10-K 1 p18390_10-k.txt ANNUAL REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ( X ) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended January 31, 2004 or ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to _______ Commission File Number 33-12755 SHARPER IMAGE CORPORATION (Exact name of registrant as specified in its charter) Delaware 94-2493558 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 650 Davis Street, San Francisco, California 94111 (Address of principal executive offices) (Zip Code) Registrant's telephone number including area code: (415) 445-6000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 (Title of Class) 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 _X_ 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 the 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. _X_ Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes _X_ No ___ 1 The aggregate market value of the voting common stock held by non-affiliates of the Registrant based on the reported last sale price for the common stock on the Nasdaq National Market on July 31, 2003, was $353,076,885. There were 15,519,236 shares of Common Stock, par value $.01, outstanding on April 12, 2004. Documents incorporated by reference Portions of Registrant's Proxy Statement for the Annual Meeting of Stockholders presently scheduled to be held June 7, 2004 are incorporated by reference into Part III of this report. 2 PART I This Annual Report on Form 10-K and the documents incorporated herein by reference of Sharper Image Corporation (referred to as the "Company," "The Sharper Image," "it," "we," "our," "ours," and "us") contain forward-looking statements within the meaning of federal securities laws that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about the Company's industry, management's beliefs and certain assumptions made by the Company's management. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," or variations of such words and similar expressions, are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under "Factors Affecting Future Operating Results" on pages 13 through 22 as well as those noted in the documents incorporated herein by reference. Unless required by law, the Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. However, readers should carefully review the statements set forth in other reports or documents the Company files from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. Item 1. Business Overview The Sharper Image is a leading specialty retailer of innovative, high quality products that are useful and entertaining and are designed to make life easier and more enjoyable. We offer a unique assortment of products in the electronics, recreation and fitness, personal care, houseware, travel, toy, gifts and other categories. Our merchandising philosophy focuses principally on new and creative proprietary Sharper Image Design products and exclusive Sharper Image branded products and, to a lesser extent, on third party branded products. We design and develop our Sharper Image Design products, while Sharper Image branded products are generally designed by us with third parties.. We believe that our unique merchandising and creative marketing strategies have made The Sharper Image one of the most widely recognized retail brand names in the United States of America. The Sharper Image was founded in 1977 by Richard Thalheimer, who currently serves as Chairman and Chief Executive Officer. We mailed our first catalog in 1979, began the expansion into store operations in 1981 and commenced online operations in 1994. We market and sell our merchandise primarily through three integrated sales channels: The Sharper Image stores, The Sharper Image catalog, which includes revenue from all direct marketing activities and television infomercials, and the Internet. We believe that this multi-channel approach provides us with significant marketing, advertising, sales and operational synergies and provides our customers with enhanced shopping flexibility and superior customer service. Our merchandising strategy emphasizes products that are innovative and new-to-market. In recent years, we have focused significant resources on the development and marketing of our Sharper Image Design and Sharper Image branded products. Sharper Image Design and Sharper Image branded products typically generate higher gross margins than other products, minimize direct price comparisons and, we believe, strengthen The Sharper Image brand as well as broaden our customer reach. The percentage of our total revenues attributable to Sharper Image Design and Sharper Image branded products was approximately 73% in fiscal 2003 and 76% for fiscal 2002. 3 Our store operations generated the highest proportion of our sales, representing 58.6% and 57.2% of total revenues for fiscal 2003 and 2002, respectively. As of January 31, 2004, we operated 149 The Sharper Image stores in 37 states and the District of Columbia. The Sharper Image stores present an interactive and entertaining selling environment that emphasizes the features and functionality of our innovative, fun and useful products and allows the customer to interact with and experience the product while shopping. Our average store sales per square foot are consistently above industry averages, and during fiscal 2003 and 2002, we generated average sales of $676 and $627, respectively, per square foot. For our stores opened for more than one year, our average sales per square foot was $710. During fiscal 2003, we opened 25 new stores and we closed three stores at lease maturity. We plan to increase our number of stores by 15%-20% during fiscal 2004. We also offer our products through direct marketing activities. The Sharper Image catalog, an award winning, full-color monthly catalog, uses dramatic visuals and creative product descriptions designed and produced by our in-house staff of writers and production artists. The Sharper Image catalog generally features between 200 and 250 products in each monthly catalog, increasing to over 350 products during the holiday shopping season, and also serves as a significant advertising vehicle for our stores and our Internet operations. During fiscal 2003 and 2002 we mailed approximately 86 million and 78 million The Sharper Image catalogs to over 18 million and 16 million individuals, respectively. We also conduct a television advertising program through infomercials on a select few of our most popular products. For fiscal 2003, 19.9% of our total revenues were generated by our catalog and direct marketing operations, including revenue generated directly from catalogs, print advertising, single product mailers and television infomercials, compared to 23.0% in fiscal 2002. The Sharper Image products are also marketed through our Internet operations, primarily through our own Web site which we have operated at sharperimage.com since 1995. The Sharper Image was an early entrant into Internet retailing, and has participated in online shopping since 1994. Our Internet operations generated 14.7% and 13.5% of total revenues in fiscal 2003 and 2002, respectively. In addition to our Web site, we offer our products through Internet marketing agreements with Google, eBay, MSN Shopping, Amazon, Linkshare, Yahoo! Shopping, Catalog City, and AOL. We believe that our Sharper Image Design and Sharper Image branded products are particularly well positioned to be marketed and sold over the Internet and that our Internet operations have enabled us to expand and diversify our existing customer base. We plan to continue to allocate resources to our Internet operations by establishing additional strategic relationships with other Internet retail partners and continuing to enhance the technical capabilities and presentation of products on our Web site. We also operate an auction site where consumers can bid to win products at less than retail prices. This provides us with the opportunity to broaden our customer base and manage our closeout, repackaged and reconditioned inventory. We currently also offer international Web sites where Internet shoppers are able to get local delivery of Sharper Image Design and Sharper Image branded products, which in some cases have been specifically adapted for use throughout Europe. We are known for our varied product mix and a merchandising philosophy focusing on innovative, well designed, high quality products that are either developed by The Sharper Image, exclusive to The Sharper Image or in limited distribution. In product lines where we compete directly with other retailers, we generally choose to sell the best available version of the product with the most advanced features. Manufacturers and inventors frequently approach us to launch technologically advanced products with features that are unique and innovative. During fiscal 2003 and 2002, we continued the expansion of our in-house Sharper Image Design product development function. The percentage of total revenues attributable to Sharper Image Design and 4 Sharper Image branded products was approximately 73% of total revenues in fiscal 2003, compared with approximately 76% in fiscal 2002. The popularity of third party branded products such as digital cameras and massage chairs during fiscal 2003 contributed to the lower percentage of sales coming from Sharper Image Design and Sharper Image branded products. Our goal is to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, although we cannot assure you that this will happen. Sharper Image Design and Sharper Image branded products generally carry higher margins than third party branded products and we plan to continue to devote resources to our Sharper Image Design product development efforts and our Sharper Image brand merchandising philosophy. Our business is highly seasonal, with sales peaks in the end-of-year holiday shopping season as well as for Mother's Day, Father's Day and graduation gift-giving. See "Business--Seasonality." In addition to our primary business, we leverage our name and reputation through our Corporate Incentives and Rewards program and wholesale sales of Sharper Image brand products, which include Sharper Image Design and Sharper Image branded products. We also have wholesale marketing arrangements with established retail chains, such as Linen `n Things, Bed, Bath and Beyond, Circuit City, May Department Stores and Federated Department Stores. The Sharper Image stores Our store operations generate the highest proportion of our sales, representing 58.6% of total revenues for fiscal 2003 and 57.2% in fiscal 2002. The Sharper Image stores present an interactive and entertaining selling environment that emphasizes the features and functionality of our products and allows the customer to experience the product while shopping. We have three store formats: The Sharper Image stores, The Sharper Image Design stores and outlet stores. Each store is generally staffed with approximately 8 to 12 associates, including a manager, an assistant manager, a senior sales associate, sales associates and other support staff. A number of our high volume stores are staffed with 15 to 20 associates. Our store managers have an average tenure of over five years. Our store personnel are compensated primarily through commissions. In order to maintain a high customer service level, our sales associates undergo considerable training on our many new and often technically oriented products. The Sharper Image stores are designed by our visual design and creative staff at our headquarters in San Francisco, California to standardize, where possible, layout so as to simplify their operations. The stores are operated according to standardized procedures to maintain high level of customer service, merchandise display and pricing, product demonstration, inventory maintenance, personnel training, administration and security. The original The Sharper Image stores typically have 2,200 to 3,000 square feet of selling space and approximately 1,300 to 2,200 square feet of storage and administrative space. The typical cost of leasehold improvements, before landlord contributions, but including fixtures, equipment and pre-opening expenses, averages $400,000 to $550,000 per store. Initial inventory for a new The Sharper Image store has generally cost approximately $200,000. Outlet stores are approximately half the cost of the original The Sharper Image stores. We also operate a second retail format of The Sharper Image Design stores, which are approximately half the size of the original stores. The Sharper Image Design stores typically consist of between 1,200 to 2,000 square feet of selling space and feature higher margin Sharper Image Design and private label products, in addition to other top selling merchandise. As of January 31, 2004, we had 136 The Sharper Image stores, nine The Sharper Image Design stores and four outlet locations for a total of 149 stores. 5 Over the past five years, we have been updating the look and appeal of our new retail stores and remodeling select existing stores. The updated format presents an open, fresh and inviting environment designed to appeal to both men and women and highlight our Sharper Image Design and Sharper Image branded products and attractive product packaging. The average cost of converting an existing store to the new format is similar to that of building a new store, which ranges from $400,000 to $550,000, subject to leasehold allowances. We intend to continue to selectively remodel stores utilizing the new store format typically at the time of the store's lease renewal. The Sharper Image catalog and direct marketing The Sharper Image catalog is a full-color catalog that is mailed to an average of five to six million individuals each month, with an increase to six to eight million individuals during the Father's Day and graduation months and an increase to nine to 13 million individuals during the holiday season. The Sharper Image direct marketing operations, including revenues generated directly from catalogs, single product mailers, print ads and television infomercials, generated 19.9% of our total revenues in fiscal 2003 and 23.0% in fiscal 2002. Our catalog has been recognized for creative excellence by leading catalog industry trade groups. The catalog is currently the primary advertising vehicle for our retail stores and our Internet business. During fiscal 2003 and 2002, we mailed approximately 85 million and 78 million The Sharper Image catalogs to over 18 million and 16 million households, respectively. Circulation and number of pages of The Sharper Image catalog is under continual review to balance the costs of mailing the catalogs with the revenues generated. The mailings increase significantly for the peak seasons of Mother's Day, Father's Day, graduation gift-giving and the holiday shopping season to reflect the seasonal nature of the business. In fiscal 2003 and 2002, we increased our focus on the use of television infomercials and single product mailers highlighting select products. The Sharper Image catalog design uses dramatic visuals and problem-solving and benefit-oriented product descriptions. The catalog design features the most important products prominently. The number of items featured each month ranges between 200 and 250 products during the first three quarters of the year, increasing to more than 350 products during the holiday shopping season in the fourth quarter. The Sharper Image catalog is designed and produced by our in-house staff of writers and production artists. This enables us to maintain quality control and shorten the lead-time needed to produce the catalog. The monthly production and distribution schedule permits frequent changes in the product selection. During fiscal 2003, The Sharper Image catalog contained between 52 and 96 pages for non-peak months and between 52 and 128 pages for the peak seasons of Father's Day and the holiday shopping season. We have developed a proprietary customer database of more than 17 million names, which we use regularly. We collect customer names through our catalog and Internet order processing, as well as electronic point-of-sale registers in our retail stores. The names and associated sales information are merged daily into our customer master file. This daily merge process provides a constant source of current information to help assess the effectiveness of the catalog as a form of retail advertising, identify new customers that can be added to our in-house mailing list without using customer lists obtained from other catalogers, and identify our top purchasers. To further enhance the effectiveness of our catalog mailings to individuals in the customer database, our in-house staff utilizes our statistical evaluation and selection techniques to determine which customer segments are likely to contribute the greatest revenue per mailing. We have established a data bank of top purchasers who receive preferred services, including invitations for special sales events and enhanced customer service. During fiscal 2003 and 2002, we expanded our television infomercial presence by highlighting several popular Sharper Image Design and private label products on cable and national broadcast stations. We believe that this type of direct marketing will 6 broaden the existing customer base and will also increase customer traffic and sales in retail store locations. Internet operations The Sharper Image was an early entrant into Internet retailing. We have participated in online shopping since 1994, and have maintained our own Web site at sharperimage.com since 1995. Revenues from our Internet operations including auction sales increased to $95.1 million in fiscal 2003 from $69.2 million in fiscal 2002. During fiscal 2003, revenues from our Internet operations including auction sales increased 37.4%, transactions increased 34.4% and average revenue per transaction increased 1.9%. Our Internet operations benefit from our brand name, customer base, The Sharper Image catalogs and unique product offerings, as well as our multimedia approach to advertising. We believe that The Sharper Image catalog in particular is a significant factor in generating Internet sales. In addition, we are able to leverage our catalog operational infrastructure for fulfillment and customer service experience, providing us with a significant advantage over Internet retailers who have not developed such capabilities. Shoppers on the Web site have the convenience of exchanging or returning products purchased through the Internet at our store locations. We send out periodic email campaigns to our list of Internet shoppers. These emails include sneak previews of newly released products and special offers that are intended to drive sales in all selling channels. Our goal is to make sharperimage.com a Web site that provides our Internet customers with an interactive experience similar to The Sharper Image stores. We continue to update our Web site by incorporating advanced technologies to improve our product presentations and make our site increasingly customer friendly, while retaining our entertainment quality. Our Web site, www.sharperimage.com, incorporates much of the look and feel of the new store design. It includes features such as dynamic browsing, inventory status, order tracking, Flash technology, gift guides by category and product, and catalog quick order. We continually evaluate, test and enhance the Web site and during fiscal 2003 we added an online gift registry and upgraded our customer service area. We have also enhanced our backend systems by updating our servers and programs to ensure the speed and efficiency of the Web site. In fiscal 2003 and 2002, the editors and readers of Internet Retailer Magazine honored sharperimage.com as one of the industry's 50 best Web sites. We also have an established Internet auction site which allows customers to bid on and acquire a broad range of new, returned, repackaged and refurbished Sharper Image products for less than regular retail price. Our products are also featured on eBay's auction site, as well as on our eBay store. Most products purchased on the auction site have the same warranty that accompanies full price products and customers also enjoy a thirty-day return privilege. We believe that bidders have an enhanced level of confidence in our operations since, unlike many other Internet auction sites, we are an established retailer with an inventory of well-known products under warranty with established return policies. The auction site not only offers consumers the enjoyment of bidding and winning products at less than retail price, it also allows us the opportunity to effectively manage our closeout products, while maintaining gross margin goals. We are pursuing additional steps to achieve continued growth of our Internet operations. These steps include technological improvements, dramatic visual presentations, development of international Web sites in Europe and establishment of strategic Internet marketing arrangements. We have established relationships with Google, eBay, MSN Shopping, Linkshare, Amazon, Yahoo! Shopping, Catalog City, and AOL. 7 Other operations In addition to our store, catalog and Internet operations, we also have a business-to-business operation, which includes wholesaling, our Sharper Image Corporate Incentives and Rewards program and licensing. We also derive revenues from our customer list rental program. Our business development department is the primary group responsible for wholesale marketing to other retailers, including fine department and specialty stores in the United States, as well as retailers in other countries. We have wholesale marketing arrangements with established retail chains such as Linen `n Things, Bed, Bath and Beyond, Circuit City, May Department Stores and Federated Department Stores. This group's sales increased by 54% and were $27.0 million in fiscal 2003, as compared to $17.5 million in fiscal 2002. Under the Sharper Image Corporate Incentives and Rewards program, we sell product, rewards cards, incentive and merchandise certificates to major corporations and not-for-profit entities, who in turn distribute them under their programs to increase their sales, or to motivate and reward their high achiever employees and best customers. The Sharper Image stores, catalog and Internet Web site are the primary means of offering, delivering and redeeming the incentives and gifts. We record revenues and expenses for our Sharper Image Rewards program through our stores, catalog and direct marketing and Internet operations. We continue to pursue opportunities in foreign countries, primarily through wholesale and Internet channels as well as through limited licensing arrangements. For fiscal 2003 and 2002, international sales accounted for less than 1% of total revenues. Merchandising, sourcing and development Merchandising Our merchandise mix emphasizes innovative products that are new-to-market, unique Sharper Image Design and Sharper Image branded products which are generally available exclusively through The Sharper Image, or branded products not available in broad distribution. We choose each product separately because our sales are driven by individual products, and our marketing efforts focus on each item's unique attributes, features and benefits. This approach distinguishes us from other retailers who are oriented more to category or product classification. We adjust our merchandise mix to reflect market trends and customer buying habits. New products are selected or developed and brought into our merchandise mix based on criteria such as anticipated popularity, gross margin, uniqueness, value, competitive alternatives, exclusivity, quality and vendor performance. As a result of such shifting emphasis among individual items and depending on the customers' demand and the level of marketing and advertising programs, the mix of sales by category changes from time to time and the sales volume of individual or related products can be significant to any particular reporting period's total sales. The effect of changes from year to year in the mix of sales by category can be to increase or decrease the merchandise gross margin rates since margins vary according to category of merchandise. Our current merchandise strategy is to offer an assortment of products with emphasis on Sharper Image Design and Sharper Image branded products. We intend to continue to focus on offering products in the $20 to $500 price range to appeal to a wide customer base. We also intend to continue to increase our Sharper Image Design and Sharper Image branded product offerings. 8 Sharper Image Design products are produced for us on a contract basis, substantially all by manufacturers in Asia, primarily China. We provide all product specifications to the contract manufacturers. Development lead-time is generally in the range of 12 to 18 months, although certain product introductions may require a shorter or longer lead-time. We generate information frequently on merchandise orders and inventory, which is reviewed by our buyers, our senior merchandising staff and top management. We average new offerings of approximately 50 to 100 products during the peak selling seasons. We carefully consider which products will not be offered in future months based upon numerous factors, including revenues generated, gross margins, the cost of catalog and store space devoted to each product, product availability and quality. Product sourcing The process of finding new products involves our buyers reviewing voluminous product literature, traveling extensively throughout the United States and Asia to attend trade shows and exhibitions and meeting with manufacturers. We enjoy relationships with many major manufacturers who use The Sharper Image regularly to introduce their newest products in the United States. We purchase merchandise from numerous foreign and domestic manufacturers and importers. We had a single supplier that provided approximately 21% of our net merchandise purchases in fiscal 2003. In fiscal 2003 and 2002, substantially all of the products offered by us were manufactured in Asia, primarily China. Product development Our Sharper Image Design group has over ten years of experience in designing and developing new products, as well as finding new product ideas from outside sources. The product development group meets regularly with the merchandising and sales staff to review new Sharper Image Design product opportunities, product quality and customer feedback. From these creative sessions, product ideas are put into design, development and production. Successful product introductions during the past three years include: Car Console Cooler; Feel Good Fan; Turbo Groomer 5.0; Automatic Eyeglass Cleaner; CD Shower Companion; Ultrasonic Jewelry Cleaner; Personal Entertainment Center; Big Screen Travel Clock; CD Soother Alarm Clock with 20 Soother Sounds; DVD Power Tower; Electric X7 Scooter; Hot and Cold Mini Fridge; Ionic Breeze GP Silent Air Purifier with Germicidal Protection; Ionic Breeze Personal Air Purifier; Ionic Breeze Quadra Silent Air Purifier; Ionic Conditioning Quiet Hair Dryer; "Now You Can Find It" Wireless Electronic Locator; Personal Cooling System; Shower Companion Plus; Sound Soother 20; and the Talking Travel Companion. In addition, we emphasize and work with vendors to develop private label products focusing on unique and innovative features that would distinguish us from competitors. Successful private label introductions include, among others, several uniquely styled stereo systems, as well as various personal care and home-related products. We believe that the appeal of the Sharper Image Design and Sharper Image branded products also serves as a key factor in broadening our customer base and enhancing and strengthening our brand appeal. Our goal is to continue to increase sales of these products through the introduction of new, and the continued popularity of existing, Sharper Image Design and private label products. 9 Customer service We are committed to providing our customers with courteous, knowledgeable and prompt service. Our customer service and catalog sales groups at the corporate headquarters, in Little Rock, Arkansas and in Ontario, California provide personal attention to customers who call toll free or send emails to request a catalog subscription, place an order or inquire about a product. Our customer service group is also responsible for resolving customer problems promptly and to the customer's complete satisfaction. We also contract with third party call centers for additional sales and customer service representative coverage. These third party call centers are subject to the same high-level expectations of customer service as our internal staff. We seek to hire and retain qualified sales and customer service representatives in our store, catalog and Internet operations and to train them thoroughly. Each new store manager undergoes an intense program during which the manager is trained in all aspects of our business. Sales personnel are trained during the first two weeks of employment, or during the weeks before a new store opens, and updated periodically with on-going sales training sessions. Training for sales personnel focuses primarily on acquiring a working knowledge of our products and on developing selling skills and an understanding of our high customer service standards. Each sales associate is trained to adhere to our philosophy of "taking ownership" of every customer service issue that may arise. We have also developed ongoing programs conducted at each store and by district that are designed to keep each salesperson up to date on each new product offered. Order fulfillment and distribution We own a fulfillment and distribution facility in Little Rock, Arkansas of approximately 110,000 square feet. During fiscal 2003, we entered into a lease for a distribution center in Richmond, Virginia, and re-located our distribution center in Ontario, California to a larger space. We currently have leased facilities in Little Rock, Arkansas, Ontario, California and Richmond, Virginia, totaling approximately 350,000 square feet for mail order and store fulfillment needs, returns processing and storage. Our merchandise generally is delivered to the catalog and Internet customers and to The Sharper Image stores directly from our distribution facilities. Some products are shipped directly from the vendor to the customer or to the stores. The shipment of products directly from vendors to the stores and customers reduces the level of inventory required to be carried at the distribution center, freight costs and the lead-time required to receive the products. Each catalog order is received via remote terminal at the distribution facility after the order has been approved for shipment. Our goal is to ship the majority of catalog and Internet orders within 24 - 48 hours after the order is received. We believe that the additional distribution center and added capacity will allow us to reach our goal. Store customers generally take their purchases with them. Maintaining sufficient inventory levels is critical to our business and sales and inventory information about store, catalog and Internet operations is provided on an ongoing basis to our merchandising staff and to top management for review. Our stores are equipped with electronic point-of-sale registers that communicate daily with the main computer system at our corporate headquarters, transmitting sales, inventory and customer data, as well as receiving data from our headquarters. The sales, inventory and customer data enable sales and corporate personnel to monitor sales by item on a daily basis, provide the information utilized by the automatic replenishment system, or ARS, and merchandising personnel for inventory allocations, provide management with current inventory and merchandise information, and enable our in-house mailing list to be updated regularly with customer names and activity. We have developed a proprietary ARS to improve sales with minimal inventory investment. The ARS generates information on merchandise inventory and sales by each store location, which management reviews daily. Sales information by product and location is systematically compared daily to each 10 product's "model stock" to determine store shipment quantities and frequency. The ARS computes any adjustments to the model stock level based on factors such as sales history by location in relation to our total sales of each product. Under this system, the model stock is continually revised based on this analysis. Recommended adjustments to model stock levels and recommended shipment amounts are reviewed daily by a group of our store distributors and merchandising managers who are responsible for allocating inventory to stores. Advertising While the catalog remained our primary advertising vehicle during fiscal 2003 and 2002, we also broadened our customer base through increased multimedia advertising, including television infomercials, single product mailers, newspapers, magazines, radio, email marketing programs, Internet advertising and marketing programs, and business-to-business trade publications. We increased our spending on television media infomercials, which highlighted selected Sharper Image Design and Sharper Image branded products. We believe we will be able to achieve our goal of near break-even results on this type of advertising due to the broad appeal of the products in conjunction with the higher gross margin that Sharper Image Design and private label products generally carry, although there is no assurance that this goal will be met. These increased advertising initiatives were utilized to realize our goal of acquiring new customers, which we believe will produce additional sales in the stores, catalog and Internet channels, and business-to-business sales in the current and future periods. We continually re-evaluate our advertising strategies to improve the effectiveness of our advertising programs. Information technology We maintain an integrated management information system for merchandising, point-of sale, order fulfillment, distribution and financial reporting. We believe our system increases productivity by providing extensive merchandise information and inventory control. We continually evaluate and enhance our computer systems and information technology in connection with providing additional and improved management and financial information. We have backup systems for our mainframe and servers located at our distribution center in Little Rock, Arkansas. Our Web site, www.sharperimage.com, incorporates much of the look and feel of the new store design. It includes features such as dynamic browsing, inventory status, order tracking, Flash technology, gift guides by category and product, and catalog quick order. We continually evaluate, test and enhance the Web site and during fiscal 2003 we added an online gift registry and upgraded our customer service area. We have also enhanced our backend systems by updating our servers and programs to ensure the speed and efficiency of the Web site. Competition We operate in a highly competitive environment. We compete principally with a diverse mix of department stores, sporting goods stores, discount stores, specialty retailers and other catalog and Internet retailers that offer products similar to or the same as some of those we offer. Many of our competitors are larger companies with greater financial resources, a wider selection of merchandise and greater inventory availability. Larger retailers, such as department stores, offer a wider range of products and offer the convenience of one-stop shopping. Specialty retailers, such as electronic stores, may offer only a certain category of products but often offer a wider range of selection within a particular category of product. Discount stores may offer analogous products at lower price points. 11 Since we offer a more limited range of products compared to our competitors, our ability to anticipate the preferences of our customers and effectively market and distinguish The Sharper Image brand is critical. Although we attempt to market products not generally available elsewhere and have emphasized exclusive products in our merchandising strategy, some of our products or similar products can also be found in other retail stores or through other catalogs or through the Internet. We offer competitive pricing where other retailers market certain products similar to our products at lower prices. In addition, a number of other companies have attempted to imitate the presentation and method of operation of our catalog and stores and our Sharper Image Design products. Our ability to distinguish our products from similar products offered by our competitors is particularly important in order to maintain pricing and because of the ease with which customers can comparison shop on-line. A significant portion of our sales and net income are generated by our air purification line of products. We believe the success of this product line has and will continue to encourage other companies to imitate these products. We compete principally on the basis of product exclusivity, selection, brand recognition, quality and price of our products, merchandise presentation in the catalog, stores and on the Internet, our customer list and the quality of our customer service. We have committed additional resources to our internal product development group to create and produce Sharper Image Design products, and to our merchandising team to support a program to increase the Sharper Image brand products exclusively available from us. We believe that these Sharper Image Design and Sharper Image brand products provide a competitive advantage for us in our merchandising offering. Intellectual Property We believe our registered service mark and trademark "The Sharper Image" and the brand name recognition that we have developed are of significant value. We actively protect our brand name and other intellectual property rights to ensure that the quality of our brand and the value of our proprietary rights are maintained. We seek patents to establish and protect our proprietary rights relating to the technologies and products we are currently developing, that we may develop, or that our competitors may develop. We have taken and will continue, in the future, to take all steps necessary to broaden and enhance our patent protection by obtaining both utility and design patent protection directed to our proprietary products. For instance, we currently own 46 U.S. utility patents and more than 90 U.S. design patents. We have at least six U.S. utility patents and several U.S. design patents that protect our air purification line of products. The earliest expiration date of any of these utility patents is 2018. In addition, we own license rights under a utility patent relating to our air purification line of products. This patent is due to expire in December 2005. We also have multiple foreign and domestic pending patent applications directed to our air purification line of products. Although we believe our existing patents, as well as our ongoing patent prosecution efforts, will continue to provide protection for our air purification products, upon the expiration of our licensed patent, this product line could face additional competition. We own or have rights to various copyrights, trademarks and trade names used in our business. These include The Sharper Image(R), Sharper Image Design(R), Sound Soother(R), Ionic Breeze(R), The Breeze(R), Quadra(R), and Ionic Hair Wand II(R), Personal Cooling System(TM), Quiet Power(TM) Motorized Tie Rack, Shower Companion(TM), and Turbo Groomer(TM). Seasonality Our business is highly seasonal, with sales peaks in the end-of-year holiday shopping seasons as well as for Mother's Day, Father's Day and graduation gift-gift giving. A substantial portion of our total 12 revenues, and all or most of our net earnings, occur in our fourth fiscal quarter ending January 31. We generally experience lower revenues during the other quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. In addition, similar to many retailers, we make merchandising and inventory decisions for the holiday season well in advance of the holiday selling season. Accordingly, unfavorable economic conditions or deviations from projected demand for products during the fourth quarter could have a material adverse effect on our financial position or results of operations for the entire fiscal year. The fourth quarter accounted for more than 40% of total revenues in both fiscal 2003 and 2002. In addition, the fourth quarter accounted for all of our net earnings in fiscal 2002 and substantially all of our net earnings in 2003. Employees As of January 31, 2004, we employed approximately 2,400 associates, approximately 60% of whom were full time. We also hire a significant number of seasonal employees during our peak holiday selling season. We consider our associate relations to be good. Available information Our Internet address is www.sharperimage.com. We make available on our Web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. Information on our Web site is not incorporated into this annual report. Factors Affecting Future Operating Results The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating us and our prospects. This report (including without limitation the following Factors Affecting Future Operating Results) contains 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) regarding us and our business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. Additionally, statements concerning future matters such as the development of new products, store expansions, possible changes in economic conditions and other statements regarding matters that are not historical are forward-looking statements. Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as those discussed elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of the report. If we fail to continuously offer new merchandise that our customers find attractive, the demand for our products may be limited. In order to meet our strategic goals, we must successfully offer our customers new, innovative and high quality products on a continuous basis. Our product offerings must be affordable, useful to the 13 customer, well made, distinctive in design and not widely available from other retailers. We cannot predict with certainty that we will successfully offer products that meet these requirements in the future. Some products or a group of related products can produce sales volumes that are significant to our total sales volume in a particular period. If other retailers, especially department stores or discount retailers, offer the same products or products similar to those we sell, or if our products become less popular with our customers, our sales may decline or we may decide to offer our products at lower prices. If customers buy fewer of our products or if we have to reduce our prices, our revenues and earnings will decline. Our products must appeal to a broad range of consumers whose preferences we cannot predict with certainty and may change between sales seasons. If we misjudge either the market for our products or our customers' purchasing habits, our sales may decline, our inventories may increase or we may be required to sell our products at lower prices. This would have a negative effect on our business. If we do not maintain sufficient inventory levels, or if we are unable to deliver our products to our customers in sufficient quantities, our operating results will be adversely affected. We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling seasons. If we fail to achieve these goals, we may be unable to meet customer demand, and our future results will be adversely affected if we are not successful in achieving these goals. Our success depends on our ability to anticipate and respond to changing product trends and consumer demands in a timely manner. A significant portion of our sales during any given period of time may be generated by a particular product or line of products and if sales of those products or line of products decrease, our stock price may be adversely affected. During fiscal 2003 and 2002, the sales of our air purification line of products constituted a significant portion of our total revenues and net income. Although not as significant, the sales from our home and portable stereo system and massage product lines constituted a substantial portion of our total revenues and net income. Our future growth will be substantially dependent on the continued increase in sales growth of existing core and new products, while at the same time maintaining or increasing our current gross margin rates. We cannot predict whether we will be able to increase the growth of existing core and new products or successfully introduce new products, increase our revenue level or maintain or increase our gross margin rate in future periods. Failure to do so may adversely affect our stock price. Poor economic conditions may reduce consumer spending on discretionary retail products such as the ones we offer. Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, consumer confidence and consumer perception of economic conditions. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. We may not be able to accurately anticipate the magnitude of these effects on future quarterly results. 14 Our success depends in part on our ability to internally design and develop our Sharper Image Design products. We have invested significant resources in and are increasingly dependent on the success of the Sharper Image Design products that we design and develop. These products have typically generated higher gross margins than other products and our merchandising strategy emphasizes these products. Some of these products or a group of related products, which are affected by customers' demands and the level of our marketing and advertising efforts, can produce sales volumes that are significant to our total sales volume in a particular period. In order to be successful, we must continue to design and develop products that meet the demands of our customers, as well as create customer demand for these products. Our goal is to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, although we expect this percentage may decline from time to time, as it did from 2002 to 2003, and cannot assure you we will otherwise achieve our goal. If we are unable to successfully design and develop these products, our operating results may be adversely affected. We rely on foreign sources of production and our business would be adversely affected if our suppliers are not able to meet our demand and alternative sources are not available. We must ensure that the products we design and develop are manufactured cost-effectively. We rely solely on a select group of contract manufacturers, most of whom are located in Asia (primarily China), to produce these products in sufficient quantities to meet customer demand and to obtain and deliver these products to our customers in a timely manner. These arrangements are subject to the risks of relying on products manufactured outside the United States, including political unrest and trade restrictions, local business practice and political issues, including issues relating to compliance with domestic or international labor standards, currency fluctuations, work stoppages, economic uncertainties, including inflation and government regulations, availability of raw materials and other uncertainties. If we are unable to successfully obtain and timely deliver sufficient quantities of these products, our operating results may be adversely affected. There is increasing political pressure on China to permit the exchange rate of its currency, the Yuan, to float against the dollar. Although substantially all of our supply contracts in China are denominated in dollars, our suppliers could attempt to renegotiate these contracts if the Yuan/dollar exchange rate were to change. We had a single supplier for a number of our products, located in Asia that provided approximately 21% of the net merchandise purchases in fiscal 2003 and is expected to provide a comparable percentage in the future. If we were unable to obtain products from this supplier on a timely basis or on commercially reasonable terms, our operating results may be adversely affected. Some of our smaller vendors have limited resources, limited production capacities and limited operating histories. We have no long-term purchase contracts or other contracts that provide continued supply, pricing or access to new products and any vendor or distributor could discontinue selling to us at any time. We compete with many other companies for production facilities and import quota capacity. We cannot assure you that we will be able to acquire the products we desire in sufficient quantities or on terms that are acceptable to us in the future. In addition, we cannot assure you that our vendors will make and deliver high quality products in a cost-effective, timely manner. We may also be unable to develop relationships with new vendors. We depend on our vendors' ability to timely deliver sufficient quantities of products and our business can be harmed by work stoppages or other interruptions to delivery of products. 15 All products we purchase from our vendors in Asia must be shipped to our distribution centers by freight carriers and we cannot assure you that we will be able to obtain sufficient freight capacity on a timely basis and at favorable rates. Our inability to acquire suitable products in a cost-effective, timely manner or the loss of one or more key vendors or freight carriers could have a negative effect on our business. Our ability to protect our proprietary technology, which is vital to our business, particularly our air purification products, is uncertain and our inability to protect these rights could impair our competitive advantage and cause us to incur substantial expense to enforce our rights. We believe our registered service mark and trademark "The Sharper Image" and the brand name recognition that we have developed are of significant value. We actively protect our brand name and other intellectual property rights to ensure that the quality of our brand and the value of our proprietary rights are maintained. We seek patents to establish and protect our proprietary rights relating to the technologies and products we are currently developing, that we may develop, or that our competitors may develop. We have taken and will continue, in the future, to take all steps necessary to broaden and enhance our patent protection by obtaining both utility and design patent protection directed to our proprietary products. For instance, we currently own 46 U.S. utility patents and more than 90 U.S. design patents. We have at least six U.S. utility patents and several U.S. design patents that protect our air purification line of products. The earliest expiration date of any of these utility patents is 2018. In addition, we own license rights under a utility patent relating to our air purification line of products. This patent is due to expire in December 2005. We also have multiple foreign and domestic pending patent applications directed to our air purification line of products. Although we believe our existing patents, as well as our ongoing patent prosecution efforts, will continue to provide protection for our air purification products, upon the expiration of our licensed patent, this product line could face additional competition. We cannot assure you that a third party will not infringe upon or design around any patent issued or licensed to us, including the patents and license agreement related to our air purification line of products, or that these patents will otherwise be commercially viable. Litigation to establish the validity of patents, to defend against patent infringement claims of others and to assert patent infringement claims against others can be expensive and time-consuming even if the outcome is favorable to us. If the outcome is unfavorable to us, we may be required to pay damages, stop production and sales of infringing products or be subject to increased competition from similar products. We have taken and may, in the future, take steps to enhance our patent protection, but we cannot assure you that these steps will be successful or that, if unsuccessful, our patent protection will be adequate. We also rely upon trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position. We attempt to protect our proprietary technology in large part by confidentiality agreements with our employees, consultants and other contractors. We cannot assure you, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that competitors will not know of or independently discover our trade secrets. Our quarterly operating results and comparable store sales are subject to significant fluctuations and seasonality. Our business is seasonal, reflecting the general pattern of peak sales and earnings for the retail industry during the holiday shopping season. Typically, a substantial portion of our total revenues and all or most of our net earnings occur during our fourth quarter ending on January 31. The fourth quarter 16 accounted for more than 40% of total revenues in both fiscal 2003 and 2002. In addition, the fourth quarter accounted for all of our net earnings in fiscal 2002 and substantially all of our net earnings in fiscal 2003. In anticipation of increased sales activity during the fourth quarter, we incur significant additional expenses, including significantly higher inventory costs and the costs of hiring a substantial number of temporary employees to supplement our regular store staff. If for any reason our sales were to be substantially below those normally expected during the fourth quarter, our annual operating results would be adversely affected. Due to this seasonality, our operating results for any one period may not be indicative of our operating results for the full fiscal year. We generally experience lower revenues and net operating results during our first three quarters of the fiscal year and have historically experienced losses in these quarters. Our quarterly results of operations may fluctuate significantly as a result of a variety of factors, including, among other things, the timing of new store openings, net sales contributed by new stores, increases or decreases in comparable store sales, changes in our merchandise mix and net catalog sales. In addition, like other retailers, we typically make merchandising and purchasing decisions well in advance of the holiday shopping season. As a result, poor economic conditions or differences from projected customer demand for our products during the fourth quarter could result in lower revenues and earnings. Our comparable store sales also fluctuate significantly and can contribute to fluctuations in our quarterly operating results. Our comparable store sales are affected by a variety of factors, including customer demand in different geographic regions, our ability to efficiently source and distribute products, changes in our product mix, competition and advertising. Our comparable store sales have fluctuated significantly in the past and we believe that such fluctuations may continue. Our historic comparable net store sales changes from the prior fiscal year were as follows: Fiscal year Percentage increase (decrease) ----------- ------------------------------ 1999 12.3 2000 29.0 2001 (16.0) 2002 13.6 2003 15.3 Comparable store sales are defined as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 full months. Stores generally become comparable once they have a full year of comparable sales. We cannot assure you that our comparable store sales results will increase in the future. Any reduction in or failure to increase our comparable store sales results could impact our future operating performance and cause the price of our common stock to decrease. We are dependent on the success of our advertising and direct marketing efforts and our profitability will be adversely affected by increased costs associated with these efforts. 17 Our revenues depend in part on our ability to effectively market and advertise our products through The Sharper Image catalog and direct marketing operations. Increases in advertising, paper or postage costs may limit our ability to advertise without reducing our profitability. If we decrease our advertising efforts due to increased advertising costs, restrictions placed by regulatory agencies or for any other reason, our future operating results may be materially adversely affected. We are also utilizing and constantly testing other advertising media, such as television infomercials, radio and single product mailings. Our advertising expenditures increased by approximately $26.0 million or 26.7% in fiscal 2003 from the prior fiscal year. While we believe that increased expenditures on these and other media have resulted in increased revenues during fiscal 2003, we cannot assure you that this trend will continue in the future. If our advertising is ineffective and our increased advertising expenditures do not result in increased sales volumes, our sales and profits will be adversely affected. We depend on the continued availability of television infomercial time at reasonable prices. Although we do not currently expect any difficulties in obtaining television infomercial time generally, 2004 is a presidential election year and a substantial increase in political advertising may limit the availability, or increase the price, of infomercial time available to us. We expect to continue to spend on advertising and marketing at increased levels in the future, but may not continue to produce a sufficient level of sales to cover such expenditures, which would reduce our profitability. Our business will be harmed if we are unable to successfully implement our growth strategy. Our growth strategy primarily includes the following components: o increase Sharper Image Design and private label product offerings; o broaden our customer base; o open new stores; and o broaden our sales and marketing channels Any failure on our part to successfully implement any or all of our growth strategies would likely have a material adverse effect on our financial condition, results of operations and cash flows. We believe our past growth has been attributable in large part to our success in meeting the merchandise, timing and service demands of an expanding customer base with changing demographic characteristics, but there is no assurance that we will be able to continue to have such success. The expansion of our store operations could result in increased expenses with no guarantee of increased profitability. We plan to increase our number of stores by 15%-20% annually. We may not be able to attain our target new store openings, and any of our new stores that we open may not be profitable, either of which could have an adverse impact on our financial results. Our ability to expand by opening new stores will depend in part on the following factors: o the availability of attractive store locations; o our ability to negotiate favorable lease terms; o our ability to identify customer demand in different geographic areas; 18 o the availability and cost of store fixtures; o general economic conditions; and o availability of sufficient funds for expansion Even though we continue to expand our store base, we have remained concentrated in limited geographic areas. This could increase our exposure to customer demand, weather, competition, distribution problems and poor economic conditions in these regions. In addition, our catalog sales, Internet sales, or existing store sales in a specific region may decrease as a result of new store openings. In order to continue our expansion of stores, we will need to hire additional management and staff for our corporate offices and employees for each new store. We must also expand our management information systems and distribution systems to serve these new stores. If we are unable to hire necessary personnel or grow our existing systems, our expansion efforts may not succeed and our operations may suffer. Some of our expenses will increase with the opening of new stores. If store sales are inadequate to support these new costs, our profitability will decrease. For example, inventory costs will increase as we increase inventory levels to supply additional stores. We may not be able to manage this increased inventory without decreasing our profitability. We may need financing in excess of that available under our current credit facility. Furthermore, our current credit facility has various loan covenants we must comply with in order to maintain the credit facility. We cannot predict whether we will be successful in obtaining additional funds or new credit facilities on favorable terms or at all. We rely on our catalog operations which could have significant cost increases and could have unpredictable results. Our success depends in part on the success of our catalog operations. We believe that the success of our catalog operations depends on the following factors: o our ability to achieve adequate response rates to our mailings; o our ability to continue to offer a merchandise mix that is attractive to our mail order customers; o our ability to cost-effectively add new customers; o our ability to cost-effectively design, produce and deliver appealing catalogs; and o timely delivery of catalog mailings to our customers Catalog production and mailings entail substantial paper, postage, merchandise acquisition and human resource costs, including costs associated with catalog development and increased inventories. We incur nearly all of these costs prior to the mailing of each catalog. As a result, we are not able to adjust the costs being incurred in connection with a particular mailing to reflect the actual performance of the catalog. Increases in costs of mailing, paper or printing would increase costs and would adversely impact our earnings if we were unable to pass such increases directly on to our customers or offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment 19 systems. If we were to experience a significant shortfall in anticipated revenue from a particular mailing, and thereby not recover the costs associated with that mailing, our future results would be adversely affected. In addition, response rates to our mailings and, as a result, revenues generated by each mailing are affected by factors such as consumer preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings and changes in our merchandise mix, several or all of which may be outside our control. Further, we have historically experienced fluctuations in the response rates to our catalog mailings. If we are unable to accurately target the appropriate segment of the consumer catalog market or to achieve adequate response rates, we could experience lower sales, significant markdowns or write-offs of inventory and lower margins, which would adversely affect our future results. We have distribution and fulfillment operations located in Little Rock, Arkansas, Ontario, California and Richmond, Virginia. Any disruption of the operations in these centers could hurt our ability to make timely delivery of our products. We conduct the majority of our distribution operations and all of our catalog and Internet order processing fulfillment functions from our owned facility in Little Rock, Arkansas, and leased facilities in Little Rock, Arkansas; Ontario, California and Richmond, Virginia. During fiscal 2003, we entered into a lease for a distribution center in Richmond, Virginia, which we are planning to have fully operational during fiscal 2004. We also use contract fulfillment and warehouse facilities for additional seasonal requirements. Any disruption in the operations at any distribution center, particularly during the holiday shopping season, could result in late delivery of products and make it difficult to meet customer demand for our products. In addition, we rely upon third party carriers for our product shipments, including shipments to and from all of our stores. As a result, we are subject to certain risks, including employee strikes and inclement weather, associated with such carriers' ability to provide delivery services to meet our shipping needs. We are also dependent on temporary employees to adequately staff our distribution facilities, particularly during busy periods such as the holiday shopping season. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient sources of temporary employees. We experience intense competition in the rapidly changing retail markets and if we are unable to compete effectively, we may not be able to maintain profitability. We operate in a highly competitive environment. We principally compete with a variety of department stores, sporting goods stores, discount stores, specialty retailers and other catalogs that offer products similar to or the same as our products. We may increasingly compete with major Internet retailers. Many of our competitors are larger companies with greater financial resources, a wider selection of merchandise and greater inventory availability and offer the convenience of one-stop shopping. Specialty retailers, such as electronics stores, may offer only a certain category of products but often offer a wider range of selection within a particular category of product. Discount stores may offer analogous products at lower price points. We offer a more limited range of products compared to our competitors, and if we are unable to anticipate the preferences of our customers and effectively market and distinguish The Sharper Image brand or if we experience increased competition, our business and operating results could be adversely affected. The U.S. retail industry, the specialty retail industry in particular, and e-commerce sector are dynamic in nature and have undergone significant changes over the past several years. Our ability to 20 anticipate and successfully respond to continuing challenges is critical to our long-term growth and we cannot assure you that we will anticipate and successfully respond to changes in the retail industry and e-commerce sectors. We maintain a liberal merchandise return policy, which allows customers to return most merchandise, and as a result, excessive merchandise returns could harm our business. We make allowances for returns of store, catalog and Internet sales in our financial statements based on historical return rates. We cannot assure you that actual merchandise returns will not exceed our allowances. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise in our stores or catalogs, the opening of new stores, the introduction of new catalogs, increased sales over the Internet, changes in our merchandise mix or other factors will not cause actual returns to exceed return allowances. Any significant increase in merchandise returns that exceed our allowances could have a material adverse effect on our future results. We may be subject to risks associated with our products, including product liability or patent and trademark infringement claims. Our current and future products may contain defects, which could subject us to product liability claims and product recalls. Although we maintain limited product liability insurance, if any successful product liability claim or product recall is not covered by or exceeds our insurance coverage, our business, results of operations and financial condition would be harmed. Additionally, third parties may assert claims against us alleging infringement, misappropriation or other violations of patent, trademark or other proprietary rights, whether or not such claims have merit. Such claims can be time consuming and expensive to defend and could require us to cease using and selling the allegedly infringing products, which may have a significant impact on total company sales volume, and to incur significant litigation costs and expenses. If we lose our key personnel, we may not be able to successfully develop and merchandise our products. Our success depends to a significant extent upon the abilities of our senior management, particularly Richard Thalheimer, our Founder, Chairman and Chief Executive Officer. The loss of the services of any of the members of our senior management or of certain other key employees could have a significant adverse effect on our business, financial condition and operating results. We maintain key man life insurance on Mr. Thalheimer in the amount of $15 million. The terms of Mr. Thalheimer's employment are governed by an employment agreement. Our future performance will depend upon our ability to attract and retain qualified management, merchandising and sales personnel. There can be no assurance that the members of our existing management team will be able to manage our company or our growth or that we will be able to attract and hire additional qualified personnel as needed in the future. A single shareholder exerts considerable influence over our business affairs and may make business decisions which may not be in your best interest. As of January 31, 2004, Richard Thalheimer, our Founder, Chairman and Chief Executive Officer, beneficially owned approximately 21% of our common stock. As a result, Mr. Thalheimer will continue to exert substantial influence over the election of directors and over our corporate actions. 21 Our common stock price is volatile. Our common stock is quoted on the Nasdaq National Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could reduce the market price of our common stock without regard to our operating performance. From February 1, 2003 to January 31, 2004, the price per share of our common stock has ranged from a high of $ 36.16 to a low of $14.51. We believe that among other factors, any of the following factors could cause the price of our common stock to fluctuate substantially: o monthly fluctuations in our comparable store sales; o announcements by other retailers; o the trading volume of our common stock in the public market; o general economic conditions; o financial market conditions; o acts of terrorism; and o threats of war Our charter documents, Delaware law, our stockholders rights plan and other agreements may make a takeover of us more difficult. We are a Delaware corporation. The Delaware General Corporation Law contains certain provisions that may make a change in control of our company more difficult or prevent the removal of incumbent directors. In addition, our Certificate of Incorporation and Bylaws and our stockholders rights plan and other agreements contain provisions that may have the same effect. These provisions may have a negative impact on the price of our common stock, may discourage third- party bidders from making a bid for our company or may reduce any premiums paid to stockholders for their common stock. Item 2. Properties The Company occupies approximately 58,000 square feet of office space for its corporate headquarters in San Francisco, CA. The Company signed a lease extension in February 2000, extending the expiration date to January 2006. The Company also leases approximately 5,600 square feet for its product development offices in Northern California. As of January 31, 2004 the Company operated 149 The Sharper Image stores under leases covering a total of approximately 595,135 square feet. The Company owns and operates a 110,000 square foot distribution facility located in Little Rock, Arkansas. Distribution and warehouse functions are conducted through this facility, a 137,000 square foot leased facility in Ontario, California, a 104,000 square foot leased facility in Little Rock, Arkansas, and a 113,000 square foot leased facility in Richmond, Virginia and other seasonally occupied space rented by the Company in close proximity thereto. 22 Item 3. Legal Proceedings We aggressively pursue claims against companies with products that infringe our intellectual property. In addition, from time-to-time, we are involved in various disputes and legal proceedings that arise in the ordinary course of business. These include disputes and lawsuits related to intellectual property, product liability and employee relations matters. We do not believe that the resolution of these matters will have a material adverse effect on our financial position or results of operations. Item 4. Submission of Matters to a Vote of Security Holders None. Item 4A. Executive Officers of the Registrant Set forth below is a list of the executive officers of the Company, together with brief biographical descriptions. Name Position Age ---- -------- --- Richard Thalheimer Founder, Chief Executive Officer 56 and Chairman of the Board Tracy Wan President and Chief Operating Officer 44 Jeffrey Forgan Executive Vice President, Chief 46 Financial Officer and Corporate Secretary Anthony Farrell Senior Vice President, Creative Services 54 Craig Trabeaux Senior Vice President, Retail Operations 47 Richard Thalheimer is our founder and has served as our Chief Executive Officer and a Director since 1978 and as Chairman of the Board of Directors since 1985. Mr. Thalheimer also served as our President from 1977 through July 1993. Tracy Wan has been our President and Chief Operating Officer since April 1999. Ms. Wan served as Executive Vice President and Chief Financial Officer from August 1998 through April 1999; Senior Vice President and Chief Financial Officer from February 1995 through August 1998; as Vice President and Chief Financial Officer from September 1994 through February 1995; as Vice President and Controller from November 1991 through September 1994; and as Controller from July 1989 through November 1991. Jeffrey Forgan has been our Executive Vice President and Chief Financial Officer since May 2002. Mr. Forgan served as our Senior Vice President and Chief Financial Officer from April 1999 through May 2002. Prior to that, Mr. Forgan served as Vice President, Corporate Finance with Foundation Health Systems from 1995 to 1998, and was with Deloitte & Touche LLP from 1980 to 1995, serving as an audit partner during 1995. Mr. Forgan is a certified public accountant. Anthony Farrell has been our Senior Vice President, Creative Services, since July 1998. Mr. Farrell was a consultant to The Sharper Image from April 1998 through July 1998. Mr. Farrell was senior vice president, merchandising with SelfCare Catalog from March 1991 through December 1997. 23 Craig Trabeaux has been our Senior Vice President, Retail Operations since September 2000. Mr. Trabeaux served as Vice President, Stores from September 1999 through September 2000; as Regional Manager from February 1998 through September 1999; as Senior District Manager from October 1995 through January 1998; as District Manager from February 1989 through September 1995; and as Store Manager July 1987 through January 1989. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The common stock of Sharper Image Corporation is traded in the NASDAQ National Market under the symbol SHRP. The following table sets forth, for the period indicated, the range of high and low last sale prices reported for our common stock. Fiscal Year 2003 Fiscal Year 2002 High Low High Low First Quarter $21.10 $14.51 $22.68 $10.70 Second Quarter 30.74 19.50 22.85 14.26 Third Quarter 29.09 23.15 22.09 13.90 Fourth Quarter 36.16 27.78 24.95 14.46 We have not paid cash dividends to holders of its common stock and do not intend to pay cash dividends for the foreseeable future. As of April 12, 2004, there were 368 holders of record and the closing price of our common stock was $33.02 per share as reported by the NASDAQ Stock Market 24 Item 6. Selected Financial Data
Fiscal Year Ended January 31, Dollars are in thousands -------------------------------------------------------------------------------------- except for earnings 2004 2003 2002 2001 2000 per share and statistics (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) (Fiscal 2000) (Fiscal 1999) ------------ ------------ ------------ ------------ ------------ Operating Results Revenue $ 647,511 $ 513,769 $ 389,105 $ 414,550 $ 300,432 Earnings before income taxes 42,803 26,956 1,878 28,739 15,541 Net earnings $ 25,254 $ 15,907 $ 1,127 $ 16,978 $ 9,325 Earnings per common equivalent share-- Basic $ 1.75(1)(2)$ 1.29(2) $ 0.09(2) $ 1.41(2) $ 0.89(2) Diluted $ 1.65(1)(2)$ 1.21(2) $ 0.09(2) $ 1.34(2) $ 0.85(2) Balance Sheet Data Working capital $ 131,334 $ 70,223 $ 53,128 $ 58,978 $ 54,644 Total assets 309,555 214,427 162,522 179,323 142,119 Long-term notes payable -- -- 2,033 2,206 2,366 Stockholders' equity $ 189,926 $ 117,384 $ 94,103 $ 93,091 $ 77,123 Current ratio 2.27 1.80 1.88 1.74 1.93 Statistics Number of stores at year end 149 127 109 97 89 Comparable store sales 15.3% 13.6% (16.0%) 29.0% 12.3% increase (decrease) Annualized net sales per 676 627 578 763 546 square foot Number of catalogs mailed(3) 85,247,000 77,772,000 70,135,000 62,252,000 47,581,000 Average revenue per transaction Stores $ 142 $ 128 $ 118 $ 117 $ 106 Catalog $ 198 $ 199 $ 174 $ 164 $ 145 Internet(4) $ 148 $ 145 $ 127 $ 108 $ 97 Return on average 16.4% 15.0% 1.2% 19.9% 16.4% stockholders' equity Book value per share $ 13.15 $ 9.52 $ 7.90 $ 7.73 $ 7.33 Weighted average number of shares outstanding Basic 14,446,128 12,327,157 11,904,562 12,036,569 10,516,358 Diluted 15,333,235 13,182,050 12,302,852 12,659,265 11,021,520
(1) The earnings per common equivalent share reflect the effect of the additional 2.1 million shares issued from the May 2003 stock offering. (2) The earnings per common equivalent share reflect the additional 3.0 million shares issued from the July 1999 secondary offering. (3) Based upon Sharper Image catalog - excludes other specialty and test mailing catalogs. (4) Includes results from auction site opened in the quarter ended April 30, 1999. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Overview The Sharper Image is a multi-channel specialty retailer of innovative, high quality products that are useful and entertaining and are designed to make life easier and more enjoyable. Our unique assortment of products offers design, creativity and technological innovation, in addition to fun and entertainment. We market and sell our merchandise primarily through three integrated sales channels: The Sharper Image stores, The Sharper Image catalog, which includes revenue from all direct marketing activities and television infomercials, and the Internet. We also market to other businesses through our corporate sales, where revenues are recorded in each of our three sales channels and wholesale operations. Our total revenues increased 26.0% to $647.5 million in the year ended January 31, 2004 (fiscal 2003) from $513.8 million in the year ended January 31, 2003 (fiscal 2002). This increase was due primarily to the popularity of our Sharper Image Design and Sharper Image branded products, including our air 25 purification line of products, the opening of 22 net new stores, a comparable store sales increase of 15.3%, and an increase in our multimedia advertising which we believe increased sales in all selling channels. Our store operations generated the highest proportion of our sales, representing 58.6% and 57.2% of total revenues for fiscal 2003 and 2002, respectively. As of January 31, 2004, we operated 149 The Sharper Image stores in 37 states and the District of Columbia. As part of our growth strategy, we have opened 25, 20 and 14 The Sharper Image stores, and closed three, two and two stores at lease maturity, in fiscal 2003, 2002 and 2001, respectively. Our catalog and direct marketing operations, including revenue generated directly from catalogs, print advertising, single product mailers and television infomercials, generated 19.9% and 23.0% of our total revenues for fiscal 2003 and 2002, respectively. Our Internet operations generated 14.7% and 13.5% of total revenues in fiscal 2003 and 2002, respectively. One of our goals is to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, which typically generate higher margins than our third party branded products. The percentage of our total revenues attributable to Sharper Image Design and Sharper Image branded products was approximately 73% in fiscal 2003 from approximately 76% in fiscal 2002. The popularity of third party branded products such as digital cameras and massage chairs during fiscal 2003 contributed to the lower percentage of sales coming from Sharper Image Design and Sharper Image branded products. Our business is highly seasonal, with sales peaks in the end-of-year holiday shopping seaons as well as for Mother's Day, Father's Day and graduation gift-gift giving. A substantial portion of our total revenues, and all or most of our net earnings, occur in our fourth fiscal quarter ending January 31. We generally experience lower revenues during the other quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. In addition, similar to many retailers, we make merchandising and inventory decisions for the holiday season well in advance of the holiday selling season. Accordingly, unfavorable economic conditions or deviations from projected demand for products during the fourth quarter could have a material adverse effect on our financial position or results of operations for the entire fiscal year. The fourth quarter accounted for more than 40% of total revenues in both fiscal 2003 and 2002. In addition, the fourth quarter accounted for all of our net earnings in fiscal 2002 and substantially all of our net earnings in 2003. Our financial statements for fiscal 2003 reflect certain reclassifications made to prior year financial statements in order to conform to the January 31, 2004 financial statements. Critical accounting policies and estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures. Estimates and assumptions include, but are not limited to, the carrying value of inventory, fixed asset lives, deferred cost recovery period, income taxes and contingencies and litigation. We base our estimates on analyses 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 may differ from these estimates under different assumptions or conditions. We believe that the following represents our more critical estimates and assumptions used in the preparation of our financial statements. 26 Revenue recognition. We recognize revenue at the point of sale at our retail stores and at the time of customer receipt for our catalog and direct marketing sales, including the Internet. We recognize revenue for sales to resellers of sales made on a wholesale basis when the products are shipped, which is the time title passes to the purchaser. We record estimated reductions to revenue for customer returns based on our historical return rates. Revenues are recorded net of sale discounts and other rebates and incentives offered to customers. Deferred revenue represents merchandise certificates, gift cards and rewards cards outstanding and unfilled cash orders at the end of the fiscal period. Delivery revenue is recognized at the time of customer receipt. Merchandise inventories. We write down inventory for estimated obsolescence on unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory writedowns may be required. Accounts receivable. Counterparties to our accounts receivable include credit card issuers, corporate marketing incentive customers, wholesale customers, installment plan customers for purchases of a limited number of products, merchandise vendors, and landlords from whom we expect to receive amounts due. We record an allowance for credit losses based on estimates of customers' ability to pay. If the financial condition of our customers were to deteriorate, additional allowances may be required. Store closure reserves. We record reserves for closed stores based on future lease commitments, anticipated future subleases of properties and current risk-free interest rates. If interest rates or the real estate leasing markets change, additional reserves may be required. Other accounting estimates inherent in the preparation of our financial statements include estimates associated with our evaluation of the recoverability of deferred tax assets as well as those used in the determination of liabilities related to litigation, product liability, and taxation. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact specific and takes into account factors such as historical experience, current and expected economic conditions and product mix. We constantly re-evaluate these significant factors and make adjustments where facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. As discussed in the Notes to the Financial Statements, we are involved in litigation incidental to our business, the disposition of which is expected to have no material effect on our financial position or results of operations. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions related to these proceedings. We accrue our best estimates of the probable cost for the resolution of legal claims. Such estimates are developed in consultation with outside counsel handling these matters and are based upon a combination of litigation and settlement strategies. To the extent additional information arises or our strategies change, it is possible that our best estimates of our probable liability in these matters may change. 27 Results of Operations Percentage of Total Revenues
Fiscal Year Ended January 31, 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------- -------------- ------------- Revenues: Net store sales 58.6% 57.2% 59.3% Net catalog sales 19.9 23.0 21.9 Net Internet sales 14.7 13.5 12.7 Net wholesale sales 4.2 3.4 2.8 Delivery 2.6 2.7 3.1 List rental and licensing 0.0 0.2 0.2 ---------------------------------------------------- Total Revenues 100.0 100.0 100.0 Costs and Expenses: Cost of products 42.8 42.9 46.9 Buying and occupancy 9.0 9.4 10.2 Advertising 19.0 19.0 17.6 General, selling and administrative 22.6 23.5 24.8 ---------------------------------------------------- Operating income 6.6 5.2 0.5 Other income 0.0 0.0 0.0 ---------------------------------------------------- Earnings before income tax expense 6.6 5.2 0.5 Income tax expense 2.7 2.1 0.2 ---------------------------------------------------- Net Earnings 3.9% 3.1% 0.3% ====================================================
Fiscal Year Ended January 31, ---------------------------------------------------------------- 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------------ ------------------- --------------------- Revenues: Dollars in thousands Net store sales $379,349 $293,795 $230,799 Net catalog and direct marketing sales 128,652 118,192 85,087 Net Internet sales 95,086 69,208 49,349 Net wholesale sales 26,997 17,507 10,893 ---------------------------------------------------------------- Total net sales 630,084 498,702 376,128 List rental and licensing 377 977 985 Delivery 17,050 14,090 11,992 ---------------------------------------------------------------- Total revenues $647,511 $513,769 $389,105 ================================================================
28 Year ended January 31, 2004 (fiscal 2003), compared to year ended January 31, 2003 (fiscal 2002) Revenues. Net sales for fiscal 2003 increased $131.4 million or 26.3%, from the prior fiscal year. Returns and allowances for fiscal 2003 were 10.7% of sales, as compared to 12.0% for fiscal 2002. The increase in net sales was attributable primarily to increases in net sales from stores of $85.6 million; from catalog and direct marketing of $10.5 million; from Internet operations of $25.9 million; and from wholesale of $9.5 million. The increase in total revenue for fiscal 2003, as compared to fiscal 2002 was due primarily to the popularity of our Sharper Image Design and Sharper Image branded products, which continues to be a key factor in the increases in net sales in all selling channels. Sales of Sharper Image Design and Sharper Image branded products decreased to approximately 73% of total revenues in fiscal 2003 from approximately 76% for fiscal 2002. The popularity of third party branded products such as digital cameras and massage chairs during fiscal 2003 contributed to the lower percentage of sales coming from Sharper Image Design and Sharper Image branded products. We believe that the continued development and introduction of new and popular products is a key strategic objective and important to our future success. Contributing to the increase in net sales was a comparable store sales increase of 15.3% over fiscal 2002 and the opening of 22 net new stores during fiscal 2003. We also believe that the increased investment in our advertising initiatives in fiscal 2003 and 2002, which include the significant increase in television infomercial advertising and single product mailers, highlighting primarily selected Sharper Image Design and Sharper Image branded products and the 9.6% increase in catalogs circulated contributed to the higher revenues in all selling channels. Net store sales for fiscal 2003 increased $85.6 million, or 29.1%, while comparable store sales increased by 15.3% from fiscal 2002. The increase in net store sales was attributable primarily to the opening of 25 new stores during fiscal 2003, the increased sales of Sharper Image Design and Sharper Image branded products, the 15.3% increase in comparable store sales, and the increased television infomercial and single product mailer advertising, partially offset by the closing of three stores at their lease maturity. The opening of 25 new stores, offset by the three store closures in fiscal 2003, resulted in an incremental increase to net store sales of $26.3 million from the prior fiscal year. The increase in comparable store sales primarily resulted from a 17.9% increase in total store transactions for fiscal 2003 and an 11.1% increase in the average revenue per transaction, compared with fiscal 2002. The increase in average revenue per transaction was attributable primarily to the overall product mix offered, and multimedia advertising strategies, including infomercial advertising. Also contributing to the increase in average revenue per transaction are the increased sales of Sharper Image Design and Sharper Image branded products, particularly our air purification products. Average net sales per square foot for fiscal 2003 for all stores increased to $676 from $627 in fiscal 2002. Average net sales per square foot for our comparable store base for fiscal 2003 was $710. Average net sales per square foot is calculated by averaging over all stores the amount of each store's net sales divided by that store's total square footage under lease. Average revenue per transaction is calculated by dividing the amount of gross sales, exclusive of delivery revenue and sales taxes, per channel by the gross number of transactions in that channel. Comparable store sales is not a measure that has been defined under generally accepted accounting principles. We define comparable store sales as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 months. A store opened on or prior to the 15th of a month is treated as open for the entire month. Stores generally become comparable once they have 24 months of comparable sales for our annual calculation. We believe that 29 comparable store sales, which excludes the effect of a change in the number of stores open, provides a more useful measure of the performance of our store sales channel than does the absolute change in aggregate net store sales. Net catalog and direct marketing sales, which includes direct sales generated from catalog mailings, single product mailers, print advertising and television infomercials, for fiscal 2003 increased $10.5 million or 8.8%, from fiscal 2002. This increase was due primarily to a 24.7% increase in television infomercial advertising expense, a 26.1% increase in single product mailers circulated, and a 23.1% increase in The Sharper Image catalog pages circulated, which includes a 9.6% increase in The Sharper Image catalogs circulated. The increase in net catalog and direct marketing sales for fiscal 2003 reflects a 10.4% increase in transactions and a decrease of 0.2% in average revenue per transaction, compared to fiscal 2002. For fiscal 2003 and 2002, 29.4% and 29.9% of the net catalog and direct marketing sales were generated from television infomercial direct sales. We intend to continue our aggressive multimedia advertising programs during fiscal 2004 to attract new customers, while achieving a favorable return on advertising investment. Our goal is to achieve direct response sales resulting in near breakeven results on all direct marketing advertising initiatives. We continually review our advertising initiatives, including the pages and number of catalogs and single product mailers circulated, and the amount of and return on investment from television infomercial advertising, in our efforts to improve revenues from catalog and direct marketing advertising. Net Internet sales from our sharperimage.com Web site, which includes The Sharper Image and eBay auction sites, in fiscal 2003 increased $25.9 million, or 37.4%, from fiscal 2002. This increase was attributable primarily to a 120.3% increase in Internet advertising which includes paid for search engine key word placement and revenue share costs incurred for affiliate programs, a 34.4% increase in Internet transactions and a 1.9% increase in average revenue per transaction. During fiscal 2003, our Web site enhancements included the launch of our online gift registry, customer service site contents and navigation bar enhancements to highlight our online outlet store. We have also continued to improve the speed and efficiency of the processing and hardware capabilities. Net wholesale sales for fiscal year 2003 increased $9.5 million, or 54.2%, compared to fiscal 2002. The increase is attributable primarily due to increasing Sharper Image Design product sales to our existing wholesale customer base and to test programs with new wholesale customers. We believe that the wholesale business, pursued with select partners, will continue to strengthen our brand name and broaden our customer base. Cost of Products. Cost of products for fiscal 2003 increased $56.5 million, or 25.6%, from fiscal 2002. This increase is due primarily to the higher sales volume, partially offset by the lower relative cost of products for our Sharper Image Design and Sharper Image branded products. The gross margin rate for fiscal 2003 was 57.2%, or 0.1 percentage points higher, than the fiscal 2002 rate of 57.1%. The gross margin rate was adversely affected by delivery expense of $20.6 million in excess of delivery income collected of $17.1 million due primarily to the increase in single product mailers which offered free shipping when an order is placed and free shipping given on infomercial orders when a customer elects a single payment plan. Our gross margin rate fluctuates with changes in our merchandise mix, primarily Sharper Image Design and Sharper Image branded products, which changes as we make new items available in various categories or introduce new proprietary products. The variation in merchandise mix from category to category from year to year is characteristic of our sales results being driven by individual products rather than by general product lines. Additionally, the auction sites and other selected promotional activities, such as free 30 shipping offers, in part, tend to offset the rate of increase in our gross margin rate. Our gross margins may not be comparable to those of other retailers, since some retailers include the costs related to their distribution network in cost of products while we, and other retailers, exclude them from gross margin and include them instead in general, selling and administrative expenses. We cannot accurately predict future gross margin rates, although our goal is to continue to increase sales of Sharper Image Design and Sharper Image branded products to capitalize on the higher margins realized on these products. Buying and Occupancy. Buying and occupancy costs for fiscal 2003 increased $9.7 million, or 20.2%, from fiscal 2002. This increase reflects a full year of occupancy costs for the 20 new stores opened in fiscal 2002, the occupancy costs associated with the 25 new stores opened in fiscal 2003 and rent increases for some existing store locations, partially offset by five stores closed at lease maturity during fiscal 2003 and 2002. Buying and occupancy costs as a percentage of total revenues decreased to 9.0% in fiscal 2003 from 9.4% for fiscal 2002. In fiscal 2003, we opened a total of 25 new stores, exceeding our goal of a 15%-20% increase in the number of stores opened on an annual basis. Our goal is to continue to increase new store openings by 15%-20% in fiscal 2004 but we cannot assure you we will achieve this goal. Advertising. Advertising expenses for fiscal 2003 increased $26.0 million, or 26.7%, from fiscal 2002. The increase in advertising expense was attributable primarily to a 24.7% increase in television infomercial advertising expense and a 120.3% increase in Internet advertising, which includes search engine key word placement and revenue share costs incurred for affiliate programs. Also contributing to the increase in advertising is a 26.1% increase in the number of single product mailers circulated and a 23.1% increase in the number of Sharper Image catalog pages circulated, which includes a 9.6% increase in the number of Sharper Image catalogs circulated. During fiscal 2003, we continued our other multimedia advertising initiatives, which included radio, television and print advertising, among others. Although we believe these initiatives contributed to the increase in sales in the stores, catalog and direct marketing and Internet channels, there can be no assurance of the continued success of these advertising initiatives. During fiscal 2003, we increased the circulation of our single product mailer, which highlights our most popular Sharper Image Design products. We believe that the single product mailer will continue to extend our brand name by prospecting to future Sharper Image customers, at a reduced cost in comparison to mailing a Sharper Image catalog. We also increased our television media spending on infomercials highlighting selected Sharper Image Design and Sharper Image branded products and expanded our multimedia advertising initiatives of various print ads and radio. Advertising expenses as a percentage of total revenues remained constant at 19.0% for fiscal 2003 and fiscal 2002. Although there is a declining marginal benefit obtained by increasing advertising expenditures, we monitor the effectiveness of our advertising in order to achieve a reasonable overall return on our investment in advertising. We believe that expansion of all our advertising initiatives contributed to the sales increases for fiscal 2003 and increased brand awareness. Our advertising strategy will continue to be an important factor in our future revenue growth and as a result, we expect advertising costs to be higher in fiscal 2004 than in fiscal 2003. General, Selling and Administrative. General, selling and administrative, or GS&A, expenses for fiscal 2003 increased $25.9 million, or 21.5%, from fiscal 2002. Contributing to this increase was an increase of $12.5 million due primarily to variable expenses from increased net sales, which includes $9.5 million due to variable expenses from increased sales from all sales channels and $3.0 million due to variable expenses from increased sales and selling expenses related to the 25 new stores opened in fiscal 2003. Also contributing to the increase were increases of $1.6 million for health care and insurance, $3.0 million for 31 distribution center shipping costs incurred for product delivery to our stores, and $1.1 million related to professional fees. GS&A expenses for fiscal 2003 decreased as a percentage of total revenues to 22.6% from 23.5% in fiscal 2002 due to better leverage of fixed costs on an expanding sales base. GS&A costs were controlled as a result of our continual review of GS&A expenses and infrastructure. Other income (expense)- The increase in other income is primarily due to the interest income earned on higher investment balances generated from the proceeds from our public stock offering and improved operating results, offset by the write-off of fixed assets for store locations remodeled prior to the expiration of their existing lease. Income taxes. The effective tax rate was 41% for fiscal 2003 and 2002. Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, all expected future events then known to us are considered, other than changes in the tax law or rates. Year ended January 31, 2003 (fiscal 2002), compared to year ended January 31, 2002 (fiscal 2001) Revenues. Net sales for fiscal 2002 increased $122.6 million or 32.6%, from the prior fiscal year. Returns and allowances for fiscal 2002 were 12.0% of sales, as compared to 12.1% for fiscal 2001. The increase in net sales was attributable primarily to increases in net sales from stores of $63.0 million; from catalog and direct marketing of $33.1 million; from Internet operations of $19.9 million; and from wholesale of $6.6 million. The increase in total revenue for fiscal 2002, as compared to fiscal 2001 was due primarily to the popularity of our Sharper Image Design and Sharper Image branded products, which continues to be a key factor in the increases in net sales in all selling channels. Sharper Image Design and Sharper Image branded products increased to approximately 76% of total revenues in fiscal 2002 from approximately 70% for fiscal 2001. We believe that the continued development and introduction of new and popular products is a key strategic objective and important to our future success. Contributing to the increase in net sales was a comparable store sales increase of 13.6% over fiscal 2001 and the opening of 18 net new stores during fiscal 2002. We also believe that the increased investment in our advertising initiatives in fiscal 2002 and 2001, including the significant increase in television infomercial advertising and single product mailers, highlighting primarily selected Sharper Image Design and Sharper Image branded products, contributed to the higher revenues in all selling channels. We believe that fiscal 2001 revenues were adversely affected by the onset of the economic recession, the events of September 11, 2001 and subsequent anthrax scare, and a faster-than-expected end to the Razor Scooter fad which drove exceptional sales volumes in fiscal 2000. Net store sales for fiscal 2002 increased $63.0 million, or 27.3%, while comparable store sales increased by 13.6% from fiscal 2001. The increase in net store sales was attributable primarily to the opening of 20 new new stores during fiscal 2002, the increased sales of Sharper Image Design and Sharper Image branded products, the 13.6% increase in comparable store sales, and the increased television infomercial and single product mailer advertising, partially offset by the closing of two stores at lease maturity. The opening of 18 net new stores resulted in an incremental increase to net store sales of $22.9 million from the prior fiscal year. Total store transactions for fiscal 2002 increased 16.0% and average revenue per transaction increased 8.5%, compared with fiscal 2001. The increase in average revenue per transaction was attributable 32 primarily to the overall product mix offered, multimedia advertising strategies, including infomercial advertising which highlighted products with retail prices which are higher than our average in the prior year, and the increased sales of Sharper Image Design and Sharper Image branded products, particularly our air purification products. Average net sales per square foot for fiscal 2002 increased to $627 from $578 in fiscal 2001. Average net sales per square foot is calculated by averaging over all stores the amount of each store's net sales divided by that store's square footage under lease. Average revenue per transaction is calculated by dividing the amount of gross sales, exclusive of delivery revenue and sales taxes, per channel by the gross number of transactions in that channel. Net catalog and direct marketing sales, which includes sales generated from catalog mailings, single product mailers, print advertising and television infomercials, for fiscal 2002 increased $33.1 million or 38.9%, from fiscal 2001. This increase was due primarily to a 44.4% increase in television infomercial advertising expense, a 264.6% increase in single product mailers circulated, and a 20.8% increase in The Sharper Image catalog pages circulated, which includes a 10.9% increase in The Sharper Image catalogs circulated. The increase in net catalog and direct marketing sales for fiscal 2002 reflects a 21.8% increase in transactions and an increase of 14.5% in average revenue per transaction, compared to fiscal 2001. Net Internet sales from our sharperimage.com Web site, which includes The Sharper Image auction site, in fiscal 2002 increased $19.9 million, or 40.2%, from fiscal 2001. This increase was attributable primarily to a 47.0% increase in Internet advertising, a 24.4% increase in Internet transactions and a 14.2% increase in average revenue per transaction. Excluding auction sales for these periods, net Internet sales increased 53.4%, transactions increased 34.4% and average revenue per transaction increased 15.8%. We believe the decrease in auction sales for fiscal 2002 compared to fiscal 2001 was attributable primarily to our decision to raise bid prices during late fiscal 2001 and to reduce the number of products offered on our auction site, which resulted in an improved gross margin rate and gross margin dollars from auctions. We continue to utilize the auction site to increase our Internet business, broaden our customer base and manage inventories, including closeouts, repackaged and reconditioned items. Net wholesale sales for fiscal year 2002 increased $6.6 million, or 60.7%, compared to fiscal 2001. The increase is attributable primarily to a strategic wholesale marketing arrangement we tested with Circuit City Stores. The arrangement with Circuit City Stores initially allowed for the showcase and testing of a select assortment of Sharper Image Design and Sharper Image branded products on large dedicated fixtures in over 600 Circuit City Superstores. We will continue to evaluate this wholesale marketing arrangement in fiscal 2003. Cost of Products. Cost of products for fiscal 2002 increased $38.1 million, or 20.9%, from fiscal 2001. This increase is due primarily to the higher sales volume, partially offset by the lower relative cost of products for our Sharper Image Design and Sharper Image branded products. The gross margin rate for fiscal 2002 was 57.1%, or 4.0 percentage points higher, than the fiscal 2001 rate of 53.1%. This increase was due primarily to increased sales of Sharper Image Design and Sharper Image branded products, which generally carry higher margins than third party branded products. Sharper Image Design and Sharper Image branded products as a percentage of total revenues, exclusive of net wholesale sales, increased to approximately 76% for fiscal 2002, as compared to approximately 70% for fiscal 2001. We believe that our gross margin for fiscal 2002 was negatively affected by the labor dispute between the Pacific Maritime Association, or PMA, and the International Longshore and Warehouse Union, or ILWU, whose members are primarily responsible for the removal of cargo from container loaded shipping vessels in West Coast U.S. ports. In response to the 10-day lockout by the PMA in October 2002 and drop in productivity during the subsequent months, we increased usage of airfreight transportation, which 33 adversely affected our gross margins for the third and to a greater extent the fourth quarters of fiscal 2002. Buying and Occupancy. Buying and occupancy costs for fiscal 2002 increased $8.3 million, or 20.8%, from fiscal 2001. This increase reflects a full year of occupancy costs for the 14 new stores opened in fiscal 2001, the occupancy costs associated with the 20 new stores and one temporary store opened in fiscal 2002 and rent increases for some existing store locations, partially offset by two stores closed at lease maturity during fiscal 2002. Buying and occupancy costs as a percentage of total revenues decreased to 9.4% in fiscal 2002 from 10.2% for fiscal 2001. In fiscal 2002, we opened a total of 20 new stores, exceeding our goal of a 10%-15% increase in the number of stores opened on an annual basis. Advertising. Advertising expenses for fiscal 2002 increased $28.9 million, or 42.2%, from fiscal 2001. The increase in advertising expense was attributable primarily to a 44.4% increase in television infomercial advertising expense, a 264.6% increase in the number of single product mailers circulated, and a 20.8% increase in the number of Sharper Image catalog pages circulated, which included a 10.9% increase in the number of The Sharper Image catalogs circulated. During fiscal 2002, we continued our other multimedia advertising initiatives, which included radio, television and print advertising, among others. The higher cost of postage on various direct marketing mailers, including the catalog and single product mailers, contributed to advertising cost increases although these increases were partially offset by the savings from lower paper costs during fiscal 2002. Advertising expenses as a percentage of total revenues increased to 19.0% in fiscal 2002 from 17.6% in fiscal 2001. General, Selling and Administrative. General, selling and administrative, or GS&A, expenses for fiscal 2002 increased $24.1 million, or 25.0%, from fiscal 2001. Contributing to this increase was an increase of $5.4 million due primarily to variable expenses from increased net sales and selling expenses related to the 20 new stores opened during fiscal 2002, and the annualized selling expenses related to the 14 stores opened in fiscal 2001, partially offset by the reduced selling expenses of two stores closed at lease maturity during fiscal 2002. Also contributing to the increase were increases of $3.3 million for distribution shipping costs incurred for product delivery to our stores (which primarily reflects additional airfreight costs incurred in connection with the West Coast Port Strike), $2.5 million related to technological system enhancements made in our operational areas and $1.1 million due to increases in health benefits and company-wide insurance premiums. GS&A expenses for fiscal 2002 decreased as a percentage of total revenues to 23.5% from 24.8% in fiscal 2001. The decline in the GS&A percentage is the result of our continual review of GS&A expenses and infrastructure combined with better leverage of fixed costs on an expanding sales base. Other income (expense)- The decrease in other income is due to a reduction in the interest rate earned on invested balances, an increase in interest expense incurred on the early payoff of our mortgage loan, partially offset by a reduction in losses on the disposal of assets. Liquidity and capital resources We met our short-term liquidity needs and our capital requirements during fiscal 2003 with cash generated from operations, trade credits, existing cash balances and proceeds from a public offering of our common stock. Net cash provided by operating activities totaled $21.1 million for fiscal 2003, as compared to $37.0 million for fiscal 2002. The fiscal 2003 net cash provided by operating activities decreased $15.9 million compared to fiscal 2002, is due primarily to the increased merchandise inventory levels required as a result of the 25 new stores opened during fiscal 2003, the timing of the receipt of imported products due to Chinese New 34 Years when many factories overseas close for up to three weeks, and the inventory we believe necessary to sustain our current sales growth trends. The comparable decrease was also due to the increase in accounts receivable balances and decreases in accounts payable. Partially offsetting the comparable decrease in net cash provided by operating activities was the increase in net earnings from fiscal 2003 over 2002. Net cash used in investing activities, primarily capital expenditures for new and remodeled stores, technological enhancements, tooling costs for Sharper Image Design products and the expansion of our distribution facilities totaled $35.2 million in fiscal 2003 compared to $23.2 million in fiscal 2002. In fiscal 2003, we opened 25 new stores and remodeled six stores. In fiscal 2002, we opened 20 new stores and remodeled six stores. Net cash provided by financing activities totaled $41.9 million during fiscal 2003, which was the result of $38.5 million in net proceeds from the public offering of our common stock in May 2003, and, $4.2 million in proceeds from the issuance of common stock in connection with our stock option plan, offset partially by $0.8 million in financing fees. On October 31, 2003, we terminated our secured credit facility and entered into a new revolving secured credit facility with Wells Fargo Bank, National Association. The new credit facility has a maturity date of October 31, 2006, and will allow borrowings and letters of credit up to a maximum of $50 million at all times during the year, with a "borrowing base" determined by inventory levels and specified accounts receivable. The new credit facility is secured by our inventory, accounts receivable, accounts and specified other assets. Borrowings under the new credit facility bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo's prime rate less 0.25%. The new credit facility contains financial covenants that only apply during an event of default or when the borrowing base falls below a specified level. These financial covenants require us to maintain a minimum EBITDA (as defined) of $35 million and to maintain capital expenditures below a specified level based on our projections. The new credit facility contains limitations on incurring additional indebtedness, making additional investments and permitting a change of control. As of January 31, 2004, letter of credit commitments outstanding under the new credit facility were $4.2 million, which includes a $2.9 million backstop letter of credit to cover credit commitments outstanding under our old secured credit facility. The table below presents our significant commercial credit facilities and their associated expiration dates. ($ in millions) Maximum Amount of Commitment expiration Per Period ------------------------------------------------------------------------------ Maximum Commercial Commitments Less than 1 Year 1-3 Years Total Amount Committed -------------------------------------------------- ---------- ------------ Revolving Credit Facility $0.0 $50.0 $50.0 ------------------ ---------- ------------ Total Commercial Commitment $0.0 $50.0 $50.0 ================== ========== ============ *This represents the maximum commitment under the revolving credit facility. It includes limits of $35 million for letters of credit. 35 As of January 31, 2003, we paid off the mortgage loan collateralized by our Little Rock, Arkansas distribution center. This note reflected a fixed interest rate of 8.40%, provided for monthly payments of principal and interest in the amount of $29,367 and was scheduled to mature in January 2011. The table below presents our significant contractual obligations at January 31, 2004.
$ in millions Less 1-3 4-5 After 5 Total Contractual Obligations than 1 Years Years Years Year ------------------------------------ ---------- ----------- ----------- ----------- ------------ Revolving Credit Facility $4.2 - - - $4.2 Letters of Credit Operating Leases (1) 30.4 $52.9 $44.2 $75.4 202.9 Purchase Obligations (2) 59.0 - - - 59.0 ---------- ----------- ----------- ----------- ------------ Total Contractual Cash Obligations $93.6 $52.9 $44.2 $75.4 $266.1 ========== =========== =========== =========== ============
(1) The Company's operating leases are described in Note F of the Notes to the Financial Statements. (2) As of January 31, 2004, the Company had $59 million of outstanding purchase orders, which were primarily related to orders for general merchandise inventories. Such purchase orders are generally cancelable at the discretion of the Company until the order has been shipped. The table above excludes certain immaterial executory contract for goods and serves that tend to be recurring in nature and similar in amount year after year. For fiscal 2004, we plan to continue our accelerated new store unit growth goal with a 15% to 20% increase target in the number of stores on an annual basis and to remodel five to 10 of our existing store locations. We plan to continue our capital investment in tooling costs for proprietary products and to further expand our infrastructure through exercising our lease options to increase our distribution center capabilities and continue our enhancement of our technological systems. We believe that our total capital expenditures for fiscal 2004 will be approximately $35 million to $40 million. Absent unfavorable economic conditions or deviations from projected demand for our products, particularly during the fourth quarter, we expect to achieve positive cash flow from operations on an annual basis, although we likely will need to finance holiday and new-store increases in inventories through trade credits and our credit facility. We believe we will be able to fund our capital expenditures for new and remodeled stores, technological enhancements and tooling costs for Sharper Image Design products through existing cash balances, cash generated from operations, trade credits, and, as necessary, our credit facility. New accounting pronouncements In December 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 46(R) "Consolidation of Variable Interest Entities." FIN 46(R) replaces FIN 46 and addresses consolidation by business enterprises of variable interest entities. The provisions of FIN 46(R) are effective for the first reporting period that ends after December 15, 2003 for variable interests in those entities commonly referred to as special-purpose entities. Application of the provisions of FIN 46(R) for all other entities is effective for the first reporting period ending after March 15, 2004. The Company has no interest in any entity considered a special purpose entity. The Company believes the adoption of the provisions of FIN 46(R) in the first quarter of 2004 will have no impact on net earnings, cash flows or financial position. 36 Uncertainties and risks This discussion and analysis should be read in conjunction with our financial statements and notes thereto. This discussion contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in these forward-looking statements. These risks and uncertainties include, without limitation, risks of changing market conditions in the overall economy and the retail industry, consumer demand, the opening of new stores, actual advertising expenditures by us, the success of our advertising and merchandising strategy, availability of products, and other factors detailed from time to time in our annual and other reports filed with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligations to publicly release any revisions to these forward-looking statements or reflect events or circumstances after the date of this report. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Quantitative and qualitative disclosure about market risk We are exposed to market risks, which include changes in interest rates and, to a lesser extent, foreign exchange rates. We do not engage in financial transactions for trading or speculative purposes. The interest payable on our credit facility is based on variable interest rates and therefore affected by changes in market interest rates. If interest rates on existing variable rate debt increased .4% (10% from the bank's reference rate) as of January 31, 2004 our results from operations and cash flows would not have been materially affected. In addition, we have fixed and variable income investments consisting of cash equivalents and short-term investments, which are also affected by changes in market interest rates. We do not use derivative financial instruments in our investment portfolio. We enter into a significant amount of purchase obligations outside of the United States, which are settled in U.S. dollars and, therefore, have only minimal exposure to foreign currency exchange risks. We do not hedge against foreign currency risks and believe that foreign currency exchange risk is immaterial. 37 Item 8. Financial Statements and Supplementary Data Board of Directors and Stockholders Sharper Image Corporation San Francisco, California We have audited the accompanying balance sheets of Sharper Image Corporation as of January 31, 2004 and 2003, and the related statements of operations, stockholders' equity and cash flows for each of the three fiscal years in the period ended January 31, 2004. 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. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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, such financial statements present fairly, in all material respects, the financial position of Sharper Image Corporation as of January 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three fiscal years in the period ended January 31, 2004 in conformity with accounting principles generally accepted in the United States of America. /s/ Deloitte & Touche LLP San Francisco, California April 12, 2004 38 Sharper Image Corporation Balance Sheets
January 31, January 31, (Dollars in thousands, except per share amounts) 2004 2003 -------- -------- Assets Current assets: Cash and equivalents $ 83,471 $ 55,633 Accounts receivable, net of allowance for doubtful accounts of $1,266 and $967 21,196 12,597 Merchandise inventories 110,058 74,756 Prepaid expenses, deferred taxes and other 20,303 15,527 -------- -------- Total current assets 235,028 158,513 Property and equipment, net 70,190 52,165 Deferred catalog costs and other assets 4,337 3,749 -------- -------- Total assets $309,555 $214,427 ======== ======== Liabilities and stockholders' equity Current liabilities: Accounts payable $ 23,434 $ 26,597 Accrued expenses 16,126 14,996 Accrued compensation 11,793 8,614 Reserve for refunds 17,161 12,498 Deferred revenue 25,781 19,113 Income taxes payable 9,399 6,472 -------- -------- Total current liabilities 103,694 88,290 Deferred taxes and other liabilities 15,935 8,753 Commitments and contingencies -- -- -------- -------- Total liabilities 119,629 97,043 Stockholders' equity: Preferred stock, $0.01 par value: Authorized, 3,000,000 shares: Issued and outstanding, none -- -- Common stock, $0.01 par value: Authorized, 25,000,000 shares: Issued and outstanding, 15,322,635, and 12,638,952 shares 153 126 Additional paid-in capital 97,211 49,950 Retained earnings 92,562 67,308 -------- -------- Total stockholders' equity 189,926 117,384 -------- -------- Total liabilities and stockholders' equity $309,555 $214,427 ======== ========
See notes to financial statements. 39 Sharper Image Corporation Statements of Operations
Fiscal Year Ended January 31, ----------------------------- 2004 2003 2002 (Dollars in thousands, except per share amounts) (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------ ------------ ------------ Revenues: Net sales $ 630,084 $ 498,702 $ 376,128 Delivery 17,050 14,090 11,992 List rental and licensing 377 977 985 ------------ ------------ ------------ 647,511 513,769 389,105 ------------ ------------ ------------ Costs and expenses: Cost of products 277,043 220,519 182,436 Buying and occupancy 57,918 48,185 39,901 Advertising 123,339 97,360 68,479 General, selling, and administrative 146,465 120,556 96,464 ------------ ------------ ------------ 604,765 486,620 387,280 ------------ ------------ ------------ Other income (expense): Interest income 785 367 702 Interest expense (291) (465) (355) Other income -- 1 99 Other expense (437) (96) (393) ------------ ------------ ------------ 57 (193) 53 ------------ ------------ ------------ Earnings before income tax expense 42,803 26,956 1,878 Income tax expense 17,549 11,049 751 ------------ ------------ ------------ Net earnings $ 25,254 $ 15,907 $ 1,127 ============ ============ ============ Earnings per common equivalent share: Basic $ 1.75 $ 1.29 $ 0.09 ============ ============ ============ Diluted $ 1.65 $ 1.21 $ 0.09 ============ ============ ============ Weighted average shares used in the computation of earnings per common equivalent share: Basic 14,446,128 12,327,157 11,904,562 Diluted 15,333,235 13,182,050 12,302,852
See notes to financial statements. 40 Sharper Image Corporation Statements of Stockholders' Equity
Additional Common Stock Paid-in Retained (Dollars in thousands) Shares Amount Capital Earnings Total ----------- ----------- ----------- ----------- ----------- Balance at February 1, 2001 11,961,911 $ 120 $ 42,697 $ 50,274 $ 93,091 Issuance of common stock for stock options exercised (including income tax benefit) 108,773 1 872 873 Repurchase of common stock (100,000) (1) (987) (988) Net earnings 1,127 1,127 ----------- ----------- ----------- ----------- ----------- Balance at January 31, 2002 11,970,684 120 42,582 51,401 94,103 Issuance of common stock for stock options exercised (including income tax benefit) 668,268 6 7,368 7,374 Net earnings 15,907 15,907 ----------- ----------- ----------- ----------- ----------- Balance at January 31, 2003 12,638,952 126 49,950 67,308 117,384 Issuance of common stock for stock options exercised (including income tax benefit) 546,259 6 8,767 8,773 Issuance of common stock due to stock follow-on offering (net of expenses) 2,137,424 21 38,494 38,515 Net earnings 25,254 25,254 ----------- ----------- ----------- ----------- ----------- Balance at January 31, 2004 15,322,635 $ 153 $ 97,211 $ 92,562 $ 189,926 =========== =========== =========== =========== ===========
See notes to financial statements. 41 Sharper Image Corporation Statements of Cash Flows
Fiscal Year Ended January 31, ----------------------------- 2004 2003 2002 (Dollars in thousands) (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) -------- -------- -------- Cash provided by (used for) operating activities: Net earnings $ 25,254 $ 15,907 $ 1,127 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 16,426 15,456 11,560 Tax benefit from stock option exercises 4,622 3,733 209 Deferred rent expenses and landlord allowances 361 279 332 Deferred income taxes 399 (2,331) (123) Loss on disposal of equipment 744 94 395 Change in operating assets and liabilities: Accounts receivable (8,599) (4,499) 1,624 Merchandise inventories (35,302) (24,075) 11,905 Prepaid catalog costs, prepaid expenses and other (2,575) 2,577 (24) Accounts payable, reserve for refunds and accrued expenses 5,809 20,932 (13,242) Deferred revenue, taxes payable and other liabilities 13,998 8,908 (4,609) -------- -------- -------- Cash provided by operating activities 21,137 36,981 9,154 -------- -------- -------- Cash provided by (used for) investing activities: Property and equipment expenditures (35,195) (23,199) (20,284) Proceeds from sale of equipment -- -- 11 -------- -------- -------- Cash used for investing activities (35,195) (23,199) (20,273) -------- -------- -------- Cash provided by (used for) financing activities: Proceeds from issuance of common stock upon exercise of stock options 4,151 3,641 664 Repurchase of common stock -- -- (988) Payments made for financing fees (770) -- -- Proceeds from notes payable and revolving credit facility -- 19,000 15,625 Principal payments on notes payable and revolving credit facility -- (21,207) (15,784) Proceeds from issuance of common stock due to follow-on stock offering, net of expenses 38,515 -- -- -------- -------- -------- Cash provided by (used for) financing activities 41,896 1,434 (483) -------- -------- -------- Net increase (decrease) in cash and equivalents 27,838 15,216 (11,602) Cash and equivalents at beginning of period 55,633 40,417 52,019 -------- -------- -------- Cash and equivalents at end of period $ 83,471 $ 55,633 $ 40,417 ======== ======== ======== Supplemental disclosure of cash paid for: Interest expense $ 131 $ 456 $ 349 Income taxes $ 9,615 $ 743 $ 8,991
See notes to financial statements. 42 Sharper Image Corporation Notes to financial statements Note A--Summary of significant accounting policies Sharper Image Corporation (the "Company") is a leading specialty retailer that introduces and sells quality, innovative and entertaining products. These products are sold through its retail stores, catalogs (which includes other sources of direct marketing such as single product mailers, television infomercials, radio and newspapers), and over the Internet. The Company also markets to other businesses through its corporate sales and wholesale operations. Accounting Estimates: The preparation of 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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company's significant accounting judgments and estimates include depreciable lives of long-lived assets, long-lived asset impairment, reserves on inventory and sales return reserve. Revenue Recognition: The Company recognizes revenue at the point of sale at its retail stores and at the time of customer receipt for its catalog and direct marketing sales, including the Internet. The Company recognizes revenue for sales to resellers of sales made on a wholesale basis when the products are shipped, which is the time title passes to the purchaser. The Company records estimated reductions to revenue for customer returns based upon historical return rates. Revenues are recorded net of sale discounts and other rebates and incentives offered to customers. Deferred revenue represents merchandise certificates gift cards and rewards cards outstanding and merchandise that is still in the delivery process at the end of the fiscal period. Delivery revenue is recognized at the commencement of delivery to customers. Cost of Products: Cost of products includes total cost of products sold, inventory shrink, letter of credit fees, inventory write-downs, inbound freight costs, costs to refurbish products for resale, inspection costs, cost of customer accommodations and promotions and costs to deliver product to customers. Buying and Occupancy: Buying and occupancy includes salaries for merchandise buyers, occupancy costs for all store locations and distribution facilities including rent, utilities, real estate taxes, common area maintenance, repairs and maintenance, depreciation on leasehold improvements and fixtures, janitorial services and waste removal. General, Selling and Administrative: General, selling and administrative includes all costs related to sales associates, including payroll and benefits, all corporate personnel cost, including payroll and benefits, supplies, store signs, credit card fees, third party fees including telemarketing expenses, Internet hosting charges, telephone-related to the corporate offices, toll free phone numbers for catalog and other direct marketing orders, freight charges related to delivery of product from distribution centers to stores and between distribution centers, purchasing and receiving costs, warehouse costs, corporate insurance, depreciation on corporate assets such as computers and distribution center facilities, bad debt expense, check guarantee fees and professional fees. Start-up Activities: All start-up and pre-opening costs are expensed as incurred. Deferred Catalog and Advertising Costs: Direct costs incurred for the production and distribution of catalogs are capitalized and amortized, once the catalog is mailed, over the expected sales period, which does not exceed three months. Other advertising costs are expensed as incurred and amounted to $80.7 43 million, $60.0 million and $35.3 million for the fiscal years ended January 31, 2004, 2003, and 2002, respectively. Fair Value of Financial Instruments: The carrying value of cash, accounts receivable, accounts payable and notes payable approximates their estimated fair value. Cash and Equivalents: Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less. Receivables from banks related to debit and credit cards are shown in accounts receivable and totaled $5.8 million and $2.8 million at January 31, 2004 and 2003, respectively. Merchandise Inventories: Merchandise inventories are stated at lower of cost (first-in, first-out method) or market. The Company reduces the carrying value of its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. Property and Equipment: Property and equipment are stated at cost net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the various assets which range from three to 10 years for office furniture and equipment and transportation equipment, and 40 years for buildings. Leasehold improvements are amortized using the straight-line method over the lesser of their estimated useful lives or the term of the applicable leases, which range from seven to 18 years. The Company designs and produces its own proprietary products for sale. External costs incurred for tooling, dies, patents and trademarks are capitalized and amortized over the estimated life of these products, which is generally two years. At January 31, 2004, and 2003, capitalized costs included in property and equipment, net of related amortization, were $3.4 million and $2.8 million, respectively. Costs incurred in the development of the Internet Web site and enhancements to the Company's information infrastructure are capitalized once the preliminary project stage is completed and management authorizes and commits to funding a computer software project and it is probable that the project will be completed and the software will be used to perform the function intended. Costs incurred for training and ongoing maintenance are expensed as incurred. The Company reviews its long-lived assets, including identifiable intangible assets, whenever events or changes indicate the carrying amount of such assets may not be recoverable. The Company's policy is to review the recoverability of all assets, at a minimum, on an annual basis. Based on the Company's review at January 31, 2004 and 2003, no material adjustments were made to long-lived assets. Income Taxes: Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events then known to management that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, all expected future events then known to management are considered other than changes in the tax law or rates. Store Closure Reserves - Prior to January 1, 2003, the Company recorded the estimated costs associated with closing a store during the period in which the store was identified and approved by management under a plan of termination, which included the method of disposition and the expected date of completion. These costs include direct costs to terminate a lease, lease rental payments net of expected sublease income, and the difference between the carrying values and estimated recoverable values of long-lived tangible and intangible assets. Severance and other employee-related costs were recorded in the 44 period in which the closure and related severance packages were communicated to the affected employees. No such reserves were provided for the reporting periods presented. Effective with the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, on January 1, 2003, the Company recognizes a liability for costs associated with closing a store when the liability is incurred. The present value of expected future lease costs and other closure costs is recorded when the store is closed. Severance and other employee-related costs are recorded in the period in which the closure and related severance packages are communicated to the affected employees. Accretion of the discounted present value of expected future costs is recorded in operations. Store closure reserves are reviewed and adjusted periodically based on changes in estimates. No such reserves are recorded at January 31, 2004 and 2003. Accounts Payable: Accounts payable represents amounts owed to third parties at the end of the period. Deferred Rent. When a lease requires fixed escalations of the minimum lease payments, rental expense is recorded on a straight-line basis and the difference between the average rental amount charged to expense and the amount payable under the lease is recorded as deferred rent. At January 31, 2004 and 2003, the balance of deferred rent was $4.4 million and $3.6 million, respectively, and is included in long-term liabilities on the accompanying balance sheet. Derivative Instruments and Hedging Activities. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, requires the Company to record all derivatives as either assets or liabilities on the balance sheet and to measure those instruments at fair value. The Company did not hold or trade any derivative instruments in 2003, 2002 or 2001. Stock-Based Compensation - The Company has one stock-based employee compensation plan, as described in Note G. The Company accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees. No compensation expense is recognized for employee stock options, because it is the Company's practice to grant stock options with an exercise price equal to the market price of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to all stock-based employee compensation:
Fiscal year ended January 31, -------------------------------------------------------------------- Dollars in thousands, except per share amounts 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) --------------------- -------------------- ----------------------- Net income, as reported $25,254 $15,907 $1,127 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,006) (1,539) (1,098) ------- ------- ------ Pro forma net income $23,248 $14,368 $29 ======= ======= ====== Basic earnings per share: As reported $1.75 $1.29 $0.09 Pro forma $1.61 $1.17 $0.00 Diluted earnings per share: As reported $1.65 $1.21 $0.09 Pro forma $1.52 $1.09 $0.00
45 The Company estimates the fair value of stock option grants using the Black-Scholes option pricing model, with the following weighted average assumptions: Fiscal year ended January 31, ------------------------------------------------------ 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------- ------------- ------------- Dividend yield -- -- -- Expected volatility 52% 59% 37% Risk-free interest rate 3.12% 1.81% 4.09% Expected life (years) 5 5 5 Earnings Per Share - Basic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing net income by the weighted average number of common shares and dilutive common equivalent shares (stock options) outstanding during the period. The following is a reconciliation of the number of shares used in the Company's basic and diluted earnings per share computations:
Fiscal year ended January 31, ----------------------------------------------------- 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ---------- ---------- ---------- Basic weighted average number of shares outstanding 14,446,128 12,327,157 11,904,562 Application of treasury stock method on stock options outstanding: Assumed options exercised due to exercise price being less than average market price, net of assumed stock repurchases 887,107 854,893 398,290 ---------- ---------- ---------- Diluted weighted average number of shares outstanding 15,333,235 13,182,050 12,302,852 ========== ========== ==========
The computations of diluted earnings per share in fiscal 2003, 2002 and 2001 exclude 31,100, 51,850 and 303,500 stock options, respectively, because their exercise price exceeded the average market price for the period and thus, their effect would have been anti-dilutive. Comprehensive Income: Comprehensive income consists of net earnings or loss for the current period and other comprehensive income (income, expenses, gains and losses that currently bypass the income statement and are reported directly as a separate component of equity). Comprehensive income does not differ from net earnings for the Company for the years ended January 31, 2004, 2003 and 2002. New Accounting Pronouncements: In December 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 46(R) "Consolidation of Variable Interest Entities." FIN 46(R) replaces FIN 46 and addresses 46 consolidation by business enterprises of variable interest entities. The provisions of FIN 46(R) are effective for the first reporting period that ends after December 15, 2003 for variable interests in those entities commonly referred to as special-purpose entities. Application of the provisions of FIN 46(R) for all other entities is effective for the first reporting period ending after March 15, 2004. The Company has no interest in any entity considered a special purpose entity. The Company believes the adoption of the provisions of FIN 46(R) in the first quarter of 2004 will have no impact on net earnings, cash flows or financial position. Reclassification: Certain reclassifications were made to prior years' financial statements in order to conform to the classifications of the January 31, 2004 financials statements. Note B--Property and equipment Property and equipment is summarized as follows: January 31, --------------------- (Dollars in thousands) 2004 2003 -------- -------- Leasehold improvements $ 37,885 $ 33,032 Furniture, fixtures and equipment and other capitalized costs 110,126 86,240 Land 53 53 Building 2,874 2,874 -------- -------- 150,938 122,199 Less accumulated depreciation and amortization 80,748 70,034 -------- -------- $ 70,190 $ 52,165 ======== ======== Note C--Other assets The Company had an agreement to advance the premiums on a split-dollar life insurance policy for its Founder, Chairman and Chief Executive Officer, which was terminated during fiscal 2003. The Company had an interest in the insurance benefits equal to the amount of the premiums advanced. The amount receivable for premiums advanced as of January 31, 2003 was $2.1 million. Upon termination of the agreement in fiscal 2003, the Company was reimbursed for all premiums paid. As of January 31, 2004, the balance in other assets is comprised of investments and deferred financing costs. Note D--Revolving loan and notes payable On October 31, 2003, the Company terminated its secured credit facility and entered into a new revolving secured credit facility with Wells Fargo Bank, National Association. The new credit facility has a maturity date of October 31, 2006, and will allow borrowings and letters of credit up to a maximum of $50 million at all times during the year, with a "borrowing base" determined by inventory levels and specified accounts receivable. The new credit facility is secured by the Company's inventory, accounts receivable, accounts and specified other assets. Borrowings under the new credit facility bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo's prime rate less 0.25%. The new credit facility contains financial covenants that only apply during an event of default or when the borrowing base falls below a specified level. These financial covenants require the Company to maintain a minimum EBITDA (as defined) of $35 million and to maintain capital expenditures below a specified level based on the Company's projections. The new credit facility contains limitations on incurring additional indebtedness, making additional investments and permitting a change of control. As of January 31, 2004, letter of credit 47 commitments outstanding under the new credit facility were $4.2 million, which includes a $2.9 million backstop letter of credit to cover credit commitments outstanding under the Company's old secured credit facility. As of January 31, 2003, letter of credit commitments outstanding under the previous secured credit facility were $2.1 million. There were no direct borrowings under the credit facilities during fiscal 2003 and 2002. The weighted average interest rate incurred on the revolving credit facility was 4.10% and 4.75% for fiscal 2003 and 2002, respectively. Note E--Income taxes Fiscal year ended January 31, ----------------------------- 2004 2003 2002 (Dollars in thousands) (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) -------- -------- -------- Current: Federal $ 14,640 $ 11,422 $ 746 State 2,510 1,958 128 -------- -------- -------- 17,150 13,380 874 -------- -------- -------- Deferred: Federal 340 (1,990) (105) State 59 (341) (18) -------- -------- -------- 399 (2,331) (123) -------- -------- -------- $ 17,549 $ 11,049 $ 751 ======== ======== ======== The difference between the effective income tax rate and the United States federal income tax rate is summarized as follows:
Fiscal year ended January 31, ----------------------------- 2004 2003 2002 (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------- ------------- ------------- Federal tax rate 35.0% 35.0% 35.0% State income tax, less federal benefit 6.0 6.0 6.0 Other -- -- (1.0) ---- ---- ---- Effective tax rate 41.0% 41.0% 40.0% ==== ==== ====
48 Deferred taxes result from differences in the recognition of expense for income tax and financial reporting purposes. The principal components of deferred tax assets (liabilities) are as follows:
January 31, ----------- 2004 2003 ------------------------- -------------------------- Deferred Deferred Deferred Deferred Tax Tax Tax Tax Assets Liabilities Assets Liabilities ------- ------- ------- ------- Current: Nondeductible reserves $14,654 $11,973 Deferred catalog costs $ 1,384 $ 1,131 State taxes 2,674 2,265 ------- ------- ------- ------- Current 14,654 4,058 11,973 3,396 ------- ------- ------- ------- Noncurrent: Deferred rent 1,761 1,432 Depreciation 762 3,135 Deductible software costs 5,596 4,314 Other 59 967 ------- ------- ------- ------- Noncurrent 2,523 5,655 4,567 5,281 ------- ------- ------- ------- Total $17,177 $ 9,713 $16,540 $ 8,677 ======= ======= ======= =======
Note F--Leases The Company leases retail facilities, offices, and equipment under operating leases for terms expiring at various dates through 2017. Under the terms of certain of the leases, rents are adjusted annually for changes in the consumer price index and increases in property taxes. The aggregate minimum annual lease payments under leases in effect at January 31, 2004, are as follows: (Dollars in thousands) Fiscal year ending January 31, 2005 $30,363 2006 28,627 2007 24,317 2008 22,703 2009 21,471 Later years 75,385 --------- Total minimum lease commitments $202,866 ========= Many of the Company's leases contain predetermined fixed escalations of the minimum rentals during the initial term. For these leases, the Company has recognized the related rental expense on a straight-line basis and has recorded the difference between the expense charged to income and amounts 49 payable under the leases as deferred rent, which is included in Deferred Taxes and Other Liabilities on the accompanying balance sheet. Total minimum rent to be received by the Company from non-cancelable sublease agreements through 2005 is approximately $269,000 as of January 31, 2004, which has not been netted against the above amounts. Some store leases contain renewal options for periods ranging up to five years. Most leases also provide for payment of operating expenses, real estate taxes and for additional rent based on a percentage of sales. Rental expense for all operating leases was as follows:
Fiscal year ended January 31, ----------------------------- 2004 2003 2002 (Dollars in thousands) (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) ------------------ ------------------ ------------------- Minimum rentals $30,108 $25,999 $22,941 Percentage rentals and other charges 12,286 10,448 8,436 ------- ------- ------- $42,394 $36,447 $31,377 ======= ======= =======
Note G--Stockholders' equity On May 7, 2003, the Company completed a public offering of its common stock in which it sold 1.9 million shares at a price to the public of $19.50. On May 13, 2003, the Company closed the sale of an additional 237,424 shares of common stock subject to the underwriters' over-allotment option. The Company received proceeds from the public offering of $38.5 million, net of underwriters' discount and offering expenses. During fiscal 2000, the Company adopted the 2000 Stock Incentive Plan. The Stock Incentive Plan combines the 1985 Stock Option Plan, as amended, and the 1994 Non-Employee Director Stock Option Plan, as amended, into a single comprehensive equity incentive plan. The 2000 Stock Incentive Plan is divided into four separate equity incentive programs and will allow the issuance of non-qualified options to key employees, non-employee Board members and consultants up to an initial aggregate of 3,147,107 shares. An automatic increase of shares available for issuance will occur on the first trading day of each fiscal year, beginning with fiscal 2001, by an amount equal to 3% of the total number of shares of common stock outstanding on the last trading day of the immediately preceding fiscal year. In no event will the annual increase exceed 500,000 shares. Options issued to key employees and consultants will generally vest over a four- to six-year period from the date of the grant and are priced at 100% of the fair market value at the date of the grant. Options issued to non-employee Board members will be immediately exercisable, vest over one year of board service from the date of the grant and are priced at 100% of the fair market value at the date of the grant. Any shares purchased under the option plan will be subject to repurchase by the Company at the exercise price paid per share, upon the optionee's cessation of Board service prior to vesting. 50 The following table reflects the activity under this plan:
Weighted Number of average options exercise price --------- -------------- Balance at January 31, 2001 2,142,887 $ 7.46 Granted (weighted average fair value of $3.14) 800,350 7.96 Exercised (86,655) 5.00 Cancelled (82,619) 8.36 --------- Balance at January 31, 2002 2,773,963 $ 7.65 Granted (weighted average fair value of $7.60) 687,650 14.41 Exercised (665,801) 5.42 Cancelled (100,441) 10.33 --------- Balance at January 31, 2003 2,695,371 $ 9.83 Granted (weighted average fair value of $10.97) 580,500 23.18 Exercised (544,559) 7.20 Cancelled (43,660) 9.99 --------- Balance at January 31, 2004 2,687,652 $ 13.24 ========= Exercisable at January 31, 2002 1,397,869 $ 6.79 ========= Exercisable at January 31, 2003 1,272,707 $ 9.10 ========= Exercisable at January 31, 2004 1,272,652 $ 10.88 =========
Options outstanding Options exercisable -------------------------------------------------------------------- ------------------------------- Weighted average Number remaining Weighted Number Weighted Range of of options contractual average of options average Exercise prices Outstanding life (years) exercise price exercisable exercise price --------------- ----------- ------------ -------------- ----------- -------------- $1.16 - $1.99 100 0.1 $ 1.88 100 $ 1.88 2.00 - 3.99 14,618 4.5 3.66 14,618 3.66 4.00 - 7.99 308,860 7.9 6.88 115,940 6.84 8.00 - 11.99 1,293,904 7.0 9.51 856,424 9.42 11.99 - 29.70 1,070,170 9.4 19.72 285,570 17.28 --------- --------- $1.16 - $29.70 2,687,652 8.0 $ 13.24 1,272,652 $ 10.88 ========= =========
Note H--401(k) savings plan The Company maintains a defined contribution, 401(k) Savings Plan, covering all employees who have completed one year of service with at least 1,000 hours and who are at least 21 years of age. The Company makes employer matching contributions at its discretion. Company contributions amounted to $190,000, $176,000, and $172,000 for the fiscal years ended January 31, 2004, 2003 and 2002, respectively. 51 Note I--Commitments and contingencies The Company is party to various legal proceedings arising from normal business activities. Management believes that the resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations. Note J--Segment information The Company classifies its business interests into three reportable segments: retail stores, catalog and direct marketing, and the Internet. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (Note A). The Company evaluates performance and allocates resources based on operating contribution, which excludes unallocated corporate general and administrative costs and income taxes. The Company's reportable segments are strategic business units that offer the same products and utilize common merchandising, distribution, and marketing functions, as well as common information systems and corporate administration. The Company does not have intersegment sales, but the segments are managed separately because each segment has different channels for selling the products. Financial information for the Company's business segments is as follows:
Year ended January 31, ---------------------- 2004 2003 2002 (Dollars in thousands) (Fiscal 2003) (Fiscal 2002) (Fiscal 2001) --------- --------- --------- Revenues Stores $ 379,349 $ 293,795 $ 230,799 Catalog and direct marketing 128,652 118,192 85,087 Internet 95,086 69,208 49,349 Other 44,424 32,574 23,870 --------- --------- --------- Total revenues $ 647,511 $ 513,769 $ 389,105 ========= ========= ========= Operating contributions Stores $ 53,457 $ 38,923 $ 24,056 Catalog and direct marketing 24,164 19,628 7,610 Internet 16,265 12,031 8,833 Unallocated (51,083) (43,626) (38,621) --------- --------- --------- Earnings before income tax expense $ 42,803 $ 29,956 $ 1,878 ========= ========= ========= Depreciation and amortization Stores $ 7,734 $ 6,224 $ 4,782 Catalog and direct marketing -- -- -- Internet 3,071 3,884 1,845 Unallocated 5,621 5,348 4,933 --------- --------- --------- Total depreciation and amortization $ 16,426 $ 15,456 $ 11,560 ========= ========= ========= Capital asset expenditures Stores $ 21,774 $ 13,983 $ 12,296 Catalog and direct marketing -- -- -- Internet 1,727 2,400 2,134 Unallocated 11,694 6,816 5,854 --------- --------- --------- Total capital asset expenditures $ 35,195 $ 23,199 $ 20,284 ========= ========= ========= Assets Stores $ 48,725 $ 35,281 $ 27,613 Catalog and direct marketing -- -- -- Internet 1,974 3,330 4,825 Unallocated 258,856 175,816 130,084 --------- --------- --------- Total assets $ 309,555 $ 214,427 $ 162,522 ========= ========= =========
52 Note K--Quarterly financial information (unaudited)
Fiscal Year Ended January 31, 2004 Three months ended (Dollars in thousands, except per share April 30, July 31, October 31, January 31, amounts) 2003 2003 2003 2004 --------- --------- --------- --------- Revenues $ 116,309 $ 124,699 $ 128,121 $ 278,382 Expenses Cost of products 47,617 53,526 56,417 119,483 Buying and occupancy 13,021 13,174 14,331 17,392 Advertising 25,565 25,877 24,260 47,637 General, selling and administrative 28,900 30,935 31,726 54,904 Other income (expense) (57) 182 283 (351) Earnings before income tax expense 1,149 1,369 1,670 38,615 Income tax expense 471 561 685 15,832 --------- --------- --------- --------- Net earnings $ 678 $ 808 $ 985 $ 22,783 ========= ========= ========= ========= Earnings per common equivalent share Basic (1) $ 0.05 $ 0.05 $ 0.07 $ 1.50 Diluted(2) $ 0.05 $ 0.05 $ 0.06 $ 1.40
53
Fiscal Year Ended January 31, 2003 Three months ended (Dollars in thousands, except per share April 30, July 31, October 31, January 31, amounts) 2002 2002 2002 2003 --------- --------- --------- --------- Revenues $ 92,221 $ 100,464 $ 104,605 $ 216,479 Expenses Cost of products 37,830 43,328 46,714 92,647 Buying and occupancy 10,989 11,408 11,813 13,975 Advertising 20,193 21,137 20,027 36,003 General, selling and administrative 23,040 25,656 26,832 45,028 Other income (expense) 84 19 (73) (223) Earnings (loss) before income tax expense (benefit) 253 (1,046) (854) 28,603 Income tax expense (benefit) 104 (429) (350) 11,724 --------- --------- --------- --------- Net earnings (loss) $ 149 $ (617) $ (504) $ 16,879 ========= ========= ========= ========= Earnings (loss) per common equivalent share Basic (1) $ .01 $ (0.05) $ (0.04) $ 1.34 Diluted(2) $ .01 $ (0.05) $ (0.04) $ 1.26
(1) Basic earnings per share is calculated for interim periods including the effect of stock options exercised in prior interim periods. Basic earnings per share for the fiscal year is calculated using weighted shares outstanding based on the date stock options were exercised. Therefore, basic earnings per share for the cumulative four quarters may not equal fiscal year basic earnings per share. (2) Diluted net earnings per share for the fiscal year and for quarters with net earnings are computed based on weighted average common shares outstanding which include common stock equivalents (stock options). Net loss per share for quarters with net losses is computed based solely on weighted average common shares outstanding. Therefore, the net earnings (loss) per share for each quarter do not sum up to the earnings per share for the full fiscal year. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Item 9A Controls And Procedures. Evaluation of Disclosure Controls and Procedures. Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this report, have concluded, based on the evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15, that our disclosure controls and procedures were adequate and designed to ensure that material information relating to us would be made known to them by others within those entities. Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 54 PART III Item 10. Directors and Executive Officers of the Registrant Information with respect to our directors is incorporated herein by reference to our 2004 Proxy Statement to Stockholders. Information with respect to our executive officers is contained in Part I of this Annual Report on Form 10-K. Item 11. Executive Compensation Information with respect to executive compensation is incorporated herein by reference to our 2004 Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management Except as set forth below, information with respect to security ownership of beneficial owners and management is incorporated herein by reference to our 2004 Proxy Statement. EQUITY COMPENSATION PLAN INFORMATION We have one equity based compensation plan, the 2000 Stock Incentive Plan which was approved by our security holders. The following table sets forth information as of January 31, 2004 of our equity compensation plan.
Number of Securities Remaining Available for Future Issuance Number of Securities to be Weighted-Average Per Share Under Equity Compensation Plan issued Upon Exercise of Exercise Price of (Excluding Securities Reflected Plan Category Outstanding Options Outstanding Options in the First Column) ----------------------------- --------------------------- ------------------------------ --------------------------------- Equity compensation plan approved by security holders.......... 2,687,652 $13.24 31,192
Item 13. Certain Relationships and Related Transactions Not applicable. Item 14. Principal Accountant Fees and Services Information with respect to principal accountant fees and services is incorporated herein by reference to our 2004 Proxy Statement. 55 PART IV Item 15. Exhibits, Financial Statement Schedule and Reports on Form 8-K (a)1. List of Financial Statements. The following Financial Statements and Notes thereto are included herein in PART V, Item 8: Independent Auditors' Report Statements of Operations for the years ended January 31, 2004, 2003 and 2002 Balance sheets at January 31, 2004 and 2003 Statements of Stockholders' Equity for the years ended January 31, 2004, 2003 and 2002 Statements of Cash Flows for the years ended January 31, 2004, 2003 and 2002 Notes to Financial Statements. (a)2. List of Financial Statement Schedule. The following are filed as part of this Report: Independent Auditors' Report on Schedule. Schedule II - Valuation and Qualifying Accounts (a)3. List of Exhibits. Incorporated herein by reference is a list of the Exhibits contained in the Exhibit Index, which begins on page 41 of this report. (b) Reports on Form 8-K. None. SIGNATURES Pursuant to the requirements of 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. SHARPER IMAGE CORPORATION SHARPER IMAGE CORPORATION By:/s/ Richard J. Thalheimer By:/s/ Jeffrey P. Forgan ------------------------- --------------------- Richard J. Thalheimer Jeffrey P. Forgan Chief Executive Executive Vice President, Chief Financial Officer, Chairman Officer, Corporate Secretary (Principal Executive Officer) (Principal Financial & Accounting Officer) 56 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Richard Thalheimer and Jeffrey P. Forgan, and each of them, as such person's true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for such person and in such person's name, place, and stead, in any and all capacities, to sign any and all amendments to this report, 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, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ Richard J. Thalheimer Chief Executive April 15, 2004 ------------------------- Officer, Chairman Richard J. Thalheimer (Principal Executive Officer) /s/ Jeffrey P. Forgan Executive Vice President, April 15, 2004 --------------------- Chief Financial Officer, Jeffrey P. Forgan Corporate Secretary (Principal Financial and Accounting Officer) /s/ Alan Thalheimer Director April 15, 2004 ------------------- Alan Thalheimer /s/ Gerald Napier Director April 15, 2004 ----------------- Gerald Napier /s/ Morton David Director April 15, 2004 ---------------- Morton David /s/ George James Director April 15, 2004 ---------------- George James 57 SHARPER IMAGE CORPORATION SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS ----------------------------------------------- ($000)
COLUMN COLUMN COLUMN COLUMN COLUMN A B C D E ------------------------------------------------------------------------------------------------------------------------------------ Balance at Additions Balance Beginning Charged to at End of DESCRIPTION of Period Costs & Exp. Deductions Period ------------------------------------------------------------------------------------------------------------------------------------ ACCOUNTS RECEIVABLE YEAR ENDED JANUARY 31, 2004: Allowance for doubtful accounts $967 $1,426 $1,127 $1,266 YEAR ENDED JANUARY 31, 2003: Allowance for doubtful accounts $1,082 $1,072 $1,187 $967 YEAR ENDED JANUARY 31, 2002: Allowance for doubtful accounts $730 $682 $330 $1,082
58 INDEPENDENT AUDITORS' REPORT ON SCHEDULE Board of Directors and Stockholders of Sharper Image Corporation We have audited the financial statements of Sharper Image Corporation as of January 31, 2004 and 2003 and for each of the three fiscal years in the period ended January 31, 2004, and have issued our report thereon dated April 12, 2004; such financial statements and report are included in your 2003 Annual Report on Form 10-K. Our audits also included the financial statement schedule of Sharper Image Corporation, listed in Item 15. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such 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. /s/ Deloitte & Touche LLP San Francisco, California April 12, 2004 59 EXHIBIT INDEX 3.1 Certificate of Incorporation. (Incorporated by reference to Exhibit 3.1 to Registration Statement on Form S-1 (Registration No. 33-12755).) 3.2 Amended and Restated Bylaws. 3.3 Form of Certificate of Designation of Series A Junior participating Preferred Stock. (Incorporated by reference to Exhibit 3.01 to Amendment No. 2 to the Registration Statement on Form S-2.) 4.1 Form of Rights Certificate. (Incorporated by reference to Exhibit 4.01 to Amendment No. 2 to the Registration Statement on Form S-2.) 4.2 Form of Rights Agreement dated June 7, 1999. (Incorporated by reference to Exhibit 4.02 to Amendment No. 2 to the Registration Statement on Form S-2.) 10.1 Amended and Restated Stock Option Plan (as amended through September 25, 1998). (Incorporated by reference to Registration Statement on Form S-8 filed on January 19, 1996 (Registration No. 33-3327) and Exhibit to Definitive Proxy Statement on Schedule 14A filed April 29, 1999.) 10.2 1994 Non-Employee Director Stock Option Plan dated October 7, 1994 (as amended through September 25, 1998). (Incorporated by reference to Registration Statement on Form S-8 filed on January 19, 1996 (Registration No. 33-3327) and Exhibit to Definitive Proxy Statement on Schedule 14A filed April 29, 1999.) 10.3 Cash or Deferred Profit Sharing Plan, as amended. (Incorporated by reference to Exhibit 10.2 to Registration Statement on Form S-1 (Registration No. 33-12755).) 10.4 Cash or Deferred Profit Sharing Plan Amendment No. 3. (Incorporated by reference to Exhibit 10.15 to Form 10-K for fiscal year ended January 31, 1988.) 10.5 Cash or Deferred Profit Sharing Plan Amendment No. 4. (Incorporated by reference to Exhibit 10.16 to Form 10-K for fiscal year ended January 31, 1988.) 10.6 Form of Stock Purchase Agreement dated July 26, 1985 relating to shares of Common Stock purchased pursuant to exercise of employee stock options. (Incorporated by reference to Exhibit 10.3 to Registration Statement on Form S-1 (Registration No. 33-12755).) 10.7 Form of Stock Purchase Agreement dated December 13, 1985 relating to shares of Common Stock purchase pursuant to exercise of employee stock options. (Incorporated by reference to Exhibit 10.4 to Registration Statement on Form S-1 (Registration No. 33-12755).) 10.8 Form of Stock Purchase Agreement dated November 10, 1986 relating to shares of Common Stock purchased pursuant to exercise of employee stock options. (Incorporated by reference to Exhibit 10.5 to Registration Statement on Form S-1 (Registration No. 33-12755).) 60 10.9 Form of Director Indemnification Agreement. (Incorporated by reference to Exhibit 10.42 to Registration Statement on Form S-1 (Registration No. 33-12755).) 10.10 Financing Agreement dated September 21, 1994 between the Company and CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.12 to Form 10-Q for the quarter ended October 31, 1994.) 10.11 The Sharper Image 401(K) Savings Plan. (Incorporated by reference to Exhibit 10.21 to Registration Statement of Form S-8 (Registration No. 33-80504) dated June 21, 1994.) 10.12 Split-Dollar Agreement between the Company and Mr. R. Thalheimer, its Chief Executive Officer dated October 13, 1995, effective as of May 17, 1995. (Incorporated by reference to Exhibit 10.17 to Form 10-K for the fiscal year ended January 31, 1996.) 10.13 Assignments of Life Insurance Policy as Collateral, both dated October 13, 1995, effective May 17, 1995. (Incorporated by reference to Exhibit 10.18 to Form 10-K for the fiscal year ended January 31, 1996.) 10.14 Amendment to the Financing Agreement dated May 15, 1996 between the Company and The CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.19 to the Form 10-Q for the quarter ended April 30, 1996.) 10.15 Amendment to the Financing Agreement dated February 13, 1997 between the Company and The CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.21 to Form 10-K for the fiscal year ended January 31, 1997.) 10.16 Amendment to the Financing Agreement dated March 24, 1997 between the Company and The CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.23 to Form 10-K for the fiscal year ended January 31, 1997.) 10.17 Amendment to the Financing Agreement dated April 6, 1998 between the Company and The CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.25 to Form 10-K for the fiscal year ended January 31, 1998.) 10.18 Amendment to the Financing Agreement dated March 23, 2000 between the Company and The CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.22 to Form 10-K for the fiscal year ended January 31, 2000.) 10.19 Amendment to the Corporate Headquarters Office Lease Agreement dated February 9, 2000 between the Company and its landlord, CarrAmerica Realty Corporation. (Incorporated by reference to Exhibit 10.23 to Form 10-K for the fiscal year ended January 31, 2000.) 10.20 Amendment to the Financing Agreement dated July 18, 2000 between the Company and The CIT Group/Business Credit, Inc. (Incorporated by reference to Exhibit 10.23 to Form 10-Q for the quarter ended October 31, 2000.) 61 10.21 Amendment to the Financing Agreement dated September 29, 2000 between the Company and The CIT Group/Business Credit, Inc. (Incorporated by reference to Exhibit 10.24 to Form 10-Q for the quarter ended October 31, 2000.) 10.22 Executive Bonus Plan. (Incorporated by reference to the Definitive Proxy Statement on Schedule 14A filed May 4, 2001.) 10.23 Amendment to the Split-Dollar Agreement between the Company and Richard Thalheimer, its Chief Executive Officer dated July 12, 2001, effective as of March 28, 2001. (Incorporated by reference to Exhibit 10.24 to Form 10-Q for the quarter ended October 31, 2001.) 10.24 Officer Non-Qualified Deferred Compensation Plan. (Incorporated by reference to Exhibit 10.27 to Form 10-Q for the quarter ended October 31, 2003.) 10.25 Employment Agreement dated October 21, 2002 between the Company and Richard Thalheimer. (Incorporated by reference to Exhibit 10.26 to Form 10-Q for the quarter ended October 31, 2003.) 10.26 Amendment to the Financing Agreement dated March 3, 2003 between the Company and the CIT Group/Business Credit Inc. (Incorporated by reference to Exhibit 10.28 to Form 10-Q for the quarter ended April 30, 2003). 10.27 Loan and Security Agreement dated October 31, 2003 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended October 31, 2003). 23.1 Independent Auditors' Consent 31.1 Certification by Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification by Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification by Chief Executive Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. 32.2 Certification by Chief Financial Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. 62