10-Q 1 0001.txt FORM 10-Q FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: June 24, 2000 Commission file No. 0-15338 ------------- ------- PHOTOWORKS, INC. ---------------- (Exact name of registrant as specified in its charter.) Washington 91-0964899 ---------------------------- ------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1260 16th Avenue West, Seattle, WA 98119 ----------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (206) 281-1390 -------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. Yes [X] No [_] As of July 28, 2000, there were issued and outstanding 16,416,753 shares of common stock, par value $.01 per share. Index to Exhibits at Page 18 Page 1 of 18 PHOTOWORKS, INC. INDEX Page No. -------- PART I -- FINANCIAL INFORMATION Item 1 - Financial Statements .................................. 3-10 Consolidated Balance Sheets as of June 24, 2000 and September 25, 1999 .................................. 3-4 Consolidated Statements of Operations for the third quarter and nine months ended June 24, 2000 and June 26, 1999 ... 5 Consolidated Statements of Cash Flows for the nine months ended June 24, 2000 and June 26, 1999 ................... 6 Notes to Consolidated Financial Statements ................ 7-10 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations ........... 11-15 PART II -- OTHER INFORMATION Item 1 - Legal Proceedings ..................................... 16 Item 6 - Exhibits and Reports on Form 8-K ...................... 16 SIGNATURES .............................................................. 17 INDEX TO EXHIBITS ....................................................... 18 EXHIBITS .......................................................... Edgar filing Page 2 of 18 PART I -- FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS PHOTOWORKS, INC. CONSOLIDATED BALANCE SHEETS (in thousands) (UNAUDITED) (AUDITED) June 24, September 25, ASSETS 2000 1999 ================================================================================ CURRENT ASSETS Cash and cash equivalents ........................ $ 2,867 $15,001 Securities available-for-sale .................... 8,036 4,513 Accounts receivable, net of allowance for doubtful accounts ................................ 1,393 1,460 Inventories ...................................... 6,799 6,475 Prepaid income taxes ............................. 995 1,439 Prepaid promotional expenditures ................. 2,777 -- Prepaid expenses and other ....................... 253 431 Deferred income taxes ............................ -- 645 ------- ------- TOTAL CURRENT ASSETS .................................. 23,120 29,964 FURNITURE, FIXTURES, AND EQUIPMENT, at cost, less accumulated depreciation ........... 12,898 10,424 DEFERRED INCOME TAXES ................................. -- 689 DEPOSITS AND OTHER ASSETS ............................. 370 23 ------- ------- TOTAL ASSETS .......................................... $36,388 $41,100 ======= ======= See notes to consolidated financial statements. Page 3 of 18 PHOTOWORKS, INC. CONSOLIDATED BALANCE SHEETS (continued) (in thousands, except per share and share data) (UNAUDITED) (AUDITED) June 24, September 25, LIABILITIES AND SHAREHOLDERS' EQUITY 2000 1999 ================================================================================ CURRENT LIABILITIES Accounts payable .................................... $11,446 $ 4,599 Accrued compensation ................................ 2,298 1,928 Accrued expenses .................................... 1,569 1,538 Current portion of capital lease obligations ........ 247 186 Income taxes payable ................................ 7 7 ------- ------- TOTAL CURRENT LIABILITIES ............................... 15,567 8,258 LONG-TERM CAPITAL LEASE OBLIGATIONS, net of current portion ..................................... 356 521 ------- ------- TOTAL LIABILITIES ....................................... 15,923 8,779 SHAREHOLDERS' EQUITY Preferred Stock, $.01 par value, authorized 2,000,000 shares, issued and outstanding 15,000 Shares of Series A convertible preferred ... -- -- Common Stock, $.01 par value, authorized 101,250,000 shares, issued and outstanding 16,416,753 ......... 164 163 Additional paid-in capital .......................... 15,462 154 Retained earnings ................................... 4,839 32,004 ------- ------- TOTAL SHAREHOLDERS' EQUITY .............................. 20,465 32,321 ------- ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY .............. $36,388 $41,100 ======= ======= See notes to consolidated financial statements. Page 4 of 18 PHOTOWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (in thousands, except per share and share data)

Third Quarter Ended Nine Months Ended ----------------------- ---------------------- June 24, June 26, June 24, June 26, 2000 1999 2000 1999 ==================================================================================================== Net revenues ........................... $ 19,862 $ 22,801 $ 59,149 $ 63,615 Cost of goods and services ............. 15,261 14,818 42,219 41,082 ----------- ----------- ------------ ----------- Gross Profit ........................... 4,601 7,983 16,930 22,533 Operating expenses: Amortized customer acquisition costs -- 4,200 -- 12,600 Marketing expenses .................. 24,221 8,621 38,089 18,007 Research and development ............ 532 506 1,616 961 General and administrative .......... 1,890 1,252 4,875 3,905 ----------- ----------- ------------ ----------- Total operating expenses ......... 26,643 14,579 44,580 35,473 ----------- ----------- ------------ ----------- Loss from Operations ................... (22,042) (6,596) (27,650) (12,940) Other income (expense): Interest income ..................... 317 183 952 603 Non-operating income (expense), net . 6 (58) (39) (112) ----------- ----------- ------------ ----------- Total other income ............... 323 125 913 491 ----------- ----------- ------------ ----------- Loss before income taxes ............... (21,719) (6,471) (26,737) (12,449) Benefit (Provision) for income taxes ... (183) 2,337 (428) 4,730 ----------- ----------- ------------ ----------- Net Loss ............................... (21,902) (4,134) (27,165) (7,719) Preferred stock accretion .............. (1,511) -- (2,546) -- ----------- ----------- ------------ ----------- Loss attributable to common shareholders $ (23,413) $ (4,134) $ (29,711) $ (7,719) =========== =========== ============ =========== Net Loss per Share ..................... $ (1.33) $ (.25) $ (1.66) $ (.47) =========== =========== ============ =========== Net loss per Common Share .............. $ (1.43) $ (.25) $ (1.81) $ (.47) =========== =========== ============ =========== Weighted Average Shares Outstanding .... 16,415,000 16,300,000 16,370,000 16,298,000 =========== =========== ============ ===========

See notes to consolidated financial statements. Page 5 of 18 PHOTOWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (in thousands)

Nine Months Ended -------------------- June 24, June 26, 2000 1999 ==================================================================================== OPERATING ACTIVITIES: Net loss ................................................. $(27,165) $(7,719) Charges to income not affecting cash: Depreciation and amortization ........................... 3,675 3,452 Amortization of capitalized customer acquisition expenditures .............................. -- 12,600 Deferred income taxes ................................... 1,334 (4,423) Net change in receivables, inventories, payables and other 7,613 (1,009) Capitalized promotional expenditures, net ................ (2,777) 106 -------- ------- NET CASH FROM (USED IN) OPERATING ACTIVITIES ................ (17,320) 3,007 INVESTING ACTIVITIES: Purchase of furniture, fixtures, and equipment ........... (6,496) (4,106) Purchases of securities available-for-sale ............... (13,740) (2,699) Sales of securities available-for-sale ................... 10,217 2,367 -------- ------- NET CASH USED IN INVESTING ACTIVITIES ....................... (10,019) (4,438) FINANCING ACTIVITIES: Proceeds from issuance of Preferred Stock ................ 14,936 -- Payment on purchase of Common Stock ...................... -- (1,493) Proceeds from issuance of Common Stock ................... 373 199 Payment on capital lease obligation ...................... (104) (129) -------- ------- NET CASH FROM (USED IN) FINANCING ACTIVITIES ................ 15,205 (1,423) -------- ------- DECREASE IN CASH AND CASH EQUIVALENTS ....................... (12,134) (2,854) Cash and cash equivalents at beginning of period ............ 15,001 11,780 -------- ------- CASH AND CASH EQUIVALENTS AT END OF PERIOD .................. $ 2,867 $ 8,926 ======== =======

See notes to consolidated financial statements. Page 6 of 18 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE A -- BASIS OF PRESENTATION PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading Internet photo services company, dedicated to providing its customers with innovative ways to enjoy and use their photos. The PhotoWorks service provides both traditional and digital camera users with the easiest way to store and organize photos online, share them with friends and family and order reprints, photo albums and photo related products. The Company offers an array of complementary services and products primarily under the brand names PhotoWorks(R) and Seattle FilmWorks(R). The Company, formerly Seattle FilmWorks, Inc., changed its corporate name to PhotoWorks, Inc. on February 1, 2000. The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation of interim results have been included. The Company follows a policy of recording its interim period and year-end results on a 5 week, 4 week and 4 week basis for comparability of results and to be consistent with its internal weekly reporting. Fiscal year 2000 reporting will include 53 weeks with the fourth quarter including one extra week as compared to fiscal 1999. Due to the seasonality of the Company's business and other factors, operating results for the third quarter ended June 24, 2000 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2000. For further information, refer to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 2 below and under Item 7 of Part II of the Company's Annual Report on Form 10-K for the year ended September 25, 1999 and the Company's consolidated financial statements and footnotes thereto also included in the Company's Annual Report. NOTE B -- CUSTOMER ACQUISITION EXPENDITURES Historically, the Company's principal technique for acquiring new customers was its Introductory Offer of two rolls of 35mm film for $2.00 or less. Prior to the first quarter of fiscal 1999, the direct costs of customer acquisition were deferred as "capitalized customer acquisition expenditures." During the fourth quarter of fiscal 1998, the overall performance of the customer acquisition programs showed a decline and management concluded the lower response rates to customer acquisition programs required an adjustment to the amount of capitalized costs associated with those programs. Effective in the first quarter of fiscal 1999, the Company began expensing customer acquisition costs as incurred. The September 26, 1998 deferred capitalized customer acquisition balance of $16,800,000 was fully amortized during fiscal 1999. NOTE C -- INVENTORIES Inventories are stated at the lower of cost (using the first-in, first-out method) or market. Inventories consist primarily of film and photofinishing supplies. NOTE D -- RECLASSIFICATIONS Certain prior year balances have been reclassified to conform to the current year's presentation. NOTE E -- SEGMENT REPORTING The Company currently operates in one principal business segment. Page 7 of 18 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE F -- INCOME TAXES In the second quarter of fiscal 2000, it was determined that due to the Company's continued focus on promotional activities related to its digital imaging and online services and the effects of such costs on its ongoing profitability, it was appropriate to provide a valuation allowance equal to the amount of deferred tax assets not recoverable through operating loss carrybacks. During the third quarter of fiscal 2000, the Company finalized and filed its tax return for fiscal 1999. The amount of operating loss carrybacks estimated during the second quarter was updated to reflect book to return differences primarily related to alternative minimum tax calculations. As a result, quarterly income tax expense for the third quarter of fiscal 2000 was $183,000 or .8% of pre-tax operating loss, as opposed to a benefit of approximately $7,400,000 (assuming a normal statutory rate of 34%). For the nine months ended June 24, 2000, income tax expense was $428,000 or 1.6% of pre-tax operating loss, as opposed to a benefit of approximately $9,100,000 (assuming a normal statutory rate of 34%). Utilization of the remaining deferred tax assets of approximately $10,040,000 is dependent on future profits that are not assured. NOTE G -- EARNINGS PER SHARE The Company calculates earnings per share in accordance with the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 128, "Earnings per Share". Net loss per share and per common share is based on the weighted average number of common shares outstanding. Convertible preferred shares, outstanding warrants and stock options to purchase shares of common stock were excluded from the computation of earnings per share because their effect was antidilutive. See Note I for discussion of Convertible Preferred Stock and Warrants. The following table sets forth the computation of loss per share:

Third Quarter Ended Nine Months Ended ----------------------------- ---------------------------- June 24, 2000 June 26, 1999 June 24, 2000 June 26, 1999 ========================================================================================================= Numerator for loss per share: Net loss ............................... $(21,902,000) $ (4,134,000) $(27,165,000) $(7,719,000) Preferred stock accretion ............ (1,511,000) -- (2,546,000) -- ------------ ------------ ------------ ----------- Loss attributable to common shareholders $(23,413,000) $ (4,134,000) $(29,711,000) $(7,719,000) ============ ============ ============ =========== Denominator: Weighted-average number of common shares 16,415,000 16,300,000 16,370,000 16,298,000 ============ ============ ============ =========== Net loss per share ..................... $ (1.33) $ (.25) $ (1.66) $ (.47) ============ ============ ============ =========== Net loss per common share .............. $ (1.43) $ (.25) $ (1.81) $ (.47) ============ ============ ============ ===========

NOTE H -- CONTINGENCIES The Company is a defendant in a legal proceeding that was filed by Fuji Photo Film Co., Ltd. with the International Trade Commission on February 13, 1998. The action was filed against a number of importers, including the Company's OptiColor, Inc. subsidiary, alleging patent infringement of U.S. patents held by Fuji on single-use cameras through the importation and resale of recycled cameras. Fuji was seeking an order prohibiting importation of infringing cameras into the U.S. and prohibiting further sales of such products which had been imported. Sales of recycled cameras accounted for 4.1% of the Company's net revenues during fiscal 1999 and 3.8% for fiscal 1998. After an evidentiary hearing before an ITC Administrative Law Judge in November 1998, the ITC Commissioners issued a final order in June 1999 prohibiting the Company and its subsidiaries from importing and selling imported recycled single-use cameras. The Company has appealed the ITC Commissioners' order to the Federal Circuit Court of Appeals. A decision on the appeal has not yet issued but is expected to occur sometime in the latter half of 2000. There is a risk that Fuji might bring a civil action against OptiColor Page 8 of 18 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE H -- CONTINGENCIES (continued) and the Company for damages caused by the sales of cameras which have been found in the ITC proceeding to infringe Fuji patents. In 1999, Fuji brought civil action's for patent infringement against three other companies and has stated in a press release that it is reviewing its options with respect to other companies involved in the sale of products that infringe its patents. If such an action were brought against the Company, the ITC decision would not be binding in the civil proceeding and would not prevent OptiColor and the Company from raising and litigating all available defenses, but may be persuasive against the Company. At this time, the likelihood that such an action would be brought, and, if brought, its ultimate outcome and impact on the Company, are not determinable. The Company does not expect the litigation to have a significant impact on its financial condition, results of operations or liquidity. A complaint was filed against the Company on March 29, 2000, and amended April 24, 2000, by five individual plaintiffs who are suing on their own behalf and purportedly on behalf of a class of all private citizens and non-governmental entities who have received from the Company, and had the Company process, "C-41" 35 mm color film from the Company or who have received replacement rolls of film from the Company after film processing. This complaint alleges that the Company has engaged in unfair and deceptive practices by allegedly misrepresenting that film received from the Company must be processed only by the Company and that replacement film is "free." This complaint requests injunctive and declaratory relief and restitution and damages in unspecified amounts, and also requests trebling of damages and recovery of litigation expenses pursuant to the Washington Consumer Protection Act. The suit is in its beginning stage, and the court has not yet determined whether the individual plaintiffs will be permitted to prosecute the suit as a class action. Management of the Company intends to contest the suit vigorously, both as to the complaint's substantive allegations and as to whether the suit may properly be prosecuted as a class action. The Company is also involved in various routine legal proceedings in the ordinary course of its business. NOTE I -- CONVERTIBLE PREFERRED STOCK In February 2000, PhotoWorks completed a private offering of 15,000 shares of Series A convertible preferred stock for $14,936,000, net of offering costs of $65,000. The shares of Series A Preferred Stock have a conversion price of $4.75 and include warrants to purchase common stock at an exercise price of $6.00 per share. The shares of Series A preferred stock are convertible into a total of 3,157,895 shares of common stock and the warrants are exercisable to purchase a total of 789,474 shares of common stock. The shares are convertible at the holder's option at any time after August 1, 2000 and may be redeemed by the Company anytime after February 14, 2003. The holders of Series A preferred stock have preferential rights to receive dividends at the rate of 6% (which may increase to 10% if the Company has not hired a Chief Operating Officer acceptable to the holders of Series A preferred stock by August 15, 2000) but only when and if declared by the Company's Board of Directors. The holders are entitled to the number of votes equal to the number of shares of common stock into which the preferred stock could be converted. The difference between the conversion price of $4.75 and market value on the date of closing and the fair value of the warrants has been recorded as a discount to paid in capital. The discount of $3,023,000 is being accreted over the six-month holding period prior to eligible conversion of the Series A. Through June 24, 2000 $2,546,000 has been recorded as preferred stock accretion. The preferred stock accretion is a deduction of amounts available to common shareholders in earnings per share calculations. Page 9 of 18 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE J -- ADOPTION OF ACCOUNTING STANDARDS In March 2000, the Financial Accounting Standards Boards ("FASB") issued FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation." The interpretation provides guidance regarding the application of APB Opinion No. 25 for certain issues related to stock compensation. The interpretation is effective July 1, 2000. As of July 1, 2000, the Company had a total of 48,750 stock options subject to variable accounting, which will be measured quarterly against the July 3, 2000 stock price of $3.06. The difference between the July 3, 2000 price of $3.06 and the fair market value at each reporting period will be recognized as compensation expense. In May 2000, the Emerging Issues Task Force ("EITF") reached a consensus on EITF 00-14 "Accounting for Certain Sales Incentives." The consensus addressed the recognition, measurement and income statement classification for sales incentives such as discounts and coupons offered by a vendor to customers for use in a single exchange transaction. The implementation date of this consensus is the fourth quarter of a registrants fiscal year beginning after December 15, 1999. Upon application of this consensus, comparative financial statements for prior periods should be reclassified to comply with the classification provisions of this Issue. If the Company had implemented this consensus during the quarter ended June 24, 2000, approximately $280,000 would have been reclassified from marketing expenses to cost of goods sold for the three and nine months ended June 24, 2000. Page 10 of 18 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Safe Harbor Statement under the Private Securities Litigation Reform Act of --------------------------------------------------------------------------- 1995: ----- This report contains forward-looking statements including, without limitation, statements identified by an asterisk (*). These statements relate to future events, product or service offerings or the future financial performance of the Company or its industry. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue" or the negative of such terms and other comparable terminology. These statements only reflect the Company's management's expectations and estimates. Actual events or results may differ materially from those expressed or implied by such forward-looking statements due to a number of known and unknown risks and uncertainties. These risks and uncertainties include the possibility of delays in the expansion of image storage capacity due to delays in deliveries from suppliers or technical problems; system performance problems due to technical difficulties, system malfunctions, Internet interruptions or other factors; pricing and other activities by competitors; and other risks including those described in the Company's Annual Report on Form 10-K and those described from time to time in the Company's other filings with the Securities and Exchange Commission, press releases and other communications. Any forward-looking statements in this report reflect the Company's expectations at the time of this report only, and the Company disclaims any responsibility to revise or update any such forward-looking statements except as may be required by law. General ------- PhotoWorks, Inc. ("PhotoWorks" or the "Company") is the leading Internet photo services company, dedicated to providing its customers with innovative ways to enjoy and use their photos.* With more than 125 million images archived, PhotoWorks.com (www.photoworks.com) is the largest consumer photo site on the Web.* The PhotoWorks service provides both traditional and digital camera users with the easiest way to store and organize photos online, share them with friends and family and order reprints, photo albums and other photo related products.* The Company draws upon a unique dual heritage as a top-rated photofinisher with over twenty years of experience along with a tradition of innovation and leadership in digital and online photo services. The Company was the first to offer free scanning, online archiving and e-mail sharing services to both traditional and digital camera users, and hosts the largest consumer online photo archive in the world, currently with over 125 million images. The Company offers services and products primarily under the brand names PhotoWorks(R) and Seattle FilmWorks(R). The Company, formerly Seattle FilmWorks, Inc., changed its corporate name to PhotoWorks, Inc. on February 1, 2000. Since 1978, the Company has been an industry leader in the introduction of value-added photo-related services and products and has continued this tradition by launching its online photo sharing service, PhotoWorks(R) in April 1999. The Company offers prints, slides, digital images and online archiving, all from the same roll of 35mm film. PhotoWorks can process any brand of 35mm film, Advanced Photo Systems (24mm) film or 35mm single-use camera. PhotoWorks was among the first to provide express-mail delivery, cross-referenced data on prints and negatives, a composite photo index and a convenient reorder system. To a lesser extent, the Company provides photofinishing services, products and supplies on a wholesale basis. The Company anticipates phasing out a portion of its wholesale business during fiscal year 2000. Net revenues attributable to wholesale products and services in fiscal 1999 were approximately 9.1% of the Company's total net revenues. Since 1994, the Company has been a pioneer in providing digital-imaging technologies which enable photofinishing customers to share personal photographs with friends, family and business associates. Products incorporating these technologies include (i) Pictures On Disk(TM), a floppy disk containing digital images from a roll of film; (ii) PhotoWorks(R) software, which can be used to create digital photograph albums and screen savers; (iii) Pictures On Disk(TM) on CD, a CD containing digital images from a roll of film; and (iv) PhotoWorks(R), an online service that provides both traditional and digital camera users with the easiest way to store and organize photos online, share them with friends and family, and order reprints, photo albums and other photo related products.* In February 2000, the Company announced the initial launch of its PhotoWorks(R) UpLoader service for digital cameras, signifying its commitment to the online business model.* PhotoWorks(R) UpLoader provides free downloadable software that customers can use to extract images from their cameras and upload them to their password-protected PhotoWorks(R) online archive. Customers may upload as many images as they wish and archive Page 11 of 18 them at the PhotoWorks(R) site free as long as they remain an active customer of PhotoWorks. PhotoWorks provides online services for all photographers regardless of what type of camera they use to take their photos. Recently, the Company introduced PhotoWorks(R) Albums, an online service which allows customers to organize their archived images into personal albums. In addition, the Company introduced a new scanning service to allow customers to send in any photo for scanning into their personal archive. PhotoWorks anticipates development of additional products and services to enable customers to view and share their photos over the Internet.* The Company has recently partnered with other Internet-related companies to broaden the marketing of its PhotoWorks(R) services, and provide customers with new and interesting ways to share their photos. The Company has entered into agreements with AT&T WorldNet(R) Services, Amazon.com Auctions, RealNetworks, and Evoke, and most recently announced an agreement with Visioneer, the inventor of OneTouch(TM) scanning technology. PhotoWorks and Visioneer plan to work together to enable customers to easily scan digital images with a touch of a button directly into the PhotoWorks' online consumer photo archive.* Other recent partnering agreements with CelebrateExpress.com, and Family Beat.com and a variety of other alliances enable customers to integrate their digital images into the partnering companies' services and products.* The Company primarily uses direct-marketing techniques to target selected consumers, measure customer response and obtain direct customer feedback to changes in marketing strategies. The Company has developed comprehensive statistical models for the design and analysis of its direct-response marketing programs using proprietary customer data compiled over 18 years. The Company also uses other traditional advertising such as radio, television and print advertising, to promote its new PhotoWorks(R) services and products. Over the past several years, the Company has targeted the growing population of personal computer users in connection with the introduction of digital-imaging services and products. In May 2000, the Company launched a major advertising and branding campaign to promote its online services and products. The marketing campaign significantly increased marketing expenses for the third quarter of fiscal 2000 as compared to the prior year third quarter. The advertising and branding campaign will continue into the fourth quarter of fiscal 2000, although the Company expects its expenditures on the campaign in this quarter to be significantly lower than its third quarter expenditures.* Net loss for the first nine months of fiscal 2000 was $27,165,000 compared to net loss of $7,719,000 for the first nine months of fiscal 1999. Net loss for the first nine months of fiscal 1999 included charges of $12,600,000 related to accelerated amortization of previously deferred customer acquisition costs, while fiscal 2000 reflects the increased promotional and marketing expenses of $24,221,000 described above. The Company expects that operating results will fluctuate in the future due to changes in the mix of sales, intensity and effectiveness of promotional activities (and in particular, the Company's marketing campaign launched in May 2000), price increases or decreases by suppliers, the Company's ability to enter into partnering arrangements with other Internet-related companies, introductions of new products, research and development requirements, introduction of new products, pricing, advertising and other activities by competitors, foreign currency exchange rates, conditions in the direct-to-consumer market and the digital imaging and photofinishing industries in general, fluctuation in Internet use, national and global economic conditions and other factors.* Demand for the Company's photo-related services and products is seasonal, with the highest volume of photofinishing activity occurring during the summer months. However, seasonality of demand may be offset by the introduction of new services and products, changes in the level of effectiveness of customer acquisition programs, activities by competitors, production difficulties and other factors.* This seasonality has produced greater photofinishing net revenues during the last half of the Company's fiscal year (April through September), with a peak occurring in the fourth fiscal quarter. Net income is affected by the seasonality of the Company's net revenues due to the fixed nature of a portion of the Company's operating expenses, seasonal variation in sales mix, and the Company's practice of incurring relatively higher marketing program expenditures prior to the summer months. Page 12 of 18 Results of Operations --------------------- The following table presents information from the Company's consolidated statements of operations, expressed as a percentage of net revenues for the periods indicated.

Third Quarter Ended Nine Months Ended ------------------- ------------------ June 24, June 26, June 24, June 26, 2000 1999 2000 1999 =================================================================================== Net revenues .......................... 100.0% 100.0% 100.0% 100.0% Cost of goods and services ............ 76.8 65.0 71.4 64.6 ------ ----- ----- ----- Gross profit .......................... 23.2 35.0 28.6 35.4 Operating expenses: Amortized customer acquisition costs -- 18.4 -- 19.8 Marketing expenses ................. 121.9 37.8 64.4 28.3 Research and development ........... 2.7 2.2 2.7 1.5 General and administrative ......... 9.5 5.5 8.2 6.1 ------ ----- ----- ----- Total operating expenses ......... 134.1 63.9 75.3 55.7 ------ ----- ----- ----- Loss from Operations .................. (110.9) (28.9) (46.7) (20.3) Total other income .................... 1.6 0.5 1.5 0.8 ------ ----- ----- ----- Loss before income taxes .............. (109.3) (28.4) (45.2) (19.5) Benefit (provision) for income taxes .. (.9) 10.3 (.7) 7.4 ------ ----- ----- ----- Net loss .............................. (110.2)% (18.1)% (45.9)% (12.1)% ====== ===== ===== =====

Net revenues for the third quarter of fiscal 2000 were $19,862,000 compared to net revenues of $22,801,000 for the third quarter of fiscal 1999. For the nine months ended June 24, 2000, net revenues were $59,149,000 compared to $63,615,00 for the same period of fiscal 1999. For the quarter, the decrease in net revenues was primarily due to a decline in net revenues from traditional photofinishing of approximately 45% from the same period of the prior year, which was partially offset by a 20% increase in net revenues from orders including digital services. Management believes the increase in orders including digital services indicates a transition in customer preference for digital services.* Pricing changes for Pictures On Disk(R) and 4 x 6 prints, combined with marketing promotions offering free film processing to first time customers (which typically result in lower net revenues on a per order basis) contributed to an overall decline in net revenues for the quarter and year to date. In addition, net revenues from ancillary businesses decreased $731,000 in the third quarter of fiscal 2000 compared to the third quarter of fiscal 1999 and decreased $2,277,000 for the first nine months of fiscal 2000 as compared to the first nine months of fiscal 1999. The decline in net revenues from ancillary businesses was primarily due to reduced sales of the Company's wholesale film primarily attributable to lower retail pricing of major competing film brands and the Company's curtailment of recycled single-use camera sales following the June 1999 ruling by the International Trade Commission prohibiting the importation and sales of recycled single-use cameras. The Company plans to phase out wholesale film sales and certain other wholesale activities during fiscal year 2000. * Cost of goods and services consist of labor, postage, supplies and fixed operating costs related to the Company's services and products. Gross profit in the third quarter of fiscal 2000 decreased to 23.2% of net revenues compared to 35.0% in the third quarter of fiscal 1999. For the first nine months of fiscal 2000, gross profit decreased to 28.6% compared to 35.4% for the same period of fiscal 1999. The decreases in gross profit were primarily due to increased expenditures for scanning and archiving costs for online services, labor, materials, delivery costs, and overhead costs associated with services and products. Service enhancements such as priority mail upgrades and increases in customer service costs account for approximately 4% of the decrease in gross profit during the third quarter of fiscal 2000. During the second quarter of fiscal 2000, the Company began setting new service standards to better serve its customers. These standards which include priority mail and expanded e-mail communications with customers as to order status and marketing promotions, have significantly Page 13 of 18 increased the number of e-mail inquires which are responded to by customer service representatives. Labor and equipment costs for production areas increased as a percentage of net revenues due primarily to a ramp up in capacity in anticipation of projected volumes increases. This accounted for approximately 3% of the decline in gross profit during the third quarter of fiscal 2000. Depreciation and lease costs for archiving equipment and facilities accounted for approximately 4% of the decline in gross profit during the third quarter of fiscal 2000. Fluctuations in gross profit will occur in future periods due to the seasonal nature of revenues, mix of product sales, free promotion offers, level and nature of marketing activities and other factors.* Total operating expenses in the third quarter of fiscal 2000 increased to $26,643,000, or 134.1% of net revenues, compared to $14,579,000, or 63.9% of net revenues in the third quarter of fiscal 1999. For the first nine months of fiscal 2000, total operating expenses increased to $44,580,000, or 75.3% of net revenues compared to $35,473,000, or 55.7% of net revenues for the same period of fiscal 1999. Operating expenses for each of the first three quarters in fiscal 1999 included $4,200,000 amortization of previously deferred capitalized customer acquisition costs which were fully amortized during fiscal 1999. Excluding these accelerated amortization costs, total operating expenses would have been $10,379,000, or 45.5% of net revenues in the third quarter of fiscal 1999 and $22,873,000, or 35.9% of net revenues, for the first nine months of fiscal 1999. Comparable fiscal 2000 operating expenses increased over the third quarter and first nine months of the previous fiscal year due to significant increases related to an aggressive branding and marketing campaign which was launched in the third quarter of fiscal 2000. This campaign includes a national branding campaign combined with customer acquisition programs and marketing communications to existing customers. Operating expenses also include increased research and development costs related to the Company's online services and products and general and administrative costs. Future periods may reflect increased or decreased operating costs due the timing and magnitude of marketing, research and development and general and administrative activities.* Marketing expenses include current period expenses associated with customer acquisition, building brand awareness, testing of new marketing strategies and marketing to existing customers. Marketing expenses in the third quarter of fiscal 2000 increased to $24,221,000, or 121.9% of net revenues, compared to $8,621,000, or 37.8% of net revenues, for the third quarter of fiscal 1999. For the first nine months of fiscal 2000, marketing expenses were $38,089,000, or 64.4% of net revenues, compared to $18,007,000, or 28.3% of net revenues, for the first nine months of fiscal 1999. During the third quarter of fiscal 2000, the Company launched an $8 million national brand advertising campaign to promote brand awareness in the online photo services market, approximately 75% of the costs of which were incurred in the third quarter. Other marketing programs during the third quarter targeted existing customers to inform them of the Company's online product offerings and name change. The Company also initiated this quarter, a major direct mail and Internet campaign to acquire new customers interested in its online digital services and products. The Company anticipates additional marketing costs in the fourth quarter of fiscal 2000 to be significantly less than the third quarter, although it has existing commitments for marketing expenditures and expects it will continue to market at levels higher than the prior year fourth quarter.* Accordingly, the Company anticipates that marketing expenses in the fourth quarter of fiscal 2000 will increase as compared to the prior year period. * At this point, it is too early to measure the success of the branding and marketing campaigns. Research and development expenses consist primarily of costs incurred in developing digital services and computer software products and equipment necessary to provide customers with new computer-related photographic services and products. Research and development expenses increased to $532,000, or 2.7% of net revenues, for the third quarter of fiscal 2000 compared to $506,000, or 2.2% of net revenues, in the third quarter of fiscal 1999. Research and development expenses for the first nine months of fiscal 2000 increased to $1,616,000, or 2.7% of net revenues, as compared to $961,000, or 1.5% of net revenues, for the first nine months of fiscal 1999. These increases were due primarily to additional personnel hired to support research and development for PhotoWorks(R) online archiving and photo sharing services and web-based initiatives. General and administrative expenses consist of costs related to computer operations, human resource functions, finance, legal, accounting, investor relations and general corporate activities. General and administrative expenses increased to $1,890,000, or 9.5% of net revenues, for third quarter of fiscal 2000 compared to $1,252,000, or 5.5% of net revenues, for the third quarter of fiscal 1999. General and administrative costs increased to $4,875,000, or 8.2% of net revenues, for the first nine months of fiscal 2000 as compared to $3,905,000, or 6.1% of net revenues, for the first nine months of fiscal 1999. These increases were primarily a result of increased expenditures related to information technology systems to support the Company's expanding computer-based and Internet-related operations combined with increases in recruiting, investor relations, legal and professional fees, and wages and benefits. General and administrative expenses may continue to increase Page 14 of 18 as a result of expansions in information technology systems and administrative staff and expenses related to recruiting and investor relations.* The Company also anticipates increased legal fees to defend the recently filed litigation (see Legal Proceedings in Item 1 of Part II below).* Total other income for the third quarter of fiscal 2000 increased to $323,000 as compared to $125,000 for the third quarter of fiscal 1999. For the first nine months of fiscal 2000, total other income was $913,000 as compared to $491,000 for the first nine months of fiscal 1999. These increases were primarily due to higher interest income primarily attributable to the Company's higher cash and short-term investment balances following the sale of Series A preferred stock in the second quarter of fiscal 2000. In the second quarter of fiscal 2000, it was determined that due to the Company's continued focus on promotional activities related to its digital imaging and online services, and the effects of such costs on its ongoing profitability, it was appropriate to provide a valuation allowance equal to the amount of deferred tax assets not recoverable through operating loss carrybacks. During the third quarter the Company finalized and filed its tax return for fiscal 1999. The amount of operating loss carrybacks estimated during the second quarter was updated to reflect book to return differences primarily related to alternative minimum tax calculations. As a result, quarterly income tax expense for the third quarter of fiscal 2000 was $183,000 or .8% of pre-tax operating loss, as opposed to a benefit of approximately $7,400,000 (assuming a normal statutory rate of 34%). For the nine months ended June 24, 2000, income tax expense was $428,000 or 1.6% of pre-tax operating loss, as opposed to a benefit of approximately $9,100,000 (assuming a normal statutory rate of 34%). Utilization of the remaining deferred tax assets of approximately $10,040,000 is dependent on future profits that are not assured. Net loss increased to $21,902,000, or 110.2% of net revenues, in the third quarter of fiscal 2000 as compared to a net loss of $4,134,000, or 18.1% of net revenues, in the third quarter of fiscal 1999. For the first nine months of fiscal 2000, net loss increased to $27,165,000, or 45.9% as a percentage of net revenues, compared to a loss of $7,719,000, or 12.1% of net revenues, for the same period of fiscal 1999. The fiscal 2000 period increases in net loss were primarily due to increased operating expenses, primarily marketing expenses, combined with decreases in net revenues and gross profit. The net loss for the fiscal 1999 periods included previously deferred customer acquisition costs as discussed in operating expenses above. Liquidity and Capital Resources ------------------------------- As of July 28, 2000, the Company's principal sources of liquidity included cash and short-term investments of approximately $9,531,000. The Company also has a line of credit of $6,000,000 secured by the Company's cash and investments. The line of credit is currently primarily reserved for outstanding letters of credit of approximately $5,115,000. A letter of credit for $5,000,000 was issued during the third quarter to secure national media advertising. The $5,000,000 letter of credit expires on September 15, 2000. The Company anticipates that the line of credit will be reduced to approximately $1,000,000 at that time.* The ratio of current assets to current liabilities for the Company was 1.5 to 1 at the end of the third quarter of fiscal 2000, as compared to a current ratio of 3.6 to 1 at September 25, 1999. During the first nine months of fiscal 2000, prepaid promotions increased by $2,777,000 related to marketing programs planned for the fourth quarter of fiscal 2000 and accounts payable increased by $6,847,000 primarily due to marketing programs during the third quarter of fiscal 2000. Although the Company does not currently have any fixed material commitments with regard to capital expenditures, it currently expects to spend approximately $1,000,000 during the remainder of fiscal 2000, principally for data storage, computer network equipment, and photofinishing equipment. In addition, the Company is committed to approximately $2,000,000 of television and print advertising to promote its online services for sharing, printing and storing photos. The Company currently anticipates that existing funds together with anticipated cash flow from operations and the Company's available line of credit will be sufficient to finance its operations and planned capital expenditures and to service its indebtedness for the near future. However, if the Company does not generate sufficient cash from operations to satisfy its ongoing expenses, the Company will be required to seek external sources of financing or to refinance its obligations. Possible sources of additional financing include the sale of equity securities or additional bank borrowings. There can be no assurance, however, that the Company will be able to obtain adequate financing in the future. Page 15 of 18 PART II -- OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS For an update concerning the legal proceeding filed by Fuji Photo Film Co., Ltd. on February 13, 1998, and the class action filed on March 29, 2000, see Note H of Notes to Consolidated Financial Statements in Part I above. A complaint was filed against the Company on March 29, 2000, and amended April 24, 2000, by five individual plaintiffs who are suing on their own behalf and purportedly on behalf of a class of all private citizens and non-governmental entities who have received from the Company, and had the Company process, "C-41" 35 mm color film from the Company or who have received replacement rolls of film from the Company after film processing. This complaint alleges that the Company has engaged in unfair and deceptive practices by allegedly misrepresenting that film received from the Company must be processed only by the Company and that replacement film is "free." This complaint requests injunctive and declaratory relief and restitution and damages in unspecified amounts, and also requests trebling of damages and recovery of litigation expenses pursuant to the Washington Consumer Protection Act. The suit is in its beginning stage, and the court has not yet determined whether the individual plaintiffs will be permitted to prosecute the suit as a class action. Management of the Company intends to contest the suit vigorously, both as to the complaint's substantive allegations and as to whether the suit may properly be prosecuted as a class action. ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. --------- 3.1 Bylaws of the Company, as amended and restated on November 13, 1996. (Incorporated by reference to Exhibit 3.2 filed with the Company's Annual Report on Form 10-K for the year ended September 28, 1996) 3.2 Third Amended and Restated Articles of Incorporation of the Company dated February 5, 1998 (Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended September 25, 1999, as amended by Form 10-K/A filed on January 14, 2000) 3.3 Form of Certificate of Designation Preferences and Rights of Series RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the Company's Annual Report on 10-K for the year ended September 25, 1999) 4.1 Rights Agreement dated December 16, 1999 between the Registrant and Chase Mellon Shareholder Services L.L.C., as Rights Agent (Incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed with the Commission on December 17, 1999) 10.1 Third Amendment to Credit Agreement and Security Agreement with Wells Fargo Bank 27.1 Financial Data Schedule - 2000 27.2 Financial Data Schedule - 1999 (b) Reports on Form 8-K. -------------------- None Page 16 of 18 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PHOTOWORKS, INC. DATED: August 7, 2000 /s/ Gary R. Christophersen --------------------------------- Gary R. Christophersen President/Chief Executive Officer (Principal Executive Officer) /s/ Loran Cashmore Bond ---------------------------------- Loran Cashmore Bond Treasurer/Chief Accounting Officer Page 17 of 18 INDEX TO EXHIBITS PHOTOWORKS, INC. Quarterly Report on Form 10-Q For The Quarter Ended June 24, 2000

Exhibit Description Page No. ------- ----------- -------- 3.1 Bylaws of the Company, as amended and restated on November 13, 1996 (Incorporated by reference to Exhibit 3.2 filed with the Company's Annual Report on Form 10-K for the year ended September 28, 1996) 3.2 Third Amended and Restated Articles of Incorporation of the Company dated February 5, 1998 (Incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended September 25, 1999, as amended by Form 10-K/A filed on January 14, 2000) 3.3 Form of Certificate of Designation Preferences and Rights of Series RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the Company's Annual Report on 10-K for the year ended September 25, 1999) 4.1 Rights Agreement dated December 16, 1999 between the Registrant and Chase Mellon Shareholder Services L.L.C., as Rights Agent (Incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed with the Commission on December 17, 1999) 10.1 Third Amendment to Credit Agreement and Security Agreement with Wells 19-35 Fargo Bank 27.1 Financial Data Schedule - 2000 27.2 Financial Data Schedule - 1999

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