EX-13 2 form10k063004exh13.txt The Reader's Digest Association, Inc. and Subsidiaries Management's Discussion and Analysis Dollars in millions, except per share data Unless otherwise indicated, references in Management's Discussion and Analysis to "we," "our" and "us" are to The Reader's Digest Association, Inc. and its subsidiaries. All references to 2004, 2003 and 2002, unless otherwise indicated, are to fiscal 2004, fiscal 2003 and fiscal 2002, respectively. Our fiscal year represents the period from July 1 through June 30. The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion should be read in conjunction with our Consolidated Financial Statements and related Notes. Certain amounts and percentages do not recalculate due to rounding. Results of Operations: Company-Wide Our Reportable Segments Each of our three segments (Reader's Digest North America, Consumer Business Services and Reader's Digest International (formerly International Businesses)) reports its results to our chief operating decision maker, who uses such information to assess segment performance. Additionally, we separately report Corporate Unallocated expenses, which include the cost of governance and other corporate-related expenses, as well as income and expenses associated with our U.S. pension plans and retiree healthcare benefits, and executive compensation programs. Below is a brief description of the activities included within our reportable segments. Reader's Digest North America This segment comprises our operations in the United States and Canada that publish and market Reader's Digest magazine, Reiman's magazines and several special interest magazines. This segment also includes operations that publish and market Books and Home Entertainment products, including Select Editions, series and general books, and music and video products related to the following affinities: reading, home and health, and entertainment. All of these businesses have a common focus on the direct marketing aspect of new customer acquisition at a minimal cost. The performance of Reader's Digest magazine and our special interest magazines is driven primarily by circulation revenues and, to a lesser extent, by advertising sales. Reiman's publications have minimal advertising revenues, and accordingly, circulation is the principal driver of performance in this business. The results of our Books and Home Entertainment business are driven by its universe of promotable customers, new customer acquisition programs, the response rates to its promotional mailings, customer payment rates and membership in our continuity series business. Consumer Business Services The principal businesses in this segment are our display marketing business, Books Are Fun, and our youth fundraising businesses in the United States and Canada, QSP. This segment also includes smaller businesses, such as Trade Publishing and Young Families, which publish and market Books and Home Entertainment products through direct and retail channels, and the results of financial services alliances. The operations of Gifts.com were included in this segment until 2002, when it ceased operations. The primary focus of Consumer Business Services, which sells products through non-direct marketing channels, is to grow revenues by selling products through their sales forces. Performance of the larger businesses is also driven by product selection, the number of accounts or events held and the average sales per account or event. Reader's Digest International This segment comprises our operations outside of the United States and Canada. The businesses in this segment publish and market Reader's Digest magazine in numerous editions and languages, several special interest magazines and Books and Home Entertainment products (described above), and include the results of financial services marketing alliances. Growth initiatives in this segment include: entering new markets, developing new products, acquiring customers through new channels and expanding U.S. businesses such as Books Are Fun and Young Families into markets overseas. The performance of these businesses is driven by similar factors to those in the Reader's Digest North America segment except that results are more susceptible to changes in local market conditions due to the number of countries in which we operate. The results for Reader's Digest magazine in international markets are driven principally by circulation and secondarily by advertising revenues. The results of our Books and Home Entertainment products in these markets are driven by its universe of promotable customers, new customer acquisition programs, the response rates to its promotional mailings, customer payment rates and membership in our continuity series business. Intercompany Eliminations and Corporate Unallocated Expenses We present our segment revenues and operating profits on an arm's-length basis, consistent with how we manage our operations and how our chief operating decision maker reviews our results. Revenues and expenses attributable to intercompany transactions are included in the results of our reportable segments. Such amounts are eliminated (under the Intercompany Eliminations caption below) to reconcile our reportable segment amounts to consolidated amounts, as reported in the income statements. In addition to intercompany revenues and expenses, we separately report Corporate Unallocated expenses, which cover expenses that are not directly attributable to business unit performance. Corporate Unallocated expenses include the cost of governance and other corporate-related expenses, as well as income and expenses associated with our U.S. pension plans and retiree healthcare benefits, and executive compensation programs. Summary of Reportable Segment Results Years ended June 30, 2004 2003 2002 Revenues Reader's Digest North America $ 835 $ 854 $ 649 Consumer Business Services 609 641 668 Reader's Digest International 970 1,008 1,078 Intercompany eliminations (26) (28) (26) ------- ------- ------- Total revenues $ 2,388 $ 2,475 $ 2,369 ======= ======= ======= Operating profit (loss) Reader's Digest North America $ 71 $ 61 $ (2) Consumer Business Services 64 91 88 Reader's Digest International 57 49 106 Magazine deferred promotion charge (1) (27) -- -- Corporate Unallocated (44) (22) (7) Other operating items, net(2) (15) (40) (27) ------- ------- ------- Operating profit $ 106 $ 139 $ 158 ======= ======= ======= Intercompany eliminations Reader's Digest North America $ (1) $ (1) $ (4) Consumer Business Services (21) (24) (16) Reader's Digest International (4) (3) (6) ------- ------- ------- Total intercompany eliminations $ (26) $ (28) $ (26) ======= ======= ======= (1) Magazine deferred promotion charge relates to: 45% to Reader's Digest North America and 55% to Reader's Digest International. (2) Other operating items, net in 2004 related to: 12% to Reader's Digest North America, 22% to Consumer Business Services, 61% to Reader's Digest International and 5% to corporate departments that benefit the entire organization. In 2003, these items related to: 13% to Reader's Digest North America, 6% to Consumer Business Services, 64% to Reader's Digest International and 17% to corporate departments that benefit the entire organization. In 2002, these items related to: 22% to Reader's Digest North America, 27% to Consumer Business Services, 16% to Reader's Digest International and 35% to corporate departments that benefit the entire organization. Overview At the end of 2003, we announced a plan to achieve sustainable revenue and profit growth by fiscal 2005. We have completed the first half of the two-year plan and have made progress on a number of metrics we identified, at the end of 2003, to track our performance. In 2004, we made investments in new customer acquisition at Reiman and launched two new magazines in North America. Outside of North America, we tested new magazines and our Books and Home Entertainment business in several new markets, and introduced the display marketing concept in certain markets. At the same time, we took aggressive measures in Reader's Digest International to reduce costs, eliminate marginal activity, improve forecasting and execution, reduce risk and test new business opportunities. As a result of these initiatives, and the impact of cost reduction initiatives to rightsize our business, two of our three reportable segments reported low double-digit profit improvements. Although there were a number of positive events during the year, we had disappointing results at Books Are Fun and QSP. Early in the year, we experienced higher turnover in the sales forces in both of these businesses. Coupled with increased competition at QSP and product issues at Books Are Fun, sales in the second quarter, our peak selling season, were lower. Because of this, and other issues enumerated below, Consumer Business Services results for the year decreased. Revenues and Operating Profit 2004 v. 2003 Revenues Revenues decreased 3% to $2,388 in 2004, compared with $2,475 in 2003. Excluding the effect of foreign currency translation, revenues decreased 8%. Revenues in all three of our reportable segments declined. The most significant decline was in Reader's Digest International. We anticipated the decline in Reader's Digest International because of weak economic conditions in most of the markets where we operate. Our strategy to stabilize these businesses by scaling back promotional mailings and exiting marginally profitable businesses in certain markets worsened the decline. Although response rates, principally related to Books and Home Entertainment products, continued to decline, the rate of decline decreased. The most significant revenue declines were in the United Kingdom, Germany and France. Revenues for Consumer Business Services declined due to lower sales at QSP and Books Are Fun because of turnover in the sales force earlier in the year. Increased competition at QSP, and weaker product selection at Books Are Fun in the second quarter of 2004, our peak selling season, also contributed to the decline. These declines were partly offset by improved performance for our Trade Publishing business due to increased sales of stronger products. Revenues for Reader's Digest North America declined because of continued lower circulation and advertising revenues for Reader's Digest magazine driven by our decision to reduce the rate base in January 2003 and 2004. Lower sales at Reiman were attributed to lower series book product sales and lower renewal rates for certain magazines. These declines were partially offset by revenues from new magazines and increased sales of RD Specials (a newsstand product that was introduced in the second quarter of 2003) due to an increase in the number of issues published. Operating Profit Operating profit declined 24% to $106 in 2004, compared with $139 in 2003. Excluding the effect of foreign currency translation, profits declined 29%. The effect of the magazine deferred promotion charge recorded in the fourth quarter of 2004 (described in more detail below) Consumer Business Services and higher Corporate Unallocated expenses drove the overall decline in profitability. Improved profits at two of our reportable segments, Reader's Digest North America and Reader's Digest International, and lower restructuring and other charges, partly offset the decline. Reportable Segments Lower profits for Consumer Business Services were driven by a combination of lower revenues and increased investments in the sales force for QSP and Books Are Fun. The increase in profits for Reader's Digest North America was driven by lower product, promotion and fulfillment costs for Reader's Digest magazine, principally attributable to the rate base reductions, increased profits for Special Interest Magazines and the benefits of cost reduction initiatives. Costs incurred to launch two new Reiman-inspired magazines, Backyard Living and Our Canada, and investments in new customer acquisition at Reiman partially offset this improvement. Profits for Reader's Digest International improved principally due to significant cost reduction, improved mailing efficiency and better execution. Product, distribution and editorial expenses decreased 3% to $973 in 2004, compared with $1,002 in 2003. Excluding the effect of foreign currency translation, these costs declined 7%. Lower product and fulfillment costs, because of the rate base reduction for U.S. Reader's Digest magazine and lower sales activity, were the principal drivers of the decline. The results of efforts to renegotiate supply contracts and to leverage existing relationships across all of our businesses contributed to the decrease in costs. Promotion, marketing and administrative expenses were flat at $1,294 for 2004 and 2003. In 2004, this caption includes the magazine deferred promotion charge (recorded in the fourth quarter), described in further detail below. Excluding the effect of foreign currency translation, these costs decreased 4%. The decline in promotion costs parallels our efforts to reduce risk, stabilize Reader's Digest International and standardize marketing programs in Reader's Digest North America. Certain cost-reduction initiatives, including reductions in staff and other actions, contributed to the decline. These declines were partially offset by investments in new customer acquisition at Reiman and costs incurred to develop and launch new products in Reader's Digest North America and Reader's Digest International. Corporate Unallocated Corporate Unallocated expenses reflect the cost of governance and centrally managed expenses, as well as the accounting for U.S. pension plans, postretirement healthcare costs, and executive compensation programs that are not allocated to the reportable segments. These expenses were $(44) in 2004, compared with $(22) in 2003. The increase was driven by a: - $(19) decrease in net pension income (from our over-funded U.S. pension plan), partly because of our decision to lower the assumed rate of return on our pension assets in accordance with our outlook on long-term asset return trends (see Critical Accounting Policies for additional information). - $(4) increase in compensation expense due to a greater mix of restricted stock versus stock options. - $(3) increase associated with postretirement healthcare costs. Other Operating Items, Net Other operating items, net, decreased to $(15) in 2004, compared with $(40) in 2003. Charges recorded in the second, third and fourth quarters of 2004 comprised $(14) for severance and $(3) for contract terminations, asset impairments and pension curtailments, partially offset by reversals of $2, principally related to severance. Charges of $(14) for severance related to streamlining operations in certain international markets, domestic businesses and corporate departments. These charges relate to the termination of approximately 240 employees, of which almost 40% were terminated as of June 30, 2004. The remaining employees are expected to be terminated over the next several fiscal quarters. Charges of $(3) for contract terminations, asset impairments and pension curtailments principally represent costs associated with closing our Norway location and a lease termination at Books Are Fun. These charges were partially offset by reversals of $2, principally severance, recorded in the third quarter of 2004 related to charges recorded in previous periods that were no longer necessary. We generally review our restructuring charges periodically to determine the appropriateness of existing reserves in light of current circumstances. Accordingly, these charges were reversed because of the occurrence of events that affected our original plans. In 2003, we recorded net charges of $(40) comprised of: $(35), net, related to severance, $(3) related to write-downs of assets and $(5) related to other costs. We also recorded a gain of $3 related to net adjustments to litigation-related accrual balances that were established in previous years. The severance and other charges principally related to lowering our cost base and streamlining our business processes. Magazine Deferred Promotion Charge During the fourth quarter of 2004, we reassessed our accounting for magazine promotion costs in response to changes in our business, as well as the strategies and initiatives being undertaken by our magazine business. As a result of these changes, pursuant to American Institute of Certified Public Accountants Statement of Position (SOP) 93-7, "Reporting on Advertising Costs," effective fiscal 2005, we will no longer defer and amortize magazine promotion costs, but will expense such costs when the promotion is mailed to prospective customers. As of June 30, 2004, we have recorded a pre-tax charge of $27, to reflect the impact of this change in circumstances on our existing asset. Such amount is included as a component of promotion, marketing and administrative expenses on the income statements. The remaining balance will be amortized in fiscal 2005. 2003 v. 2002 Revenues Revenues increased 4% to $2,475 in 2003, compared with $2,369 in 2002. Excluding the effect of foreign currency translation, revenues increased 1%. The revenue increase was primarily attributable to an increase in revenues in Reader's Digest North America, driven by the addition of a full year of revenues from Reiman, which was acquired on May 20, 2002. Offsetting this growth were lower revenues in Reader's Digest International and, to a lesser extent, Consumer Business Services. In Reader's Digest North America, the increase in revenues from the addition of a full year of revenues from Reiman was partially offset by lower revenues for U.S. Books and Home Entertainment, due to the elimination of marginally profitable and unprofitable product lines, and by lower revenues for Reader's Digest magazine, due to lower circulation and advertising revenues. In addition, revenues in 2002 were higher due to the inclusion of revenues from Walking and New Choices magazines, which were discontinued during 2002. The decline in revenues in Reader's Digest International was primarily across Books and Home Entertainment products, with significant declines in general books, music and video products, and certain series products. The primary markets with declining revenues were the United Kingdom, Germany, France, Mexico and Australia. These declines were partially offset by improved performance in the developing markets of Russia and Hungary. The decline in revenues in Consumer Business Services was attributable to the absence of revenues from Gifts.com, Inc., which ceased operations in 2002, and to lower revenues from our financial services marketing alliances as a result of the receipt of a one-time payment in connection with the termination of an alliance in 2002. In addition, lower revenues from Young Families due to the elimination of marginally profitable and unprofitable products contributed to the decline. These declines were partially offset by increased revenues at Books Are Fun and Children's Publishing. Operating Profit Operating profit declined 12% to $139 in 2003, compared with $158 in 2002. Excluding the effect of foreign currency translation, operating profit declined 16%. The higher restructuring charge in 2003 contributed most of the decline. Other operating items, net in 2003 were $(40), compared with $(27) in 2002. In addition, Corporate Unallocated expenses were significantly higher ($22 in 2003, compared with $7 in 2002), primarily due to lower net pension income and increased employee-related costs. Partially offsetting a portion of these cost increases were higher profit from certain reportable segments, which are described in further detail below. Reportable Segments The increase in operating profit from our reportable segments was driven by Reader's Digest North America, which benefited from the addition of a full year of profit from Reiman and an 80% reduction in losses in our U.S. Books and Home Entertainment business. This increase was partially offset by a 54% reduction in profit for Reader's Digest International (excluding the effect of foreign currency translation, profit in Reader's Digest International declined 60%). The significant decline in Reader's Digest International was primarily attributable to profit declines in established international markets, including France, Germany, the United Kingdom and Mexico due to the decline in revenues, and was partially offset by lower product and promotion costs. Product, distribution and editorial expenses increased 6% to $1,002 in 2003, compared with $948 in 2002. Excluding the effect of foreign currency translation, these expenses increased 2%. The increase was driven by the incremental costs, including postage, related to the addition of a full year of costs attributable to Reiman. This increase was partially offset by reduced activity in U.S. Books and Home Entertainment, Reader's Digest magazine and Special Interest Magazines. Costs for other businesses in Reader's Digest North America decreased due to a combination of factors, including the decline in sales volume and our decision to reduce the rate base for Reader's Digest magazine (both of which resulted in fewer products printed), rebates from suppliers and cost-cutting measures. The decline in costs in Reader's Digest International was attributable to lower manufacturing and delivery costs stemming from a decline in sales volume. Promotion, marketing and administrative expenses increased 5% to $1,294 in 2003, compared with $1,237 in 2002. Excluding the effect of foreign currency translation, these expenses increased 1%. The increase in these expenses was driven by the addition of a full year of costs for Reiman and the amortization of intangible assets acquired with Reiman. This increase was partially offset by a decrease in costs in other businesses in Reader's Digest North America and in Reader's Digest International. These decreases were principally driven by a significant reduction in promotion costs due to our decision to reduce mailing activity in U.S. Books and Home Entertainment and several international markets, and to our decision to lower the rate base for Reader's Digest magazine. Corporate Unallocated Corporate Unallocated expenses were $(22) in 2003, compared with $(7) in 2002. The increase in expenses was attributable to significantly lower net pension income from our U.S. pension plans ($25 in 2003, compared with $37 in 2002), a higher mix of restricted stock in equity compensation and higher retiree healthcare costs. Expenses for governance and other corporate-related expenses were marginally reduced by cost-reduction initiatives. The decline in net pension income was partially a result of our decision to lower the assumed rate of return on our pension assets in accordance with our outlook on long-term asset return trends. Other Operating Items, Net Other operating items, net increased significantly to $(40) in 2003, compared with $(27) in 2002. The increase was primarily due to higher severance costs in 2003 relative to 2002, as we implemented cost-reduction programs. Other operating items, net of $(40) in 2003 comprised: Charges of $(38) for severance and related items, $(3) related to write-downs of assets and $(5) of other costs. These charges were taken to lower our cost base in commensuration with our current revenues and to streamline our business processes. These costs were partially offset by a gain of $3 related to the reversal of severance accruals recorded in previous years and a gain of $3 related to net adjustments to litigation-related accrual balances that had been established in previous years, following settlement of a six-year old lawsuit in the first quarter of 2003. Reversals of accruals recorded in previous years represent circumstances where conditions changed after the date the accrual was established. Severance charges recorded in the third and fourth quarters of 2003 of $(38) represent charges taken to terminate approximately 580 positions (35% in North America and 65% in various international markets), of which approximately 90% have been separated as of June 30, 2004. The remaining positions will be terminated during the next several fiscal quarters. Asset impairments of $(3) principally comprised write-offs related to software and to unprofitable and discontinued products. Other costs of $(5) principally comprised expenses incurred to prepare and review the restructuring plans utilized to streamline our operations in certain domestic and international markets. Other operating items, net of $(27) in 2002 comprised: Charges of $(36), including $(15) for severance costs, $(8) for contract terminations, and $(13) for asset impairments and other items, adjustments of $7 related to accruals from charges originally recorded in 2002 and prior periods, and a reversal of $2 pertaining to a legal matter that was originally recorded in prior years in other operating items, net. Other (Expense) Income, Net 2004 v. 2003 Other (expense) income, net for 2004 was $(40), compared with $(39) in 2003. The primary changes were: - Additional interest expense, net of $(8) in 2004, principally due to the write-off of deferred financing fees and other items of $(7) as a result of refinancing a portion of our existing debt and terminating some of our interest rate caps that were no longer required (see Note 7, Financial Instruments and Note 11, Debt, in our Notes to Consolidated Financial Statements). - Lower gains on sales of shares of LookSmart, Ltd. of $(4) because we completely liquidated our remaining investment in LookSmart in the first quarter of 2004. - A gain of $6 on the sale of our building in Hong Kong in 2004, compared with a gain of $2 from the sale of a building in Australia in 2003. - A gain of $3 from proceeds received in exchange for our interest in Schoolpop, Inc., which merged into an unrelated third-party in the first quarter of 2004 (we had written this investment down to zero in the fourth quarter of 2002). - Expenses of $(3) incurred in 2003 in connection with our recapitalization transactions. 2003 v. 2002 Other (expense) income, net for 2003 was $(39), compared with $(17) in 2002. The primary changes were: - Additional interest expense, net of $(28), primarily attributable to the inclusion of a full year of interest expense associated with additional borrowings in the fourth quarter of 2002 to consummate the Reiman acquisition and share recapitalization transactions. - Minimal losses from foreign currency transactions in 2003, compared with a loss of $(4) in 2002. This was partially due to the discontinuance of a portion of our hedging program (see Note 7, Financial Instruments, in our Notes to Consolidated Financial Statements). - A gain of $2 from the sale of a building in Australia in 2003. - Lower sales of shares of LookSmart, Ltd. of $5 in 2003, compared with $7 in 2002. Income Taxes 2004 v. 2003 The effective tax rate for 2004 was 25.1%, compared with a rate of 38.9% for 2003. Excluding non-deductible costs associated with the recapitalization transactions in 2003, the comparable effective tax rate for 2003 was 35.3%. The lower tax rate was due to the favorable resolution of tax audit matters in certain domestic and international markets and the tax-free sale of our building in Hong Kong. Lower statutory tax rates in some of our markets and smaller restructuring charges in international markets with more favorable tax rates contributed to the lower effective tax rate. 2003 v. 2002 The effective tax rate for 2003 was 38.9%, compared with a rate of 35.1% for 2002. The higher tax rate was due to the lower tax benefit realized on our international restructuring charges and non-deductible costs associated with our recapitalization transactions. Excluding these items, the comparable effective tax rate for 2003 was 35.3%, compared with 35.1% in 2002. Net Income 2004 v. 2003 As a result of the items discussed above, net income in 2004 was $49 or $0.49 per share on a diluted-earnings basis ($0.50 per share for basic earnings per share). In 2003, net income was $61 or $0.60 per share on a diluted-earnings basis ($0.61 per share for basic earnings per share). 2003 v. 2002 Net income in 2003 was $61 or $0.60 per share on a diluted-earnings basis ($0.61 per share for basic earnings per share). In 2002, net income was $91 or $0.89 per share on a diluted-earnings basis ($0.90 per share for basic earnings per share). Results of Operations: Reportable Segments Reader's Digest North America 2004 v. 2003 Revenues for Reader's Digest North America decreased 2% to $835 in 2004, compared with $854 in 2003. Excluding the effect of foreign currency translation, revenues declined 4%. The largest declines in revenue related to Reader's Digest magazine and Reiman. The decline in revenues for Reader's Digest magazine was attributable to lower circulation and advertising revenues due to the January 2003 and 2004 reductions in the rate base. Circulation revenues continued to be adversely affected by a decline in renewal pools, partially offset by the introduction of new subscribers at lower introductory rates. In addition, in the first half of 2004, newsstand sales declined, consistent with softness in this market. Although this trend showed signs of stabilizing in the second half of 2004, newsstand volume for the year declined 11%. Advertising revenues declined due to a lower rate per page, because of the January 2003 and 2004 reductions in the rate base for Reader's Digest magazine. This decline was partially offset by an increase in the number of advertising pages sold. The decline in revenues for Reiman were principally driven by lower sales for certain series book products and lower sales of single sales books because of stronger product offerings in 2003. In addition, circulation revenues for certain magazines declined due to lower renewal rates. These declines were partially offset by strong sales of new annual book products and new products for sale in retail outlets. In addition to the activity noted above, revenues for U.S. Books and Home Entertainment also declined modestly. This was largely attributable to lower sales of Select Editions, because of lower membership in the series, and the discontinuance of certain unprofitable series products. At the same time, increased promotional activity for single sales products and higher prices and payment rates for Select Editions, partially offset the decline. Revenues in Canada declined slightly because of lower response rates to mailings for video products and the discontinuance of certain series products. These declines were partially offset by improved response rates for general book products. Along with these declines in revenues for Reader's Digest North America, there were also increases from the introduction of new products, including RD Specials (introduced in the second quarter of 2003) and Backyard Living (launched in the third quarter of 2004) in the United States, and Our Canada (launched in the third quarter of 2004) in Canada. Furthermore, advertising and circulation revenues for Selecciones increased due to an increase in the rate base. Operating profit for this segment improved 16% to $71 in 2004, compared with $61 in 2003. Excluding the effect of foreign currency translation, profit increased 14%. The most significant improvements, in U.S. Books and Home Entertainment and Reader's Digest magazine, were driven by lower product, fulfillment and promotion costs because of the rate base reductions described above and the standardization of certain marketing activities. A lesser reliance on subscriptions generated by agents (also due to the rate base reductions described above), increased profits for Special Interest Magazines and the benefits of cost-reduction initiatives contributed to the improvement. These improvements were partially offset by investments in new customer acquisition for Taste of Home magazine and costs incurred to develop and launch Backyard Living and Our Canada. 2003 v. 2002 Revenues for Reader's Digest North America increased 32% to $854 in 2003, compared with $649 in 2002. This increase was driven by the addition of a full year of revenues for Reiman in 2003 (in 2002 we recognized revenues for Reiman from the date of acquisition, May 20, 2002, until June 30, 2002). Contributing to the improvement were the introduction of new products, including RD Specials and increased advertising and circulation revenues from Selecciones, Reader's Digest Large Print and The Family Handyman. These improvements in revenues were partially offset by a 36% decrease in revenues in U.S. Books and Home Entertainment, a 5% decline in revenues for Reader's Digest magazine, and the absence of revenues from Walking and New Choices magazines. The decline in revenues for U.S. Books and Home Entertainment was driven by lower revenues for music and video products due to the elimination of unprofitable products, which was announced in the fourth quarter of 2002. At the same time, we also announced that we were exiting the catalog business and certain continuity series. Revenues for Select Editions declined due to lower series membership and planned reductions in mailings to third-party customer lists. Lower Reader's Digest magazine revenues were driven by lower circulation revenues, attributable to the July 2002 and January 2003 reductions in the rate base, and lower renewal pools, partially offset by new subscribers at lower introductory rates. In addition, advertising revenues were lower due to our decision to lower the circulation rate base. Operating profit for this segment improved to $61 in 2003, compared with a loss of $(2) in 2002. The profit improvement was principally attributable to the revenue changes described above, specifically the addition of a full year of profit from Reiman, the elimination of unprofitable products and lower promotion costs in U.S. Books and Home Entertainment, and the impact of cost-cutting measures. Consumer Business Services 2004 v. 2003 Revenues for Consumer Business Services declined 5% to $609 in 2004, compared with $641 in 2003. Excluding the effect of foreign currency translation, revenues declined 6%. Revenue declines for QSP and Books Are Fun were partially offset by increased revenues for Trade Publishing. Revenues for QSP declined 9% due to lower same-account sales and fewer accounts launched in the relevant reporting periods. This resulted in lower sales volumes of magazines and gift and food products. These declines were attributable to turnover in the sales force in certain territories, increased competition for fundraising dollars and a soft economy. Increased account incentives contributed to the decline. Despite these declines, gross sales of World's Finest Chocolate products increased 2%, while the tonnage credited toward our minimum purchase commitment increased 15%. Slightly higher pricing for gift products partially offset these declines. Revenues for Books Are Fun declined 6% primarily due to lower average sales per event and, to a lesser extent, fewer events held. We attribute the weaker average sales per event to shortages of strong selling products in the second quarter of 2004, which was an unforeseen side effect of aggressively managing our inventory, and to weaker product selection. The decline in the number of events held was primarily due to turnover in the sales force earlier in the year. At Books Are Fun, we changed our purchasing management and reviewed our product allocation strategy and testing processes to rectify the product issues noted above. Because of our efforts to grow the sales force, we have more sales representatives as of June 30, 2004 than we had as of June 30, 2003 to serve new and existing markets for both QSP and Books Are Fun. However, because of the time required to develop territories, the additional sales representatives did not make a significant impact in 2004. These declines were partially offset by an 8% increase in revenues for Trade Publishing driven by increased sales of products through retail and other channels. Operating profit for this segment decreased 29% to $64 in 2004, compared with $91 in 2003. The main drivers of this decline in profits were the revenue changes described above and investments in the sales force for both QSP and Books Are Fun. Increased commission rates and higher freight and warehousing costs at Books Are Fun contributed to the decline. During the year, QSP recorded a penalty of $1 associated with the minimum purchase commitment related to our World's Finest Chocolate, Inc. licensing agreement. As noted above, because our purchases under the agreement were higher, the penalty recorded in 2004 was less than half of the penalty recorded in 2003. These declines were partially offset by the impact of cost-reduction initiatives and increased sales for Trade Publishing. 2003 v. 2002 Revenues for Consumer Business Services decreased 4% to $641 in 2003, compared with $668 in 2002. The decline was driven by the absence of revenues from Gifts.com, Inc., which ceased operations in 2002, and lower revenues from financial services marketing alliances due to a one-time payment received in connection with the termination of a financial services marketing alliance in 2002. In addition, the elimination of unprofitable product lines for Young Families, and lower sales volume due to increased competition for QSP Canada, contributed to the decline. These declines were partially offset by a 4% increase in revenues at Books Are Fun and increased revenues for Children's Publishing. The improvement in revenues at Books Are Fun was attributable to an increase in the number of events held and an increase in the average sales per event, for business and corporate fairs. In addition, the introduction of new product lines at Books Are Fun contributed to the increased revenues. Revenues in Children's Publishing increased due to better selling products and increased sales to mass marketers. Revenues for QSP, Inc. increased 2% in 2003, compared with 2002. Increased revenues due to a higher pricing mix were partially offset by lower volumes for most products, including gift and magazine products, due principally to softness in the economy. Operating profit increased 2% to $91 in 2003, compared with $88 in 2002. The increase was principally due to profit improvement attributable to the elimination of unprofitable businesses and product lines, including Gifts.com, Inc. Profit at QSP, Inc. was lower as a result of expenses associated with investments in the sales force, the recording of a penalty associated with the minimum purchase commitment related to our World's Finest Chocolate, Inc. licensing agreement and the effect of the dockworkers' strike on the west coast of the United States. Profit at QSP Canada declined due to lower sales volumes and increased fulfillment and other costs. These decreases in profit were partially offset by the impact of a higher pricing mix at QSP, Inc. and the impact of cost-reduction initiatives. Reader's Digest International 2004 v. 2003 Revenues for Reader's Digest International declined 4% to $970 in 2004, compared with $1,008 in 2003. Excluding the effect of foreign currency translation, revenues declined 13%. Revenues declined in substantially all of our markets. The decline in revenues in this segment was driven by lower response rates to promotional mailings and lower series membership in many markets. In addition, weaker economic conditions in our markets contributed to the decline. To mitigate these factors and the residual effect of lower response rates in 2003, we reduced mail quantities and the frequency of our mailings. While these reductions lessened the risk of unprofitable mailings and mailing intensity, they also reduced the number of promotable customers, further lowering revenues. Although response rates continued to decline, principally related to Books and Home Entertainment products, the rate of decline was lower. The most significant revenue declines were in the United Kingdom, Germany, France and to a lesser extent, Central Europe, Asia, Switzerland, Brazil and Australia. Revenues also declined in Spain and Norway as we discontinued certain significant lines of business in those markets to enhance profitability. Revenue increases in Russia partially offset declines elsewhere. Revenues have improved principally due to increased promotional mailings for single sales products, partially offset by lower response rates to promotional mailings. Operating profit for this segment increased 16% to $57 in 2004, compared with $49 in 2003. Excluding the effect of foreign currency translation, profit increased 6%. The most significant profit improvements were in Australia, Mexico, France and Poland. In 2003, issues associated with our transition to new outsource vendors adversely affected profits in Australia and France. The resolution of these issues and active management of costs drove the profit improvement. The impact of cost-reduction initiatives, principally overhead reductions across most markets, and the discontinuance of marginal lines of business in certain markets, contributed to the improvement. These improvements were partially offset by lower profits in Germany, Switzerland and the United Kingdom due to the revenue factors described above. 2003 v. 2002 Revenues for Reader's Digest International decreased 6% to $1,008 in 2003, compared with $1,078 in 2002. Excluding the effect of foreign currency translation, revenues decreased 14%. The decline was principally driven by lower revenues for Books and Home Entertainment products in the United Kingdom, Germany, France, Mexico and Australia principally due to: - lower response rates to mailings and lower payment performance partially attributable to weak economies; - planned reductions in mail quantities to eliminate marginally profitable mailings and to reduce the unfavorable effect of the intensity of our mailings on our response rates; - lower membership in Select Editions and illustrated series products due to a smaller universe of active promotable customers and lower response rates to mailings; and - issues associated with outsourcing to new fulfillment vendors in Australia and France. These decreases were partially offset by improved revenues in two of our developing markets. Revenues in Russia increased due to the introduction of new products and increased series membership. In Hungary, revenues improved due to increased response rates to mailings and increased mail quantities. Operating profit in this segment declined 54% to $49 in 2003, compared with $106 in 2002. Excluding the effect of foreign currency translation, profit declined 60%. The profit decline was attributable to the changes in revenues described above, partially offset by lower product and promotion costs. Critical Accounting Policies (includes forward-looking information) Our significant accounting policies are more fully described in Note 1, Organization and Summary of Significant Accounting Policies, in our Notes to Consolidated Financial Statements. The accounting policies described below are those that we believe are critical to an understanding of our financial statements and require management to make significant judgments. These judgments entail estimates and assumptions that are essential to determining the recorded amounts and their impact on our operating results. Due to the uncertainty inherent in these estimates and assumptions, actual results may differ. The determination of the accounting policies that are critical and the assumptions and estimates that we have made have been reviewed and discussed with the Audit Committee of our Board of Directors. Estimates of Returns and Bad Debt Our ability to accurately estimate returns and bad debt is critical in determining the amount of revenue to recognize and promotion and agent costs to defer. We present our revenues net of an allowance for returns and bad debt. We estimate returns for all products, as well as cancellations of magazine subscriptions, based on historical data, method of promotion and results of market testing for the products. Reserve levels are adjusted as actual return data is received. On a consolidated basis, our estimates of returns have not differed significantly from actual results. Estimates of bad debts are prepared using historical data based on the type of product and promotion and the source of customer. We review our bad debt reserves periodically to ensure they are appropriately stated. If actual results differ from our estimates, the reserve is adjusted as actual bad debt data is received. On a consolidated basis, our estimates of bad debts have not differed significantly from actual results. Revenues for our Books and Home Entertainment and magazine businesses are principally driven by direct mail and, therefore, are the most sensitive to changes in payment rates and returns. Our Consumer Business Services businesses are much less susceptible to changes in payment rates and returns because the largest businesses in this segment collect most of their cash at the point of sale. Inventory Valuation We periodically assess our inventory for obsolescence and to ensure it is recorded at the lower of cost or market value. In estimating the necessary inventory reserve, we forecast demand for products on hand and assess market conditions, including potential usage in future promotions. Adjustments to inventory reserves are recorded in product, distribution and editorial expenses on the income statements. Although half of our net inventory relates to Books Are Fun, their reserve levels are significantly lower than our other businesses. Historically, Books Are Fun has successfully been able to sell older inventory profitably through secondary marketing channels and by complementing existing product offerings. Based on this experience, we believe their reserve levels are adequate. Inventory for our remaining businesses principally relates to magazine paper and other products. During the last few years, reserve levels have declined for our other businesses because of continued efforts to better manage inventories. Deferred Promotion Costs and Related Amortization During the fourth quarter of 2004, we reassessed our accounting for magazine promotion costs in response to changes in our business, as well as the strategies and initiatives being undertaken by our magazine business. As a result of these changes, pursuant to SOP 93-7, effective fiscal 2005, we will no longer defer and amortize magazine promotion costs, but will expense such costs when the promotion is mailed to prospective customers. As of June 30, 2004, we have recorded a pre-tax charge of $27, to reflect the impact of this change in circumstances on our existing asset. Such amount is included as a component of promotion, marketing and administrative expenses on the income statements. The remaining balance will be amortized in fiscal 2005. Promotion costs are deferred only if certain criteria are met, including whether the future profit expected to be generated by a promotional campaign is greater than the costs deferred. Estimates of revenues and profits to be generated and of returns are made using historical data based on the type of product, method of promotion and customer targeted. As actual results for a specific promotional campaign are received, the campaign is reassessed. To the extent that capitalized costs of the campaign exceed the profit expected to be generated, the difference is expensed immediately. Amortization related to deferred promotion expenses is included in promotion, marketing and administrative costs on the income statements. Pension Assumptions The calculation of pension income (expense) is based on various actuarial assumptions. The expected return on assets, a significant factor in determining pension expense, requires significant judgment. We review this assumption annually, together with actuarial consultants, to determine a reasonable rate. During our periodic review of assumptions used in determining the net pension expense to be recorded in 2004 (our measurement date is March 31 of the previous fiscal year), we examined the assumed long-term rate of return on pension assets and the discount rate. The long-term rate of return on pension assets is the most significant factor in determining our net pension income. The discount rate is not as significant an assumption in calculating the net pension income or benefit obligation for our U.S. plan because our plan is mature, and includes a significant number of retirees who are currently receiving benefits. Accordingly, the period over which the obligation is discounted is much smaller than it would be for other employers' plans. The assumed long-term rate of return on pension assets represents the rate of return we expect our pension assets to return over an extended time horizon. Accordingly, significant changes in this rate due to short-term fluctuations in market conditions are not appropriate. In 2003, our assumed long-term rate of return on pension assets, used to determine net pension income for our over-funded U.S. pension plan, was 9.25%. Due to lower anticipated rates of return for portfolios with asset allocations similar to those of our pension plans, we reduced our long-term rate of return on pension assets to 8.75% for 2004. Based on our projections and expectations of future performance, we have not changed our long-term rate of return on pension assets for fiscal 2005. A 25 basis point decrease in the long-term rate of return on pension assets used for 2004 would have decreased net pension income by $1. In 2003, the discount rate used to determine the pension obligation for our U.S. plans as of year-end was 6.25%. In the United States, the discount rate should approximate high-quality long-term corporate bond rates. Due to declining interest rates, at the measurement date, our discount rate for 2004 was reduced to 5.75%. Income and expenses associated with our pension plans are included in promotion, marketing and administrative expenses on the income statements. Restructuring Charges We establish reserves for severance costs, contract terminations and asset impairments as a result of costs incurred to streamline our organization and reposition certain businesses. In 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement superseded Emerging Issues Task Force Issue (EITF) No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs To Exit an Activity (Including Certain Costs Associated with a Restructuring)," and required that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, as opposed to when management is committed to an exit plan. Such liabilities are recorded based on their fair value, as defined. The provisions of this statement apply to all costs accrued related to restructuring activities, including one-time severance benefits. However, because our severance benefits are not considered one-time, we recognize these benefits under the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits" and SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits" (the impact of pension curtailments and settlements that are directly attributable to our restructuring actions were recorded in accordance with SFAS No. 88). As such, amounts for severance are recognized when a termination plan is developed and approved and when payment is probable and estimable. Restructuring charges for all other types of costs, such as contract terminations, are recorded in accordance with SFAS No. 146. Asset impairments are calculated in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." For charges prior to December 31, 2002, estimates of costs incurred to complete those actions, such as future lease payments, sublease income, the fair value of assets and contract termination settlements, were based on assumptions at the time management was committed to a plan. To the extent actual costs differed from those estimates, reserve levels were adjusted. In addition, plans for certain severance actions were revised due to changes in business conditions that we did not foresee at the time such plans were approved. The impact of restructuring charges is recorded in other operating items, net on the income statements. Goodwill and Other Intangible Assets In accordance with SFAS No. 142, goodwill and intangibles with indefinite lives must be assessed annually for impairment. These assessments, which require a great deal of judgment, involve management's estimates of future cash flows, market trends and other factors. If goodwill is determined to be impaired, a loss is recorded in accordance with the statement. Management's estimates of future cash flows take into consideration market trends and our internal projections of performance relative to other constraints, including the efficiency and effectiveness of sales channels and potential changes in market penetration. External factors, such as competition and the health of regional economies must also be considered. Although these factors are critical to assessing impairment, estimates of fair value are also sensitive to small changes in profit margins and discount rates. In accordance with SFAS No. 144, intangible assets with finite lives must be assessed for impairment whenever changes in circumstances indicate that the assets may be impaired. Similar to goodwill, the assessment for impairment requires estimates of future cash flows related to the intangible asset. To the extent the carrying value of the asset exceeds its future cash flows, an impairment loss is recorded based on the fair value of the asset. Asset impairments are recorded in other operating items, net on the income statements. Liquidity and Capital Resources (includes forward-looking information) The consolidated statement of cash flows for the year ended June 30, 2004, is summarized below: Cash and cash equivalents at June 30, 2003 $ 51 Net change in cash due to: Operating activities 174 Investing activities (6) Financing activities (170) Effect of exchange rate changes on cash and cash equivalents 1 ----- Net change in cash and cash equivalents (1) ----- Cash and cash equivalents at June 30, 2004 $ 50 ===== Cash and cash equivalents decreased 2% to $50 as of June 30, 2004, compared with $51 as of June 30, 2003. Cash flow from operations increased to $174 in 2004, compared with $162 in 2003. Principal factors affecting the comparability of operating cash flow include increased amortization of financing fees, due to the refinancing described below, and increased amortization of stock-based compensation, due to a higher mix of restricted stock instead of incentive stock options. Significant uses of cash in 2004 related to: - Repayment of $144 of our borrowings. - Cash payments for dividends of $21. Borrowings Our primary debt obligations are: the Five-Year Revolving Credit and Competitive Advance Facility Agreement, Term Loan Agreement (collectively referred to as the 2002 Credit Agreements) and $300 in senior unsecured notes. The 2002 Credit Agreements were entered into in connection with the Reiman acquisition and the recapitalization transactions (see Note 12, Capital Stock, in our Notes to Consolidated Financial Statements for additional information). Borrowings under the Five-Year Revolving Credit and Competitive Advance Facility Agreement may be used for general corporate purposes, including acquisitions, share repurchases and commercial paper backup. Borrowings under the 2002 Credit Agreements are secured by substantially all of our assets and are subject to various covenants, including limitations on additional debt for money borrowed and related guarantees, liens, and minimum interest coverage and maximum leverage ratios. In addition, we are permitted to repurchase shares, pay cash dividends and make certain other restricted payments, in any combination thereof, up to $50 each fiscal year. The leverage ratio, calculated as total debt divided by EBITDA, as defined in the 2002 Credit Agreements, is our most restrictive financial covenant. As of June 30, 2004, this ratio was 3.54 (including 0.41 related to the magazine deferred promotion charge) compared with a maximum permitted leverage ratio of 3.75. Although the deferred promotion charge, recorded in the fourth quarter of 2004, is non-cash in nature, it is included in the leverage ratio calculation above. This charge, together with the continued amortization of the aforementioned deferred promotion balance in fiscal 2005, will affect the leverage ratio calculation and other financial covenants in future periods, and therefore necessitate an amendment to our credit agreements. We believe we will obtain this amendment in the first quarter of fiscal 2005 and are in discussions with our lenders to exclude this item from our financial covenant calculations. During the third quarter of 2004, we completed a private placement, with registration rights, of $300 of 6 1/2% senior unsecured notes due in 2011 (Senior Notes), in order to refinance a portion of amounts outstanding under the Term Loan. These notes were exchanged for registered notes in the fourth quarter of 2004. The Term Loan Agreement requires quarterly principal repayments, with the final payment due in 2008. Aggregate mandatory principal payments are $39 in fiscal 2005, $67 in fiscal 2006, $77 in fiscal 2007 and $194 in fiscal 2008. The Term Loan Agreement also requires us to use our excess cash flow to prepay the principal amount of borrowings. The weighted average interest rate charged on our borrowings was 4.4%, 4.0% and 3.8% in 2004, 2003 and 2002, respectively. In the fourth quarter of 2004, because of our improved credit profile, we repriced our Term Loans, reducing the LIBOR spread charged on these borrowings by 100 basis points. The benefit of the repricing will be reflected in future periods. The interest rate under the Term Loan Agreement is required to be reset from time to time for periods of up to six months. The interest rate is either LIBOR plus a spread based on our credit rating at the time the rate is established, or the Alternate Base Rate, as defined in the Term Loan Agreement. Assuming the LIBOR option, if our credit rating at June 30, 2004 were to decrease one increment, the interest rate under both the Term Loan Agreement and the Five-Year Revolving Credit and Competitive Advance Facility would increase 25 basis points. If our credit rating at June 30, 2004 were to improve one increment, the interest rate on the Five-Year Revolving Credit and Competitive Advance Facility would decrease 25 basis points. The interest rate on the Term Loan would not change. The interest rate charged on the Senior Notes is not affected by changes in our credit rating. Under the 2002 Credit Agreements, we are required to hedge at least one-third of borrowings outstanding under the Term Loan Agreement. In July 2002, we entered into agreements to cap at 6% the interest rate on $400 of the LIBOR component of our borrowings under the Term Loan Agreement for a period of three years. As a result of the refinancing described above, the total amount of outstanding borrowings under the Term Loan, and the total notional amount of related interest rate caps required, declined. Accordingly, in the third quarter of 2004 we terminated interest rate caps with a notional value of $250 and recognized the remaining unamortized premium on those instruments, $(1), in interest expense. We currently maintain interest rate caps with a notional amount of $150. Recapitalization Agreement On October 15, 2002, we entered into a revised agreement with the DeWitt Wallace-Reader's Digest Fund, Inc. and the Lila Wallace-Reader's Digest Fund, Inc. (the Funds) providing for a series of actions that resulted in all shares of our Class B Voting Common Stock (Class B Stock) and Class A Nonvoting Common Stock (Class A Stock) being recapitalized into a single class of Common Stock with one vote per share. The October 15, 2002 recapitalization agreement replaced the recapitalization agreement that we entered into with the Funds on April 12, 2002. The transactions contemplated by the October recapitalization agreement were completed on December 13, 2002. As a result: - We repurchased approximately 4.6 million shares of Class B Stock from the Funds for $100 in cash in the aggregate; - Each share of Class A Stock was recapitalized into one share of Common Stock having one vote per share; - Each remaining share of Class B Stock was recapitalized into 1.22 shares of Common Stock; - We amended our charter to, among other things, reflect the reclassification of the stock, divide our Board of Directors into three classes and eliminate action by written consent of our stockholders; and - We reclassified as long-term debt the $100 borrowed under the Term Loan Agreement on May 20, 2002 to repurchase stock. On June 30, 2002, the $100 was classified as short-term debt pending completion of the recapitalization transactions. Four legal actions were commenced against us, our directors and the Funds challenging the original recapitalization transaction announced in April 2002. Three of the four actions were purported class actions; the fourth action was brought by individual stockholders. The parties in two of the three class actions, which were brought on behalf of holders of Class B Stock, entered into a settlement agreement, subject to court approval, with respect to the settlement of those actions. The third class action, which was brought on behalf of holders of Class A Stock, was dismissed with prejudice by the Court of Chancery of the State of Delaware pursuant to a comprehensive settlement agreement that was approved by the Court of Chancery on February 12, 2003. The fourth action was voluntarily dismissed. Other Liquidity Matters In May 2001, we announced authorization to repurchase up to a total of $250 in shares of our outstanding Common Stock. As of June 2002, we had purchased approximately 3.6 million shares for approximately $64 under the May 2001 authorization. As described above, the 2002 Credit Agreements place certain restrictions on the amount of share repurchases allowed. At June 30, 2004, some of our international subsidiaries had available lines of credit and overdraft facilities totaling $29. There were no borrowings outstanding under these facilities at June 30, 2004. In 2005, we expect to generate funds through the sale of some of our properties in certain domestic and international markets. This includes the potential sale and partial leaseback of our headquarters in Westchester County, New York, announced in January 2004. We believe that our liquidity, capital resources, cash flows and borrowing capacity are sufficient to fund normal capital expenditures, working capital requirements, the payment of dividends, debt service and the implementation of our strategic initiatives. Contractual Obligations and Commitments (includes forward-looking information) For information regarding debt and other obligations, including lease commitments and contingencies, see Note 6, Goodwill and Other Intangible Assets, Net; Note 11, Debt; and Note 13, Commitments and Contingencies, in our Notes to Consolidated Financial Statements. In the normal course of business, we enter into long-term arrangements with suppliers for raw materials and merchandise and with other parties whose recordings or works we use in our products. These arrangements may contain minimum purchase requirements. We enter into these agreements to facilitate an adequate supply of materials and to enable us to develop better products for sale to our customers. The table below details our significant contractual obligations and the timing of payments due for those contracts with minimum purchase requirements. Less than One to Three to More than Contractual Obligations one year three years five years five years Debt obligations: Term Loan Agreement(1) $ 39 $ 144 $ 194 $ -- Senior Notes(2) -- -- -- 300 Revolving Credit facility 45 -- -- -- Lease commitments: Operating leases 17 26 23 55 Purchase commitments: World's Finest Chocolate(3) 59 123 138 759 Royalty contracts 6 2 -- -- Pension and postretirement obligations(4) 60 122 123 334 Service and outsource contracts(5) 25 27 10 2 ------ ------ ------ ------ Total $ 251 $ 444 $ 488 $1,450 ====== ====== ====== ======
(1)In the fourth quarter of 2002, we borrowed $950 to complete the Reiman acquisition, finance the recapitalization transactions and pay down existing debt balances. The commitments detailed above represent the mandatory scheduled principal repayments detailed in the Term Loan Agreement, adjusted for the effect of principal repayments made in 2004 in excess of those required, and those related to the Senior Notes. See Note 11, Debt, in our Notes to Consolidated Financial Statements for additional information. (2)In the third quarter of 2004, we issued 6 1/2% Senior Notes in a private placement. We used the proceeds from this offering to refinance amounts outstanding under the Term Loan. (3)In May 2000 QSP, Inc. entered into a licensing agreement with World's Finest Chocolate, Inc. to obtain the exclusive right to distribute World's Finest Chocolate products for fundraising purposes. This agreement was amended in 2003. The commitments detailed above represent our minimum purchase requirement of chocolate products from fiscal 2005 until the agreement terminates, in fiscal 2020. See Note 6, Goodwill and Other Intangible Assets, Net, in our Notes to Consolidated Financial Statements for additional information. (4)This item includes payments that are expected to be made for pension and postretirement benefits. Amounts in the "More than five years" category only include projected payments from fiscal 2010 through fiscal 2014. See Note 8, Pension Plans and Other Postretirement Benefits, in our Notes to Consolidated Financial Statements for additional information. (5)This caption includes a number of service contracts, such as: product fulfillment agreements, information technology license and maintenance agreements, and agreements with postal authorities. These contracts terminate at varying dates ranging from fiscal 2005 through fiscal 2010. Currency Risk Management (includes forward-looking information) In the normal course of business, we are exposed to the effects of foreign exchange rate fluctuations on the U.S. dollar value of our foreign subsidiaries' results of operations and financial condition. We hedge significant known transactional exposures, but generally do not hedge the impact of foreign currency translation on our earnings. Additional information concerning derivative financial instruments is available in Note 7, Financial Instruments, in our Notes to Consolidated Financial Statements. Fiscal 2005 Outlook (includes forward-looking information) The end of 2004 marked the midpoint of our two-year plan to achieve sustainable revenue and profit growth by Fiscal 2005. The plan included a series of actions ranging from reengineering efforts to cost-reduction initiatives, as well as incremental investment spending to focus on activities that represent the best opportunity to drive future growth. Throughout the year, we made progress against the plan, particularly in Reader's Digest North America and Reader's Digest International. However, both QSP and Books Are Fun had disappointing years that led to total company performance that was lower than expected, and which should affect fiscal 2005 as well. Overall, for fiscal 2005 we expect to have a solid performance and will approach our goal of sustainable revenue and profit growth. We expect that for fiscal 2005: 1. Revenues should grow slightly, except for a couple of small businesses that will be purposely downsized. 2. Operating profit should reflect the following performances from the business units: -- Low double-digit gains at Reader's Digest North America. -- Mid single-digit growth at Reader's Digest International. -- Flat to slightly lower results at Consumer Business Services. -- Lower Corporate Unallocated expenses. 3. The estimates for operating profits should include at least $15 in new investments. 4. Operating profit will include the impact of our change in magazine promotion accounting: -- Continued amortization of $77 ($0.49 per share after tax) of magazine deferred promotion costs related to our existing asset, which will be in addition to expenses related to promotions in fiscal 2005. -- Excluding continued amortization, this accounting change will also result in shifts of expense between quarters within fiscal 2005, but the full year projected expense for magazine promotions will be unaffected by this change. As a result of our change in accounting to expense magazine promotion costs when the promotion is mailed, the first half of fiscal 2005 will be adversely affected by the change (because of seasonally higher mailings), whereas the second half will be benefited by a comparable amount. 5. Other (expense) income, net should be favorable in fiscal 2005, reflecting lower interest expense and potential international asset sales. 6. As previously announced and prior to the resolution of our magazine deferred promotion accounting, earnings per share should be in the range of $0.77 to $0.87 per share, excluding any restructuring charges and one-time items. As outlined above, amortization of the aforementioned $77 of magazine deferred promotion costs will reduce estimated fiscal 2005 earnings per share by $(0.49). Year-over-year comparisons in the first and second quarters should be favorable, while the timing of investments and promotional marketing campaign activity will result in unfavorable comparisons in the third quarter and improved results in the fourth quarter. Recent Accounting Standards (includes forward-looking information) In December 2003, the FASB issued a revision to SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The statement revises the financial statement disclosures required for pension and postretirement obligations. Additional disclosures include descriptions of plan assets and the investment strategy employed. In addition to these annual disclosures, SFAS No. 132 also requires interim disclosures such as the components of net periodic pension cost. The statement does not change the recognition or measurement of benefit plan obligations. The annual disclosure requirements are effective for fiscal years ending after December 15, 2003 (fiscal 2004 and thereafter for us). The interim disclosure requirements are effective for interim periods beginning after December 15, 2003 (the third quarter of 2004 and thereafter for us). Adoption of the revision to SFAS No. 132 did not have any impact on our operating results or financial position. On January 12, 2004, the FASB issued FASB Staff Position (FSP) 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." FSP 106-1 relates to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) signed into law by President Bush on December 8, 2003. The Act introduced a prescription drug benefit under Medicare Part D (Part D) and a federal subsidy for sponsors of retiree healthcare benefit plans that provide a benefit that is at least "actuarially equivalent" to Part D. Based on the level of benefits provided under our retiree healthcare plans, we believe the majority of retiree participants are eligible to receive benefits that are at least "actuarially equivalent" to those provided by Part D. In accordance with the provisions of FSP 106-1, we have elected not to defer the effect of the Act on our accumulated postretirement benefit obligation. We reflected an $11.2 benefit as an unrecognized actuarial gain as of our measurement date, March 31, 2004. This gain will be amortized as a component of net periodic postretirement cost over ten years. In the fourth quarter of 2004, we recorded $0.2 of income related to this subsidy. See Note 8, Pension Plans and Other Postretirement Benefits, for additional information. In March 2004, the FASB issued an exposure draft, "Share-Based Payment," which would supersede SFAS No. 123, "Accounting for Stock-Based Compensation," SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123" and Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." The most significant change proposed is the requirement to recognize in the income statements the value of employee stock options and other stock-based compensation (including employee stock purchase plans) as calculated using the fair value based method, as opposed to the intrinsic value method currently used. The full impact of this proposed statement will not be known until the FASB issues a final SFAS, which is expected to be effective for fiscal years beginning after December 15, 2004 (fiscal 2006 and thereafter for us). Cautionary Statement (includes forward-looking information) This report contains or incorporates by reference "forward-looking statements" within the meaning of the U.S. federal securities laws. Forward-looking statements include any statements that address future results or occurrences. These forward-looking statements inherently involve risks and uncertainties that could cause actual future results and occurrences to differ materially from the forward-looking statements. Some of these risks and uncertainties include factors relating to: - the effects of potentially more restrictive privacy and other governmental regulation relating to our marketing methods; - the effects of modified and varied promotions; - our ability to identify customer trends; - our ability to continue to create and acquire a broadly appealing mix of new products; - our ability to attract and retain new and younger magazine subscribers and product customers in view of the maturing of an important portion of our customer base; - our ability to attract and retain subscribers and customers in an economically efficient manner; - the effects of selective adjustments in pricing; - our ability to expand and more effectively utilize our customer database; - our ability to expand into new international markets and to introduce new product lines into new and existing markets; - our ability to expand into new channels of distribution; - our ability to negotiate and implement productive acquisitions, strategic alliances and joint ventures; - our ability to successfully integrate newly acquired and newly formed businesses (including the Reiman business); - the strength of relationships of newly acquired and newly formed businesses (including the Reiman business) with their employees, suppliers and customers; - the accuracy of the basis of forecasts relating to newly acquired and newly formed businesses (including the Reiman business); - our ability to achieve financial savings related to restructuring programs; - our ability to contain and reduce costs, especially through global efficiencies; - the cost and effectiveness of our reengineering of business processes and operations; - the accuracy of our management's assessment of the current status of our business; - the evolution of our organizational and structural capabilities; - our ability to respond to competitive pressures within and outside the direct marketing and direct sales industries, including the Internet; - our ability to recruit, train and retain effective sales personnel; - the effects of worldwide paper and postage costs; - the effects of possible postal disruptions on deliveries of promotions, products and payments; - the effects of foreign currency fluctuations; - the accuracy of our management's assessment of the future effective tax rate and the effects of initiatives to reduce the rate; - the adequacy of our financial resources; - the effects of the terms of, and increased leverage resulting from additional borrowings under, our credit facilities; - the effects of interest rate fluctuations; - the effects of downgrades of our credit ratings; - the effects of economic and political changes in the markets where we compete; - the effects of weather in limiting access to consumers; and - the economic effects of terrorist activity and related events, especially those limiting access to consumers and otherwise affecting the direct marketing and direct sales industries. We do not undertake to update any forward-looking statements. The Reader's Digest Association, Inc. and Subsidiaries Consolidated Statements of Income Years ended June 30, In millions, except per share data 2004 2003 2002 Revenues $ 2,388.5 $ 2,474.9 $ 2,368.6 Product, distribution and editorial expenses (972.9) (1,002.2) (947.7) Promotion, marketing and administrative expenses (1,294.5) (1,293.8) (1,236.5) Other operating items, net (15.0) (39.8) (26.7) ----------- ----------- ----------- Operating profit 106.1 139.1 157.7 Other (expense) income, net (40.0) (38.7) (17.1) ----------- ----------- ----------- Income before provision for income taxes 66.1 100.4 140.6 Provision for income taxes (16.6) (39.1) (49.4) ----------- ----------- ----------- Net income $ 49.5 $ 61.3 $ 91.2 =========== =========== =========== Basic and diluted earnings per share Basic earnings per share Weighted average common shares outstanding 97.1 98.1 100.2 ----------- ----------- ----------- Basic earnings per share $ 0.50 $ 0.61 $ 0.90 =========== =========== =========== Diluted earnings per share Adjusted weighted average common shares outstanding 99.2 99.2 100.6 ----------- ----------- ----------- Diluted earnings per share $ 0.49 $ 0.60 $ 0.89 =========== =========== ===========
See accompanying Notes to Consolidated Financial Statements. The Reader's Digest Association, Inc. and Subsidiaries Consolidated Balance Sheets At June 30, In millions 2004 2003 Assets Current assets Cash and cash equivalents $ 50.3 $ 51.3 Accounts receivable, net 229.0 256.5 Inventories 152.0 155.7 Prepaid and deferred promotion costs 106.9 132.7 Prepaid expenses and other current assets 152.1 191.8 ---------- ---------- Total current assets 690.3 788.0 Property, plant and equipment, net 155.8 162.5 Goodwill 1,009.5 1,009.4 Other intangible assets, net 173.9 212.3 Other noncurrent assets 413.2 427.3 ---------- ---------- Total assets $ 2,442.7 $ 2,599.5 ========== ========== Liabilities and stockholders' equity Current liabilities Loans and notes payable $ 83.9 $ 31.3 Accounts payable 110.6 97.5 Accrued expenses 268.7 281.4 Income taxes payable 15.5 36.5 Unearned revenues 403.4 414.8 Other current liabilities 10.2 19.7 ---------- ---------- Total current liabilities 892.3 881.2 Postretirement and postemployment benefits other than pensions 119.5 121.9 Unearned revenues 129.3 127.6 Long-term debt 637.7 834.7 Other noncurrent liabilities 200.8 233.8 ---------- ---------- Total liabilities $ 1,979.6 $ 2,199.2 Commitments and Contingencies (Notes 6, 11 and 13) Stockholders' equity (Note 12) Capital stock 17.8 17.6 Paid-in capital 210.1 215.0 Retained earnings 1,330.4 1,301.6 Accumulated other comprehensive (loss) income (89.4) (109.2) Treasury stock, at cost (1,005.8) (1,024.7) ---------- ---------- Total stockholders' equity 463.1 400.3 ---------- ---------- Total liabilities and stockholders' equity $ 2,442.7 $ 2,599.5 ========== ==========
See accompanying Notes to Consolidated Financial Statements. The Reader's Digest Association, Inc. and Subsidiaries Consolidated Statements of Cash Flows Years ended June 30, In millions 2004 2003 2002 Cash flows from operating activities Net income $ 49.5 $ 61.3 $ 91.2 Depreciation and amortization 63.2 64.7 35.9 Magazine deferred promotion charge 27.2 -- -- Asset impairments 1.1 3.2 11.7 Investment impairments -- -- 2.5 Amortization of debt issue costs 12.1 4.3 1.0 Stock-based compensation 10.2 6.2 2.7 Net (gain) loss on the sales of certain assets (10.0) (8.6) (6.9) Changes in current assets and liabilities, net of effects of acquisitions and dispositions Accounts receivable, net 34.1 55.0 2.5 Inventories 6.4 6.4 21.8 Unearned revenues (14.3) (12.1) (5.2) Accounts payable and accrued expenses (6.8) (20.1) 24.7 Other, net 10.2 4.2 35.7 Changes in noncurrent assets and liabilities, net of effects of acquisitions and dispositions (8.5) (2.4) (65.1) -------- -------- -------- Net change in cash due to operating activities 174.4 162.1 152.5 -------- -------- -------- Cash flows from investing activities Proceeds from maturities and sales of marketable securities and short-term investments 0.8 5.2 11.6 Proceeds from sales of businesses and other long-term investments, net 3.0 -- 2.2 Proceeds from sales of property, plant and equipment 7.1 5.5 2.4 Purchases of investments, marketable securities and licensing agreements (1.3) (10.5) (1.3) Payments for business acquisitions, net of cash acquired -- -- (763.2) Capital expenditures (16.1) (15.7) (24.6) -------- -------- -------- Net change in cash due to investing activities (6.5) (15.5) (772.9) -------- -------- -------- Cash flows from financing activities Proceeds (repayments) of revolving credit and other short-term facilities, net 43.9 (0.6) (160.4) Proceeds from Senior Notes offering 300.0 -- -- (Repayments on) proceeds from Term Loan (488.4) (84.7) 950.0 Cash paid for financing fees (7.6) (2.7) (17.6) Proceeds from employee stock purchase plan and exercise of stock options 2.5 4.3 8.6 Dividends paid (20.7) (21.0) (21.3) Common stock repurchased -- (101.7) (64.1) Other, net 0.5 0.8 0.3 -------- -------- -------- Net change in cash due to financing activities (169.8) (205.6) 695.5 -------- -------- -------- Effect of exchange rate fluctuations on cash and cash equivalents 0.9 2.7 (2.9) -------- -------- -------- Net change in cash and cash equivalents (1.0) (56.3) 72.2 -------- -------- -------- Cash and cash equivalents at beginning of year 51.3 107.6 35.4 -------- -------- -------- Cash and cash equivalents at end of year $ 50.3 $ 51.3 $ 107.6 ======== ======== ======== Supplemental information Cash paid for interest $ 34.2 $ 39.6 $ 9.3 Cash paid for income taxes $ 28.7 $ 36.2 $ 40.8
See accompanying Notes to Consolidated Financial Statements. The Reader's Digest Association, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity Capital Stock Accumulated Unamortized Other Treasury Preferred Common Restricted Paid-in Retained Comprehensive Stock, at In millions Stock Stock Stock Capital Earnings (Loss) Income Cost Total Balance at June 30, 2001 $ 28.8 $ 1.4 $ (0.6) $ 226.1 $ 1,191.3 $ (84.6) $ (902.6) $ 459.8 -------- ------- -------- ---------- ---------- -------- ---------- -------- Comprehensive income Net income 91.2 91.2 Other comprehensive income: Translation gain 13.0 13.0 Net unrealized gain on investments, net of deferred 3.6 3.6 taxes of $(1.9) Reclassification adjustments for investment gains that are included in net income, net of deferred taxes of $2.5 (4.7) (4.7) Net realized loss on derivatives, net of deferred taxes of $0.5 (0.8) (0.8) Minimum pension liability, net of deferred taxes of $6.8 (16.2) (16.2) -------- Total comprehensive income 86.1 ======== Stock issued under various plans (4.1) (1.5) 17.0 11.4 Common Stock repurchased (64.1) (64.1) Common Stock dividends (20.0) (20.0) Preferred Stock dividends (1.3) (1.3) -------- ------- -------- ---------- ---------- -------- ---------- -------- Balance at June 30, 2002 28.8 1.4 (4.7) 224.6 1,261.2 (89.7) (949.7) 471.9 -------- ------- -------- ---------- ---------- -------- ---------- -------- Comprehensive income Net income 61.3 61.3 Other comprehensive income: Translation gain 19.0 19.0 Reclassification adjustments for investment gains that are included in net income, net of deferred taxes of $1.8 (3.3) (3.3) Net realized loss on derivatives, net of deferred taxes of $0.8 (1.4) (1.4) Minimum pension liability, net of deferred taxes of $14.7 (33.8) (33.8) -------- Total comprehensive income 41.8 ======== Stock issued under various plans (8.0) (9.5) 26.7 9.2 Reclassification of par value due to the recapitalization transactions 0.1 (0.1) -- Common Stock repurchased (101.7) (101.7) Common Stock dividends (19.6) (19.6) Preferred Stock dividends (1.3) (1.3) -------- ------- -------- ---------- ---------- -------- ---------- -------- Balance at June 30, 2003 $ 28.8 $ 1.5 $ (12.7) $ 215.0 $ 1,301.6 $ (109.2) $ (1,024.7) $ 400.3
The Reader's Digest Association, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders' Equity, continued Capital Stock Accumulated Unamortized Other Treasury Preferred Common Restricted Paid-in Retained Comprehensive Stock, at In millions Stock Stock Stock Capital Earnings (Loss) Income Cost Total Comprehensive income Net income $ 49.5 $ 49.5 Other comprehensive income: Translation gain 5.8 5.8 Net unrealized gain on investments, net of deferred taxes of $(0.1) 0.2 0.2 Reclassification adjustments for investment gains that are included in net income, net of deferred taxes of $0.3 (0.5) (0.5) Net realized loss on derivatives, net of nominal deferred taxes (0.1) (0.1) Reclassification adjustments for derivative losses that are included in net income, net of deferred taxes of $(0.5) 0.9 0.9 Minimum pension liability, net of deferred taxes of $(5.6) 13.5 13.5 -------- Total comprehensive income 69.3 ======== Stock issued under various plans 0.2 (4.9) 18.9 14.2 Common Stock dividends (19.4) (19.4) Preferred Stock dividends (1.3) (1.3) -------- ------- -------- ---------- ---------- -------- ---------- -------- Balance at June 30, 2004 $ 28.8 $ 1.5 $ (12.5) $ 210.1 $ 1,330.4 $ (89.4) $ (1,005.8) $ 463.1 ======== ======= ======== ========== ========== ======== ========== ========
See accompanying Notes to Consolidated Financial Statements. The Reader's Digest Association, Inc. and Subsidiaries Notes to Consolidated Financial Statements Dollars in millions, except per share data Unless otherwise indicated, references in Notes to Consolidated Financial Statements to "we," "our" and "us" are to The Reader's Digest Association, Inc. and its subsidiaries. All references to 2004, 2003 and 2002, unless otherwise indicated, are to fiscal 2004, fiscal 2003 and fiscal 2002, respectively. Our fiscal year represents the period from July 1 through June 30. Note 1 Organization and Summary of Significant Accounting Policies Nature of Our Business We are a diversified media company that produces and distributes books, magazines and other products worldwide. We sell these and other products through direct marketing and direct sales channels. Our best known trademark is our flagship magazine, Reader's Digest. We conduct business through three reportable segments: Reader's Digest North America, Consumer Business Services and Reader's Digest International (formerly International Businesses). For further commentary regarding these segments, see Management's Discussion and Analysis and Note 14, Segments. Basis of Presentation and Use of Estimates The accompanying consolidated financial statements include the accounts of The Reader's Digest Association, Inc. and its majority-owned subsidiaries. These financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of operating revenues and expenses during the reporting period. These estimates are based on management's knowledge of current events and actions that we may undertake in the future; however, actual results may ultimately differ from those estimates. The primary estimates underlying our consolidated financial statements include allowances for returns and doubtful accounts, valuations of inventories, direct response advertising and subscriber acquisition costs, deferred tax assets, and estimates of pension, postemployment and postretirement benefits. Concentrations of Credit Risk Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of trade accounts receivable. However, we believe our concentrations of credit risk with respect to trade receivables are limited due to our large number of customers, their low dollar balances and their dispersion across many different geographic and economic environments. Cash and Cash Equivalents We consider all highly liquid investments with original maturities of three months or less at the date of purchase to be cash equivalents. The carrying amount approximates fair value based upon the short-term maturity of these investments. Inventories Inventories consist primarily of finished goods and raw materials (including paper) and are stated at the lower of cost or market value. For all inventories, cost is determined using the weighted average cost method, which approximates the first-in, first-out (FIFO) method. Long-Lived Assets Property, Plant and Equipment, Net Assets that comprise property, plant and equipment, net are stated at cost less accumulated depreciation. Depreciation expense is generally calculated on a straight-line basis over the estimated useful lives of the assets: 10-40 years for buildings and three to ten years for equipment, furniture and fixtures. Leasehold improvements are amortized on a straight-line basis over the term of the lease or the useful life of the improvement, whichever is shorter. Goodwill and Other Intangible Assets, Net Goodwill is composed of the excess of costs over the fair value of net assets of acquired businesses. Other intangible assets, net is composed of licensing agreements, customer lists, tradenames and other items. Acquired intangibles with finite lives are amortized, on a straight-line basis, over their estimated useful lives. See Note 6, Goodwill and Other Intangible Assets, Net, for additional information. Impairment of Long-Lived Assets We review the carrying amount of goodwill and intangibles with indefinite lives, at least annually, for recoverability. This assessment involves comparing the fair value of the reporting unit or asset, as applicable, to its carrying value. Recognition of the impairment, if any, is determined in accordance with the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." Intangible assets with finite lives and assets that are held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of that asset may not be recoverable in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." We assess recoverability by comparing the asset's carrying amount to the undiscounted future net cash flows expected to be generated by the asset. If we determine that the asset is impaired, the impairment recognized is the amount by which the carrying amount of the asset exceeds the fair value of the asset. Investments Marketable securities are classified as available-for-sale. Accordingly, these securities are recorded at fair value in other noncurrent assets on the balance sheet. Unrealized gains and losses on available-for-sale securities, net of tax, are recorded in other comprehensive (loss) income in stockholders' equity on the balance sheet. Realized gains and losses, and declines in carrying value deemed to be other than temporary, are recorded in other (expense) income, net on the income statements. As of June 30, 2004, we do not hold any marketable securities. Debt Issuance Costs Debt issuance costs consist of fees and expenses incurred in connection with our borrowings. These fees are being amortized over the terms of the related debt agreements, currently ranging from two to seven years. Capitalized debt issuance costs are included in other noncurrent assets on the balance sheets. To the extent we retire a significant portion of our borrowings, a proportionate amount of debt issue costs related to those borrowings is written off. Stock-Based Compensation We account for stock-based compensation under SFAS No. 123, "Accounting for Stock-Based Compensation." As permitted by this standard, compensation cost is recognized for stock-based compensation using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Under this method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date over the amount an employee must pay to acquire the stock. Since our practice is to grant stock options with an exercise price equal to the market price at the date of grant, no compensation cost is recognized. Compensation cost is recognized with respect to restricted stock and similar instruments. The table below presents our net income and basic and diluted earnings per share as reported on the income statements for the respective periods and adjusts these amounts to include the pro forma impact of using the fair value based method to calculate stock compensation expense as prescribed under SFAS No. 123. The fair value of our options and shares to be issued in connection with employee stock purchase plans on the date of grant was calculated using the Black-Scholes option-pricing model. Adopting the fair value based method would result in a additional compensation expense of $(10.7), $(13.1) and $(14.2) of expense, net of tax, for the years ended June 30, 2004, 2003 and 2002, respectively. 2004 2003 2002 Net income As reported $49.5 $61.3 $91.2 Pro forma $38.8 $48.2 $77.0 Earnings per share As reported - basic $0.50 $0.61 $0.90 Pro forma - basic $0.39 $0.48 $0.76 As reported - diluted $0.49 $0.60 $0.89 Pro forma - diluted $0.38 $0.47 $0.75 For the years ended June 30, 2004, 2003 and 2002, $(6.6), $(4.0) and $(1.8), net of tax, respectively, of expenses related to restricted stock and other stock-based compensation are included in our net income and earnings per share, as reported. Additional information is presented in Note 9, Employee Equity Compensation Plans. Financial Instruments Due to the short maturities of our cash, investments, receivables and payables, the carrying value of these financial instruments approximates their fair values. The fair values of all of our debt instruments approximate their carrying values. We record all derivative instruments on the balance sheets at fair value. Derivatives that are not classified as hedges are adjusted to fair value through earnings. Changes in fair value of the derivatives that we have designated and that qualify as effective hedges are recorded in either other comprehensive income or earnings, as appropriate. The ineffective portion of our derivatives that are classified as hedges is immediately recognized in earnings. Revenues Magazines Sales of our magazine subscriptions, less estimated cancellations, are deferred and recognized as revenues proportionately over the subscription period. Revenues from sales of magazines through the newsstand are recognized at the issue date, net of an allowance for returns. Advertising revenues are recorded as revenues at the time the advertisements are published, net of discounts and advertising agency commissions. Sponsor Fundraising Programs Our sponsor fundraising program business, which operates principally through QSP, Inc., receives its revenues net of amounts due to its sponsors. Accordingly, we present revenues net of sponsors' earnings. Sales of subscriptions to magazines published by other companies and sales of music products are recorded as revenues at the time orders are submitted to the publisher, net of bad debts and remittances to magazine and music publishers. Books, Display Marketing and Other Products Revenues are recorded when title passes, net of provisions for estimated returns and bad debts. For our display marketing products, title passes either at the point of sale or at the time of shipment. In certain circumstances, our promotion entitles the customer to a preview period. Revenue generated by these promotions is recognized after the preview period lapses. When we recognize revenues for most of our products, we also record an estimate of bad debts and returns. These estimates are based on historical data and the method of promotion. Reserve levels are adjusted as actual data is received. In the direct marketing business, returns and bad debts are tied to customer responses to our promotional efforts. Accordingly, we deduct both estimates of bad debts and of returns from gross revenue. Financial Services Marketing Alliances Revenues from our financial services marketing alliances are based on amounts negotiated through contracts with our alliance partners. Such amounts are recognized as revenue as they are earned. In circumstances where amounts are received in advance, we defer revenue recognition until such amounts are earned. Promotion Costs Costs of direct response advertising are accounted for under the American Institute of Certified Public Accountants Statement of Position (SOP) 93-7, "Reporting on Advertising Costs." Under SOP 93-7, costs associated with direct response advertising that can be directly linked to eliciting sales and result in probable future benefits are capitalized on a cost-pool-by-cost-pool basis. Magazine related direct response advertising costs were amortized over the expected future revenue stream, which was generally one to three years. Books and home entertainment advertising costs are amortized over a period that is generally less than one year. We assess the carrying amount of our capitalized direct response advertising costs for recoverability on a periodic basis. During the fourth quarter of 2004, we reassessed our accounting for magazine promotion costs in response to changes in our business, as well as the strategies and initiatives being undertaken by our magazine business. As a result of these changes, pursuant to SOP 93-7, effective fiscal 2005, we will no longer defer and amortize magazine promotion costs, but will expense such costs when the promotion is mailed to prospective customers. As of June 30, 2004, we have recorded a pre-tax charge of $27.2, to reflect the impact of this change in circumstances on our existing asset. Such amount is included as a component of promotion, marketing and administrative expenses on the income statements. The remaining balance will be amortized in fiscal 2005, over the initial subscription period, generally one year. Direct response advertising consists primarily of promotion costs incurred in connection with the sale of magazine subscriptions, books and other products. Promotion expense, which consists of both amortization of capitalized promotion costs and costs expensed as incurred, included in the income statements totaled $(678.5)in 2004, including $(27.2) related to our magazine deferred promotion charge, $(670.6) in 2003, and $(666.3) in 2002. Prepaid and deferred promotion costs included on the balance sheets were $106.9 and $132.7 as of June 30, 2004 and 2003, respectively. Amounts included in other noncurrent assets on the balance sheets were $20.7 and $21.2 as of June 30, 2004 and 2003, respectively. Commissions earned by agents for new magazine subscribers are included in promotion, marketing and administrative expenses on the income statements. These costs are deferred and amortized over the related subscription term, typically one to three years. Amounts deferred and included in prepaid expenses and other current assets on the balance sheets were $26.0 and $33.2 as of June 30, 2004 and 2003, respectively. Amounts included in other noncurrent assets on the balance sheets were $24.3 and $26.5 as of June 30, 2004 and 2003, respectively. Income Taxes Income taxes are accounted for under the provisions of SFAS No. 109, "Accounting for Income Taxes." In accordance with SFAS No. 109, deferred income taxes, net of valuation allowances, reflect the future tax consequences of differences between the financial statement and tax bases of assets and liabilities. These deferred taxes are calculated by applying currently enacted tax laws. Valuation allowances are recorded when it is "more likely than not" that a deferred tax asset will not realized. Basic and Diluted Earnings Per Share Basic earnings per share is computed by dividing net income less preferred stock dividend requirements ($1.3 for each of 2004, 2003 and 2002) by the weighted average number of shares of Common Stock outstanding during the year. Diluted earnings per share is computed in the same manner except that the weighted average number of shares of Common Stock outstanding assumes the exercise and conversion of certain stock options and vesting of certain restricted stock (2.2 million shares for 2004, 1.2 million shares for 2003 and 0.4 million shares for 2002). Options to purchase approximately 10.8 million shares of Common Stock were outstanding during 2004, but were not included in the computation of diluted earnings per share (12.1 million shares in 2003 and 10.3 million shares in 2002). The exercise prices of these options were greater than the average market price of the Common Stock during the period. Foreign Currency Translation The functional currency for most foreign operations is the local currency. Revenues and expenses denominated in foreign currencies are translated at average monthly exchange rates prevailing during the year. The assets and liabilities of international subsidiaries are translated into U.S. dollars at the rates of exchange in effect at the balance sheet date. The resulting translation adjustment is reflected as a separate component of stockholders' equity in accumulated other comprehensive (loss) income. The U.S. dollar is used as the functional currency for subsidiaries operating in highly inflationary economies, for which both translation adjustments and gains and losses on foreign currency transactions are included in other (expense) income, net. Reclassifications Certain reclassifications have been made to amounts in prior periods to conform to the current period presentation. Recent Accounting Standards In December 2003, the FASB issued a revision to SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The statement revises the financial statement disclosures required for pension and postretirement obligations. Additional disclosures include descriptions of plan assets and the investment strategy employed. In addition to these annual disclosures, SFAS No. 132 also requires interim disclosures such as the components of net periodic pension cost. The statement does not change the recognition or measurement of benefit plan obligations. The annual disclosure requirements are effective for fiscal years ending after December 15, 2003 (2004 and thereafter for us). The interim disclosure requirements are effective for interim periods beginning after December 15, 2003 (the third quarter of 2004 and thereafter for us). Adoption of the revision to SFAS No. 132 did not have any impact on our operating results or financial position. On January 12, 2004, the FASB issued FASB Staff Position (FSP) 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." FSP 106-1 relates to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) signed into law by President Bush on December 8, 2003. The Act introduced a prescription drug benefit under Medicare Part D (Part D) and a federal subsidy for sponsors of retiree healthcare benefit plans that provide a benefit that is at least "actuarially equivalent" to Part D. Based on the level of benefits provided under our retiree healthcare plans, we believe the majority of retiree participants are eligible to receive benefits that are at least "actuarially equivalent" to those provided by Part D. In accordance with the provisions of FSP 106-1, we have elected not to defer the effect of the Act on our accumulated postretirement benefit obligation. We reflected an $11.2 benefit as an unrecognized actuarial gain as of our measurement date, March 31, 2004. This gain will be amortized as a component of net periodic postretirement cost over ten years. In the fourth quarter of 2004, we recorded $0.2 of income related to this subsidy. See Note 8, Pension Plans and Other Postretirement Benefits, for additional information. In March 2004, the FASB issued an exposure draft, "Share-Based Payment," which would supersede SFAS No. 123, "Accounting for Stock-Based Compensation," SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123" and APB Opinion No. 25. The most significant change proposed is the requirement to recognize in the income statements the value of employee stock options and other stock-based compensation (including employee stock purchase plans) as calculated using the fair value based method, as opposed to the intrinsic value method currently used. The full impact of this proposed statement will not be known until the FASB issues a final SFAS, which is expected to be effective for fiscal years beginning after December 15, 2004 (fiscal 2006 and thereafter for us). Note 2 Acquisitions and Investments Acquisitions On May 20, 2002, we purchased substantially all of the assets and assumed certain liabilities of Reiman Holding Company, LLC and subsidiaries (Reiman). Reiman publishes cooking, gardening, country lifestyle and nostalgia magazines and books and operates other complementary businesses in the United States and Canada. The total purchase price of $760.0, plus capitalized acquisition costs of $8.2, was financed entirely through bank and institutional borrowings. The acquisition was accounted for using the purchase method of accounting and resulted in $651.7 of goodwill on the date of acquisition, which is deductible for tax purposes. Reiman's results have been consolidated since May 20, 2002. We acquired Reiman to: - generate significant purchasing and product-related synergies with our existing businesses, - reduce our reliance on sweepstakes promotions, - expand our direct marketing database, and - allow for geographic expansion of certain Reiman products. As with most acquisitions of magazine publishers, we also acquired a significant subscription liability. The following table represents the fair values of assets acquired and liabilities assumed at the date of acquisition: Current assets $ 101.1 Property, plant and equipment 10.7 Identified intangible assets 206.8 Goodwill 651.7 Other noncurrent assets 21.6 ------- Total assets acquired 991.9 Current liabilities (154.2) Long-term liabilities (69.5) ------- Net assets acquired $ 768.2 ======= Identified intangible assets comprised tradenames and subscriber lists. The tradenames, with a fair value of $89.7, were determined to have an indefinite life. The subscriber lists, with a fair value of $117.1, are amortized over their estimated useful lives, ranging from three to six years. On the acquisition date, the weighted average useful life of the subscriber lists was approximately 3.5 years. For changes in goodwill and acquired intangibles subsequent to the date of acquisition, see Note 6, Goodwill and Other Intangible Assets, Net. The following table presents pro forma information as though the acquisition took place at the beginning of 2002. Pro forma information (unaudited): Revenues $ 2,648.2 Net income $ 92.3 Earnings per share (unaudited): Basic $ 0.91 Diluted $ 0.90 These unaudited pro forma results have been prepared for comparative purposes only and include certain adjustments, such as additional amortization expense for identified intangibles, increased interest expense from the incurrence of debt and lower interest income from reduced cash on hand. The results are not intended to be indicative of the results of operations that actually would have resulted had the acquisition occurred at the beginning of 2002, or of future results of operations of our consolidated entity. Available-for-Sale Marketable Securities Marketable securities included in other noncurrent assets on the balance sheet primarily represents the fair market value (based on quoted market prices) of our investment in LookSmart, Ltd. These securities were accounted for and classified as available-for-sale securities. We sold all of our remaining shares in LookSmart in the first quarter of 2004. As of June 30, 2003, the market value of our investment in LookSmart shares totaled $0.6. The net unrealized gain on these investments, net of deferred taxes, is included in accumulated other comprehensive (loss) income in stockholders' equity on the balance sheet and amounted to $0.4 as of June 30, 2003. During 2004, 2003 and 2002 we sold approximately 0.2 million shares, 2.7 million shares and 4.2 million shares, respectively, of LookSmart and recorded pre-tax gains of $0.8, $5.1 and $7.3, respectively, in other (expense) income, net on the income statements. Note 3 Other Operating Items, Net Charges included in other operating items, net primarily represent the streamlining of our organizational structure and the strategic repositioning of certain businesses. Charges recorded prior to December 31, 2002 were recorded in accordance with Emerging Issues Task Force Issue (EITF) No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs To Exit an Activity (Including Certain Costs Associated with a Restructuring)." EITF No. 94-3 required that amounts related to restructuring actions be recorded only when management was committed to an exit plan. Charges subsequent to December 31, 2002 are recorded in accordance with SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which superseded EITF No. 94-3. Under SFAS No. 146, costs associated with restructuring actions, including one-time severance benefits, are only recorded once a liability has been incurred. SFAS No. 146 does not consider severance benefits determined pursuant to an existing formula as one-time benefits. As our severance programs do not qualify as one-time benefits, we recognize severance amounts pursuant to SFAS No. 112, "Employers' Accounting for Postemployment Benefits" and SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits" (the impact of pension curtailments and settlements that are directly attributable to our restructuring actions are recorded in accordance with SFAS No. 88). As such, severance amounts were recorded when a termination plan was developed and approved and when payment was probable and estimable. Other amounts related to restructuring actions, including contract terminations, are recorded based upon fair value in accordance with SFAS No. 146. Asset impairments were calculated in accordance with the provisions of SFAS No. 144. We recorded charges for other operating items, net, on the income statements, of $(15.0) in 2004, $(39.8) in 2003 and $(26.7) in 2002. The components of other operating items, net are described in further detail below: - Severance Costs - These charges represent the cost to separate employees from our operations as a result of costs incurred to streamline the organization. This separation is accomplished through a combination of voluntary and involuntary severance programs. The positions to be separated were identified when the charge was recorded. - Contract Terminations - These charges represent costs incurred to terminate contractual obligations in connection with streamlining activities. - Impairment Losses - As a result of streamlining activities, we have previously incurred charges related to the carrying value of certain long-lived assets. At June 30, 2004, we had restructuring reserves for other operating items, net of $21.7, primarily for severance costs and contract terminations that will take place during the next several fiscal quarters. These reserves are included in accrued expenses on the balance sheet. At June 30, 2003, restructuring reserves totaled $34.7, primarily for severance costs and contract terminations. During 2004, we recorded additional restructuring and other reserves of $17.1, which were partially offset by adjustments to reserve balances of $0.7. In addition, $29.4 was charged against these reserves primarily for severance and costs incurred to restructure business processes in certain departments. Included in the June 30, 2003 balance is a reclassification of approximately $0.9 to properly reflect spending against the appropriate year of the charge. The table below outlines the activity related to the restructuring actions recorded in 2004 and previous years. Initial year Balance at (Adjustments)/ Balance at of charge June 30, 2003 Accruals Spending June 30, 2004 2002 & prior $ 7.0 $ (0.5) $ (3.3) $ 3.2 2003 27.7 (0.1) (20.9) 6.7 2004 -- 17.0 (5.2) 11.8 ------ ------ ------- ------- Total $ 34.7 $ 16.4 $ (29.4) $ 21.7 ====== ====== ======= ======= In certain instances, circumstances arose that resulted in decisions to retain employees previously identified for termination, and in certain other instances the costs associated with actions identified were settled for less than originally anticipated. In these instances, the associated charges were reversed. During 2004, other operating items, net of $(15.0) comprised: - Charges of $(13.7) for severance and $(4.3) for contract terminations, asset impairments and costs associated with closing our Norway location. The severance charges related to streamlining operations in certain international markets and corporate departments. As a result of these actions, approximately 240 employees were identified to be separated from our operations. As of June 30, 2004, almost 40% of these positions were terminated. The remaining positions are expected to be terminated over the next several fiscal quarters. - Income of $1.3 related to pension curtailments as a result of employee terminations. - These charges were partially offset by $1.7 of reversals of charges recorded in previous periods that are no longer necessary. We generally review our restructuring charges quarterly to determine the appropriateness of existing reserves in light of current circumstances. Accordingly, these charges, principally consisting of severance, were reversed because of the occurrence of events that affected our original plans. During 2003, other operating items, net of $(39.8) comprised: - Charges of $(45.3), including $(37.6) for severance costs, $(3.2) related to asset impairments and $(4.5) related to other items. These charges were taken to lower our cost base in commensuration with our current revenues and in an effort to streamline our operations. The $(37.6) of severance costs related to the termination of approximately 580 positions, of which 35% were located in North America and 65% were located outside North America. Of the total positions, approximately 90% have been separated as of June 30, 2004. The remaining positions will be terminated during the next several fiscal quarters. Asset impairment charges of $(3.2) were primarily attributable to write-offs of software and other capitalized costs related to unprofitable businesses and discontinued products. Other costs of $(4.5) principally comprised costs incurred to review and compile the restructuring plan utilized to streamline our operations in certain domestic and international markets. - Income of $2.8 representing net adjustments to litigation-related accrual balances, established in previous years, following settlement of a lawsuit in the first quarter of 2003. - Income of $2.7 related to reversals, primarily severance, of charges recorded in previous years. Reversals of accruals recorded in previous years represent circumstances where conditions changed after the date the accrual was established. During 2002, other operating items, net of $(26.7) comprised the following actions: $(5.6) related to the closure of Gifts.com, Inc.; $(12.8) related to the scaling back of our U.S. Books and Home Entertainment business; and $(17.2) related to streamlining various U.S. and international businesses and reducing global staffing levels. These charges were partially offset by adjustments to reserves of $8.9. These charges and adjustments comprised: - Charges of $(35.6), including $(14.7) for severance costs, $(8.0) for contract terminations, and $(12.9) for asset impairments and other items. The $(14.7) of severance costs related to the separation of 289 employees. Approximately 16% of the employees identified were located outside the United States. A majority of the employee separations included in the severance charge were related to U.S. Books and Home Entertainment and administrative functions that support this business, including information technology personnel and Gifts.com, Inc. Substantially all of these employees had been separated by June 30, 2003. Severance charges associated with those positions that were not eliminated were reversed in 2003. - Adjustments of $6.9 related to accrual balances from charges originally recorded in 2001 and prior periods. Reversals of accruals recorded in previous years represent circumstances where conditions changed after the date the accrual was established. - A reversal of $2.0 pertaining to a pending legal matter that was originally recorded in prior years in other operating items, net. Note 4 Other (Expense) Income, Net 2004 2003 2002 Interest income $ 5.2 $ 5.1 $ 4.7 Interest expense(1) (55.0) (46.5) (18.6) Investment impairments(2) -- -- (2.5) Net gain on the sales of certain assets(3) 10.0 8.6 6.9 Net (loss) gain on foreign exchange (0.1) (0.1) (4.2) Recapitalization costs(4) -- (3.4) (3.5) Other (expense) income, net (0.1) (2.4) 0.1 ------- ------- ------- Total other (expense) income, net $ (40.0) $ (38.7) $ (17.1) ======= ======= ======= (1) Interest expense in 2004 included $(7.3) related to the expensing of deferred financing fees because we refinanced a portion of our existing indebtedness, terminated some of our interest rate caps and repriced a portion of our borrowings. See Note 11, Debt, for additional information. (2) Investment impairments in 2002 reflected a write-down of our investments in Schoolpop, Inc. (3) Net gain on the sales of certain assets in 2004 included a gain of $6.1 from the sale of a building in Hong Kong and proceeds of $2.7 received in exchange for our interest in Schoolpop, which merged into an unrelated third-party. This item also included sales of our shares in LookSmart of $0.8, $5.1 and $7.3 in 2004, 2003 and 2002, respectively. In 2003, this item included a gain of $2.2 on the sale of a building in Australia and a gain of $1.6 from settlement of a class action lawsuit related to fine art sales in previous years. (4) See Note 12, Capital Stock, for additional information. Note 5 Supplemental Balance Sheet Information The components of certain balance sheet accounts as of June 30 are as follows: Accounts Receivable, Net 2004 2003 Gross accounts receivable, trade $ 383.4 $ 422.7 Beginning reserve for returns (44.0) (55.2) Additions to allowances(1) (332.7) (349.3) Actual returns(2) 333.9 360.5 ------- ------- Ending reserve for returns (42.8) (44.0) Beginning reserve for bad debts (122.2) (121.8) Additions to allowances(1) (102.9) (118.2) Actual bad debts(2) 113.5 117.8 ------- ------- Ending reserve for bad debts (111.6) (122.2) ------- ------- Ending reserve for returns and bad debts (154.4) (166.2) ------- ------- Accounts receivable, net $ 229.0 $ 256.5 ======= ======= (1) Additions to allowances represent estimated reserves established at the time of revenue recognition for returns and bad debts in accordance with SFAS No. 48, "Revenue Recognition When Right of Return Exists." Amounts are recorded as an offset to revenues. (2) Actual returns and bad debts include actual experience during the period and the effects of foreign currency translation. Inventories 2004 2003 Raw materials $ 9.7 $ 9.3 Work-in-progress 5.0 6.2 Finished goods 137.3 140.2 --------- --------- Total inventories $ 152.0 $ 155.7 ========= ========= Property, Plant and Equipment, Net 2004 2003 Land $ 12.4 $ 12.8 Buildings and building improvements 190.9 188.9 Furniture, fixtures and equipment 165.5 175.3 Leasehold improvements 13.5 14.5 --------- --------- 382.3 391.5 Accumulated depreciation and amortization (226.5) (229.0) --------- --------- Total property, plant and equipment, net $ 155.8 $ 162.5 ========= ========= Other Noncurrent Assets 2004 2003 Pension benefits $ 291.9 $ 270.2 Deferred tax assets 38.7 64.4 Other, principally operating assets 82.6 92.7 --------- --------- Total other noncurrent assets $ 413.2 $ 427.3 ========= ========= Accrued Expenses 2004 2003 Compensation and other employee benefits $ 68.4 $ 73.1 Royalties and copyrights payable 16.9 15.0 Taxes, other than income taxes 6.7 9.0 Other operating items, net 21.7 34.7 Other, principally operating expenses 155.0 149.6 --------- --------- Total accrued expenses $ 268.7 $ 281.4 ========= ========= Other Noncurrent Liabilities 2004 2003 Accrued pension $ 125.9 $ 146.3 Deferred tax liabilities 16.6 27.4 Other, principally operating liabilities 58.3 60.1 --------- --------- Total other noncurrent liabilities $ 200.8 $ 233.8 ========= ========= Note 6 Goodwill and Other Intangible Assets, Net The changes in the carrying amount of goodwill by segment for the fiscal year ended June 30, 2004, are as follows: Reader's Digest Consumer North America Business Services Total Balance as of June 30, 2003 $ 686.4 $ 323.0 $ 1,009.4 Impact of foreign currency translation on goodwill balances outside the United States 0.1 -- 0.1 -------- -------- ---------- Balance as of June 30, 2004 $ 686.5 $ 323.0 $ 1,009.5 ======== ======== ==========
We conducted our annual impairment assessment for goodwill and indefinite-lived intangible assets as of the end of our third quarter and concluded there was no impairment at that time. The following categories of acquired intangible assets are included in other intangible assets, net as of June 30, 2004 and 2003: 2004 2003 Gross Net Gross Net Intangible assets with indefinite lives: Tradenames $ 89.7 $ 89.7 $ 89.7 $ 89.7 Intangible assets with finite lives: Licensing agreements 56.0 36.5 54.8 41.0 Customer lists 137.8 47.7 137.8 81.6 Other tradenames and noncompete agreements 3.0 -- 3.0 -- -------- -------- -------- -------- Total intangible assets $ 286.5 $ 173.9 $ 285.3 $ 212.3 ======== ======== ======== ========
Amortization related to intangible assets with finite lives amounted to $(39.6), $(39.6) and $(11.1) for 2004, 2003 and 2002, respectively. Our most significant licensing agreement is principally amortized over the initial 10-year contract term, with a portion being amortized over the remaining 16-year term of our amended agreement. Customer lists are being amortized principally between three and six years from the date of acquisition. Our most significant customer list intangible was purchased as part of the Reiman acquisition. It will be fully amortized over the next four years. Estimated fiscal year amortization expense for intangible assets with finite lives is as follows: fiscal 2005 - $36.8; fiscal 2006 - $15.9; fiscal 2007 - $10.5; fiscal 2008 - $5.8; and fiscal 2009 - $5.6. Licensing Agreement In May 2000, QSP, Inc. entered into a long-term licensing agreement with World's Finest Chocolate, Inc. The cost associated with the agreement was assigned to licensing agreements and is included in other intangible assets, net on the balance sheets. In September 2002, this agreement was amended to extend the term of the original agreement by ten years, reduce the annual minimum tonnage purchase requirements, favorably adjust pricing and permit QSP to sell World's Finest Chocolate products through marketing channels other than fundraising, under specified circumstances. In connection with these amended terms, QSP paid World's Finest Chocolate $10.5 in 2003. The amount paid in May 2000 to consummate the initial agreement is being amortized over the original 10-year license term. Amounts paid to amend the agreement have been assigned various amortization periods ranging from 7 to 17 years (the remaining period of the amended agreement). The approximate annual minimum purchase amounts under the amended agreement are: fiscal 2005 - $59.0; fiscal 2006 - $61.0; fiscal 2007 - $62.0; and from fiscal 2008 to fiscal 2020, approximately $69.0 per year. The amounts are estimates based on minimum tonnage requirements and nominal price increases as stipulated in the amended agreement. In 2004 and 2003, we did not meet the minimum purchase requirements under this agreement. Accordingly, we accrued penalties of $0.8 and $2.0 in 2004 and 2003, respectively. Note 7 Financial Instruments Risk Management and Objectives Under the 2002 Credit Agreements (referred to in Note 11, Debt), we are required to enter into interest rate protection agreements to fix or limit the interest cost with respect to at least one-third of the outstanding borrowings under the Term Loan Agreement. Accordingly, in July 2002, we entered into agreements to cap at 6% the LIBOR interest rate component of $400.0 of our borrowings for a period of three years. Our interest rate cap agreements qualify as cash flow hedges, the effect of which is described below. In the normal course of business we are exposed to market risk from the effect of foreign exchange rate fluctuations on the U.S. dollar value of our foreign subsidiaries' results of operations and financial condition. A significant portion of our risk is associated with foreign exchange rate fluctuations of the euro. During the fourth quarter of 2002, we ceased our practice of purchasing foreign currency option and forward contracts to minimize the effect of fluctuating foreign currencies on our foreign subsidiaries' earnings and certain foreign currency denominated assets and liabilities. However, we hedge significant known transactional exposures. Accordingly, gains and losses on derivative instruments are comprised of different instruments in 2002 when compared with 2004 and 2003. As a matter of policy, we do not speculate in financial markets and, therefore, we do not hold financial instruments for trading purposes. We continually monitor foreign currency risk and our use of derivative instruments. As of June 30, 2004 and 2003, we did not hold any forward or option contracts. Quantitative Disclosures of Derivative Instruments Cash Flow Hedges - As of June 30, 2004 and 2003, the fair value of our interest rate cap was zero and $0.1, respectively. For 2004, the fair value of our interest rate caps decreased, resulting in a loss of $(0.1), net of deferred taxes of zero. For 2003, the fair value of our interest rate caps decreased, resulting in an unrealized loss of $(1.4), net of deferred taxes of $0.8. These changes are reported in accumulated other comprehensive (loss) income, which is included in stockholders' equity on the balance sheets. The unrealized gains and losses are deferred and recognized in earnings when the related interest expense is recognized. As described in Note 11, Debt, in the third quarter of 2004 we refinanced a portion of our borrowings outstanding under the Term Loan. As a result, the total amount of outstanding borrowings under the Term Loan, and the total notional amount of related interest rate caps required, declined. Accordingly, we terminated interest rate caps with a notional value of $250.0 and recognized the remaining unrealized loss on those instruments, $(1.3), in interest expense. We currently maintain interest rate caps with a notional amount of $150.0, all of which terminate in fiscal 2006. There were no cash flow hedges discontinued during the 12-month period ended June 30, 2003. The ineffective portion of the change in market value of our foreign currency option contracts, specifically the time-value component of $(0.4) was recognized as a loss in other (expense) income, net on the income statements for 2002. Other Derivatives - For 2002 changes in the spot value of the foreign currencies and contract settlements associated with option and forward contracts amounted to a loss of $(4.6). This change was reported in gain (loss) on foreign exchange, which is included in other (expense) income, net on the income statements. This effect would generally be offset by the translation of the assets, liabilities and future operating cash flows being hedged. Note 8 Pension Plans and Other Postretirement Benefits We account for our pension and postretirement benefits in accordance with SFAS No. 87, "Employers' Accounting for Pensions," and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Pursuant to these statements, obligations are determined using actuarial models that incorporate estimates for employee turnover and mortality, increases in employee compensation and healthcare costs and an employee's age at retirement. While these models help determine the obligation, SFAS No. 87 and 106 attempt to match recognition of the obligation with the period over which the employee earns benefits. Because employees earn benefits over many years of service, the accounting rules require the recognition of certain events (including plan amendments and certain gains and losses) over multiple years rather than the year the event occurs. This principle also applies to recognition of the expected return on plan assets. Although this rate is our expectation of the long-term performance of our asset portfolio, in the short-term, performance will likely vary. In order to recognize this discrepancy, we amortize the difference between the actual and expected return on assets over a five-year period. SFAS No. 87 also requires us to recognize a minimum pension liability in certain instances where the plan's accumulated benefit obligations as of our measurement date, March 31, exceeds the fair value of plan assets. This amount is adjusted based on whether we have a net pension asset or liability. The minimum pension liability, as adjusted, is included in accumulated other comprehensive (loss) income, which is included in stockholders' equity on the balance sheets. Defined Benefit Pension Plans We offer defined benefit plans for substantially all of our employees in the United States and in several international markets. Contributions to these plans meet the minimum funding requirements in each respective market. Benefit payments are principally based on a combination of years of service and compensation. U.S. Plans In the U.S. we maintain funded and unfunded defined benefit plans. The Reader's Digest Association, Inc. Retirement Plan (Retirement Plan) is our largest plan. It comprises almost 84% of our total U.S. benefit obligation and all of our U.S. plan assets. Because the Retirement Plan is over-funded, we have not made any contributions in 2004, 2003 or 2002, nor do we expect to make any contributions in fiscal 2005. However, as permitted by the Internal Revenue Code (IRC) section 401(h), in 2003 and 2002 we elected to transfer $5.9 and $5.7, respectively, of excess pension assets to fund postretirement benefits. Our unfunded benefits were established for certain officers. Since these benefits are only available to certain executives, they are not qualified under the IRC. In addition, because these benefits are unfunded, contributions made offset benefit payments. The overriding principle followed in managing our Retirement Plan assets is to obtain a reasonable rate of return in terms of both income and appreciation, consistent with the "Prudent Man" Rule of the Employee Retirement Income Security Act of 1974 (ERISA), while providing liquidity to satisfy short-term obligations. The table below details our current and target asset allocation as of our measurement date. Actual Allocation as of March 31, Target Allocation Asset Class 2004 2003 Range Equities 69% 65% 52% - 72% Fixed income 26% 29% 23% - 35% Other 5% 6% 0% - 19% --- --- Total 100% 100% === === Equities include companies with both large and small market capitalizations, as well as listed companies in international markets. Our allocation tends to be heavily weighted in favor of large capitalized companies. More than half of the Retirement Plan's funds are invested in equity markets because these investments tend to provide better returns and offer some protection from inflation. Fixed income securities are included in the portfolio to protect the Retirement Plan's assets from inflation and to preserve capital. Other assets, including private equity and real estate investments, are utilized to a small extent to take advantage of investments that provide higher returns. The Retirement Plan allows investment managers to invest in derivative instruments, provided that certain criteria specified in the plan's investment policy are satisfied. The expected rate of return on plan assets is a significant driver in calculating our net pension (benefit) cost. In order to calculate our 2004 (benefit) cost, we used an expected return on plan assets of 8.75%. This rate was based on an analysis of historical returns generated by asset classes in which our funds are invested and on projected returns for portfolios with assets similar to ours. Estimated benefit payments during the next 10 years are expected to be: fiscal 2005 - $42.2; fiscal 2006 - $43.6; fiscal 2007 - $42.3; fiscal 2008 - $42.0; fiscal 2009 - $42.6; and from fiscal 2010 to fiscal 2014 - a total of $228.6. International Plans We offer defined benefit pension plans in several markets outside the United States. In fiscal 2005 we expect to contribute $9.5 to these plans. The table below reflects the actual allocation of assets held for our international plans and the allocation required pursuant to our most recent investment policy for these plans. These percentages have been calculated on a weighted average basis because the assets comprised several plans. Actual Allocation as of March 31, Asset Class 2004 2003 Target Allocation Equities 68% 60% 64% Fixed income 32% 40% 36% --- --- Total 100% 100% === === Similar to the U.S. plans, the expected rate of return on plan assets is also a significant driver in calculating the net pension (benefit) cost for our international plans. In order to calculate our 2004 expense, we used a weighted average expected return on plan assets of 6.77%. This rate was based on a methodology similar to that used to determine the rate of return for our Retirement Plan. Estimated benefit payments during the next 10 years are expected to be: fiscal 2005 - $11.1; fiscal 2006 - $11.1; fiscal 2007 - $11.5; fiscal 2008 - $12.3; fiscal 2009 - $12.2; and from fiscal 2010 to fiscal 2014 - a total of $68.8. Assumptions The table below outlines the weighted average assumptions used to determine our projected benefit obligation as of year-end and pension (benefit) cost for the fiscal year for: U.S. plans: Benefit obligation 2004 2003 2002 Discount rate 5.75% 6.25% N/A Compensation increase rate 4.50% 4.50% N/A Pension (benefit) cost Discount rate 6.25% 7.25% 7.25% Compensation increase rate 4.50% 5.00% 5.00% Long-term rate of return on plan assets 8.75% 9.25% 9.75% International plans: 2004 2003 2002 Benefit obligation Discount rate 5.50% 5.58% N/A Compensation increase rate 3.70% 3.63% N/A Pension (benefit) cost Discount rate 5.58% 6.17% 6.07% Compensation increase rate 3.63% 3.72% 3.66% Long-term rate of return on plan assets 6.77% 7.43% 7.49% Components of net periodic pension (benefit) cost are as follows: U.S. Plans 2004 2003 2002 Service cost $ 11.3 $ 8.8 $ 9.0 Interest cost 31.4 33.4 33.0 Expected return on plan assets (50.1) (63.8) (69.0) Amortization (0.7) (0.8) (0.7) Recognized actuarial gain 2.1 (2.7) (8.6) Curtailments, settlements and other items -- -- (1.3) ------- ------- ------- Net periodic pension (benefit) cost $ (6.0) $ (25.1) $ (37.6) ======= ======= ======= International Plans 2004 2003 2002 Service cost $ 7.4 $ 7.4 $ 7.4 Interest cost 13.4 13.6 11.2 Expected return on plan assets (14.0) (16.6) (15.7) Amortization (0.5) 0.1 (0.3) Recognized actuarial gain 3.1 0.7 0.2 Curtailments, settlements and other items (1.1) 1.5 -- ------- ------- ------- Net periodic pension (benefit) cost $ 8.3 $ 6.7 $ 2.8 ======= ======= ======= A reconciliation of the beginning and ending balances of benefit obligations and fair value of plan assets, and the funded status of the defined benefit pension plans are as follows: U.S. Plans International Plans 2004 2003 2004 2003 Change in benefit obligation: Benefit obligation at beginning of year $ 525.7 $ 489.3 $ 241.2 $ 219.8 Service cost 11.3 8.8 7.4 7.4 Interest cost 31.4 33.4 13.4 13.6 Actuarial loss 20.5 39.0 7.4 (2.1) Plan amendments -- (0.3) (6.3) -- Exchange rate changes -- -- 19.7 20.3 Settlements/curtailments/termination benefits -- -- (5.0) (7.7) Benefits paid (46.9) (44.5) (12.5) (11.8) Other items -- -- 2.1 1.7 -------- -------- -------- -------- Benefit obligation at end of year 542.0 525.7 267.4 241.2 -------- -------- -------- -------- Change in plan assets: Fair value at beginning of year 511.9 635.8 173.3 201.1 Actual return on plan assets 156.1 (77.3) 38.1 (34.4) Employer contribution 8.1 7.6 10.3 6.5 IRC section 401(h) transfer -- (5.9) -- -- Exchange rate changes -- -- 12.7 16.9 Benefits paid (46.9) (44.5) (12.5) (11.8) Other items (2.8) (3.8) (0.4) (5.0) -------- -------- -------- -------- Fair value at end of year 626.4 511.9 221.5 173.3 -------- -------- -------- -------- Funded status 84.4 (13.8) (45.9) (67.9) Unrecognized actuarial loss (gain) 102.7 187.3 82.6 98.0 Unrecognized transition (asset) obligation -- -- (1.6) (1.9) Unrecognized prior service obligation benefit (5.2) (5.9) (3.6) 1.8 Employer - fourth quarter contribution -- -- 2.2 2.1 -------- -------- -------- -------- Net amount recognized $ 181.9 $ 167.6 $ 33.7 $ 32.1 ======== ======== ======== ========
The accumulated benefit obligation (the actuarial present value of benefits earned, excluding future compensation increase assumptions) for our U.S. plans was $530.2 and $514.5 as of June 30, 2004 and 2003, respectively. The accumulated benefit obligation for our international plans was $236.6 and $215.1 as of June 30, 2004 and 2003, respectively. Other Postretirement Benefits We provide medical and dental benefits to certain retired employees and their dependents. The plans that provide these benefits cover substantially all of our employees in the U.S., and to a lesser extent, Canada. The table below outlines the weighted average assumptions used to determine our postretirement benefit obligation as of year-end and our postretirement cost for the fiscal year: Postretirement benefit obligation 2004 2003 2002 Discount rate 5.75% 6.25% N/A Healthcare cost trend rate assumed for next year 11.50% 13.00% N/A Rate to which the cost trend rate is assumed to decline 5.00% 5.00% N/A Number of years to ultimate trend rate 9 10 N/A Postretirement cost Discount rate 6.19% 7.25% 7.25% Healthcare cost trend rate assumed for next year 13.00% 6.00% 6.50% Rate to which the cost trend rate is assumed to decline 5.00% 5.50% 5.50% Number of years to ultimate trend rate 10 1 2
Components of net periodic postretirement (benefit) cost are as follows: 2004 2003 2002 Service cost $ 1.3 $ 0.9 $ 0.9 Interest cost 6.0 5.0 4.1 Amortization (1.0) (0.5) (0.5) Recognized actuarial gain -- (2.2) (3.4) Curtailments, settlements and other items -- -- (0.8) ----- ----- ----- Net periodic postretirement (benefit) cost $ 6.3 $ 3.2 $ 0.3 ===== ===== =====
A reconciliation of the beginning and ending balances of benefit obligations and fair value of plan assets, and the funded status of the plans are as follows: 2004 2003 Change in benefit obligation: Benefit obligation at beginning of year $ 103.1 $ 72.1 Service cost 1.3 0.9 Interest cost 6.0 5.0 Actuarial (gain) loss (4.9) 32.1 Plan amendments (7.1) (1.2) Exchange rate changes -- 0.2 Benefits paid (6.3) (6.0) -------- -------- Benefit obligation at end of year 92.1 103.1 -------- -------- Change in plan assets: Fair value at beginning of year -- -- Employer contribution 6.3 0.1 IRC section 401(h) transfer -- 5.9 Benefits paid (6.3) (6.0) -------- -------- Fair value at end of year -- -- -------- -------- Funded status (92.1) (103.1) Unrecognized actuarial (gain) loss (0.4) 4.4 Unrecognized transition (asset) obligation 0.6 0.6 Unrecognized prior service obligation benefit (9.8) (3.7) -------- -------- Net amount recognized $ (101.7) $ (101.8) ======== ======== Assumed healthcare cost trend rates have a significant effect on the amounts reported for postretirement benefits. A one-percentage-point increase in assumed healthcare cost trend rates would increase the total of the service and interest cost components by $0.7 and the postretirement benefit obligation by $9.5. A one-percentage-point decrease in assumed healthcare cost trend rates would decrease the total of the service and interest cost components by $(0.6) and the postretirement benefit obligation by $(8.1). Estimated benefit payments during the next 10 years are expected to be: fiscal 2005 - $6.9; fiscal 2006 - $7.3; fiscal 2007 - $7.5; fiscal 2008 - $7.6; fiscal 2009 - $8.1; and from fiscal 2010 to fiscal 2014 - a total of $41.5. Estimated receipts pursuant to the Medicare Reform Act during the next 10 years are expected to be: fiscal 2005 - zero; fiscal 2006 - $0.4; fiscal 2007 - $0.8; fiscal 2008 - $0.8; fiscal 2009 - $0.9; and from fiscal 2010 to fiscal 2014 - a total of $4.9. Balance Sheet Classification Amounts recognized on the balance sheets related to our pension and postretirement plans are as follows: Pension Benefits Other Benefits 2004 2003 2004 2003 Assets $ 291.5 $ 278.4 $ -- $ -- Liabilities (131.2) (153.1) (101.7) (101.8) Accumulated other comprehensive income 55.3 74.4 -- -- -------- -------- ------- ------- Net amount recognized $ 215.6 $ 199.7 $(101.7) $(101.8) ======== ======== ======= =======
Balances of plans with projected and accumulated benefit obligations in excess of the fair value of plan assets are as follows: Plans with Plans with Projected Benefit Accumulated Benefit Obligations in Excess Obligations in Excess of Plan Assets of Plan Assets 2004 2003 2004 2003 Projected benefit obligation $ 318.0 $ 280.8 N/A N/A Accumulated benefit obligation N/A N/A $ 269.6 $ 254.4 Fair value of plan assets $ 163.5 $ 109.0 $ 139.2 $ 102.0 Note 9 Employee Equity Compensation Plans We maintain several employee compensation plans relating to stock or stock-based awards, including stock options, restricted stock, stock appreciation rights, phantom stock and phantom stock options. As discussed in Note 1, Organization and Summary of Significant Accounting Policies, we have adopted the disclosure provisions of SFAS No. 123 and SFAS No. 148 and, as permitted by those statements, have continued to measure compensation cost using the intrinsic value method under APB No. 25. SFAS No. 123 requires disclosure of pro forma net income and earnings per share as if the fair-value-based method had been applied in measuring compensation cost for stock-based awards granted after 1995. Such disclosure is included in Note 1, Organization and Summary of Significant Accounting Policies. The weighted average fair values of options granted in 2004, 2003 and 2002 were $3.72, $4.85 and $7.30, respectively. The fair values of the options granted were estimated on the date of their grant using the Black-Scholes option-pricing model on the basis of the following weighted average assumptions: 2004 2003 2002 Risk-free interest rate 3.3% 2.9% 4.3% Expected life 4.1 years 4.1 years 4.1 years Expected volatility 35.7% 39.3% 39.5% Expected dividend yield 1.4% 1.7% 1.2% The following table summarizes information about stock options outstanding at June 30, 2004: Options Outstanding Options Exercisable Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Options Contractual Exercise Options Exercise Prices (000's) Life (yrs.) Price (000's) Price $12.16 - $18.97 4,518 7.52 $15.77 1,534 $18.08 $20.59 - $28.84 3,797 5.48 $22.97 2,656 $23.56 $30.00 - $39.75 1,436 5.17 $32.14 1,421 $32.07 $41.19 - $47.31 2,701 4.28 $42.27 2,235 $42.22 $50.94 - $50.94 30 1.39 $50.94 30 $50.94 ------ ---- ------ ----- ------ 12,482 5.91 $25.66 7,876 $29.43 ------ ---- ------ ----- ------ Changes in outstanding options are as follows: Weighted Average Options Exercise (000's) Price Outstanding at June 30, 2001 11,059 $ 33.95 Granted 2,577 $ 21.52 Exercised (230) $ 19.87 Canceled (1,676) $ 36.68 ------ --------- Outstanding at June 30, 2002 11,730 $ 30.97 Granted 2,018 $ 15.82 Exercised -- -- Canceled (1,581) $ 34.01 ------ --------- Outstanding at June 30, 2003 12,167 $ 28.10 Granted 1,731 $ 13.42 Exercised -- -- Canceled (1,416) $ 31.21 ------ --------- Outstanding at June 30, 2004 12,482 $ 25.66 ------ --------- Options exercisable at June 30, 2004 7,876 $ 29.43 ------ --------- Options available for grant at June 30, 2004 4,188 ------ --------- 1994 and 2002 Key Employee Long-Term Incentive Plans (the Plans) The Plans provide that the Compensation and Nominating Committee of the Board of Directors (the committee) may grant stock options, stock appreciation rights, restricted stock, deferred stock, performance units, performance shares and other stock-based awards to eligible employees. The committee was allowed to grant awards up to a maximum of 17,300,000 underlying shares of Common Stock under the 1994 Plan (which expired in February 2004) and may grant up to a maximum of 4,500,000 underlying shares under the 2002 Plan. Under the Plans, stock options have been granted with exercise prices not less than the fair market value of our Common Stock at the time of the grant, with an exercise term (as determined by the committee) not to exceed 10 years. The committee determines the vesting period for our stock options. Generally, such stock options become exercisable over four years. Restricted Stock - Restricted stock are shares of Common Stock that are subject to restrictions on transfer that lapse upon the fulfillment of specified conditions. The market value of restricted stock awards on the date of grant is recorded as a reduction of capital stock on the balance sheets and is amortized ratably over the term of the restriction period, ranging from two to four years. Amortization expense of restricted stock amounted to $(8.7), $(5.5) and $(2.4) for 2004, 2003 and 2002, respectively. We granted 764,300 shares, 958,080 shares and 297,622 shares of restricted stock to employees during 2004, 2003 and 2002, respectively. Deferred Stock - Outside the United States, we offer deferred stock, which are rights to receive shares of Common Stock upon the fulfillment of specified conditions, to certain employees. Deferred stock is similar to restricted stock in all respects, except that deferred stock is issued to the employee at the completion of the vesting period. We recognized expense of $(1.5), $(0.7) and $(0.3) in 2004, 2003 and 2002, respectively, related to these awards. During 2004, 2003 and 2002 we granted 119,400 shares, 164,163 shares and 60,712 shares of deferred stock, respectively. Performance Shares - The committee awards phantom shares that give the recipients the right to receive cash equal to the value of shares of Common Stock that are earned if specific performance goals are achieved during a specific performance period. Compensation cost related to performance shares is based on management's best estimate as to whether or not the performance criteria will be satisfied and the market price of our shares on the date of the financial statements. This amount is recognized ratably over the performance period. Adjustments based on changes in our estimate of whether the performance criteria will be satisfied and changes in the market value of our shares are recorded in the period in which the change occurs. In 2004 we began a two-year plan for the 2004-2005 performance period. In 2003, awards relating to two three-year performance periods (2001-2003 and 2002-2004) were canceled and replaced with an award relating to a two-year performance period (2003-2004) and a transitional award relating to operating performance for 2003. We have recorded $(0.6), $(1.8) and $(1.4) as expense during 2004, 2003 and 2002, respectively, for these awards. No amounts were earned related to the 2003-2004 performance period. In 2004, we distributed $2.8 relating to the transitional award ($1.1 was distributed in 2003 relating to the 2000-2002 performance period). Employee Stock Purchase Plans Under the U.S. Employee Stock Purchase Plan (ESPP), we are authorized to issue up to 2,650,000 shares of Common Stock (330,000 shares per annum), principally to our full-time employees in the United States, nearly all of whom are eligible to participate. Under the terms of the ESPP, employees can choose every six months to have up to 10% of their annual base earnings withheld to purchase Common Stock. The purchase price of the shares is 85% of the lower of the fair market values of the Common Stock on the first and last days of the six-month purchase period. In 2004, 2003 and 2002 approximately 25%, 28% and 32% of eligible employees participated in the ESPP, respectively. Several of our international subsidiaries have employee stock purchase plans (international ESPP) under which we are authorized to issue up to 400,000 shares of Common Stock to our full-time employees. The terms of the international ESPP in most locations are essentially the same as the ESPP. Under the ESPP and the international ESPP, employees purchased 215,011 shares in 2004, 256,870 shares in 2003 and 216,121 shares in 2002. The calculation of the fair value of these shares using the Black-Scholes option-pricing model assumes that options were issued to employees on the first day of the purchase period. The weighted average fair values of these assumed options granted in 2004, 2003 and 2002 were $3.45, $4.31 and $6.50, respectively. These fair values were estimated using the following assumptions: 2004 2003 2002 Risk-free interest rate 1.0% 1.5% 2.8% Expected life 0.5 years 0.5 years 0.5 years Expected volatility 35.3% 35.6% 35.5% Expected dividend yield 1.4% 1.7% 1.2% Other Compensation Plans Employee Ownership Plan and 401(k) Partnership (the 401(k) plan) - The 401(k) plan consists of both a profit-sharing plan and a savings plan under section 401(k) of the IRC. The savings plan component allows employees to make pre-tax contributions to their accounts, which may be invested in specified investment alternatives. We may match employee contributions to the extent determined by our Board of Directors. The matching contributions vest 20% per annum over a five-year period. Our contributions to the 401(k) plan, including matching contributions, were $3.9, $5.0 and $5.0 for 2004, 2003 and 2002, respectively. Share Incentive Plan - One of our international subsidiaries has a Share Incentive Plan. Under this program, all regular full-time employees of the respective business unit are eligible to receive Common Stock for services rendered. We did not make contributions to this plan in 2004. In 2003, we contributed $0.2. Note 10 Income Taxes Income before provision for income taxes is as follows: 2004 2003 2002 United States $ 33.0 $ 89.1 $ 47.9 International 33.1 11.3 92.7 ------ ------- ------- Income before provision for income taxes $ 66.1 $ 100.4 $ 140.6 ====== ======= ======= Components of the provision (benefit) for income taxes are as follows: 2004 2003 2002 Current U.S. Federal $ (9.5) $ 1.6 $ (12.3) U.S. State and local 2.2 0.4 (2.4) International 19.1 13.5 30.5 ------- ------- ------- Total current 11.8 15.5 15.8 ------- ------- ------- Deferred U.S. Federal 19.9 28.7 25.5 U.S. State and local 1.4 1.9 9.6 International (16.5) (7.0) (1.5) ------- ------- ------- Total deferred 4.8 23.6 33.6 ------- ------- ------- Provision for income taxes $ 16.6 $ 39.1 $ 49.4 ======= ======= ======= A reconciliation between the statutory U.S. federal income tax rate and the effective income tax rate is as follows: 2004 2003 2002 U.S. statutory tax rate 35.0% 35.0% 35.0% International operations (11.6) 1.9 (2.5) State taxes, net 3.6 1.3 3.3 Non taxable gain from disposition of assets (3.2) -- -- Favorable settlement with the Internal Revenue Service (8.0) -- -- Changes in valuation allowance 7.9 0.1 -- Other operating items, net 0.2 2.5 0.3 Other, net 1.2 (1.9) (1.0) ---- ---- ---- Effective tax rate 25.1% 38.9% 35.1% ==== ==== ==== Components of deferred tax assets and liabilities are as follows: 2004 2003 Deferred compensation and other employee benefits $ 9.0 $ 21.9 Accounts receivable and other allowances 42.8 42.0 Net operating loss carryforwards 22.2 15.2 Other operating items, net 8.2 12.3 Tax credit carryforwards 29.8 27.3 Other accrued items 15.4 15.9 Other, net 4.3 5.0 -------- -------- Gross deferred tax assets 131.7 139.6 Valuation allowance (12.2) (6.9) -------- -------- Total net assets 119.5 132.7 -------- -------- Deferred compensation and other employee benefits 8.5 7.6 Deferred promotion 12.3 20.5 Depreciation and amortization 14.5 6.0 Deferred agent commissions 19.1 19.2 Other, net 9.6 12.8 -------- -------- Total net liabilities 64.0 66.1 -------- -------- Net deferred taxes $ 55.5 $ 66.6 ======== ======== Balance sheet classifications of deferred tax assets and liabilities are as follows: 2004 2003 Prepaid expenses and other current assets $ 38.7 $ 44.4 Other noncurrent assets 38.7 64.4 Other current liabilities (5.3) (14.8) Other noncurrent liabilities (16.6) (27.4) ------ ------ Net deferred taxes $ 55.5 $ 66.6 ====== ====== We have concluded that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the net deferred tax assets. Net operating loss carryforwards of $77.0 at June 30, 2004, are available to reduce future tax obligations of certain foreign and U.S. subsidiaries in a number of jurisdictions with various expiration dates, some of which are indefinite. In addition, foreign tax credit carryforwards amounting to $23.9 and alternative minimum tax credit carryforwards of $5.9 are available as of June 30, 2004. Foreign tax credit carryforwards have various expiration dates through fiscal 2009; alternative minimum tax credit carryforwards have an indefinite life. Net operating loss carryforwards and related valuation allowances associated with the closure of businesses in certain markets have been written off totaling approximately $2.4 and $14.0, for 2004 and 2003, respectively. Approximately $8.0 of deferred tax expense and $17.3 of deferred tax benefit is included as a component of stockholders' equity in 2004 and 2003, respectively. A provision has not been made for U.S. taxes that would be payable if undistributed earnings of foreign subsidiaries, $119.2 as of June 30, 2004, were distributed to the parent company in the form of dividends because it is our intention to permanently reinvest such foreign earnings. A determination of the amount of the unrecognized deferred tax liability related to undistributed earnings is not practical. Note 11 Debt Our primary debt obligations are: a Five-Year Revolving Credit and Competitive Advance Facility Agreement, a Term Loan Agreement and $300 in senior unsecured notes. 2001 Credit Agreements On July 27, 2001, we entered into a Five-Year Revolving Credit and Competitive Advance Facility Agreement and a 364-Day Revolving Credit and Competitive Advance Facility Agreement (the 2001 Credit Agreements), each of which allowed for up to $192.5 in aggregate principal amount of bank borrowings. Interest under the 2001 Credit Agreements was based on several pricing options that varied based upon our credit rating. Borrowings from these facilities were allowed to be used for general corporate purposes, including acquisitions, share repurchases and commercial paper backup. Non-financial covenants included restrictions on our ability to incur additional debt for money borrowed, create liens and guarantee indebtedness. The financial covenants included minimum interest coverage and maximum leverage ratios. 2002 Credit Agreements On May 20, 2002, we entered into a $950.0 Term Loan Agreement with a syndicate of banks and other financial institutions, and we amended and restated the Five-Year Revolving Credit and Competitive Advance Facility Agreement to conform it to the Term Loan Agreement (the Term Loan Agreement and the Five-Year Revolving Facility Agreement are collectively referred to as the 2002 Credit Agreements); we also terminated the 364-Day Revolving Credit and Competitive Advance Facility Agreement. Proceeds from the Term Loan Agreement were used to finance the Reiman acquisition purchase price and pay related financing and transaction costs, to finance our recapitalization transactions (see Note 12, Capital Stock) and to refinance obligations under the 2001 Credit Agreements. Borrowings under the Five-Year Revolving Facility Agreement may be used for general corporate purposes, including acquisitions, share repurchases and commercial paper backup. Borrowings under the 2002 Credit Agreements bear interest at either LIBOR plus a spread based upon our credit rating at the time the rate is established, or the Alternate Base Rate, as defined in the Term Loan Agreement. The interest rate is required to be reset from time to time for periods of up to six months. Borrowings under the 2002 Credit Agreements are secured by substantially all of our assets and are subject to various covenants. Non-financial covenants include limitations on: additional debt for money borrowed and related guarantees; acquisitions; mergers and asset transfers; share repurchases; liens; and dividend payments. Financial covenants include minimum interest and fixed charge coverage, maximum leverage ratios and limitations on annual capital expenditures. The leverage ratio, calculated as total debt divided by EBITDA, as defined in the 2002 Credit Agreements, is our most restrictive financial covenant. In addition, the 2002 Credit Agreements contain provisions that could result in the acceleration of amounts outstanding. One such provision requires us to perform a calculation in the first quarter of every fiscal year (based on an excess cash flow calculation outlined in the 2002 Credit Agreements). In the fourth quarter of 2003, we amended the 2002 Credit Agreements. The terms of the amendment included modifications to ease the leverage covenant and to exclude the impact of certain cash restructuring charges from the calculation of EBITDA in 2003 and 2004. Senior Notes During the third quarter of 2004, we completed a private placement, with registration rights, of $300.0 of 6 1/2% senior unsecured notes due in 2011 (Senior Notes) in order to refinance amounts outstanding under the Term Loan. (These notes were exchanged for identical registered notes in a fourth quarter 2004 public offering.) The proceeds from this offering were used to repay $294.0 of principal outstanding under the Term Loan, with the remainder used to pay a portion of the financing costs. Concurrently with the refinancing, we amended the 2002 Credit Agreements to allow us to repurchase shares, pay cash dividends and make certain other restricted payments, in any combination thereof, up to $50.0 each fiscal year. Term Loan Repricing In the fourth quarter of 2004 we repriced the Term Loans to take advantage of our improved credit profile. As a result, we reduced the LIBOR spread charged on our Term Loan borrowings by 100 basis points. Debt Maturities and Interest Expense The Term Loan Agreement requires quarterly principal repayments with the final payment due in fiscal 2008. Total debt maturities during the next five years are as follows: 2005 $ 83.9 2006 66.9 2007 76.8 2008 194.0 2009 -- ------- Total $ 421.6 ======= At June 30, 2004, we had borrowings of $721.6 outstanding, of which $83.9 was classified as short-term debt and included in loans and notes payable on the balance sheets. As of June 30, 2003, we had total borrowings of $866.0 outstanding, of which $31.3 was classified as short-term debt. In 2004, 2003 and 2002, we recorded interest expense, net of $(49.8), $(41.4) and $(13.9), respectively. Interest expense in 2004 included the expense and write-off of financing fees of $(6.0) as a result of the refinancing and certain other transactions described above, and the write-off of $(1.3) related to the termination of some of our interest rate caps that were no longer required (see Note 7, Financial Instruments). The weighted average interest rate on our borrowings charged by our lenders was 4.4%, 4.0% and 3.8% during 2004, 2003 and 2002, respectively. Lines of Credit International lines of credit and overdraft facilities totaled $28.5 at June 30, 2004, and $36.9 at June 30, 2003, of which no amounts were outstanding at these respective dates. These lines of credit are renewed annually. Note 12 Capital Stock Capital stock and treasury stock consist of the following as of June 30: 2004 2003 First preferred stock, par value $1.00 per share; authorized 40,000 shares; issued and outstanding 29,720 shares $ 3.0 $ 3.0 Second preferred stock, par value $1.00 per share; authorized 120,000 shares; issued and outstanding 103,720 shares 10.3 10.3 Third subordinated preferred stock, par value $1.00 per share; authorized 230,000 shares; 15.5 15.5 issued and outstanding 155,022 shares Preference stock, par value $0.01 per share; authorized 25,000,000 shares; issued and outstanding none -- -- ---------- ---------- Total preferred stock 28.8 28.8 ---------- ---------- Common Stock, par value $0.01 per share; authorized 200,000,000 shares; issued 145,922,062 1.5 1.5 Unamortized restricted stock (12.5) (12.7) ---------- ---------- Total capital stock $ 17.8 $ 17.6 ---------- ---------- Common Stock in treasury, at cost Common Stock: 46,863,670 and 47,743,830 in 2004 and 2003, respectively $ (1,005.8) $ (1,024.7) ========== ========== All shares of preferred stock have a preference in liquidation of $100.00 per share. The difference between the aggregate par value and liquidation preference has been appropriated from retained earnings and is shown as part of the value of preferred stock. At our option and at any time, all preferred stock is redeemable at $105.00 per share plus accrued dividends. The terms of the first preferred stock and the second preferred stock provide for annual cumulative dividends of $4.00 per share. The terms of the third subordinated preferred stock provide for annual cumulative dividends of $5.00 per share. Recapitalization Agreement On October 15, 2002, we entered into a revised agreement with the DeWitt Wallace-Reader's Digest Fund, Inc. and the Lila Wallace-Reader's Digest Fund, Inc. (the Funds) providing for a series of actions that resulted in all shares of our Class B Voting Common Stock (Class B Stock) and Class A Nonvoting Common Stock (Class A Stock) being recapitalized into a single class of Common Stock with one vote per share. The October 15, 2002 recapitalization agreement replaced the recapitalization agreement that we entered into with the Funds on April 12, 2002. The transactions contemplated by the October recapitalization agreement were completed on December 13, 2002. As a result: - We repurchased approximately 4.6 million shares of Class B Stock from the Funds for $100.0 in cash in the aggregate; - Each share of Class A Stock was recapitalized into one share of Common Stock having one vote per share; - Each remaining share of Class B Stock was recapitalized into 1.22 shares of Common Stock; - We amended our charter to, among other things, reflect the reclassification of the stock, divide our Board of Directors into three classes and eliminate action by written consent of our stockholders; and - We reclassified as long-term debt the $100.0 borrowed under the Term Loan Agreement on May 20, 2002 to repurchase stock. On June 30, 2002, the $100.0 was classified as short-term debt pending completion of the recapitalization transactions. Four legal actions were commenced against us, our directors and the Funds challenging the original recapitalization transaction announced in April 2002. Three of the four actions were purported class actions; the fourth action was brought by individual stockholders. The parties in two of the three class actions, which were brought on behalf of holders of Class B Stock, entered into a settlement agreement, subject to court approval, with respect to the settlement of those actions. The third class action, which was brought on behalf of holders of Class A Stock, was dismissed with prejudice by the Court of Chancery of the State of Delaware pursuant to a comprehensive settlement agreement that was approved by the Court of Chancery on February 12, 2003. The fourth action was voluntarily dismissed. Share Repurchase Authorization As of June 30, 2004, under various share repurchase authorizations (announced during 2000, 2001 and 2002), we have repurchased 8.6 million shares of our Class A Nonvoting Common Stock for approximately $231.7 (no shares during 2004 and 2003, and 3.6 million shares totaling $64.1 during 2002). As of June 30, 2004, we had $186.0 remaining under a $250.0 share repurchase authorization announced in May 2001. Under the 2002 Credit Agreements, we may repurchase shares, pay cash dividends and make certain other restricted payments, in any combination thereof, up to $50.0 each fiscal year (see Note 11, Debt). We repurchased 4.6 million shares for approximately $100.0, plus capitalizable acquisition costs of $1.7, on December 13, 2002, in connection with the recapitalization transactions. Note 13 Commitments and Contingencies General Litigation We are a defendant in lawsuits and claims arising in the regular course of business. Based on the opinions of management and counsel on such matters, recoveries, if any, by plaintiffs and claimants (net of reserves established) would not significantly affect our financial position or our results of operations. Supply and Service Agreements We maintain several long-term agreements with vendors primarily for the purchase of paper, printing and fulfillment services. These agreements expire at various times through fiscal 2010. In the normal course of business, we enter into long-term arrangements with suppliers for raw materials and merchandise, including our agreement with World's Finest Chocolate (see Note 6, Goodwill and Other Intangible Assets, Net, for additional information), and with other parties whose recordings or works we use in our products. These arrangements may contain minimum purchase requirements. We enter into these agreements to facilitate an adequate supply of materials and to enable us to develop better products for sale to our customers. Sale and Leaseback During 1999, we sold and leased back a portion of our operating facility in the United Kingdom. The gain is being amortized on a straight-line basis over the term of the lease as a reduction in lease expense. Lease Obligations We occupy certain facilities under lease arrangements and lease certain equipment. Rental expense and sublease income are as follows: 2004 2003 2002 Rental expense $ 18.3 $ 19.5 $ 18.9 Sublease income (6.2) (5.0) (4.9) ------ ------ ------ Net rental expense $ 12.1 $ 14.5 $ 14.0 ====== ====== ====== Future minimum rental commitments, net of sublease income, for noncancelable operating leases for the next five fiscal years and thereafter are as follows: Minimum Minimum Rental Sublease Payments Income Net 2005 $ 16.7 $ (5.5) $ 11.2 2006 $ 13.6 $ (4.8) $ 8.8 2007 $ 12.2 $ (4.8) $ 7.4 2008 $ 11.6 $ (4.9) $ 6.7 2009 $ 10.9 $ (4.5) $ 6.4 Later years $ 54.7 $ (18.0) $ 36.7 Note 14 Segments Our three reportable segments are Reader's Digest North America, Consumer Business Services and Reader's Digest International. Additionally, we separately report Corporate Unallocated expenses, which include the cost of governance, such as our internal audit, legal, tax and treasury departments, corporate financial management and other corporate functions that benefit the entire organization. In addition, this item also captures the income and expenses associated with our U.S. pension plans and retiree healthcare benefits, and executive compensation programs. Below is a brief description of the activities included within our reportable segments. Reportable segments are based on our method of internal reporting and each reportable segment is a strategic business unit that is managed separately and whose results are regularly reviewed by the chief operating decision maker. Consequently, revenues are presented on a third-party arm's-length basis. Revenues and expenses attributable to intercompany transactions are eliminated (under the intercompany eliminations caption below) to reconcile our reportable segment amounts to consolidated amounts, as reported in the income statements. Accounting policies of our segments are the same as those described in Note 1, Organization and Summary of Significant Accounting Policies. Reader's Digest North America This segment comprises our operations in the United States and Canada that publish and market Reader's Digest magazine, Reiman's magazines and several special interest magazines. This segment also includes operations that publish and market Books and Home Entertainment products, including Select Editions, series and general books, and music and video products related to the following affinities: reading, home and health, and entertainment. All of these businesses have a common focus on the direct marketing aspect of new customer acquisition at a minimal cost. The performance of Reader's Digest magazine and our special interest magazines is driven primarily by circulation revenues and, to a lesser extent, by advertising sales. Reiman's publications have minimal advertising revenues, and accordingly, circulation is the principal driver of performance in this business. The results of our Books and Home Entertainment business are driven by its universe of promotable customers, new customer acquisition programs, the response rates to its promotional mailings, customer payment rates and membership in our continuity series business. Consumer Business Services The principal businesses in this segment are our display marketing business, Books Are Fun, and our youth fundraising businesses in the United States and Canada, QSP. This segment also includes smaller businesses, such as Trade Publishing and Young Families, which publish and market Books and Home Entertainment products through direct and retail channels, and the results of financial services alliances. The operations of Gifts.com were included in this segment until 2002, when it ceased operations. The primary focus of Consumer Business Services, which sells products through non-direct marketing channels, is to grow revenues by selling products through their sales forces. Performance of the larger businesses is also driven by product selection, the number of accounts or events held and the average sales per account or event. Reader's Digest International This segment comprises our operations outside of the United States and Canada. The businesses in this segment publish and market Reader's Digest magazine in numerous editions and languages, several special interest magazines and Books and Home Entertainment products (described above), and include the results of financial services marketing alliances. Growth initiatives in this segment include: entering new markets, developing new products, acquiring customers through new channels and expanding U.S. businesses such as Books Are Fun and Young Families into markets overseas. The performance of these businesses is driven by similar factors to those in the Reader's Digest North America segment except that results are more susceptible to changes in local market conditions due to the number of countries in which we operate. The results for Reader's Digest magazine in international markets are driven principally by circulation and secondarily by advertising revenues. The results of our Books and Home Entertainment products in these markets are driven by its universe of promotable customers, new customer acquisition programs, the response rates to its promotional mailings, customer payment rates and membership in our continuity series business. We evaluate performance and allocate resources based on operating income from continuing operations excluding other operating items and Corporate Unallocated expenses. Identifiable assets by segment are those assets that are used in the operations of that business. Corporate assets consist primarily of cash and cash equivalents, certain prepaid expenses, marketable securities, certain pension assets, certain fixed assets and certain other current assets. Sales are attributed to countries based on selling location. Long-lived assets are principally composed of: property, plant and equipment, net; intangible assets, net; and prepaid pension benefits. Reportable Segment Financial Information Years ended June 30, 2004 2003 2002 Revenues Reader's Digest North America $ 835.4 $ 854.4 $ 649.0 Consumer Business Services 609.2 640.8 668.1 Reader's Digest International 969.5 1,007.8 1,077.5 Intercompany eliminations (25.6) (28.1) (26.0) ---------- ---------- ---------- Total revenues $ 2,388.5 $ 2,474.9 $ 2,368.6 ========== ========== ========== Operating profit (loss) Reader's Digest North America $ 70.5 $ 60.6 $ (2.2) Consumer Business Services 64.5 90.6 88.4 Reader's Digest International 57.0 49.1 106.3 Magazine deferred promotion charge (1) (27.2) -- -- Corporate Unallocated (43.7) (21.4) (8.1) Other operating items, net(2) (15.0) (39.8) (26.7) ---------- ---------- ---------- Total operating profit $ 106.1 $ 139.1 $ 157.7 ========== ========== ========== Intercompany eliminations Reader's Digest North America $ (1.1) $ (1.2) $ (4.4) Consumer Business Services (21.2) (23.5) (15.3) Reader's Digest International (3.3) (3.4) (6.3) ---------- ---------- ---------- Total intercompany eliminations $ (25.6 $ (28.1) $ (26.0) ========== ========== ========== Identifiable assets Reader's Digest North America $ 1,149.9 $ 1,185.2 $ 1,401.8 Consumer Business Services 485.1 535.9 521.8 Reader's Digest International 421.8 472.7 469.9 Corporate 385.9 405.7 298.4 ---------- ---------- ---------- Total identifiable assets $ 2,442.7 $ 2,599.5 $ 2,691.9 ========== ========== ========== (1) Magazine deferred promotion charge relates to: 45% to Reader's Digest North America and 55% to Reader's Digest International. (2) Other operating items, net in 2004 related to: 12% to Reader's Digest North America, 22% to Consumer Business Services, 61% to Reader's Digest International and 5% to corporate departments that benefit the entire organization. In 2003, these items related to: 13% to Reader's Digest North America, 6% to Consumer Business Services, 64% to Reader's Digest International and 17% to corporate departments that benefit the entire organization. In 2002, these items related to: 22% to Reader's Digest North America, 27% to Consumer Business Services, 16% to Reader's Digest International and 35% to corporate departments that benefit the entire organization. Years ended June 30, 2004 2003 2002 Depreciation, amortization and asset impairments Reader's Digest North America $ 39.9 $ 40.9 $ 10.2 Consumer Business Services 11.5 11.6 12.0 Reader's Digest International 8.1 9.5 10.1 Corporate 4.8 5.9 15.3 ------- ------- ------- Total depreciation, amortization and asset impairments $ 64.3 $ 67.9 $ 47.6 Capital expenditures Reader's Digest North America $ 1.9 $ 2.5 $ 3.1 Consumer Business Services 2.2 1.2 2.7 Reader's Digest International 3.7 5.1 6.1 Corporate 8.3 6.9 12.7 ------- ------- ------- Total capital expenditures $ 16.1 $ 15.7 $ 24.6 ======= ======= ======= The following table presents our consolidated net revenues by product: Years ended June 30, 2004 2003 2002 Revenues Books $ 968.5 $ 982.9 $ 963.8 Magazines - subscription and other 702.7 750.1 610.1 Magazines - advertising 150.0 151.0 151.4 Music and videos 240.3 257.4 328.8 Food and gift 228.7 244.9 256.7 Fees from financial services marketing alliances 16.9 13.2 20.8 Other 81.4 75.4 37.0 ---------- ---------- ---------- Total revenues $ 2,388.5 $ 2,474.9 $ 2,368.6 ========== ========== ==========
Information about geographic areas is as follows: Years ended June 30, 2004 2003 2002 Revenues United States $ 1,291.3 $ 1,351.8 $ 1,176.7 International 1,102.1 1,124.6 1,196.3 Inter-area (4.9) (1.5) (4.4) ---------- ---------- ---------- Total revenues $ 2,388.5 $ 2,474.9 $ 2,368.6 ========== ========== ========== Revenues inter-area United States $ (2.6) $ (0.1) $ (2.8) International (2.3) (1.4) (1.6) ---------- ---------- ---------- Total revenues inter-area $ (4.9) $ (1.5) $ (4.4) ========== ========== ========== Long-lived assets United States $ 1,638.1 $ 1,633.3 $ 1,646.6 International 75.3 113.5 107.2 ---------- ---------- ---------- Total long-lived assets $ 1,713.4 $ 1,746.8 $ 1,753.8 ========== ========== ========== Report of Independent Registered Public Accounting Firm The Stockholders and Board of Directors The Reader's Digest Association, Inc. We have audited the accompanying consolidated balance sheets of The Reader's Digest Association, Inc. and subsidiaries as of June 30, 2004 and 2003, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended June 30, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Reader's Digest Association, Inc. and subsidiaries as of June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2004, in conformity with United States generally accepted accounting principles. KPMG LLP New York, New York August 30, 2004 Report of Management We are responsible for the preparation and integrity of the consolidated financial statements appearing in our Annual Report. The consolidated financial statements were prepared in accordance with generally accepted accounting principles; certain estimates and judgments were applied as required. Financial information in this Annual Report is consistent with that in the financial statements. We are responsible for maintaining a system of internal accounting controls and procedures to provide reasonable assurance, at an appropriate cost/benefit relationship, that assets are safeguarded and that transactions are authorized, recorded and reported properly. The system of internal safeguards is characterized by a control-oriented environment that includes written policies and procedures, careful selection and training of personnel, and audits by a professional staff of internal auditors. In accordance with the requirements of the Sarbanes-Oxley Act of 2002, we have filed our written certifications with the Securities and Exchange Commission. The certifications have been filed as exhibits to our Form 10-K for the fiscal year ended June 30, 2004. KPMG LLP, independent auditors, have audited and reported on our consolidated financial statements. Their report is presented herein. The Audit Committee of the Board, composed of non-management directors, meets periodically with KPMG LLP, the company's internal auditors and management representatives to review internal accounting control, auditing and financial reporting matters. Both KPMG LLP and the internal auditors have unrestricted access to the Audit Committee and may meet with the committee with or without management present. /s/THOMAS O. RYDER Thomas O. Ryder Chairman of the Board and Chief Executive Officer /s/MICHAEL S. GELTZEILER Michael S. Geltzeiler Senior Vice President and Chief Financial Officer Selected Financial Data In millions, except per share data 2004 2003 2002 2001 2000 Income Statement Data Revenues $ 2,388.5 $ 2,474.9 $ 2,368.6 $ 2,518.2 $ 2,484.5 Operating profit $ 106.1 $ 139.1 $ 157.7 $ 229.0 $ 253.8 Net income $ 49.5 $ 61.3 $ 91.2 $ 132.1 $ 144.7 Basic and diluted earnings per share $0.50/$0.49 $0.61/$0.60 $0.90/$089 $1.27/$1.26 $1.35/$1.34 Dividends per common share $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20 Balance Sheet Data Cash and cash equivalents, short-term investments and marketable securities $ 50.4 $ 52.1 $ 114.7 $ 47.3 $ 227.6 Total assets $ 2,442.7 $ 2,599.5 $ 2,691.9 $ 1,665.2 $ 1,707.2 Long-term debt $ 637.7 $ 834.7 $ 818.0 $ 9.8 $ 7.9 Stockholders' equity $ 463.1 $ 400.3 $ 471.9 $ 459.8 $ 478.8 Weighted-average common shares outstanding (basic and diluted) 97.1/99.2 98.1/99.2 100.2/100.6 102.7/103.7 106.0/107.0 Book value per common share $ 4.77 $ 4.08 $ 4.71 $ 4.47 $ 4.51
Selected Quarterly Financial Data and Dividend and Market Information (Unaudited) Stock Price Range Net Income (Loss) High-Low In millions, except per share data and Operating Per Per shareholder Profit Dividends Share Share Common information Revenues (Loss) Per Share(1) Amount Basic Diluted Stock(2) Class A(2) Class B(2) 2004 First Quarter $ 494.7 $(13.5) $0.05 $(13.5) $(0.14) $(0.14) $14.32 - $11.94 N/A N/A Second Quarter 796.4 113.9 $0.05 66.5 0.68 0.67 $15.01 - $13.69 N/A N/A Third Quarter 561.0 19.1 $0.05 2.2 0.02 0.02 $14.83 - $13.35 N/A N/A Fourth Quarter 536.4 (13.4) $0.05 (5.7) (0.06) (0.06) $16.30 - $13.91 N/A N/A $2,388.5 $106.1 $0.20 $ 49.5 $ 0.50 $ 0.49 $16.30 - $11.94 N/A N/A 2003 First Quarter $ 517.1 $ 2.0 $0.05 $ (5.2) $(0.05) $(0.05) N/A $18.14 - $14.70 $22.40 - $18.10 Second Quarter 830.6 146.6 0.05 84.2 0.85 0.84 $16.23 - $14.72 $17.17 - $13.89 $20.69 - $16.60 Third Quarter 563.5 (3.5) 0.05 (4.6) (0.05) (0.05) $16.00 - $ 9.50 N/A N/A Fourth Quarter 563.7 (6.0) 0.05 (13.1) (0.14) (0.14) $13.81 - $10.15 N/A N/A $2,474.9 $139.1 $0.20 $ 61.3 $ 0.61 $ 0.60 $16.23 - $ 9.50 $18.14 - $13.89 $22.40 - $16.60 As of June 30, 2004, our Common Stock was listed on the New York Stock Exchange under the symbol RDA. At that time there were approximately 1,858 holders of record of our Common Stock. (1) Cash dividends on our shares in the first quarter of 2003 were declared and paid share and share alike on Class A Stock and Class B Stock. (2) Effective December 13, 2002, we completed a recapitalization under which we recapitalized all of our Class A Stock and Class B Stock into Common Stock. See Note 12, Capital Stock, for additional information.
The Reader's Digest Association, Inc. and Subsidiaries