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A Near-Death Experience
By Jean Gruss
Editor/Lee-Collier
Leslie Flegel says he never intended his company to grow this big this quickly.
But Bonita Springs-based Source Interlink's management team decided to seize opportunities whenever they arose. Flegel, 67, Source's chairman and chief executive officer, engineered two big acquisitions in the past year that made Source Interlink the nation's dominant distributor of magazines, CDs and DVDs to more than 1,000 retail chains across the country. Customers include such giants as Wal-Mart, Target and Walgreens.
The company is on track this year to generate $1.7 billion in sales, or about four times what Source's revenues were for the fiscal year ended Jan. 31, 2005.
Above all, Flegel had a vision to modernize an industry that has operated inefficiently for decades. Regional distributors have long dominated the magazine distribution business, delivering magazines using their own fleet of trucks and drivers.
But the key to Source's success rests in large part on its reliance on freight delivery giants UPS and FedEx to deliver his goods to any zip code overnight or in two days. Because Source ships 400 million pounds of freight a year, it can negotiate competitive rates that in some cases are 20% of what it would cost to deliver them with its own fleet of trucks.
What's more, Source's historical business has been managing sales of magazines in stores, providing retailers with critical data on inventory and product placement as well as collection of rebates and incentives from publishers. It also manufactures its own racks that it sells to stores for their checkout lines and magazine aisles. Today, the company has the largest information network in the country for magazine sales and manages 70% of all the checkout lanes in 110,000 stores.
How Source Interlink reached this level offers many lessons for entrepreneurs. Chief among them: recognize an opportunity when it comes your way and find a way to capitalize on it.
An audacious move
The turning point that sparked Source Interlink's recent growth was an acquisition that nearly sank the company. In 2001, Source Interlink had been a publicly traded company for six years and was successfully collecting rebates and incentives from publishers on behalf of retail clients. At the time, it was headquartered in St. Louis.
In the late 1990s, Flegel saw that the magazine distribution business - a fragmented group of about 400 companies - was consolidating. Flegel decided to make Source Interlink one of the acquirers. It purchased International Periodical Distributors (IPD), a San Diego-based outfit that used UPS and FedEx to distribute magazines to all Borders and Barnes & Noble bookstores across the country. At the time, Source Interlink was managing the book chains' magazine inventory.
Flegel was drawn to IPD by its business model of relying on UPS and FedEx to deliver magazines nationwide at a lower cost than regional distributors could with their teams of trucks and drivers. He felt he could build on the IPD acquisition to deliver magazines more efficiently to more customers on a national scale.
Using $20 million in loans from Bank of America, Flegel purchased IPD in June 2001. But shortly thereafter, Flegel discovered that IPD had understated its losses and was on the brink of disaster.
"Everyone was mad at me," Flegel recalls. Bank of America officials were particularly incensed because Flegel had used the loan to buy what essentially turned out to be a worthless company. At the time, Source and IPD had few assets.
"The only way to get out of that trap was to perform," Flegel says.
So he and some of his managers moved to San Diego to save IPD, still convinced that the business model was viable.
It worked. IPD became profitable the first year as Flegel's team grew the number of customers who were looking for national reach. "That shut a lot of people up," Flegel says. In 2001, through IPD, Source was distributing more than 6,000 magazine titles to more than 10,000 stores.
Despite turning IPD around, Flegel says, Bank of America put Source Interlink in a "workout group," a label reserved for troubled companies that bankers fear might go out of business. What's more, Flegel says, Bank of America charged fees totaling in the hundreds of thousands of dollars to extend terms of loans that had come due.
Even as it was under pressure from its bankers, Source Interlink added new customers to its distribution business, including Hudson Group, the largest operator of airport stores in the country. At the time, Borders and Barnes & Noble accounted for about half of Source's distribution business.
To consolidate administrative functions scattered in different cities, the company moved its headquarters to Bonita Springs in 2003. At the time, Flegel owned a condominium in Naples and asked relocation consultants to include Southwest Florida in the search for the new heaquarters location. When the Bonita Springs location rose to the top of the list, Flegel decided to move the company to Lee County. It was an easy sell to employees; the other two choices were St. Louis or New York City.
Wells Fargo to the rescue
Meanwhile, Flegel was eager to find another lender who might take the place of Bank of America. But Source was tainted with the "workout" label. Banks repeatedly turned Flegel away. "It's all we did for a year. It was rejection after rejection after rejection," Flegel says.
Finally, Flegel found a receptive ear at Wells Fargo Foothill, a division of San Francisco-based Wells Fargo that provides financing to medium-sized companies for acquisitions and turnarounds. In October 2003, Flegel obtained a $50 million loan, most of which was used to pay the Bank of America loan. The term for most of the loan was the prime rate plus 0.5%, with a portion at prime plus 2.5%, according to the company's regulatory filings.
"It takes a lot for a new bank to come in after a workout," Flegel says. In the end, he says, Wells Fargo trusted Source's management team and its ability to make a profit. "It's about people, it really is," Flegel says.
Looking back today, Flegel says, the IPD acquisition was the "greatest deal" because it transformed Source into the only magazine distribution company with national reach. Without that deal, Flegel says, Source Interlink would not be the company it is today.
Back to the stock market
With respite from his bankers, Flegel then decided to raise cash in the public market.
"Fixing my balance sheet put me in a better position to wheel and deal with suppliers," Flegel says.
Also, he wanted to have the financial capacity to expand distribution so he could add supermarkets such as Kroger and chains such as Target and Walgreens to his roster of clients.
But Wall Street firms expressed the same kinds of reservations as the bankers. Eventually, Jefferies & Co. of New York took a cautious interest in the Source story. In early 2004, Jefferies agreed to lead the sale of 3.8 million shares of Source Interlink stock, which netted Source $40.5 million. At $11.50 a share, the offering was oversubscribed.
With the cash from the stock sale, Source paid off the Wells Fargo debt. With its balance sheet healthy and as the only distribution company that could deliver magazines within one day or two anywhere in the country, Source Interlink quickly landed new business. By the end of 2004, Source was supplying magazines to major chains such as Target, Walgreens, Rite Aid, CVS, 7-Eleven, Kmart and others.
Too good to pass up
As Source was growing in 2004, Flegel started hearing rumors that a regional competitor in Chicago called Chas. Levy Circulating Co. was facing financial difficulties and its owner wanted to sell. Levy was a dominant player in the Midwest and east and west coasts with $370 million in annual revenues, but the privately held firm wasn't profitable.
Flegel was reluctant to make an offer to buy the family-owned business. "I wasn't comfortable with our financial position to get back into the soup," Flegel says.
But late in 2004, Flegel met with Levy's owner, Barbara Levy Kipper, and the two agreed to mull over an acquisition. Flegel saw that if he acquired Levy he could switch its method of magazine delivery from a fleet of Levy trucks and drivers to UPS. He was sure Levy could be profitable because he had turned around Empire State News Corp. the same way.
Source had purchased Empire, a regional magazine distributor to stores in New York, Pennsylvania and Ohio in September 2004. Empire had lost $1.2 million on revenues of $22 million in the previous year, but when Source switched the delivery system to UPS, it earned $260,000 in its first quarter.
Meanwhile, Los Angeles-based billionaire Ronald Burkle had his eye on Source Interlink. Through his private investment firm, Yucaipa Cos., he had turned around a distributor of CDs and DVDs called Alliance Entertainment. Alliance's customers included bookstores such as Barnes & Noble and music stores such as Tower Records and, with $1 billion in revenues, it was three times Source Interlink's size.
One of Yucaipa's executives contacted Flegel in 2004 and suggested they meet. Flegel at first thought Yucaipa wanted to buy Source, but later discovered that Burkle wanted Source Interlink to buy Alliance using Source Interlink's stock. Burkle had turned around privately held Alliance and now wanted to give his investors the chance to cash out.
"They needed to get into a vehicle to get them liquid," Flegel says. The two businesses were complementary; in addition to magazines, Source could distribute CDs and DVDs in checkout lines and magazine stands.
On March 1, with about $300 million in newly issued stock, Source acquired Alliance, its $1 billion in revenues and enough assets so he could go back to the banks for more financing. Flegel negotiated a $250 million loan from Wells Fargo Foothill, which in turn helped it finance the acquisition of Levy for $29.7 million in cash.
"It was a bonanza for everybody," Flegel says.
Challenges ahead
Flegel's challenge is to integrate the acquisitions and win new business while keeping costs down. Already this year, it has signed agreements to distribute CDs and DVDs to 2,500 Walgreens stores and CDs to 400 Kmart stores.
One of the big prizes: Wal-Mart. Source Interlink already supplies more than 500 Wal-Mart stores with magazines. "You can't be in business without doing something with Wal-Mart," says Flegel. Source already supplies magazines to 30% of the stores of competitor Target.
Flegel also must turn Levy into a profitable operation. He's keeping the Levy fleet of trucks in cities such as Chicago and Philadelphia because they're just as efficient as UPS. But for deliveries outside dense urban areas, Flegel says the savings justify switching to UPS.
Analysts who follow Source say losses at Levy and acquisition costs were a drag on the company's recent second-quarter earnings report. The company reported earnings of $4.1 million on revenues of $393.8 million, versus identical $4.1 million in earnings on revenues of $86.9 million in the second quarter of last year.
But once the Levy operations become profitable and the acquisition costs are absorbed, analysts and company officials believe the company will report stronger profits.
Watch for more acquisitions, too. With the backing of Wells Fargo Foothill and the option to issue another 50 million shares of common stock, Source Interlink has access to capital. And the bigger Source Interlink becomes, the more it can wring savings from freight companies and the more profitable it will become.
Meantime, Flegel will be rewarded for his accomplishments. Starting this year, Flegel will earn a base salary of $915,000 and will be eligible for up to $1.8 million in incentives if the company reaches certain financial targets. Last year, Flegel earned a base salary of $535,683 and a bonus of $175,000. The company founder currently owns 1.6 million shares of Source worth about $18.7 million.
WHAT SOURCE INTERLINK DOES
Bonita Springs-based Source Interlink delivers magazines, CDs, DVDs, confections and general merchandise and manages the sales and marketing of these products in more than 110,000 stores across the United States.
Clients include Barnes & Noble, Borders Group, Kroger, Target, Walgreens and Kmart. Suppliers include Walt Disney, Time Warner and Vivendi Universal. The company also handles some distribution for online retailers such as Amazon.com.
Source Interlink is divided into two business units: the supply chain management unit and the in-store services unit.
The supply-chain management unit buys magazines, CDs and DVDs on a fully returnable basis from publishers, record labels and movie studios and receives them at five distribution centers located around the country totaling 2 million square feet. Source then ships orders to retailers using freight carriers such as UPS and FedEx. The company can ship its products to any retailer or consumer in every zip code in the country in one or two days. Retailers buy the magazines, CDs and DVDs from Source and sell them to individual customers. They return unsold inventory to Source for credit, and in turn, Source gathers the unsold inventory and returns it to the publisher.
Source's in-store services monitors, documents, claims and collects rebates and incentives from publishers for merchandise that was sold. Publishers frequently provide these incentives so that their products get the best shelf space in a store. This relieves the retailer's administrative burden of having to track a large variety of magazines, CDs and DVDs and collect incentive payments from numerous publishers. The in-store services division gathers extensive information on sales and pricing, which lets stores and publishers determine the effectiveness of specific products and act on that information. The division also designs and manufactures custom display racks for retailers.
INSIGHTS
MANAGING A
GROWING BUSINESS
Reflecting on the growth of Source Interlink, Chairman and Chief Executive Officer Leslie Flegel shares five insights about managing a growing business:
1. Every company that becomes as large as Source Interlink has made at least one bold move that transformed the company, he says. In Source Interlink's case, it was the near-fatal acquisition of a distribution company in 2001 that in the end made Flegel's company stronger.
2. Be ready to recognize an opportunity and capitalize on it. Always watch the trends in your industry and be prepared financially to move quickly and seize the opportunities.
3. The success of your business should be a self-fulfilling prophecy. Flegel likes to recount how his mother-in-law used to tell him she was always right. That's because even if she was wrong she had enough control over her circumstances to make it right. "That's the spirit you have to have," Flegel says. "Even if you make a wrong move, you can make it right."
4. Relationships with people form the basis of all business. When Flegel was negotiating the terms for a loan from Wells Fargo or a stock offering with Jefferies & Co., the deal always came down to great personal relationships, he says.
5. Realize that you're not great at doing everything. Understand your strengths and focus on those. For example, Flegel says, his company's strength is distributing magazines, DVDs and videos.
Source Interlink by the Numbers
Statement of Operations (Dollars in thousands)
REVENUES 2004 2005 % Chg.
Total revenues $315,791 $356,644 13%
EXPENSES
Selling, general & admin. expense 50,538 55,130 10%
Fulfillment freight 16,381 21,067 29%
Relocation expenses 1,730 2,450 42%
Loss on sale of land and building 0 (1,122)
OTHER INCOME (EXPENSES)
Interest expense (3,427) (1,575)
Interest income 358 175 -51%
Write-off of deferred financing
cost and original issue discount (865) (1,495)
Other 393 161 -59%
From continuing operations before
income taxes & discontinued operation 13,853 15,290 10%
Income tax expense 3,690 2,228 -40%
Income from continuing operations
before discontinued operation 10,163 13,062 29%
Loss from discontinued
operation, net of tax (115) (980)
Net income 10,048 12,082 20%
BALANCE SHEET
ASSETS
Cash $4,963 $1,387 -72%
Trade receivables, net 41,834 48,078 15%
Purchased claims receivable 5,958 2,006 -66%
Inventories 17,241 16,868 -2%
Income tax receivable 2,067 2,275 10%
Deferred tax asset 2,915 2,302 -21%
Advances under magazine export agreement 6,830 0
Other 2,536 3,349 32%
Total current assets 84,344 76,265 -10%
Property, plants and equipment 29,145 36,706 26%
Less accumulated depreciation and amortization (10,582) (14,375)
Net property, plants and equipment 18,563 22,331 20%
Goodwill, net 45,307 71,600 58%
Intangibles, net 7,931 16,126 103%
Deferred tax asset 908 2,903 220%
Other 7,048 8,528 20%
Total assets 164,101 197,793 21%
LIABILITIES
Checks issued against future advances
on revolving credit facility 14,129 1,951 -86%
Accounts payable and accrued expenses,
net of allowance for returns 44,741 25,274 -44%
Deferred revenue 1,680 2,205 31%
Other 317 19 -94%
Current maturities of debt 4,059 5,630 39%
Debt, less current maturities 31,541 34,139 8%
Other 560 852 52%
Total liabilities 97,027 70,070 -28%
Total stockholders' equity 67,074 127,683 90%
Total liabilities and stockholders' equity 164,101 197,753 21%
STOCK CHART
QUARTER HIGH LOW
Year to date
Second Quarter $13.20 $9.20
First Quarter 12.49 10.36
Year ended Jan. 31, 2005
Fourth Quarter $13.32 $10.20
Third Quarter 10.73 8.39
Second Quarter 11.39 8.89
First Quarter 13.58 10.31
Year ended Jan. 31, 2004
Fourth Quarter $14.30 $8.10
Third Quarter 9.82 7.70
Second Quarter 8.59 5.50
First Quarter 5.51 4.33
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