United States
Securities and Exchange Commission

Washington, D.C. 20549

 

Form 10-K

 

 

 

Indicate by check mark whether the Registrant:  (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  YES ý  NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in a definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  ý

 

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES ý NO o

 

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $38,570,310 as of June 30, 2003, based upon the closing price on the NASDAQ National Market on this date.  The Registrant does not have non-voting common equity.

 

As of March 1, 2004, 9,216,027 shares of the Registrant’s $.0001 par value Class A common stock and 5,400,000 shares of the Registrant’s Class B common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

The following documents (or portions thereof) are incorporated by reference into the Parts of this Form 10-K noted:

 

 

Part III incorporates by reference from the definitive proxy statement for the Registrant’s 2004 Annual Meeting of Stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form.

 

GAIAM, INC.

Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2003

 

PART I		3
Item 1.	Business	3
Item 2.	Properties	14
Item 3.	Legal Proceedings	14
Item 4.	Submission of Matters to a Vote of Security Holders	14
PART II		14
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	14
Item 6.	Selected Financial Data	15
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 8.	Financial Statements and Supplementary Data	23
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	41
Item 9A.	Controls and Procedures	41
PART III		42
Item 10.	Directors and Executive Officers of the Registrant	42
Item 11.	Executive Compensation	42
Item 12.	Security Ownership of Certain Beneficial Owners and Management	42
Item 13.	Certain Relationships and Related Transactions	42
Item 14.	Principal Accounting Fees and Services	42
PART IV		42
Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	42
SIGNATURES		44

 

FORWARD-LOOKING STATEMENTS

This report may contain forward-looking statements that involve risks and uncertainties.  When used in this discussion, the words “anticipate,” “believe,” “plan,” “estimate,” “expect,” “strive,” “future,” “intend” and similar expressions as they relate to Gaiam or its management are intended to identify such forward-looking statements.  Gaiam’s actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Market Risk” and elsewhere in this report.  Risks and uncertainties that could cause actual results to differ include, without limitation, general economic conditions, competition, loss of key personnel, pricing, brand reputation, acquisitions, security and information systems, legal liability for website content, merchandise supply problems, failure of third parties to provide adequate service, reliance on centralized customer service, overstocks and merchandise returns, reliance on a centralized fulfillment center, increases in postage and shipping costs, e-commerce trends, future Internet related taxes, control of Gaiam by its founder, fluctuations in quarterly operating results, consumer trends, customer interest in our products, the effect of government regulation and other risks and uncertainties included in Gaiam’s filings with the Securities and Exchange Commission.  We caution you that no forward-looking statement is a guarantee of future performance, and you should not place undue reliance on these forward-looking statements which reflect our management’s view only as of the date of this report.  We undertake no obligation to update any forward-looking information.

 

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Part I

 

Item 1.                                                           Business

 

OUR BUSINESS

 

Gaiam

 

Gaiam is a multi-channel lifestyle company providing a broad selection of information, products and services to customers who value natural health, personal development, ecological lifestyles and responsible media.  We offer our customers the ability to make purchasing decisions based on these values while providing a quality product at a price comparable to conventional alternatives.

 

Gaiam has established itself as a lifestyle brand, information resource and authority in the Lifestyles of Health and Sustainability (LOHAS) market and seeks to become a unifying symbol of the emerging LOHAS lifestyle. Our lifestyle brand is built around our ability to develop and offer content, products and lifestyle solutions to consumers in the LOHAS market. Our content forms the basis of our proprietary products, on which we realize our highest margins, which then drives demand for parallel product and service offerings.  Gaiam’s operations are vertically integrated from content creation, through product development and sourcing, to customer service and distribution.  We market our products and services across two segments, business and direct-to-consumer, and through five sales channels: media, national retailers, corporate accounts, catalogs and the Internet. We distribute our products in each of these sales channels from a single fulfillment center.

 

The LOHAS Market

 

The LOHAS market, which represented $227 billion in sales in 2000 according to the Natural Business Communication study, consists of five main sectors:

 

•                  Sustainable Economy.  Renewable energy, energy conservation, recycled goods, environmental management services, sustainable manufacturing processes and related information and services.

 

•                  Healthy Living. Natural and organic foods, dietary supplements, personal care products and related information and services.

 

•                  Alternative Healthcare. Health and wellness solutions and alternative health practices.

 

•                  Personal Development. Solutions, information, products and experiences relating to mind, body and spiritual development.

 

•                  Ecological Lifestyles. Environmentally friendly cleaning and household products, organic cotton clothing and bedding, and eco-tourism.

 

Gaiam participates in all five sectors of the LOHAS market.

 

Our Content

 

Gaiam’s business model revolves around content creation, which forms the basis for our proprietary products. We have an “in house” production team that produces programs on a variety of topics including “how-to” and solutions based programs on mind-body fitness, wellness, and alternative healthcare. Our programs have won 22 Telly awards and several medals at the International New York Film Festival.  We developed a new line of children’s products during 2003, which was the recipient of several Parent’s Choice and Kids First Awards recognizing new products that help kids grow imaginatively, physically, and mentally.  During 2003, we produced 44 new visual media programs. Gaiam also develops and markets music and audio CDs and publishes printed content.

 

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Our Products

 

We currently stock approximately 7,500 stock keeping units (SKUs) of which approximately 4,500 are proprietary products bearing the Gaiam brand.  Our proprietary products constituted over 62% of our sales in 2003, compared to 53% in 2001, and 24% in 1999.  Our visual media programs represent the largest part of our proprietary product offering.  Our best selling products, by LOHAS sector, are as follows:

 

Sustainable Economy		Healthy Living		Alternative Healthcare		Personal Development		Ecological Lifestyles
Solar Panels and Accessories		Air Filters		Natural Lighting		Yoga Information and Accessories		Natural Cleaners
Energy Systems		Water Filters		Back and Neck Care Products		Pilates Information and Accessories		Organic Cotton Bedding
Energy Efficient Lighting		Personal Air Supply		Massage Accessories		Meditation Information and Accessories		Organic Cotton Towels
Energy Information		UV Purifiers		Stress Relief		Fitness Accessories		Organic Cotton Clothing
Evaporative Coolers		Personal Care Products		Allergy and Pain Relief		Performance Wear		Recycled Household Paper Products
Intertie Systems		Natural Beauty Products		Sleep Enhancers		Personal Growth Information		Natural Garden Products
Composters		Whole Foods Brand Products		Wellness Information		Kids Fitness Products and Information		Non-Toxic Pest Control
Air Dryers		Healthy Cooking		Aroma Therapy		Relaxation Music		Green Cotton Home Accessories

 

Our Sales Channels

 

We conduct our business across two segments.  Our business segment customers are primarily national retailers, corporate accounts and the media. We conduct our direct-to-consumer business through our catalogs and the Internet.  Approximately 93% of our 2003 sales were made directly to retailers or end-users, and less than 7% were through distributors.

 

•                  Media

 

Gaiam develops and produces information and programming targeted to consumers who value natural health, personal development and spirituality.  Gaiam has an award-winning library of titles that it sells to retailers, licenses to selected distributors operating outside of the United States, and licenses or sublicenses for broadcast.  Our current list of licensees includes Koch Vision, Universal Studios, Fine Living, Discovery Channel and Conscious Media.  All of our licensing arrangements require Gaiam branding to be prominent on the programming and are subject to our talent royalty agreements.  While our licensing of the rights to manufacture and distribute certain of our media lowers recognized revenue, contribution margins are improved.

 

•                  Retailers

 

Since the inception of our retailer channel in 1996, we have increased its breadth and diversity.  As of the end of 2003, Gaiam products may be found in over 30,000 stores in North America, plus in retailers located in the U.K. and Australia.  Gaiam products are currently sold across a variety of leading retailers, including bookstores such as Barnes & Noble and Borders; music stores such as Musicland and Virgin Record Megastores; lifestyle stores such as Discovery Channel Stores; beauty stores such as Ulta and Origins; home furnishing stores such as Bed, Bath and Beyond and Linens ‘n Things; natural food stores such as Whole Foods Market; sporting goods stores such as Dick’s, REI and Galyan’s; mass merchants such as Target and WalMart, e-tailers such as Amazon.com and Drugstore.com; and wholesale clubs such as Costco.  Many of these retailers display our products in store-within-store lifestyle presentations that utilize custom fixtures designed and produced by Gaiam. We implemented our first store-within-store concept late in 2000 and the concept has grown to over 3,650 stores by the end of 2003.

 

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Through distributor arrangements and acquisitions, Gaiam branded products may now be found in over 3,500 international retail stores throughout Canada, the United Kingdom and Australia.  Our media products are sold to international accounts under licensing agreements and the remaining products are sold based on distributor relationships.  During 2003, Gaiam acquired a 50.1% ownership interest in Leisure Systems International (“LSI”), a U.K. based distributor and marketer of lifestyle products.  The acquisition has allowed our merchandising and product development groups to work closely with the LSI team to modify and develop new lifestyle products that fit into the cultures of countries outside of North America.

 

•                  Services

 

Gaiam provides products and services to businesses that desire renewable energy solutions or healthy and natural alternatives to traditional products or processes and services such as eco-travel.  We have a design and consulting service for corporate accounts that assesses energy needs and makes recommendations for more efficient solutions. We also organize individual and family eco-travel trips and group eco-travel adventures for museums and zoological societies, schools and universities and conservation and corporate groups.  Integral to our complete eco-travel experience is imparting an understanding of, and having our travelers experience the critical nature and work needed to protect and preserve our wildlife, wild places and environment. Clients of our lifestyle services included The White House, NASA, Fetzer Winery, the U.S. Departments of Energy, the Government of Brazil, the Smithsonian Institution, and the World Wildlife Fund.

 

•                  Catalogs

 

Gaiam offers a variety of LOHAS products directly to the consumer through our catalogs and through some consumer lifestyle publications. We produce catalogs for all aspects of LOHAS.  The typical Gaiam direct consumer is female, has an average income of $75,000 and is well educated.

 

•                  Internet

 

We use the Internet to sell our products and to provide information on the LOHAS lifestyle.  We currently offer over 7,500 SKUs on our website, www.gaiam.com.  We promote our website through our visual media, catalogs, print publications, product packaging and Internet Links.  A key component of our Internet approach is to provide customer support for Internet sales from our in-house call center.  According to a Jupiter Communications study, 90% of on-line customers prefer human interaction when they require customer service.  This is particularly important for Gaiam because the use of many of our products is enhanced by the extensive product education and information that we make available online and through our well informed customer service personnel.

 

Our Operations

 

•                  Product Development and Sourcing

 

Gaiam branded products are sold across our five sales channels.  Non-proprietary products are only available through our catalogs and over the Internet, where we initially test products before we decide to develop products under the Gaiam brand and distribute them through our other sales channels.  Our products are designed to enhance customers’ lifestyles and experiences and provide healthy, natural solutions while being eco-friendly and promoting a sustainable economy.  Because we use a multi-channel approach to our business we are able to leverage our product development costs across all channels of our business.

 

Our proprietary products are designed by our product development team, sourced both domestically and internationally by our merchandisers and produced by third party suppliers to our specifications.  We also screen the environmental and social responsibility of our suppliers.  In order to minimize risk we often identify an alternate supplier for our products in a separate location.

 

•                  Customer Service

 

Gaiam focuses on building and maintaining customer relationships that thrive on loyalty and trust.  We maintain a “no-risk guarantee” policy, whereby a customer is provided a full refund for products that are returned at any time, for any reason.  In 2003, we established a most valued customer program, which extends added benefits to our most loyal catalog and Internet customers.  Our in-house customer service department includes product

 

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specialists who have specific product knowledge and assist customers in selecting products and solutions that meet their needs.  We employ telephone routing software that directs each call to the appropriate representative.  Our policy is to ship orders no later than the next business day, which we accomplish by stocking inventory that supports over 90% of our orders. We believe that by offering exceptional customer service we encourage repeat purchases by our customers, enhance our brand identity and reputation and build stronger relationships with our customers.

 

•                  Established Infrastructure

 

We operate a 208,000 square foot fulfillment center near Cincinnati, Ohio, which provides fulfillment for a most of our current business needs and has the capacity to support the growth of our business.  This central U.S. location allows us to achieve shipping cost efficiencies to most locations.  The center is also located within 30 minutes of several major shipping company hubs.  We use a supply chain management system that supports our entire operation, including fulfillment, inventory management, and customer service.  Our fulfillment center is connected to our other facilities by a state-of-the art voice-over-Internet telecom network that allows us to maintain a high degree of connectivity within our organization.

 

Our Growth Strategies

 

•                  Expand our Media Offering

 

Proprietary and authentic content lies at the core of our business model. Our media offerings introduce customers to Gaiam and helps establish Gaiam as an authority in the LOHAS market.  Gaiam’s primary focus is on leveraging our content with branded lifestyle product offerings through various media, catalogs, the Internet, and national retailers.  We believe that the content-centric strategy is a competitive advantage and the multi-channel approach allows us the broadest possible consumer reach.

 

We will continue to develop authentic content that caters to the LOHAS lifestyle in DVD and VHS formats and also accelerate our efforts in the music, broadcast and publishing categories.  We have already expanded our visual media offerings internationally and plan to continue to leverage this opportunity.

 

•                  Strengthen our Lifestyle Brand

 

Our goal is to maintain the Gaiam brand as an authority in the LOHAS market and to establish Gaiam as a unifying symbol of the emerging LOHAS lifestyle.  Strategically, all proprietary products are now being marketed under one unified brand, “Gaiam.” We plan to strengthen the Gaiam brand by growing our media, focusing on category management initiatives, increasing our store-within-store presence across national retailers, increasing our marketing efforts, and by aggressively developing and marketing proprietary products while maintaining our high level of customer service.

 

•                  Expand our Proprietary Products

 

Our proprietary products, which we introduced in 1997, represented 62% of our revenues in fiscal year 2003.  These products carry a higher margin, provide for branding opportunity and distinguish us from many of our competitors. We currently offer over 4,500 SKUs of proprietary products that range from media products to sleep, stress relief, yoga and pilates accessories to organic cotton bedding and bath products.  We continue to develop and market proprietary products across each of the five LOHAS sectors.  We are strengthening our supply chain globally by sourcing a greater number of products offshore. We leverage our product development costs over all sales channels.

 

•                  Capitalize on our Multi-channel Approach

 

Our multi-channel strategy affords us the broadest possible customer reach. This approach makes purchasing our lifestyle products convenient regardless of the channel that a customer prefers. Additionally this diversified, strategic approach should provide for continued operating and business stability as we have the ability to cross-market lifestyle products and services regardless of the customer location or the channel to which we are marketing.  In our direct-to-consumer business we are open 24 hours a day, offering over 7,500 products on our Internet site.

 

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In our business segment, we continue to expand our presence in national retailers and currently have placements in over 30,000 retail points in North America, plus in retailers located in the U.K. and Australia.  We also continue to expand our store-within-store concept in a variety of stores, including Whole Foods Markets, Barnes & Noble Bookstores, Discovery Stores, Ulta, Dick’s Sporting Goods, REI, Galyan’s and other national retailers.

 

•                  Expand into New Product Categories in our Business Segment

 

We have successfully established Gaiam as one of the leaders in the mind-body health category.  In an effort to leverage and diversify our strong relationships with our customer base, we continue to offer products across an increasing number of lifestyle categories including functional apparel, natural home and wellness.  We continue to test products in our direct business for expansion opportunities at retailers.  We believe that the Gaiam brand can extend to all aspects of LOHAS in our business segment.

 

•                  Complement our Existing Business with Selective Strategic Acquisitions

 

Our growth strategy is not dependent on acquisitions.  However, we will consider those strategic acquisitions in the LOHAS market that complement our existing business, increase our media and related product offerings, and expand our geographical reach.  We especially focus on companies with a strong brand identity and with customer and product information databases that augment our existing databases.  Gaiam often allows some of the acquired company’s management team to retain responsibility for front-end business functions such as creative presentation and marketing, while consolidating operational functions under Gaiam’s existing infrastructure when economies of scale can be realized.

 

Our Business Segments

 

We separate our business into two business segments:  the business segment which includes sales to businesses, retailers, corporate accounts and media outlets; and the direct-to-consumer segment, which includes catalogs, print advertising, and e-commerce.

 

Our business segment provides us with increased branding opportunities, higher operating contribution and potential growth in mainstream retail stores.  The business segment represented 51% of 2003 revenues, while the direct to consumer segment represented 49% of revenues.  See Note 11 to our consolidated financial statements for further information on our segments.

 

Our Intellectual Property

 

Our tradename Gaiam and various product and Internet domain names are subject to trademark or pending trademark applications of Gaiam or a Gaiam company.  We believe these trademarks are significant assets to our business.

 

Our Competitive Position

 

We believe that fragmented supplier and distribution networks characterize the LOHAS market, and we are not aware of a dominant leader.  Gaiam’s goal is to establish itself as the market leader.

 

Our business is evolving and competitive.  Larger and better-established entities may acquire, invest in or form joint ventures with our competitors.  Many of these entities have longer operating histories and have greater financial and marketing resources than we have.  Increased competition from these or other competitors could reduce our revenue and profits.  In addition, the smaller businesses we compete against may be able to more effectively personalize their relationships with customers.

 

Because Gaiam uses multi-channel distribution for our products, we compete with various producers of similar products and services. Our competitors include Goodtimes Home Media, Anchor Bay, Ventura, PPI Entertainment, Goldhill Media, Nike, Reebok, thousands of small, local and regional businesses, and product lines or items that are offered by large retailers, manufacturers, publishers and media producers.

 

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We believe the principal competitive factors in the LOHAS market are authenticity of information, distinctiveness of products and services, quality of product, brand recognition and price, and in media offerings, unique content and distribution capabilities.  We believe we compete favorably on all these relevant factors.

 

We expect industry consolidation to increase competition. As our competitors grow, they may adopt aggressive pricing or inventory policies, which could result in reduced operating margins and loss of market share.

 

Our success also depends upon the willingness of consumers to purchase goods and services that promote the values we espouse. While we believe our business plan and assumptions are reasonable, the demographic trends on which they are based may change and the current consumption levels may not be sustained. The decrease of consumer interest in purchasing goods and services that promote the values we espouse would materially and adversely affect our customer base and revenues and, accordingly, our financial prospects.

 

Our Employees

 

As of March 1, 2004, Gaiam and the Gaiam companies employed approximately 285 persons.  None of our employees are covered by a collective bargaining agreement.

 

Regulatory Matters

 

There are a number of different bills under consideration by Congress and various state legislatures that would restrict disclosure of consumers’ personal information, which may make it more difficult for Gaiam to generate additional names for its direct marketing, and restrict a company’s right to send unsolicited electronic mail or printed materials.  Although Gaiam believes it is generally in compliance with current laws and regulations and that these laws and regulations have not had a significant impact on our business to date, it is possible that existing or future regulatory requirements will impose a significant burden on us.

 

The Gaiam companies generally collect sales taxes only on sales to residents of states in which Gaiam has locations.  Currently, Gaiam collects sales taxes in sales to residents of California, Colorado and Ohio.  A number of legislative proposals have been made at the federal, state and local level, and by foreign governments, that would impose additional taxes on the sale of goods and services over the Internet and certain states have taken measures to tax Internet-related activities.  If legislation is enacted that requires Gaiam to collect sales taxes on sales to residents of other states or jurisdictions, sales in our direct-to-consumer businesses may be adversely affected.

 

Our business is also subject to a number of other governmental regulations, including the Mail or Telephone Order Merchandise Rule and related regulations of the Federal Trade Commission.  These regulations prohibit unfair methods of competition and unfair or deceptive acts or practices in connection with mail and telephone order sales and require sellers of mail and telephone order merchandise to conform to certain rules of conduct with respect to shipping dates and shipping delays. We are also subject to regulations of the U.S. Postal Service and various state and local consumer protection agencies relating to matters such as advertising, order solicitation, shipment deadlines and customer refunds and returns. In addition, merchandise imported by Gaiam is subject to import and customs duties and, in some cases, import quotas.

 

Seasonality

 

See the Quarterly and Seasonal Fluctuations section of Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for information pertaining to the seasonal aspects of our business.

 

Available Information

 

Our corporate website at www.gaiam.com/corporate provides information about Gaiam, its history, goals and philosophy, as well as certain financial reports and corporate press releases.  Our www.gaiam.com website features a library of information and articles on personal development, healthy lifestyles and environmental issues, along with an extensive offering of products and services.  We believe our website provides us with an opportunity to deepen our relationships with our customers and investors, educate them on a variety of issues, and improve our service.  As part of this commitment, we have added a link on our corporate website to our Securities and Exchange Commission filings, including our reports on Form 10-K, 10-Q and 8-K and all amendments to such reports.  Those reports are available through our website, free of charge, as soon as reasonably practicable after these reports are filed with the Securities and Exchange Commission.

 

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We have included our website addresses only as inactive textual reference, and the information contained on our website is not incorporated by reference into the Form 10-K.

 

Factors That May Affect Future Results

 

We wish to caution you that there are risks and uncertainties that could cause our actual results to be materially different from those indicated by forward looking statements that we make from time to time in filings with the Securities and Exchange Commission, news releases, reports, proxy statements, registration statements and other written communications as well as oral forward looking statements made from time to time by our representatives.  These risks and uncertainties include, but are not limited to, those risks described below.  Additional risks and uncertainties not presently known to us or those we currently deem immaterial also may impair our business operations and historical results are not necessarily an indication of the future results.  The cautionary statements below discuss important factors that could cause our business, financial condition, operating results and cash flows to be materially adversely affected.

 

Changes in general economic conditions could have a material impact on our business

 

Our results of operations could be impacted by changes in overall economic conditions that impact consumer spending.  Future economic conditions affecting disposable income such as employment levels, consumer confidence, business conditions, stock market volatility, weather conditions, acts of terrorism, threats of war, and interest and tax rates could reduce consumer spending or cause consumers to shift their spending to our competitors.  If the current economic conditions and performance of the retail and media environment do not improve, or worsen, we may experience material adverse impacts on our business, operating results and financial condition.

 

Increased competition could impact our financial results

 

We believe that the LOHAS market has thousands of small, local and regional businesses. Some smaller businesses may be able to more effectively personalize their relationships with customers, thereby gaining a competitive advantage. Although we believe that we do not compete directly with any single company that offers our entire range of merchandise, within each merchandise category we have competitors and we may face competition from new entrants. Some of our competitors or our potential competitors may have greater financial and marketing resources. In addition, larger, well-established and well-financed entities may acquire, invest in or form joint ventures with our competitors. Increased competition from these or other competitors could negatively impact our business.

 

Changing consumer preferences may have an adverse effect on our business

 

Our business is targeted at consumers who assign high value to personal development, healthy lifestyles, responsible media, renewable energy and the environment. A decrease of consumer interest in purchasing goods and services that promote the values we espouse would materially and adversely affect our customer base and sales revenues and, accordingly, our financial prospects. Further, consumer preferences are difficult to predict. Our future success depends in part on our ability to anticipate and respond to changes in consumer preferences and we may not respond in a timely or commercially appropriate manner to such changes. Failure to anticipate and respond to changing consumer preferences could lead to, among other things, lower sales of our products, increased merchandise returns and lower margins, which would have a material adverse effect on our business.

 

We may face quarterly and seasonal fluctuations that could harm our business

 

Our revenue and results of operations have fluctuated and will continue to fluctuate on a quarterly basis as a result of a number of factors, including the timing of catalog offerings, timing of orders from retailers, recognition of costs or net sales contributed by new merchandise and catalog offerings, fluctuations in response rates, fluctuations in paper, production and postage costs and expenses, merchandise returns, adverse weather conditions that affect distribution or shipping, shifts in the timing of holidays and changes in our merchandise mix. In particular, our net sales and profits have historically been higher during the fourth quarter holiday season. We believe that this seasonality will continue in the future.

 

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Our strategy of offering branded products could lead to inventory risk and higher costs

 

An important part of our strategy is to feature branded products. These products are sold under our brand names and are manufactured to our specifications. We expect our reliance on branded merchandise to increase. The use of branded merchandise requires us to incur costs and risks relating to the design and purchase of products, including submitting orders earlier and making longer initial purchase commitments.

 

In addition, the use of branded merchandise limits our ability to return unsold products to vendors, which can result in higher markdowns in order to sell excess inventory. Our commitment to customer service typically results in us keeping a high level of merchandise in stock so we can fill orders immediately. Consequently, we run the risk of having excess inventory, which may also contribute to higher markdowns. Our failure to successfully execute a branded merchandise strategy or to achieve anticipated profit margins on these goods, or a higher than anticipated level of overstocks, may materially adversely affect our revenues.

 

We offer our customers liberal merchandise return policies. Our consolidated financial statements include a reserve for anticipated merchandise r