
    
    Yield
    
    
    Lives
    
    
    Volatility2005
    
    
    3.6
    %
    
    
    0.0
    %
    
    
    5
    
    
    
    71
    %2004
    
    
    2.9
    %
    
    
    0.0
    %
    
    
    5
    
    
    
    70
    %2003
    
    
    2.9
    %
    
    
    0.0
    %
    
    
    5
    
    
    
    73
    %
 The weighted average fair value of options granted in fiscal 2005, 2004, and 2003 was $9.19,
$3.28, and $0.87, respectively. Earnings Per Share Basic earnings per share is computed by dividing net income by the weighted average number of
common shares outstanding during the year. Diluted earnings per share is computed by dividing net
income by the sum of the weighted average number of common shares outstanding plus all additional
common shares that would have been outstanding if potentially dilutive common shares related to
stock options and warrants had been issued. The following table sets forth the computation of
basic and diluted earnings per share: (In thousands, except for per share data) Fiscal Years ended March 31,2005
    
    
    2004(Restated)
    
    
    2003Numerator:Net income
    
    $
    12,548
    
    
    $
    7,446
    
    
    $
    4,321Denominator:Denominator for basic earnings per
share  weighted average shares
    
    
    26,830
    
    
    
    22,780
    
    
    
    21,616Dilutive securities: Employee stock options
and warrants
    
    
    1,952
    
    
    
    1,332
    
    
    
    225Denominator for diluted earnings per
share  weighted average shares
    
    
    28,782
    
    
    
    24,112
    
    
    
    21,841Basic earnings per share
    
    $
    .47
    
    
    $
    .33
    
    
    $
    .20Diluted earnings per share
    
    $
    .44
    
    
    $
    .31
    
    
    $
    .20
 67




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Approximately 737,000, 975,000 and 1.9 million of the Companys stock options and warrants
were excluded from the calculation of diluted earnings per share in 2005, 2004 and 2003,
respectively, because the exercise prices of the stock options and warrants were greater than the
average price of the Companys common stock and therefore their inclusion would have been
antidilutive. Capitalized Software Development Costs Software development costs incurred subsequent to the determination of the technological
feasibility of software products are capitalized. Capitalization ceases and amortization of costs
begins when the software product is available for general release to customers. The Company tests
for possible impairment whenever events or changes in circumstances, such as a reduction in
expected cash flows, indicate that the carrying amount of the asset may not be recoverable. If
indicators exist, the Company compares the undiscounted cash flows related to the asset to the
carrying value of the asset. If the carrying value is greater than the undiscounted cash flow
amount, an impairment charge is recorded in cost of goods sold in the statement of operations for
amounts necessary to reduce the carrying value of the asset to fair value. The Company recorded an
impairment charge associated with product development costs in fiscal
2005 and 2004 of $465,000 and
$5.6 million, respectively. Unamortized software development costs
were $348,000 and $385,000 as of March 31, 2005 and
March 31, 2004, respectively. Recently Issued Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation
Number (FIN) 46 (revised December 2003), Consolidated of Variable Interest Entities(FIN 46R),
which addresses how a business enterprise should evaluate whether it has a controlling financial
interest in an entity through means other than voting rights and accordingly should consolidate the
entity. The Company is required to apply FIN 46R to variable interest entities (VIEs) created
after December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN 46R
would be applied effective April 1, 2004. As of March 31, 2005, the Company had no entities within
the scope of the statement. FASB Statement No. 150 (the Statement), Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity,was issued in May 2003. The Statement establishes
standards for the classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. The Statement also includes required disclosures
for financial instruments within its scope. For the Company, the Statement was effective for
instruments entered into or modified after May 31, 2003, and otherwise was effective as of January
1, 2004, except for mandatorily redeemable financial instruments. For certain mandatorily
redeemable financial instruments, the Statement was effective for the Company on January 1, 2005.
The effective date has been deferred indefinitely for certain other types of mandatorily redeemable
financial instruments. As of March 31, 2005, the Company had no financial instruments within the
scope of the Statement. In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151,
Inventory Costs, an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for
abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No.
151 is effective for inventory costs incurred during fiscal years beginning in the Companys first
quarter of fiscal year 2006. The Company does not believe the adoption of SFAS No. 151 will have a
material effect on its consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which replaced SFAS No.
123 and superseded APB 25. SFAS No. 123R addresses the accounting for share-based payment
transactions in which a company receives employee services in exchange for either equity
instruments of the company or liabilities 68




---



##### Table of Contents





NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

that are based on the fair value of the companys equity instruments or that may be settled by
the issuance of such equity instruments. Under SFAS No. 123R, companies will no longer be able to
account for the share-based compensation transactions using the intrinsic method in accordance with
APB 25 but will be required to account for such transactions using a fair-value method and
recognize the expense in the consolidated statement of operations. SFAS No. 123R is effective
beginning in the Companys first quarter of fiscal year 2007. Under SFAS 123R, the Company must
determine the appropriate fair value model to be used for valuing share-based payments, the
amortization method for compensation cost and the transition method to be used at date of adoption.
The transition methods include prospective and retroactive adoption options. The Company has begun,
but has not completed, evaluating the impact of the adoption of SFAS 123R on its results of
operations. In connection with evaluating the impact of SFAS 123R, the Company is considering the
potential implementation of different valuation methods to determine the fair value of share-based
compensation. The Company believes the adoption of SFAS 123R will have a material impact on our
results of operations, regardless of the valuation method used.

Note 3 Restatements

In June 2005, the Companys management, after consultation with the Companys Audit Committee
of the Board of Directors, determined that the Companys consolidated financial statements for its
third fiscal quarter ended December 31, 2003, year ended March 31, 2004, first fiscal quarter ended
June 30, 2004, second fiscal quarter ended September 30, 2004, and third fiscal quarter ended
December 31, 2004 should no longer be relied upon. As a result of the fiscal year 2005 audit, it
was determined that expenses related to the incentive-based deferred compensation of the Companys
Chief Executive Officer should have been recorded in the third fiscal quarter of 2004 and first
fiscal quarter of 2005. As a result, additional expenses and accrued liabilities of $1.5 million
and $2.2 million have been recorded in these quarters, respectively. These expenses were
determined in accordance with the provisions of the Chief Executive Officers 2001 employment
agreement, as amended.

It was also determined that the Companys deferred tax benefit recorded in the third fiscal
quarter of 2005 was improperly included in income and should have
increased common stock. Consequently, the tax benefit of $2.4 million recognized during the third fiscal
quarter of 2005 was reduced and common stock was increased by the same amount.

Presented below are the consolidated financial statement line items that have been impacted by
the items described above, taking into consideration that
prior year reported amounts reflect reclassifications to conform with current year
presentation as discussed in Note 2:

(in thousands)
    
    Year
Ended March 31, 2004Third Quarter
    
    
    Third Quarter
    
    
    March 31, 2004
    
    
    March 31, 2004(Reported)
    
    
    (Restated)
    
    
    (Reported)
    
    
    (Restated)Balance Sheet Data:Deferred compensation
    



$         
    
    
    

$     1,450
    
    
    
    $         
    
    
    
    $     1,450Total liabilities
    
    
    118,672
    
    
    
    120,122
    
    
    
    99,269
    
    
    
    100,719Total shareholders equity
    
    
    46,973
    
    
    
    45,523
    
    
    
    55,568
    
    
    
    54,118Total liabilities and shareholders equity
    
    
    $165,645
    
    
    
    $165,645
    
    
    
    $154,837
    
    
    
    $154,837Statements of Operations Data:General and administrative
    
    
    $    6,242
    
    
    
    $    7,692
    
    
    
    $  23,979
    
    
    
    $  25,429Income from operations
    
    
    4,521
    
    
    
    3,071
    
    
    
    9,147
    
    
    
    7,697Net income before tax
    
    
    3,590
    
    
    
    2,140
    
    
    
    8,313
    
    
    
    6,863Net income
    
    
    $   3,590
    
    
    
    $   2,140
    
    
    
    $   8,896
    
    
    
    $   7,446Earnings per common share:Basic
    
    
    $       .16
    
    
    
    $       .10
    
    
    
    $       .39
    
    
    
    $       .33Diluted
    
    
    $       .15
    
    
    
    $       .09
    
    
    
    $       .37
    
    
    
    $       .31Statements of Cash Flow Data:Net income
    
    
    $   5,621
    
    
    
    $   4,171
    
    
    
    $   8,896
    
    
    
    $   7,446Deferred compensation expense
    
    
    
    
    
    
    1,450
    
    
    
    
    
    
    
    1,450


69



---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

(in thousands)
    
    Year Ended March 31,
2005First
    
    
    First
    
    
    Second
    
    
    SecondQuarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter(Reported)
    
    
    (Restated)
    
    
    (Reported)
    
    
    (Restated)Balance Sheet Data:Deferred compensation
    
    $
    
    
    
    $
    3,637
    
    
    $
    
    
    
    $
    3,637Total liabilities
    
    
    92,072
    
    
    
    95,709
    
    
    
    137,588
    
    
    
    141,225Total shareholders equity
    
    
    63,418
    
    
    
    59,781
    
    
    
    69,675
    
    
    
    66,038Total liabilities and shareholders equity
    
    $
    155,490
    
    
    $
    155,490
    
    
    $
    207,263
    
    
    $
    207,263Statements of Operations Data:General and administrative
    
    $
    7,603
    
    
    $
    9,790
    
    
    $
    8,697
    
    
    $
    8,697Income from operations
    
    
    4,306
    
    
    
    2,119
    
    
    
    4,834
    
    
    
    4,834Net income before tax
    
    
    4,386
    
    
    
    2,199
    
    
    
    4,902
    
    
    
    4,902Net income
    
    $
    4,397
    
    
    $
    2,210
    
    
    $
    4,906
    
    
    $
    4,906Earnings per common share:Basic
    
    $
    .17
    
    
    $
    .08
    
    
    $
    .18
    
    
    $
    .18Diluted
    
    $
    .15
    
    
    $
    .08
    
    
    $
    .17
    
    
    $
    .17Statements of Cash Flow DataNet income
    
    $
    4,397
    
    
    $
    2,210
    
    
    $
    9,303
    
    
    $
    7,116Deferred compensation expense
    
    
    
    
    
    
    2,187
    
    
    
    
    
    
    
    2,187


(in thousands):
    

Year
Ended March 31, 2005Third
    
    
    ThirdQuarter
    
    
    Quarter(Reported)
    
    
    (Restated)Balance Sheet Data:Deferred compensation
    
    $
    
    
    
    $
    3,637Total liabilities
    
    
    140,729
    
    
    
    144,366Total shareholders equity
    
    
    80,576
    
    
    
    76,939Total liabilities and shareholders equity
    
    $
    221,305
    
    
    $
    221,305Statements of Operations Data:Tax (benefit) expense
    
    $
    (2,386
    )
    
    $
    42Net income
    
    
    10,400
    
    
    
    7,972Earnings per common share:Basic
    
    $
    .39
    
    
    $
    .30Diluted
    
    $
    .36
    
    
    $
    .28Statements of Cash Flow Data:Net income
    
    $
    19,703
    
    
    $
    15,088Deferred
compensation expense
    
    
    
    
    
    
    2,187Tax benefit
from employee stock option plans
    
    
    
    
    
    
    2,428


Note 4 Acquisition

On November 3, 2003, the Company acquired the assets of
BCI Eclipse, LLC (BCI Eclipse). Under the terms of
the acquisition, a newly-formed subsidiary of Navarre, BCI Eclipse
Company, LLC (BCI), acquired all assets of BCI Eclipse for
approximately $10.4 million in cash and one million shares of Navarre common stock with a value at
closing of $5.1 million. There is also the possibility that, depending on BCIs ability to meet
certain goals with respect to its operating income, the

70



---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Company will pay certain additional payments to BCI Eclipse each year until 2008. The
maximum amount of these annual payments varies over that period from $87,500 to $350,000. The
assets purchased by the Company included certain fixed assets, intellectual property, inventory,
receivables and contract rights related to BCI Eclipses business. The acquisition was accounted
for using the purchase method in accordance with SFAS No. 141, Business Combinations.Accordingly,
the net assets were recorded at their estimated fair values and operating results were included in
the Companys financial statements from the date of acquisition. Pro forma results of operations
were not presented for this acquisition since the effects were not material to the Company. The purchase price was allocated on a preliminary basis using information currently available.
The allocation of the purchase price was finalized in fiscal 2005. The adjusted allocation
resulted in goodwill of $6.7 million, which will not be amortized. The adjusted purchase price allocation is as follows (in thousands): Accounts receivable
    
    $
    5,739Inventories
    
    
    2,976Prepaid expenses and other current assets
    
    
    752Property and equipment
    
    
    30Identifiable intangible assets
    
    
    4,990Goodwill
    
    
    6,723Current liabilities
    
    
    (5,577
    )Total purchase price
    
    $
    15,633
 Note 5 Accounts Receivable Accounts receivable consisted of the following (in thousands): March 31, 2005
    
    March 31, 2004Trade receivables
    
    $
    88,120
    
    
    
    $
    77,700Vendor advance receivables
    
    
    16,857
    
    
    
    
    12,718Other receivables
    
    
    2,841
    
    
    
    
    689$
    107,818
    
    
    
    $
    91,107Less: allowance for doubtful accounts
and sales returns
    
    
    13,815
    
    
    
    
    11,159Total
    
    $
    94,003
    
    
    
    $
    79,948
 Note 6 Mix and Burn, Inc. The Company owns a 45% equity interest in Mix and Burn, Inc., a start-up company developing a
music listening and CD burning station. The Company utilizes the cost method to account for the
investment. The Company has also authorized a line of credit not to exceed $2.5 million, which
expires December 31, 2005 and bears interest at 6%. At March 31, 2005 and 2004, the note
receivable from Mix and Burn, Inc. was $2.5 million and
$278,000, respectively, and is reflected in
Notes receivable, related parties. Note 7 Inventories Inventories consist of the following (in thousands): March 31, 2005
    
    March 31, 2004Finished products
    
    $
    36,056
    
    
    
    $
    27,826Raw materials
    
    
    4,537
    
    
    
    
    2,325$
    40,593
    
    
    
    $
    30,151
 71




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Note 8 Goodwill and Intangible Assets As of March 31, 2005 and March 31, 2004, goodwill amounted to $9.8 million and $10.4 million,
respectively. During fiscal 2005 further purchase price adjustments of $627,000, less the annual
earn-out payment of $88,000 were made relating to the BCI acquisition resulting in a reduction in
goodwill of $539,000. The change from fiscal 2003 to fiscal 2004 resulted from the acquisition of
BCI. The changes in the carrying amount of goodwill by segment were as follows (in thousands): Distribution
    
    Publishing
    
    ConsolidatedBalances as of March 31, 2003
    
    $
    
    
    
    $
    3,109
    
    
    $
    3,109Goodwill resulting from an acquisition
    
    
    
    
    
    
    7,262
    
    
    
    7,262Balances as of March 31, 2004
    
    $
    
    
    
    $
    10,371
    
    
    $
    10,371Final purchase price allocation adjustment
    
    
    
    
    
    
    (627
    )
    
    
    (627
    )Earn-out
related to acquisition
    
    
    
    
    
    
    88
    
    
    
    88Balances as of March 31, 2005
    
    $
    
    
    
    $
    9,832
    
    
    $
    9,832
 Other identifiable intangible assets, net of amortization, of $5.2 million and $6.1 million as
of March 31, 2005 and 2004, respectively, are being amortized over useful lives ranging from three
to seven years and are as follows (in thousands):  As of March 31, 2005Gross carrying
    
    Accumulatedamount
    
    amortization
    
    NetMasters
    
    $
    6,838
    
    
    $
    1,687
    
    
    $
    5,151Other
    
    
    705
    
    
    
    682
    
    
    
    23$
    7,543
    
    
    $
    2,369
    
    
    $
    5,174
  As of March 31, 2004Gross carrying
    
    Accumulatedamount
    
    amortization
    
    NetMasters
    
    $
    6,230
    
    
    $
    220
    
    
    $
    6,010Other
    
    
    705
    
    
    
    592
    
    
    
    113$
    6,935
    
    
    $
    812
    
    
    $
    6,123
 Aggregate amortization expense for the periods ended March 31, 2005, 2004 and 2003 were
$1,557,000, $311,000 and $501,000, respectively. The following is a schedule of estimated future amortization expense (in thousands): 2006
    
    $
    1,4302007
    
    
    1,3872008
    
    
    1,1522009
    
    
    1,0512010
    
    
    154
 72




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Note 9 Property and Equipment Property and equipment consisted of the following (in thousands): March 31, 2005
    
    March 31, 2004Land and buildings
    
    $
    
    
    
    $
    399Furniture and fixtures
    
    
    1,092
    
    
    
    668Computer and office equipment
    
    
    4,400
    
    
    
    3,323Warehouse equipment
    
    
    6,868
    
    
    
    4,169Leasehold improvements
    
    
    2,894
    
    
    
    1,984Construction in progress
    
    
    74
    
    
    
    3,021Total
    
    $
    15,328
    
    
    $
    13,564Less: accumulated depreciation and
amortization
    
    
    7,247
    
    
    
    6,650Net property and equipment
    
    $
    8,081
    
    
    $
    6,914
 Note 10 Accrued Expenses Accrued expenses consisted of the following (in thousands): March 31, 2005
    
    March 31, 2004Compensation and benefits
    
    $
    8,679
    
    
    $
    2,782Royalties
    
    
    2,491
    
    
    
    1,157Rebates
    
    
    1,023
    
    
    
    649Other
    
    
    2,471
    
    
    
    1,789Total
    
    $
    14,664
    
    
    $
    6,377
 Note 11 Bank Financing and Debt In October 2001, we entered into a credit agreement with General Electric Capital Corporation
as administrative agent, agent and lender, and GECC Capital Markets Group, Inc. as Lead Arranger,
for a three year, $30.0 million revolving credit facility for use in connection with our working
capital needs. In June 2004, this credit agreement was amended and restated to, among other things,
provide for two senior secured revolving sub-facilities: a $10.0 million revolving acquisition
sub-facility, and a $40.0 million revolving working capital sub-facility. The revolving working
capital sub-facility allowed for borrowing up to $40.0 million, subject to a borrowing base
requirement, and required that we maintain a minimum excess availability of at least $10.0 million.
In addition to the provision for the two senior secured revolving sub-facilities, this credit
agreement allowed for up to $10.0 million of the revolving working capital facility to be used for
acquisitions, providing us with an aggregate revolving acquisition availability of up to $20.0
million, subject to a borrowing base requirement. The working capital revolving credit facility
included borrowing capacity available for letters of credit and for borrowings on same-day notice,
referred to as swing line loans. Under the amended and restated credit agreement, the maturity date
of the revolving working capital facility was December 2007 and the maturity date of the revolving
acquisition facility was June 2006. In
association with GE Commercial Finance credit agreement, the Company
also paid certain facility and agent fees. Interest under the GE
Capital line of credit was at the Index Rate plus .25% (5.75% and
4.25% at March 31, 2005 and 2004, respectively) and was payable
monthly. As of March 31, 2005 and 2004, respectively, the
Company had no balance under this facility. In connection with the
expansion of the Companys warehouse facility, the Company had a
construction loan. At March 31, 2005 and 2004, the Companys outstanding
balance on its construction loan was $0 and $651,000, respectively. Under the credit agreement we are required to meet certain financial and non-financial
covenants. The financial covenants include a variety of financial metrics that are used to
determine our overall financial stability and include limitations on our capital expenditures, a
minimum ratio of EBITDA to fixed charges, and a minimum of
indebtedness to EBITDA.  We were in compliance with the covenants related to our $40.0
million credit facility on March 31, 2005. The credit agreement was amended and restated in its entirety on May 11, 2005 in order to
provide the Company with funding to complete the FUNimation
acquisition (see Note 22) and was again amended and
restated in its entirety on June 1, 2005. The credit agreement currently provides a six-year
$115.0 million Term Loan B sub-facility, a $25.0 million five and one-half year Term Loan C
sub-facility, and a five-year revolving sub-facility for up to $25.0 million. The entire $115.0
million of the Term Loan B sub-facility has been drawn since May 11, 2005 and the entire $25.0
million of the Term Loan C sub-facility was drawn at June 1, 2005. The revolving sub-facility of up
to $25.0 million is available to the Company for its working capital and general corporate needs. The loans under our senior credit facilities are guaranteed by our subsidiaries and are
secured by a first priority security interest in all of our assets and in all of the assets of our
subsidiary companies, as well as the capital stock of our subsidiary companies. 73




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) In November 2003, in connection with the BCI acquisition, the Company entered into a new
agreement with Hilco Capital, L.P. for a four-year $6.0 million credit facility on November 5,
2003. On December 16, 2003, the Company paid off this credit facility in full and in doing so
recorded a special charge for a debt extinguishment expense of $908,000. Note 12 Income Taxes The income tax provision (benefit) is comprised of the following (in thousands): Fiscal Years ended March 31,2005
    
    

2004(Restated)
    
    
    2003CurrentFederal
    
    $
    3,306
    
    
    $
    417
    
    
    $
    State
    
    
    459
    
    
    
    36
    
    
    
    Deferred
    
    
    (4,257
    )
    
    
    (1,036
    )
    
    
    Tax benefit
    
    $
    (492
    )
    
    $
    (583
    )
    
    $
    
 A reconciliation of income tax benefit to the statutory federal rate is as follows (in
thousands): Fiscal Years ended March 31,2005
    
    

2004(Restated)
    
    
    2003Tax expense at statutory rate
    
    $
    4,099
    
    
    $
    2,333
    
    
    $
    1,467State income taxes, net of federal benefit
    
    
    389
    
    
    
    215
    
    
    
    259Non-deductible compensation charge
    
    
    1,972
    
    
    
    
    
    
    
    Reversal of valuation allowance
    
    
    (7,239
    )
    
    
    (3,579
    )
    
    
    (1,789
    )Other
    
    
    287
    
    
    
    448
    
    
    
    63Tax benefit
    
    $
    (492
    )
    
    $
    (583
    )
    
    $
    
 Fiscal Years ended March 31,2005
    
    

2004(Restated)
    
    
    2003Tax expense at statutory rate
    
    
    34.0
    %
    
    
    34.0
    %
    
    
    34.0
    %State income taxes, net of federal benefit
    
    
    3.2
    %
    
    
    3.1
    %
    
    
    6.0
    %Non-deductible compensation charge
    
    
    16.4
    %
    
    
    
    
    
    
    Reversal of valuation allowance
    
    
    (60.0
    )%
    
    
    (52.1
    )%
    
    
    (41.5
    )%Other
    
    
    2.4
    %
    
    
    6.5
    %
    
    
    1.5
    %Tax benefit
    
    
    (4.0
    )%
    
    
    (8.5
    )%
    
    
    
 Deferred income taxes reflect the available tax carryforwards and the net tax effects of
temporary differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Significant components of the
Companys deferred tax assets as of March 31, 2005 and 2004 are as follows (in thousands): Fiscal Years ended March 31,2005
    
    

2004
(Restated)Net deferred tax asset (liability)long-termIncentive based deferred compensation
    
    $
    1,521
    
    
    
    536Stock based compensation
    
    
    121
    
    
    
    Book/tax intangibles amortization
    
    
    (3,176
    )
    
    
    (3,276
    )
 74




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Fiscal Years ended March 31,2005
    
    

2004(Restated)Book/tax depreciation
    
    
    (423
    )
    
    
    406Net operating loss carryforwards
    
    
    
    
    
    
    4,033AMT credit carryforwards
    
    
    
    
    
    
    247Total deferred tax asset (liability)long-term
    
    $
    (1,957
    )
    
    $
    1,946Net deferred
tax asset (liability)current
Collectibility reserves
    
    $
    4,222
    
    
    $
    4,478Allowance for sales returns
    
    
    2,016
    
    
    
    1,341Reserve for sales discounts
    
    
    278
    
    
    
    186Accrued vacations
    
    
    282
    
    
    
    169Inventory  uniform capitalization
    
    
    230
    
    
    
    155Other
    
    
    222
    
    
    
    Total deferred tax asset current
    
    $
    7,250
    
    
    $
    6,329Valuation allowance
    
    
    
    
    
    
    (7,239
    )Total deferred tax asset
    
    $
    5,293
    
    
    $
    1,036
 During the year ended March 31, 2005 the Company utilized net operating loss carryforwards of
approximately $11.0 million. During the years ended March 31, 2005 and 2004, $2.4 million and $0, respectively, was added
to common stock in accordance with APB No. 25 reflecting the tax difference relating to employee
stock option transactions. The Companys
    net deferred income tax assets were completely reserved in fiscal 2003 because
    of its history of pre-tax losses. Reversals of these valuation reserves during
    fiscal 2003, 2004, and 2005 have resulted in the recording of tax benefits
    associated with its utilization of net operating loss carryforwards due to
    the generation of taxable income. As of March 31, 2005, all net-operating
    losses have been utilized. It has been determined, based on our expectation
    of future taxable income, that a valuation reserve is no longer required.
    Management has determined that it is more likely than not that the results
    of future operations will generate sufficient taxable income to realize the
    deferred tax assets. Note 13 Shareholders Equity The Company has 10,000,000 shares of preferred stock, no par value, which is authorized. No
shares are issued or outstanding. On
October 17, 2000, Navarre announced that its board of directors had
authorized it to repurchase up to 5,000,000 shares of Navarre common
stock or approximately twenty percent of its outstanding common
stock, in market or private transactions. During the year ending
March 31, 2002, Navarre repurchased 2,414,192 shares for an
average price of $1.23. Navarre did not repurchase any shares during
the fiscal years ended March 31, 2005 or March 31, 2004. On December 15, 2003, the Company completed a private placement to institutional and other
accredited investors of 2,631,547 shares of common stock and 657,887 shares of common stock
issuable upon exercise of warrants. The Company sold the securities for $4.75 per share for total
proceeds of approximately $12,500,000 and net proceeds of approximately $11,735,000. The per share
price of $4.75 represented a discount of approximately 15% of the closing price of the Companys
common stock on the date the purchase was completed. The net proceeds were used to discharge the
Companys approximate $6.6 million debt to Hilco Capital, LP incurred in connection with the BCI
acquisition and the remainder was made available for, among other things, general working
capital needs. The warrants issued to the placement investors were five-year warrants exercisable at any time
after the sixth month anniversary of the date of issuance at $7.00 per share. As of March 31,
2005, no warrants were outstanding. The Company issued to its agent in the private placement, Craig-Hallum Capital Group, LLC, a
warrant to purchase 131,577 shares. The Company exercised the mandatory exercise provision
contained in this warrant on June 9, 2004 and the warrant was exercised on June 10, 2004. On April 28, 2004, the Company registered for resale by the selling shareholders the shares of
common stock and the shares of common stock issuable upon exercise of the warrants issued in the
private placement under a 75




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) registration statement on Form S-3. This registration statement also covered the registration
of 131,577 shares issuable upon the exercise of the agents warrant as well as 320,000 shares
issuable upon the exercise of a warrant issued to Hilco Capital, LP, which provided financing in
connection with the Companys November 2003 acquisition of the assets of BCI Eclipse and 1,000,000
shares issued in connection with the BCI Eclipse acquisition. During fiscal 2005, the Company issued 300,000 shares of Navarre common stock in conjunction
with the purchase of 20,000 shares of Encore stock (see Note 20). Subsequent to March 31, 2005,
the Company issued 1,827,486 shares of Navarre common stock in conjunction with the acquisition of
FUNimation (see Note 22). Note 14 Stock Options and Grants The Company has established the
Navarre Corporation 1992 Stock Option Plan and the Navarre
Corporation 2004 Stock Plan (collectively, the
Plans). The maximum aggregate number of shares that may be granted under the Plans as of March
31, 2005 is 5.2 million and 1.0 million, respectively. Eligible participants under the plans are
key employees and directors. The options are granted at fair market value and expire between five
and ten years after the grant date. The following is a summary of stock option information and weighted average exercises prices
for the stock option plans: Plan Options
    
    
    
    
    
    Weighted AverageAvailable for
    
    Plan Options
    
    Exercise Price PerGrant
    
    Outstanding
    
    ShareBalance on March 31, 2002
    
    
    1,064,054
    
    
    
    1,985,900
    
    
    $
    3.77Granted
    
    
    (1,294,252
    )
    
    
    1,294,252
    
    
    
    1.56Canceled
    
    
    151,000
    
    
    
    (151,000
    )
    
    
    2.60Terminated
    
    
    91,200
    
    
    
    (91,200
    )
    
    
    3.00Balance on March 31, 2003
    
    
    12,002
    
    
    
    3,037,952
    
    
    $
    2.91Additional shares authorized
    
    
    1,000,000
    
    
    
    
    
    
    
    Granted
    
    
    (701,748
    )
    
    
    701,748
    
    
    
    4.91Exercised
    
    
    
    
    
    
    (765,600
    )
    
    
    2.80Canceled
    
    
    47,300
    
    
    
    (47,300
    )
    
    
    3.26Terminated
    
    
    19,600
    
    
    
    (19,600
    )
    
    
    2.78Balance on March 31, 2004
    
    
    377,154
    
    
    
    2,907,200
    
    
    $
    3.41Additional shares authorized
    
    
    1,000,000
    
    
    
    
    
    
    
    Granted
    
    
    (917,500
    )
    
    
    917,500
    
    
    
    15.25Exercised
    
    
    
    
    
    
    (724,700
    )
    
    
    3.03Canceled
    
    
    312,200
    
    
    
    (312,200
    )
    
    
    5.11Balance on March 31, 2005
    
    
    771,854
    
    
    
    2,787,800
    
    
    $
    7.24
 The following table summarizes information about the weighted average remaining contracted
life (in years) and the weighted average exercise prices for stock options outstanding as of the
year ended March 31, 2005: Options Outstanding
    
    Options ExercisableWeighted
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    AverageRange of
    
    Number of
    
    Remaining
    
    Exercise
    
    Number of
    
    ExerciseExercise Prices
    
    Options
    
    Life
    
    Price
    
    Options
    
    Price$0.93 to $1.48
    
    
    519,700
    
    
    3.25 years
    
    $
    1.23
    
    
    
    239,900
    
    
    $
    1.20$1.56 to $1.73
    
    
    546,000
    
    
    3.78 years
    
    $
    1.72
    
    
    
    158,000
    
    
    $
    1.72$1.75 to $6.09
    
    
    718,400
    
    
    3.75 years
    
    $
    5.26
    
    
    
    246,800
    
    
    $
    5.12$6.25 to $15.06
    
    
    398,700
    
    
    4.41 years
    
    $
    10.88
    
    
    
    79,200
    
    
    $
    8.14
 76




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Options Outstanding
    
    Options ExercisableWeighted
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    AverageRange of
    
    Number of
    
    Remaining
    
    Exercise
    
    Number of
    
    ExerciseExercise
Prices
    
    Options
    
    Life
    
    Price
    
    Options
    
    Price$15.33 to $17.37
    
    
    64,000
    
    
    4.09 years
    
    $
    16.64
    
    
    
    18,000
    
    
    $
    15.38$17.39 to $17.39
    
    
    534,000
    
    
    5.65 years
    
    $
    17.39
    
    
    
    
    
    
    
    $18.08 to $18.27
    
    
    7,000
    
    
    5.78 years
    
    $
    18.21
    
    
    
    
    
    
    
    2,787,800
    
    
    4.14 years
    
    $
    7.24
    
    
    
    741,900
    
    
    $
    3.70
 The Company has granted 100,000 and 250,000 options, respectively, to two current key
employees. The option to purchase 100,000 shares was later amended to 80,000 shares. The options
were deemed commensurate with their level of responsibility. The options vest depending on
attaining certain performance-based criteria. The performance-based
options were subject to fixed
accounting and were recognized when the criteria were met for vesting or due to the passage of
time. Certain criteria were met and all of the options have vested, therefore, the Company
recorded stock-based compensation expense of $269,000 and $705,000 for the years ended March 31,
2005 and 2004, respectively. The options expire September 21, 2006 and September 6, 2008,
respectively. At March 31, 2005, 60,000 of the option to purchase
80,000 shares remain outstanding and 100,000 of the option to
purchase 250,000 shares remain outstanding. Note 15 401k Plan The Company has a defined contribution 401(k) profit-sharing plan (the plan) for eligible
employees which is qualified under Sections 401(a) and 401(k) of the Internal Revenue Code of 1986,
as amended. The plan covers substantially all full-time employees. Employees are entitled to make
tax deferred contributions of up to 100% of their eligible compensation, subject to annual IRS
limitations. The Company matches up to a maximum of $750 per employee annually. The Companys
contributions charged to expense were $199,000, $129,000, and $115,000 for the years ended March
31, 2005, 2004, and 2003, respectively. The Companys matching contributions vest over three
years. Note 16 Commitments and Contingencies Leases The Company leases substantially all of its office, warehouse and distribution facilities.
The terms of the lease agreements generally range from 2 to 15 years. The leases require payment
of real estate taxes and operating costs in addition to rent. Total
rent expense was $2,669,000, $1,931,000, and $1,779,000 for the years ended March 31,
2005, 2004, and 2003, respectively. The following is a schedule of future minimum rental payments required under noncancelable
operating leases as of March 31, 2005 (in thousands): 2006
    
    $
    2,2342007
    
    
    2,0042008
    
    
    1,9122009
    
    
    1,9462010
    
    
    1,879Thereafter
    
    
    13,013$
    22,988
 Litigation In the normal course of business, the Company is involved in a number of litigation matters
that, other than the matter described immediately below, are incidental to the operation of the
business. These matters generally include, among other things, collection matters with regard to
products distributed by the Company and accounts receivable owed to the Company. The Company
currently believes that the resolution of any of these pending matters will not have a material
adverse effect on its financial position or liquidity, but an adverse decision in more than one of
the matters could be material to its consolidated results of operations. 77




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) ValueVision Media, Inc. v. Navarre Corporation On July 7, 2004, ValueVision Media, Inc. (ValueVision) commenced an action against the
Company in Hennepin County District Court for the State of Minnesota, alleging among other things
that the Company breached a 1997 Stock Purchase Agreement and Conversion Agreement between the
parties and NetRadio Corporation (NetRadio). ValueVisions Complaint (Complaint) seeks damages
in excess of $50,000, restitution and an order of specific performance requiring Navarre to convert
ValueVisions shares of NetRadio stock into Navarre common stock based upon a January 30, 2002
notice of default and the conversion formula set forth in the Conversion Agreement that is filed as
exhibit 10.19 to the Companys Form 10-K for the year ended March 31, 1997. On August 9, 2004, the Company answered the Complaint, denied liability and asserted defenses.
Among other defenses, the Company believes that ValueVisions alleged rights under the Stock
Purchase Agreement and Conversion Agreement terminated pursuant to the express terms and conditions
of the Stock Purchase Agreement and the Conversion Agreement upon the occurrence of the initial
public offering of NetRadio. This position is supported by, among other things, certain statements
that appear in the prospectus that is on file in connection with NetRadios initial public
offering. In addition, at the time the NetRadio registration statement was filed, a representative
of ValueVision sat on the board of directors of NetRadio and consented to the filing of the
NetRadio registration statement. On December 17, 2004, the Company commenced a third-party action against Gene McCaffrey. The
Company alleges that, if ValueVisions claims are correct, then McCaffrey, as a Director of
NetRadio, breached his fiduciary duties to the Company, a shareholder of NetRadio. McCaffrey
responded to the Third-Party Complaint and denied liability. In addition, the Company and
ValueVision stipulated that the Company could assert a counterclaim against ValueVision, but
ValueVision did not waive any defenses or rights by so stipulating. On or about January 21, 2005, the Court approved the parties stipulation for the Company to
assert its counterclaim against ValueVision, and on January 26, 2005, the Company served and filed
its counterclaim. ValueVisions reply to the counterclaim is due on or about February 15, 2005. The parties are in the process of conducting discovery. All parties have scheduled hearings
for summary judgment. The case is currently scheduled for trial during the courts November 2005
trial block. We intend to vigorously defend against the claims asserted by ValueVision and pursue
our claims. Because of the status of the proceeding and the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to predict a result in this
proceeding. Sybersound Records, Inc. v. BCI Eclipse, LLC, et al. On May 12, 2005, Sybersound Records, Inc. (Sybersound) filed this action against BCI
Eclipse, LLC (BCI) and others in the Superior Court of California, County of Los Angeles, West
District, Case Number SC085498. Plaintiff alleges that BCI and others sold unlicensed records in
connection with their karaoke related business or otherwise failed to account for or pay licensing
fees and/or royalties. Sybersound alleges that this conduct gives BCI and others an illegal,
competitive advantage in the marketplace. Based on this and related conduct, Sybersound asserts the
following causes of action: tortious interference with business relations, unfair competition under
the California Business and Professions Code, and unfair trade practices under Californias Unfair
Practices Act. Sybersound seeks damages, including punitive damages, of not less than $195 million
dollars plus trebled actual damages, injunctive relief, pre- and post- judgment interest, costs,
attorneys fees and expert fees. BCI Eclipse Company, LLC intends to deny the allegations of the Complaint and assert all
available and appropriate affirmative defenses. Because of the status of the proceeding and the
contingencies and uncertainties associated with litigation, it is difficult, if not impossible to
predict a result in this proceeding. Sybersound Records, Inc. v. Navarre Corporation, BCI Eclipse, LLC, et al. Sybersound Records, Inc. filed this action on or about May 12, 2005 in the Superior Court of
Justice, Toronto, Ontario, Canada, Court File Number 05-CV-289397Pd2. The factual basis for
Sybersounds claims in this case are essentially the same as those in the case described above.
However, Sybersound has named Navarre Corporation in this case in addition to BCI Eclipse, LLC. 78




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Sybersound claims that the alleged misconduct constitutes tortious interference with economic
interests, and seeks damages of not less than $5,745,000, plus punitive damages in the amount of
$800,000, plus injunctive relief against certain of the defendants other than Navarre and BCI. Navarre and BCI Eclipse Company, LLC intend to deny liability and damages and to vigorously
defend against Sybersounds claims. Because of the status of the proceeding and the contingencies
and uncertainties associated with litigation, it is difficult, if not impossible to predict a
result in this proceeding. Faulconer Productions Music Corp. v. FUNimation Productions, Inc. et al. Faulconer Productions Music Corporation (FPMC) filed a lawsuit in the U.S. District
Court
for the Eastern District of Texas on September 24, 2003 alleging that FUNimation Productions, Ltd. and certain other
defendants fraudulently induced it to enter into contracts pursuant to which FUNimation had
commissioned it to compose music for certain television episodes. FPMC also claims that it owns
all copyrights in the music and that FUNimation has infringed upon its music copyrights. FPMC is
asserting state law claims for fraudulent inducement, fraudulent misrepresentation, negligent
misrepresentation, negligence, breach of contract, unjust enrichment, breach of the duty of good
faith and fair dealing, conspiracy to commit fraud, and a host of similar claims related to a
proposed settlement agreement related to this case. FPMC seeks
damages of approximately $13.0 million. FUNimation instituted an action against FPMC and Bruce Faulconer, a principle of FPMC, in the
U.S. District Court for the Northern District of Texas. These two cases were consolidated in the
Eastern District of Texas. FUNimation asserts claims for trademark and copyright infringement,
passing off, and breach of contract. Actual damages have not yet been calculated. FUNimation also
seeks attorneys fees on the copyright infringement and contract claims and in connection with the
defense of FPMCs copyright infringement claims. FUNimation has filed a motion to dismiss all fraud-based, breach of the duty of good faith and
fair dealing, negligent misrepresentation, and negligence claims. Additionally, this motion to
dismiss seeks the dismissal of all claims relating to the individual defendants. FPMCs response
to this motion to dismiss is due on June 28, 2005. We intend to vigorously defend against the claims asserted against FUNimation and to pursue
our claims. Because of the status of the proceeding and the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to predict a result in this
proceeding. Aviva Partners LLC, individually on behalf of all other similarly
situated, v. Navarre Corporation, Eric H. Paulsen and James
Gilbertson Aviva Partners LLC individually and on behalf of all others similarly
situated (Plaintiffs) filed this putative class action lawsuit on June 13,
2005 in the United States District Court for the District of Minnesota, as Case
Number 05-1151 (PAM/RLE). Plaintiffs allege that this is a federal class
action lawsuit on behalf of all those who purchased or otherwise acquired
securities in the Company between July 23, 2003 and May 31, 2005. Plaintiffs
allege among other things, that the Company, its chief executive officer, and
its chief financial officer violated federal securities laws and regulations
because the Companys financial results were materially inflated and not
prepared in accordance with generally accepted accounting principles, which
benefited Company insiders, including the individual defendants. Plaintiffs
further allege the company failed to properly recognize executive deferred
compensation and improperly recognized a deferred tax benefit as income.
Plaintiffs allege violation of Sec. 10(b) of the Securities Exchange Act of
1934 (the Act) and Rule 10(b)5 promulgated under the Act, and as to the
individual defendants only, violation of Sec. 20(a) of the Act. Plaintiffs seek certification of the action as a class action lawsuit,
compensatory but unspecified damages allegedly sustained as a result of the
alleged wrongdoing, plus costs, counsel fees and expert fees. Neither the Company nor the individual defendants have yet been served
with the Complaint, so the date for a response has not yet been determined.
The Company intends to vigorously defend against Plaintiffs claims. Because of
the status of the proceedings as well as the contingencies and uncertainties
associated with litigation, it is difficult, if not impossible, to
predict a result in this matter. Note 17 Capital Leases The Company leases certain equipment under noncancelable capital leases. At March 31, 2005
and 2004, leased capital assets included in property and equipment were as follows (in thousands): March 31, 2005
    
    March 31, 2004Computer and office equipment
    
    $
    380
    
    
    $
    Less:
accumulated depreciation and amortization
    
    
    87
    
    
    
    Net property and equipment
    

    $
    293
    
    

    $
    
 Future minimum lease payments, excluding executory costs such as real estate taxes, insurance
and maintenance expense, by year and in the aggregate are as follows (in thousands): Minimum LeaseCommitmentsYear ending March 31 (in thousands):2006
    
    $
    1292007
    
    
    1292008
    
    
    1002009
    
    
    442010
    
    
    28Thereafter
    
    
    Total minimum lease payments
    
    $
    430Less: amounts representing interest at rates ranging
from 10% to 26%
    
    
    109Present value of minimum capital lease payments
    
    $
    321Less: current installments
    
    
    84Obligations under capital lease, less current installments
    
    $
    237
 Note 18 Sale/Leaseback of Warehouse Facility During June 2004, the Company entered into an agreement for the sale and leaseback of its
warehouse adjacent to the Companys headquarters building in New Hope, Minnesota, for net proceeds
of $6.4 million. The initial term of the lease is 15 years, with options to renew for three
additional five-year periods. The lease was classified as an operating lease. The $1.4 million difference between property and equipment sold and the net proceeds has been
established as prepaid rent and is being amortized over the life of the lease. Rental payments
under the lease approximate $659,000 for the first year, with an annual increase of 2.75% each year
thereafter. 79




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) The following is a schedule of estimated rental payments for this location for the years
ending March 31, (in thousands): 2006
    
    $
    6732007
    
    $
    6912008
    
    $
    7102009
    
    $
    7302010
    
    $
    750Thereafter
    
    $
    7,990$
    11,544
 Note 19 License and Distribution Agreement On March 29, 2004, the Company entered into a license and distribution agreement (Agreement)
with Riverdeep, Inc. (Riverdeep). The Agreement contains provisions for a license fee and a
guaranteed royalty. The Company will incur royalty expense for the license fee based on product
sales for the year. However, payment will not begin until the license fee royalties have exceeded
the guaranteed royalty (see below). License fee royalties were $9.1 million for the period ended
March 31, 2005 and are reflected in cost of sales in the consolidated statement of operations. The Company provided $11.7 million of guaranteed royalty payments to Riverdeep for the period
from April 1, 2004 to March 31, 2005. Of the amount paid, $2.6 million is reflected in prepaid
assets in the consolidated balance sheet as of March 31, 2005. The guaranteed royalty is
non-refundable, but is offset by royalties earned by Riverdeep in order to recoup the guaranteed
royalty payments. If necessary this recoupment period shall extend through the remaining term of
the agreement, plus up to an additional 42 months. The Company monitors these prepaid assets for
potential impairment based on sales activity with products provided to it under this Agreement. Note 20 Related Party Transactions Employment/Severance Agreements The Company entered into an employment agreement with its Chief Executive Officer (CEO) in
2001, which expires on March 31, 2007. The Company agreed to pay severance amounts equal to a
multiple of defined compensation and benefits under certain circumstances. In the event of a
material change in control, as defined in the employment agreement or termination under such
agreement, the Company would be required to pay approximately $1.6 million. Upon the expiration of
the contract, the Company will be required to pay this amount over a period of three years
subsequent to March 31, 2007. The employment agreement also contains a deferred compensation
component that is earned by the CEO upon the stock price achieving certain targets, which may be
forfeited in the event that he does not comply with certain non-compete obligations. As of March
31, 2005 all of the targets have been met and as of March 31, 2004, certain targets had been met.
As such, $2.5 million and $1.5 million were expensed in the consolidated financial statements as of
March 31, 2005 and 2004, respectively. At March 31, 2005 and 2004, $4.0 million and $1.5 million,
respectively, had been accrued in the consolidated financial statements. The CEOs employment agreement also includes a loan to the executive for a maximum of $1.0
million, of which $400,000 and $600,000 were outstanding at March 31, 2005 and 2004, respectively.
Under the terms of the loan, which was entered into prior to the Sarbanes-Oxley Act of 2002,
$200,000 of the $1.0 million principal and all unpaid and unforgiven interest is to be forgiven by
the Company on each of March 31, 2005, 2006 and 2007. During each of fiscal 2005, 2004 and 2003,
the Company forgave $200,000 of principal and interest. The outstanding note amount bears an
annual interest rate of 5.25%. At March 31, 2005 and 2004,
$400,000 and $600,000, respectively remained outstanding on the note. The Company has an employment agreement with its former Chief Financial Officer (CFO). The
Company agreed to pay severance amounts equal to a multiple of defined compensation and benefits
under certain circumstances. Upon termination, the Company was required to pay approximately
$597,000 over a period of four years beginning May 2004. The continued payout is contingent upon
the individual complying with a non-compete agreement. As such, the Company has estimated its
liability under this arrangement and has expensed $209,000 and accrued $49,000 in its consolidated
financial statements as of March 31, 2005. The estimates related
to the accrual will be reviewed each
reporting period. 80




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Stock Purchase Agreement Subsequent to the Companys acquisition of the assets of Encore Software, Inc. (Encore)
2002, the Company entered into a five-year agreement on August 24, 2002 with Michael Bell, to serve
as Chief Executive Officer of Encore Software, Inc. The Company also entered into a stock purchase
agreement with Mr. Bell under which he acquired 20,000 of the 100,000 outstanding shares of Encore.
In connection with the stock purchase, a stock buy and sell agreement was entered into between Mr.
Bell and Encore. During fiscal 2005, the Company exercised its option under the buy sell agreement
and purchased the 20,000 shares of Encore stock for $5.8 million which consisted of $3.4 million in
cash and 300,000 shares of Navarre common stock. The Company recorded $5.8 million in compensation
expense which is reflected in selling, general and administrative expenses in the consolidated
statements of operations for the year ending March 31, 2005. Consulting Arrangement During fiscal 2003, the Company paid a consulting fee of $187,000 to Michael Snow, a member of
the Companys Board of Directors, for consulting services provided in conjunction with the
acquisition of Encore Software, Inc. A special committee of the Board of Directors reviewed the
compensation paid to Mr. Snow following the hiring of an independent outside consultant to review
Mr. Snows involvement in the Encore transaction and assess the appropriate level of compensation.
The consulting services Mr. Snow provided included negotiation with Encores senior lender,
representation as a consultant with the Companys attorneys in a number of bankruptcy court
proceedings, negotiation with the Creditor Committee and participation in discussions with the
Companys senior lenders. Note 21 Major Customers The Company has two major customers who accounted for 39% of net sales for fiscal 2005, of
which each customer accounts for over 10% of net sales. The Company had three major customers who
accounted for 43% and 49% of net sales in fiscal 2004 and 2003, respectively. Each of the three
customers accounted for over 10% of the net sales in each fiscal year. Note 22 Subsequent Events (Unaudited) On May 10, 2005, the Company completed the acquisition of 100% of the general and limited
partnership interests of FUNimation Productions, Ltd. and The FUNimation Store, Ltd. (together
FUNimation) a leading home video distributor and licensor of Japanese animation and childrens
entertainment in the United States. The acquisition of FUNimation is
part of the Companys strategy for growth with expanded content
ownership and gross margin enhancement. The purchase price consisted of $100.4 million in cash,
subject to post-closing adjustments not to exceed $5.0 million and excess cash as defined in the
purchase agreement, and 1,827,486 shares of the Companys common stock. In addition, during the
five-year period following the closing of the transaction, the Company may pay up to an additional
$17.0 million in cash if certain financial targets are met, which
amount
will be included as part of the purchase price and thus increase
goodwill in subsequent periods. The Company entered into a credit
agreement to fund the acquisition which consists of $115.0 million in Term Loan B sub-facility, a
$25.0 million five and one-half year Term Loan C sub-facility and a five year revolving
sub-facility of up to $25.0 million. The Company is obligated to pay interest on loans made under the
facility at a variable rate. In addition, in conjunction with the acquisition of FUNimation, the
Company granted a ten year option to purchase 250,000 shares of
Navarre common stock exercisable at $8.35. The purchase price will be allocated to the underlying assets and liabilities based on their
estimated fair values. The Company will utilize the guidance in FAS 142, Goodwill and Other
Intangible Assets, when allocating the remaining purchase price. Goodwill is expected to result
from this transaction. The Company is in the process of reviewing and
finalizing the valuation of the tangible and intangible assets
acquired in the acquisition. Note 23 Business Segments The Company identifies its segments based on its organizational structure, which is primarily
by business activity. Operating profit represents earnings before interest expense, interest
income, income taxes, and allocations of corporate costs to the respective divisions. Intersegment
sales are made at market prices. The Companys corporate office maintains a majority of the
Companys cash under its cash management policy. Navarre currently operates two business segments: Distribution and Publishing. 81




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) Through the Distribution business, the Company distributes and provides fulfillment services
in connection with a variety of finished goods that are provided by our vendors, which include PC
software and video game publishers and developers, independent and major music labels, and major
motion picture studios. These vendors provide the Company with PC software, CD audio, DVD and VHS
video, and video games and accessories, which are in turn distributed to retail customers. The
Distribution business focuses on providing vendors and retailers with a range of value-added
services, including vendor-managed inventory, Internet-based ordering, electronic data interchange
services, fulfillment services, and retailer-oriented marketing services. Through the Publishing business the Company owns or licenses various PC software, CD audio,
and DVD and VHS video titles. The Publishing business packages, brands, markets and sells directly
to retailers, third party distributors, and our Distribution business. The following table provides information by business segment for the years ended March 31,
2005, 2004 and 2003 (in thousands): Fiscal Year 2005
    
    Distribution
    
    
    Publishing
    
    
    Eliminations
    
    
    ConsolidatedNet sales:
    
    $
    556,927
    
    
    $
    95,777
    
    
    $
    (56,441
    )
    
    $
    596,263Income (loss) from operations
    
    
    (1,672
    )
    
    
    14,006
    
    
    
    
    
    
    
    12,334Net income (loss) before income
taxes
    
    
    (1,523
    )
    
    
    13,579
    
    
    
    
    
    
    
    12,056Depreciation and amortization
expense
    
    
    1,826
    
    
    
    1,695
    
    
    
    
    
    
    
    3,521Capital expenditures
    
    
    8,214
    
    
    
    1,078
    
    
    
    
    
    
    
    9,292Total assets
    
    
    176,784
    
    
    
    47,944
    
    
    
    (26,926
    )
    
    
    197,802
 Fiscal Year 2004 (Restated)
    
    Distribution
    
    
    Publishing
    
    
    Eliminations
    
    
    ConsolidatedNet sales:
    
    $
    444,743
    
    
    $
    46,177
    
    
    $
    (20,043
    )
    
    $
    470,877Income (loss) from operations
    
    
    9,571
    
    
    
    (1,874
    )(1)
    
    
    
    
    
    
    7,697Net income (loss) before income
taxes
    
    
    9,418
    
    
    
    (2,555
    )
    
    
    
    
    
    
    6,863Depreciation and amortization
expense
    
    
    1,327
    
    
    
    673
    
    
    
    
    
    
    
    2,000Capital expenditures
    
    
    4,957
    
    
    
    91
    
    
    
    
    
    
    
    5,048Total assets
    
    
    143,478
    
    
    
    27,499
    
    
    
    (16,140
    )
    
    
    154,837
 Fiscal Year 2003
    
    Distribution
    
    
    Publishing
    
    
    Eliminations
    
    
    ConsolidatedNet sales
    
    $
    353,316
    
    
    $
    14,715
    
    
    $
    (11,215
    )
    
    $
    356,816Income from operations
    
    
    3,964
    
    
    
    41
    
    
    
    
    
    
    
    4,005Net income (loss) before income
taxes
    
    
    4,629
    
    
    
    (308
    )
    
    
    
    
    
    
    4,321Depreciation and amortization
expense
    
    
    1,295
    
    
    
    822
    
    
    
    
    
    
    
    2,117Capital expenditures
    
    
    994
    
    
    
    45
    
    
    
    
    
    
    
    1,039Total assets
    
    
    107,691
    
    
    
    14,797
    
    
    
    (12,823
    )
    
    
    109,665
 (1) The Company recorded an impairment charge associated with product development costs in
fiscal 2004 of $5.6 million. Note 24 Quarterly Data  Seasonality (Unaudited) The Companys quarterly operating results have fluctuated significantly in the past and will
likely do so in the future as a result of seasonal variations of products ultimately sold at
retail. The Companys business is affected by the pattern of seasonality common to other suppliers
of retailers, particularly the holiday selling season. Historically, more than 30% of the
Companys sales and substantial portions of the Companys profits have been earned in the third
fiscal quarter. 82




---



##### Table of Contents



NAVARRE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued) The following table sets forth certain unaudited quarterly historical financial data for each
of the four quarters in the periods ended March 31, 2005 and March 31, 2004 (in thousands, except
per share amounts): Quarter endedJune 30
    
    
    September 30
    
    
    December 31
    
    
    March 31(Restated)
    
    
    (Restated)
    
    
    (Restated)Fiscal year 2005Net sales
    
    $
    125,486
    
    
    $
    146,108
    
    
    $
    182,729
    
    
    $
    141,940Gross profit
    
    
    18,879
    
    
    
    20,980
    
    
    
    27,213
    
    
    
    24,040Net income (loss)
    
    $
    2,210
    
    
    $
    4,906
    
    
    $
    7,972
    
    
    $
    (2,540
    )Net earnings (loss) per share:Basic
    
    $
    0.08
    
    
    $
    0.18
    
    
    $
    0.30
    
    
    $
    (0.09
    )Diluted
    
    $
    0.08
    
    
    $
    0.17
    
    
    $
    0.28
    
    
    $
    (0.09
    )
 June 30
    
    
    September 30
    
    
    December 31
    
    
    March 31(Restated)Fiscal year 2004Net sales
    
    $
    72,613
    
    
    $
    106,200
    
    
    $
    151,170
    
    
    $
    140,894Gross profit
    
    
    10,207
    
    
    
    13,602
    
    
    
    18,117
    
    
    
    16,095Net income
    
    $
    308
    
    
    $
    1,723
    
    
    $
    2,140
    
    
    $
    3,275Net earnings per share:Basic
    
    $
    0.01
    
    
    $
    0.08
    
    
    $
    0.10
    
    
    $
    0.14Diluted
    
    $
    0.01
    
    
    $
    0.08
    
    
    $
    0.09
    
    
    $
    0.13
 83




---



##### Table of Contents



Navarre Corporation Schedule II  Valuation and Qualifying Accounts and Reserves
(in thousands) Balance at
    
    
    Charged to
    
    
    
    
    
    
    Balance atBeginning
    
    
    Costs and
    
    
    Additions/
    
    
    End ofDescription
    
    Of Period
    
    
    Expenses
    
    
    (Deductions)
    
    
    PeriodYear ended March 31, 2005:Deducted from asset accounts:Vendor advance reserve
    
    $
    4,808
    
    
    $
    4,287
    
    
    $
    (3,003
    )
    
    $
    6,092Allowance for doubtful accounts
    
    
    1,394
    
    
    
    423
    
    
    
    (442
    )
    
    
    1,375Allowance for sales returns
    
    
    3,706
    
    
    
    1,066
    
    
    
    (582
    )
    
    
    4,190Allowance for MDF and sales disc.
    
    
    1,251
    
    
    
    22,277
    
    
    
    (21,370
    )
    
    
    2,158Total
    
    $
    11,159
    
    
    $
    28,053
    
    
    $
    (25,397
    )
    
    $
    13,815Year ended March 31, 2004:Deducted from asset accounts:Vendor advance reserve
    
    $
    4,174
    
    
    $
    2,618
    
    
    $
    (1,984
    )
    
    $
    4,808Allowance for doubtful accounts
    
    
    673
    
    
    
    (123
    )
    
    
    844
    (1)
    
    
    1,394Allowance for sales returns
    
    
    4,160
    
    
    
    (1,872
    )
    
    
    1,418
    (1)
    
    
    3,706Allowance for MDF and sales disc.
    
    
    1,107
    
    
    
    15,557
    
    
    
    (15,413
    )
    
    
    1,251Total
    
    $
    10,114
    
    
    $
    16,180
    
    
    $
    (15,135
    )
    
    $
    11,159Year ended March 31, 2003:Deducted from asset accounts:Vendor advance reserve
    
    $
    433
    
    
    $
    3,338
    
    
    $
    403
    
    
    $
    4,174Allowance for doubtful accounts
    
    
    1,111
    
    
    
    93
    
    
    
    (531
    )
    
    
    673Allowance for sales returns
    
    
    1,300
    
    
    
    296
    
    
    
    2,564
    (2)
    
    
    4,160Allowance for MDF and sales disc.
    
    
    
    
    
    
    8,470
    
    
    
    (7,363
    )
    
    
    1,107Total
    
    $
    2,844
    
    
    $
    12,197
    
    
    $
    (4,927
    )
    
    $
    10,114
 (1) Additional reserves associated with the operations of BCI.
(2) Includes additional reserves associated with the operations of Encore Software. 84