The Company leased 33,478 square feet of office space in Houston, Texas for its insurance brokerage business through June 1997. The Company continues to maintain office space in Houston for its corporate headquarters.
The Company's product sales and gross profit during fiscal year 1996 increased to $9,854,000 and $5,090,000, respectively, due to the acquisition of Possible Dreams. Possible Dreams' sales figures reflect the five month period from May 1, 1996 to the end of the fiscal year. Possible Dreams' business is very seasonal in nature because its main products are Christmas related. Therefore, demand for Possible Dreams products and the company's best sales activity and gross margins are in the last two calendar quarters of any year. Selling, general and administrative expense increased to $4,086,000 for fiscal year 1996 as compared to $678,000 for fiscal year 1995. This increase can be attributed to the addition of five months of Possible Dreams' selling, general and administrative expenses to the Company's results. The Company incurred interest expense of $731,000 for fiscal year 1996, primarily due to debt incurred to acquire Possible Dreams and due to increased borrowings by Possible Dreams during its busiest seasonal period. Interest income during fiscal year 1996 decreased by $30,000 to $483,000, primarily due to the reduction in cash related to the payment of $2,700,000 to the Sellers in connection with the acquisition of Possible Dreams.
The Company's percentage of Bowen, Miclette, Descant & Britt's (the "Partnership") net revenues and expenses are classified on the Company's income statement under the caption "Income from joint enterprise" and amounted to income of $129,000 for calendar year 1997, a loss of $211,000 for the three month transitional period ended December 31, 1996 and income of $362,000 and $415,000 for fiscal years 1996 and 1995, respectively. The Company's percentage interest in the net revenues and expenses of the Partnership was 50%. Income from joint enterprise for calendar 1997 and fiscal year 1996 was down when compared to fiscal year 1995, primarily due to a change in the bonus percentage due certain officers of the Partnership, from 25% to 50%, pursuant to the terms of the Agency Agreement. On August 29, 1996, an officer of the Partnership exercised the put option in the Buy-Sell Agreement to purchase the Company's proprietary interest in Foster Insurance Services, Inc. ("FIS"), a 50% partner in the Partnership. On July 17, 1997 the Company sold, effective June 30, 1997, its beneficial interest in FIS, a Texas corporation, to Bowen, Miclette, Descant and Britt Inc. for consideration of $1,525,845 and recognized a gain of approximately $1,298,000. In an unrelated transaction, the Company in December 1997 sold Foster Insurance Managers Inc. ("FIM") for $265,000 in cash to Tri-Star Insurance Services, Ltd., a Kentucky corporation. The Company recognized no gain as part of this transaction. The Company no longer has any interest in the insurance brokerage business as a result of these two transactions.
Pumpkin also experiences a significant seasonal pattern in its working capital requirements and operating results. Pumpkin's seasonal period has historically been between July and October with approximately 90% of its sales occurring during this period each year. Pumpkin offers extended payment terms to some of its customers for seasonal merchandise and collects a substantial portion of its accounts receivable in the fourth calendar quarter. Pumpkin has had a greater working capital need in the second and third calendar quarters and has experienced its greater cash availability in the fourth calendar quarter. It is anticipated that this seasonal pattern will continue for the foreseeable future.
The acquisition of Pumpkin also had an impact on consolidated working capital. Long-term debt increased by $2,336,000 to $12,383,000, primarily due to the acquisition by the Company of Pumpkin. Of the cash paid to the Seller of Pumpkin Masters, $1,500,000 was provided by the Company and the balance was borrowed pursuant to a credit agreement. The credit agreement provides various credit facilities to Pumpkin to partially finance the acquisition, to provide for seasonal working capital and letter of credit requirements and to pay transaction expenses. The credit facility consists of a revolving credit facility of up to $3,500,000 and amortizing term debt of $5,000,000 maturing from four to six years from the closing date. The credit facilities are secured by all of the acquired assets as well as by a pledge to the lenders under such agreement of the capital stock of Pumpkin owned by Pumpkin Holdings. In connection with this credit agreement, the lenders were issued a warrant exerciseable for 10% of the Class B Common Stock, on a fully diluted basis, of Pumpkin. The Class B Common Stock is non-voting and convertible at any time into voting, Class A Common Stock of Pumpkin. An executive officer of Pumpkin was granted an option to acquire 4% of the Class A Common Stock of Pumpkin at an exercise price of $1,754 per share. This option is subject to certain restrictions on transfer of the shares of Pumpkin owned by the executive officer, together with certain preemptive rights, puts and calls and "tag along/drag along" rights with respect to these shares.
See Note 9 to Consolidated Financial Statements under this Item 8.
We have audited the accompanying consolidated balance sheets of Security Capital Corporation and subsidiaries (the "Company") as of December 31, 1997 and 1996 and the related consolidated statements of income, stockholders' equity, and cash flows for the year ended December 31, 1997, the three months ended December 31, 1996 and the years ended September 30, 1996 and 1995. 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 audits.
Notes to Consolidated Financial Statements Security Capital Corporation and Subsidiaries - -------------------------------------------------------------------------------- 1. Organization - -------------------------------------------------------------------------------- Security Capital Corporation ("Security Capital" or, when referred to together with its subsidiaries, the "Company") owns, through its 90% owned subsidiary, P.D. Holdings, Inc. ("P.D. Holdings") 90% (77.5% effective after consideration of the outstanding warrants issued in conjunction with debt to purchase outstanding shares of common stock) of the outstanding shares of Possible Dreams, Ltd. ("Possible Dreams"), a Delaware corporation. Possible Dreams acquired substantially all of the assets and assumed certain liabilities of Possible Dreams, Ltd. and Columbia National Corporation, both Massachusetts corporations, during May 1996. Possible Dreams operates as an importer, designer, warehouser and distributor of collectible Christmas figurines and ornaments and, to a lesser extent, religious articles. Pumpkin, Ltd.("Pumpkin") a Delaware corporation was established in June 1997 and was initially capitalized by the contribution of $1,500,000 from Pumpkin Masters Holdings, Inc. ("Holdings") and the issuance of a warrant for 100 shares of Class B nonvoting stock of Pumpkin at the warrant holder's option. Security Capital owns, through its 80% owned subsidiary Holdings, 100% of the capital stock of Pumpkin. Pumpkin acquired the assets and assumed certain liabilities of Pumpkin, Ltd. d/b/a Pumpkin Masters, Inc. (the "Seller of Pumpkin Masters"), in June 1997 for a total purchase price of $7,717,493. Pumpkin is engaged in the business of manufacturing and distributing pumpkin and watermelon carving kits (comprised primarily of tools and patterns) and related accessories. - -------------------------------------------------------------------------------- 2. Summary of significant accounting and reporting policies - --------------------------------------------------------------------------------
ACQUISITION OF POSSIBLE DREAMS, LTD. The Company acquired the assets and assumed certain liabilities of Possible Dreams, Ltd., a Massachusetts corporation, and Columbia National Corp., a Massachusetts corporation, in May 1996, for a total initial purchase price of $17,360,000. To finance the transaction, the Company used $3,000,000 of equity contribution from P.D. Holdings ($300,000 provided by minority owners of P.D. Holdings), borrowed $9,250,000 under term loan agreements, borrowed $2,650,000 under a line-of-credit agreement and issued $2,460,000 in subordinated debt. The subordinated debt included a note payable for $500,000 which was contingent on Possible Dreams' obtaining a certain level of cash flow from May 1, 1996 to December 31, 1996. Possible Dreams' did not achieve the required cash flow and the subordinated debt was reduced by $500,000 to $1,960,000 and goodwill was reduced in the same amount. The acquisition, after subordinated debt reduction of $500,000, was accounted for under the purchase method of accounting and the acquisition can be summarized as follows:
The Company acquired the assets and assumed certain liabilities of Pumpkin, Ltd. in June 1997, for a total purchase price of $7,717,493. The Company used a $1,500,000 equity contribution and borrowed $5,000,000 under term loan agreements to finance the acquisition. The acquisition was accounted for under the purchase method of accounting and the purchase price was allocated as follows:
Allocation of purchase price: Goodwill $3,758,659 Inventories 2,348,295 Patents 900,867 Accounts receivable 406,529 Property and equipment 289,506 Other assets 13,637 --------------------- $7,717,493 =====================
In addition to the cash purchase price paid at the closing, the purchase agreement provides for additional payments (the "Earnout Amount") to the Seller of Pumpkin Masters which are contingent upon future earnings before interest, taxes, depreciation and amortization ("EBITDA"), as defined. The Seller of Pumpkin Masters will be entitled to an Earnout Amount of $2,000,000 payable in 2002 should average annual EBITDA from the four year period January 1, 1997 through December 31, 2000 exceed $2,000,000. The Earnout Amount will be reduced proportionately if annual EBITDA is less than $2,000,000 but greater than $1,500,000. If average annual EBITDA is less than $1,500,000, the Earnout Amount will be zero.
The purchase agreement also provides for additional payments (" Additional Payments") to the Seller of Pumpkin Masters which are also contingent upon future EBITDA. At a minimum, Pumpkin will be required to make Additional Payments totaling $120,000 annually through the year 2001. The present value of the minimum Additional Payments based upon an imputed interest rate of 10% has been recorded as a liability in the accompanying balance sheet. The annual Additional Payment will increase to $160,000 in any year in which EBITDA is greater than $2,400,000.
The Company's consolidated financial statements include the operations of Pumpkin for the period June 27, 1997 (date of inception) through December 31, 1997.
CONSOLIDATED STATEMENTS OF CASH FLOWS For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents. Interest paid during calendar year 1997 and the three month transitional period ended December 31, 1996 was $2,005,000 and $507,000, respectively. The Company paid interest expense of $731,000 and $0 for fiscal years 1996 and 1995. Federal income taxes of $72,500, $30,000, $ 0, and $ 0 were paid during calendar year 1997, the three month transitional period ended December 31, 1996, fiscal year 1996 and fiscal year 1995.
REVENUE RECOGNITION Revenues from product sales are recognized in the period in which the merchandise is shipped. Customers who purchase certain minimum quantities receive extended payment terms.
INVENTORIES Inventories, comprised of finished goods, are valued at the lower of cost or market, with cost being determined by the first-in, first-out method ("FIFO") at Possible Dreams and the average cost method at Pumpkin.
PROPERTY AND EQUIPMENT Property and equipment are carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Fixed assets are comprised of the following: - --------------------------------------------------------------------------- December 31, 1997 1996 - --------------------------------------------------------------------------- (In thousands) Land and improvements $ 370 $370 Buildings and improvements 738 630 Machinery and equipment 251 54 Data processing equipment 83 24 Furniture and fixtures 95 228 ---------------------------------------- Total cost $1,537 $ 1,306 ---------------------------------------- Less: accumulated depreciation 133 211 ---------------------------------------- Net book value $1,404 $ 1,095 ========================================
INTANGIBLE ASSETS Intangible assets consist of the cost in excess of the fair value of net assets acquired in the Pumpkin and Possible Dreams acquisitions ("Goodwill") of $11,256,279 (net of amortization), deferred financing costs of $666,295 (net of amortization), and patents (net of amortization) of $844,194. Goodwill is being amortized on a straight-line basis over 20 years and deferred financing costs are being amortized over the term of the related debt. Patents are being amortized on a straight-line basis over their remaining lives of nine to twelve years.
FAIR VALUE OF FINANCIAL INSTRUMENTS Financial instruments consist of current assets (except inventories), current liabilities, notes payable, additional payment obligations and long-term debt. Current assets and current liabilities are carried at cost, which approximates fair value. Notes payable, the additional payment obligations and long-term debt bear interest at current market rates and, accordingly, the carrying value of the debt approximates fair value.
Changes in outstanding shares under option during calendar year 1997, the three months ended December 31, 1996 and the two fiscal years ended September 30, 1996 and 1995 and the balance outstanding and available for future grant at December 31, 1997 are summarized as follows:
- -------------------------------------------------------------------------------- Outstanding at September 30, 1996 4,012 $5.00 Granted - Exercised - Canceled - -------------------------------------------------------------------------------- Outstanding at December 31, 1996 4,012 $5.00 Granted Exercised Canceled (4,012) Outstanding at December 31, 1997 -0- Exercisable: At December 31, 1997 -0- - -------------------------------------------------------------------------------- Available for future grant -0- - -------------------------------------------------------------------------------- The remaining outstanding stock options have expired due to reaching the final exercise date.
At December 31, 1997, the Company had net operating loss carry-forwards for Federal income tax purposes of approximately $13 million, the expiration dates of which are as follows:
- -------------------------------------------------------------------- December 31, Amount - -------------------------------------------------------------------- (In thousands) 2002 $ 3,600 2003 1,800 2004 4,000 2005 2,400 2006 400 2007 200 2008 600 - ---------------------------------------------------------------- $ 13,000 - ----------------------------------------------------------------
In addition, in connection with the disposition of a former subsidiary of the Company, the Company incurred a tax loss amounting to approximately $26 million during the year ended September 30, 1988. The Company believes that a substantial portion of this loss is an ordinary loss for Federal income purposes which may be carried forward to 2003, although there can be no assurance that this position would prevail, if challenged. The Company believes that approximately $7.4 million of the loss is a capital loss which expired unused at September 30, 1994. The Company's Federal income tax returns have been examined by the Internal Revenue Service (the "IRS") through fiscal 1986 and the above loss carry-forwards, including the loss on disposition of the aforementioned subsidiary, remain subject to review by the IRS.
The Company computes deferred income taxes based on the differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.
- -------------------------------------------------------------------------------- December 31, 1997 1996 - -------------------------------------------------------------------------------- (In thousands) Deferred tax assets (credits): Allowance for doubtful accounts and inventory differences $ 189 $ 39 Operating loss carry-forwards 10,744 11,987 Alternative minimum tax carryover 100 - Accelerated depreciation and other (11) (17) --------------------------- 11,022 12,009
Federal income taxes based on 34% of pre-tax income $ 1,118 Utilization of Federal net operating loss carry-forwards (944) State income taxes, net of Federal benefit 198 Recognition of deferred tax asset for Federal net operating loss carry-forwards (500) Other 1 ========= Provision (benefit) for income taxes $ (127) =========
In connection with the Possible Dreams Tranche A and Tranche B loans , Possible Dreams' issued warrants to purchase 250 shares (12.5%) of Possible Dreams Class B Common Stock. The Class B Common Stock is non-voting and convertible at any time into voting, Class A Common Stock of Possible Dreams. The warrants were valued at approximately $428,571 and recorded as an original issue discount. The discount will be amortized over the life of the debt using the effective interest method. The Tranche A and B loans contain financial and prepayment of principal covenants. If Possible Dreams' cash flows meet certain thresholds, as defined in the loan agreements,
payments due under the Tranche A and B loans will become accelerated. The Possible Dreams' subordinated promissory note contained provisions under which the notes would be reduced by $500,000 if certain levels of cash flows were not met by Possible Dreams. Since these levels were not met, the subordinated notes and goodwill recorded at the acquisition were reduced in 1997 by $500,000.
Both Possible Dreams' and Pumpkin's lines of credit and term loans are secured by substantially all their assets as well as by a pledge to the lender of their common stock.
FGS and its designees purchased 30,000 shares of Preferred Stock from the Company for $3,000,000, on July 30, 1993. This non-voting preferred stock is subject to mandatory redemption on the following date or dates: (1) eight years from the date of issuance of the first shares of such stock; (2) the occurrence of a change of control in the majority of the Board of Directors; or (3) each date, if any, on which an adjustment to the purchase price of the stock shall be required. The stock has a purchase price and redemption price equal to the liquidation value, which is $100 per share. In addition, the Class A Preferred Stock bears a dividend of 15% per annum payable in cash. Until redemption or the liquidation of the Company, dividends on Preferred Stock are payable only out of cumulative net income since January 1, 1990
As of December 31, 1997, FGS and its designees converted its 30,000 shares of Class A Preferred Stock and $1,987,500 of accrued dividends into 1,246,875 shares of Class A Common Stock at a valuation of $4 per share.
In March 1996, the Company effected a one-for-eight reverse split of the Company's Common Stock and Class A Common Stock. The reverse split had the effect of decreasing the number of issued shares from 35,033,880 to approximately 4,378,741. The par value of the reduced shares in connection with the reverse split was charged to Common Stock and Class A Common Stock and a like amount credited to paid-in-capital. Accordingly, all share and per share data in the financial statements and footnotes have been restated to reflect the reverse stock split.
On April 27, 1990, Security Capital entered into an Advisory Services Agreement effective as of January 26, 1990 (the "Advisory Agreement") with Capital Partners, Inc. ("CP, Inc."), an entity affiliated with FGS, pursuant to which such entity provides certain advisory services in the areas of investments, general administration, corporate development, strategic planning, stockholder relations, financial matters and general business policy in lieu of the services previously provided by certain of the Company's officers and other support personnel from the Company's former New York office. The annual fee for such services pursuant to the Advisory Agreement was $150,000 (due in quarterly installments in advance) plus certain out-of-pocket costs (which do not include rent and utilities of CP, Inc. and compensation of CP, Inc. employees). In connection with the acquisition of Possible Dreams, the Company entered into an amendment to the Advisory Agreement with CP, Inc. to provide management advisory services to Possible Dreams for an increase in the annual fee of $175,000 to $325,000. In connection with the acquisition of Pumpkin the Company entered into another amendment to the Advisory Agreement with CP, Inc. to provide management advisory services to Pumpkin. The fee to CP, Inc. will be payable quarterly and will be the greater of $100,000 annually or 5% of the Pumpkin's annual EBITDA, as defined in the purchase agreement. Such fee is subject to appropriate adjustment should the scope of operations of the Company change, whether from an acquisition or otherwise. Pursuant to the Advisory Agreement, no compensation is paid to the current Chairman of the Board, President and Secretary and Assistant Secretary in their respective capacities as such.
Both of the key executives of Possible Dreams have entered into employment, consulting and non-competition agreements. The President and Chief Executive Officer of Possible Dreams, acquired 10% of the Class A Common Stock of P.D. Holdings for $300,000, as part of the Company's transaction to purchase Possible Dreams. The President and another executive officer were granted options to purchase an additional 10% of such Class A Common Stock at an exercise price of approximately $1,904 per share. Both executive officers, P.D. Holdings and the Company entered into a Stockholders' Agreement providing for certain restrictions on transfers of the shares of P.D. Holdings owned by them, together with certain preemptive rights, rights of first refusal, puts and calls, "tag along/drag along" rights and registration rights with respect to the Class A and Class B Common Stock of P.D. Holdings. The Company has employment agreements with both key executives for five and three year terms. In addition, at the conclusion of the employment agreements the President and the other key executive officer each have a consulting agreement for three and one year terms, respectively. During the term of the agreement, the President will be paid $75,000, adjusted for the cost of living, and the other executive officer will be paid $50,000, adjusted for the cost of living.
The Seller of Pumpkin received stock of Holdings constituting 20% of the outstanding Common Stock of Holdings. The Seller of Pumpkin is also entitled to receive a payment of up to $2,000,000 (the "Earnout Amount") if Pumpkin's average earnings before income taxes, depreciation and amortization ("EBITDA"), as defined in the asset purchase agreement, is in excess of $1,500,000 during the four fiscal years following the closing. If earned, the amount is first payable in June of 2002, with the possibility of being deferred until June 2004. In addition, the Seller of Pumpkin will receive a payment of at least $120,000 and up to $160,000 each fiscal year, payable quarterly, until the Earnout Amount is either not to be earned or, if determined to be earned, paid. The Earnout Amount is fully subordinate to debt under such credit agreement and any loans by the Company to Pumpkin. The purchase agreement also provides for certain restrictions on transfers of shares of Pumpkin Holdings owned by the Company and the Seller of Pumpkin Masters, together with certain preemptive rights, rights of first refusal, puts and calls and "tag along" rights.
days' prior notice; provided, however, that the Agency Agreement will terminate upon the earliest to occur of (i) the death or disability of Britt, (ii) a sale of the stock of FIS by Britt or the termination of the Buy-Sell Agreement, (iii) the inability of FIM and FIS to resolve material disputes on or after September 30, 1994 upon notice of termination from either party, and (iv) notice from FIM following the suspension, cancellation or failure to renew any of the insurance licenses of FIS.