10-Q 1 e400482_10q-photoworks.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: March 27, 2004 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 Identification No.) incorporation or organization) 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 |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): Yes |_| No |X| As of May 1, 2004, there were issued and outstanding 16,839,041 shares of common stock, par value $.01 per share. Index to Exhibits at Page 18 Page 1 of 20 PHOTOWORKS, INC. INDEX Page No. -------- PART I -- FINANCIAL INFORMATION Item 1 - Financial Statements 3-10 Consolidated Balance Sheets as of March 27, 2004 and September 27, 2003 3 Consolidated Statements of Operations for the second quarter and six months ended March 27, 2004 and March 29, 2003 4 Consolidated Statements of Cash Flows for the six months ended March 27, 2004 and March 29, 2003 5 Notes to Consolidated Financial Statements 6-10 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 11-14 PART II -- OTHER INFORMATION Item 1 - Legal Proceedings 15 Item 4 - Submission of Matters to a Vote of Security Holders 15 Item 6 - Exhibits and Reports on Form 8-K 15 SIGNATURES 17 INDEX TO EXHIBITS 18 CERTIFICATIONS 19-21 Page 2 of 20 PART I -- FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS PHOTOWORKS, INC. CONSOLIDATED BALANCE SHEETS (in thousands)

(UNAUDITED) (NOTE) March 27, September 27, ASSETS 2004 2003 ========================== CURRENT ASSETS Cash and cash equivalents $ 2,339 $ 4,756 Accounts receivable, net of allowance for doubtful accounts 175 28 Income taxes receivable 100 -- Inventories 730 652 Prepaid expenses 343 354 -------- -------- TOTAL CURRENT ASSETS 3,687 5,790 Furniture, fixtures and equipment at cost, less accumulated depreciation 1,356 1,821 Long-term receivables 248 -- Lease deposits 33 51 -------- -------- TOTAL ASSETS $ 5,324 $ 7,662 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 912 $ 1,376 Accrued compensation 603 1,260 Other accrued expenses 284 588 ITC penalty, current portion 246 239 Current portion of capital lease obligations 2 2 Income taxes payable -- 14 Deferred revenues 406 477 -------- -------- TOTAL CURRENT LIABILITIES 2,453 3,956 Subordinated convertible debentures 2,500 2,500 ITC penalty, non-current portion 656 636 Capital lease obligations, net of current portion 5 6 -------- -------- TOTAL LIABILITIES 5,614 7,098 SHAREHOLDERS' EQUITY (DEFICIT) Preferred Stock, $.01 par value, authorized 2,000,000 shares, issued and outstanding 15,000 shares -- -- Common Stock, $.01 par value, authorized 101,250,000 shares, issued and outstanding 16,792,540 168 167 Additional paid-in capital 15,878 15,803 Accumulated deficit (16,336) (15,406) -------- -------- TOTAL SHAREHOLDERS' EQUITY (DEFICIT) (290) 564 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 5,324 $ 7,662 ======== ========

Note: The September 27, 2003 consolidated balance sheet has been derived from audited consolidated financial statements. See accompanying notes to consolidated financial statements. Page 3 of 20 PHOTOWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (in thousands, except per share and share data)

Second Quarter Ended Six Months Ended -------------------------- -------------------------- March 27, March 29, March 27, March 29, 2004 2003 2004 2003 ====================================================================================================== Net revenues $ 4,553 $ 6,500 $ 10,308 $ 14,853 Cost of goods and services 3,708 5,477 7,761 11,955 ------------ ------------ ------------ ------------ Gross profit 845 1,023 2,547 2,898 Operating expenses: Marketing 562 493 1,139 1,412 Research and development 435 715 900 1,251 General and administrative 377 1,339 1,470 2,774 ------------ ------------ ------------ ------------ Total operating expenses 1,374 2,547 3,509 5,437 ------------ ------------ ------------ ------------ Loss from operations (529) (1,524) (962) (2,539) Other income (expense): Interest expense (59) (44) (117) (86) Other income, net 25 13 49 20 ------------ ------------ ------------ ------------ Other expense, net (34) (31) (68) (66) ------------ ------------ ------------ ------------ Loss before income taxes (563) (1,555) (1,030) (2,605) Benefit from income taxes 100 107 100 107 ------------ ------------ ------------ ------------ Net loss $ (463) $ (1,448) $ (930) $ (2,498) ============ ============ ============ ============ Loss per share $ (.03) $ (.09) $ (.06) $ (.15) ============ ============ ============ ============ Weighted average shares outstanding 16,719,000 16,655,000 16,693,000 16,655,000 ============ ============ ============ ============

See accompanying notes to consolidated financial statements. Page 4 of 20 PHOTOWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (in thousands)

Six Months Ended --------------------- March 27, March 29, 2004 2003 ============================================================================================ OPERATING ACTIVITIES: Net loss $ (930) $(2,498) Charges to income not affecting cash: Depreciation 746 1,247 Vendor settlement (738) -- Stock-based compensation 72 -- Deferred revenues (71) 113 Imputed interest 25 -- (Gain) loss on disposal of furniture, fixtures and equipment (18) 7 Income tax receivable (100) 1,701 Net change in other receivables, inventories, payables and other (1,143) 2,411 ------- ------- NET CASH (USED IN) FROM OPERATING ACTIVITIES (2,157) 2,981 INVESTING ACTIVITIES: Purchase of furniture, fixtures, and equipment (281) (193) Proceeds from sales of furniture, fixtures and equipment 18 -- ------- ------- NET CASH USED IN INVESTING ACTIVITIES (263) (193) FINANCING ACTIVITIES: Proceeds from issuance of common stock 4 -- Payments on capital lease obligation (1) (94) ------- ------- NET CASH FROM (USED IN) FINANCING ACTIVITIES 3 (94) ------- ------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (2,417) 2,694 Cash and cash equivalents at beginning of period 4,756 1,175 ------- ------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,339$ 3,869 ======= ======= Supplemental cash flow information Cash paid for interest $ 88 $ 89 Cash received from income tax refund $ -- 1,808

See notes to consolidated financial statements. Page 5 of 20 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE A - BASIS OF PRESENTATION PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a full-service photography services company dedicated to providing its customers with innovative and inspiring ways to create, share and preserve their photographic memories, primarily through online and mail-order channels. The PhotoWorks(R) service provides image printing and online image storage and management services for both digital and film based camera users, primarily in the United States, which allows customers to store and organize photos online, share them with friends and family, and order prints, photo albums, and photo related products. 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 accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of interim results have been included. The Company follows a policy of recording its interim periods and year-end on a 13-week basis for comparability of results and to be consistent with its internal weekly reporting. Operating results for the six-months ended March 27, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending September 25, 2004. 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 27, 2003 and the Company's consolidated financial statements and footnotes thereto also included in the Company's Annual Report. NOTE B - LIQUIDITY The Company has experienced significant revenue declines and has incurred operating losses in recent years. Cash flow used in operations during the first six months of fiscal 2004 was $2,157,000, primarily due to lower revenues that were partially offset by lower operating costs. Cash flows from operations were positive in fiscal 2003 and 2002 primarily due to income tax refunds aggregating $5,780,000 related to net operating tax loss carrybacks. Management has taken various actions, including workforce reductions, store closures, and reduced operating expenditures to more closely align its cost structure with its reduced revenue levels and to improve its operating margins and cash flows. Management believes that under current operational plans, its current cash balances and projected future cash flows from operations will be sufficient to fund operations through at least the next twelve months. Further, management has both the ability and intent to undertake additional actions to reduce expenses to ensure cash balances are sufficient to meet its obligations as they become due. However, the Company's inability to successfully generate sufficient cash flow from operations would have a material adverse impact on the Company's financial position and liquidity and may require the Company to seek additional sources of funding to enable it to continue operations for at least the next twelve months. 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. An inventory reserve is established based on the valuation of the Company's inventory, and those inventories which are obsolete or in excess of forecasted usage or their estimated net realizable value. NOTE D - RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform to the current year's presentation. Page 6 of 20 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE E - VENDOR SETTLEMENT During the second quarter of fiscal 2004, the Company reached a settlement agreement regarding disputed fees for services provided to the Company, resulting in a $738,000 reduction to administrative expenses. The settlement was recorded as a $398,000 reduction to accounts payable for previously invoiced amounts and $340,000 as receivables, which represents the proceeds to be received under the settlement agreement, net of a discount for interest using a 6% discount rate. The receivable is due in annual installments of $95,000 over the next four years. NOTE F - PROPERTY AND LEASES In April 2004, the Company negotiated a termination agreement for one of its two leases for operating facilities, effective April 30, 2004. The lease formerly expired in September 2005 and cost approximately $473,000 per year. As a result, management revised the estimated life of the related leasehold improvements, resulting in additional depreciation charges to cost of goods sold of approximately $240,000 for the quarter ended March 27, 2004. The Company anticipates expenses of approximately $150,000 in the quarter ending June 26, 2004 for additional depreciation and costs related to the lease termination. NOTE G - DEFERRED REVENUES At the end of fiscal 2003, the Company's deferred revenue was primarily attributable to its Frequent Customer Program. Under this program, after processing a certain number of rolls of film within a stated period of time, a customer received free processing on their next roll of film. For each roll of film for which the processing is paid under this program, the Company deferred a portion of the revenue received and recognized the revenue upon processing of the free roll, so that revenue from customers in this program was recognized ratably over all rolls of film processed. The Frequent Customer Program expired in January 2004. During the fourth quarter of fiscal 2003, the Company launched its Pick Your Prints service for film processing orders. Under this service, a customer's images are digitized and only the negatives are initially mailed back. As part of the initial transaction, a customer is issued one print credit per image developed, which they can then use to purchase only the photos they want to have printed. Prints are then produced utilizing the digital images. A portion of the initial purchase is deferred equal to the relative fair value of the digital prints. Revenue is recognized upon utilization of the print credits to order digital prints. As of March 27, 2004, approximately $200,000 was deferred under this program. In November 2004, the Company began offering a prepaid print credit product, whereby customers can buy online print credits to use on future digital print orders. Amounts received for the purchase of these credits are deferred and revenue is recognized upon fulfillment of digital print orders. As of March 27, 2004, approximately $120,000 was deferred under this program. NOTE H - INCOME TAXES During the second quarter of fiscal 2004, a tax benefit of $100,000 was recorded for refundable tax credit carrybacks for fiscal 2001 and 2002. The Company has net deferred tax assets totaling $12,112,000, comprised primarily of net operating loss carryforwards. Due to the recent history of operating losses, the uncertainty of future taxable income, and limitations on the utilization of net operating loss carryforwards under IRC Section 382, a valuation allowance of $12,112,000 has been recorded against net deferred tax assets. Page 7 of 20 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE I - STOCK-BASED COMPENSATION The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition Disclosures," and applies Accounting Principles Board Opinion No. 25 (APB 25) and related Interpretations in accounting for its stock option plans. Accordingly, the Company's stock-based compensation expense is recognized based on the intrinsic value of the option on the date of grant. Pursuant to Stock Option Plans adopted in 1982 and 1987, options may be granted to purchase up to 6,904,688 shares of Common Stock at prices equal to the fair market value of the shares at the time the options are granted. In October 1999, the Board of Directors adopted the PhotoWorks, Inc. 1999 Employee Stock Option Plan. Employees, consultants, independent contractors, advisors and agents are eligible to participate in this plan. Officers and directors are not eligible to participate. Pursuant to this plan, options may be granted to purchase up to 800,000 shares of Common Stock at prices equal to the fair market value of the shares at the time the options are granted. In February 2000, shareholders approved the 1999 Stock Incentive Compensation Plan. Officers, directors, employees, consultants, independent contractors, advisors and agents are eligible to participate in this plan. Pursuant to this plan, options may be granted to purchase up to 2,300,000 shares of Common Stock. Under this plan, pursuant to an employment agreement with Mr. Philippe Sanchez, the Company's President and CEO, the Company granted a stock option on October 28, 2003, for 250,000 shares with an exercise price of $.01. Based on the fair market value of $.70 on the date of grant, the Company will recognize stock compensation expense of $172,500 ratably over the twelve-month vesting period of the option grant. Shares of Common Stock reserved for issuance under these stock option plans totaled 4,139,585 at March 27, 2004, of which 1,248,573 shares were available for options to be granted in the future. Options generally vest over three to four years and become exercisable commencing one year after the date of grant and expiring five to seven years after the date of grant. In addition, as an incentive to employment, Mr. Sanchez was granted a stock option for 750,000 shares at a price equal to fair market value on the date of grant. These shares were granted outside of the above plans. Pro forma information regarding net loss and loss per share has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The fair value of the options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions on the option grant date: March 27, 2004 March 29,2003 ================================================================================ Risk free interest rate 1.93% 2.78% Expected volatility 183.09% 146.43% Expected option life 3.08 years 3.15 years Dividend yield 0.00% 0.00% Page 8 of 20 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE I - STOCK-BASED COMPENSATION (Continued) Under Statement No. 123, if the Company had elected to recognize the compensation cost based upon the fair value of the options at grant date, net loss would have been increased as follows:

Second Quarter Ended Six Months Ended -------------------------------- -------------------------------- March 27, 2004 March 29, 2003 March 27, 2004 March 29, 2003 ==================================================================== Net loss as reported $ (463,000) $(1,448,000) $ (930,000) $(2,498,000) Add: Stock-based compensation expense included in net loss, net of related tax effects 43,000 -- 72,000 -- Deduct: Stock-based compensation as determined under FAS 123, net of related tax effects (74,000) (115,000) (405,000) (270,000) ----------- ----------- ----------- ----------- Pro forma net loss $ (494,000) $(1,563,000) $(1,263,000) $(2,768,000) =========== =========== =========== =========== Loss per share as reported $ (.03) $ (.09) $ (.06) $ (.15) =========== =========== =========== =========== Pro-forma loss per share $ (.03) $ (.09) $ (.08) $ (.17) =========== =========== =========== ===========

NOTE J - EARNINGS (LOSS) PER SHARE Earnings per share is computed based on the weighted average number of common shares and dilutive common stock equivalents outstanding during the period. Convertible preferred shares, outstanding warrants and stock options to purchase shares of common stock were excluded from the computations of loss per share because their effect was antidilutive. The following table sets forth the computation of basic and diluted loss per share:

Second Quarter Ended Six Months Ended ------------------------------- ------------------------------- March 27, 2004 March 29, 2003 March 27, 2004 March 29, 2003 ============================================================================================================================ Numerator for basic and diluted earnings per share: Net loss $ (463,000) $ (1,448,000) $ (930,000) $ (2,498,000) ============ ============ ============ ============ Denominator: Denominator for basic earnings per share - weighted-average shares 16,719,000 16,655,000 16,693,000 16,655,000 Effect of dilutive securities: Options, warrants, convertible preferred shares -- -- -- -- ------------ ------------ ------------ ------------ Denominator for diluted earnings per share 16,719,000 16,655,000 16,693,000 16,655,000 ============ ============ ============ ============ Net loss per share $ (.03) $ (.09) $ (.06) $ (.15) ============ ============ ============ ============

At March 27, 2004, and March 29, 2003, there were 7,711,108 and 7,331,497 stock options, warrants and common stock upon conversion of Series A preferred shares, respectively, that were excluded from the computation of loss per share as their effect was antidilutive. If the Company had reported net income, the calculation of these per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method. Page 9 of 20 PHOTOWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE K - ITC PENALTY In September 2003, the Company negotiated a settlement agreement with the International Trade Commission, whereby the Company pays $250,000 in July for each of the next four years beginning in 2004. The Company accrued a penalty amount of $875,000 ($1,000,000 million penalty net of imputed interest of $125,000 at an estimated borrowing rate of 6%) in the fiscal 2003 financial statements for this matter. NOTE L - CONTINGENCIES The Company was a defendant in a claim filed by Fuji Photo Film Co., Ltd. with the International Trade Commission. There is a risk that Fuji could bring a civil action against the Company for damages for patent infringement by reason of sales of cameras that have been found in the International Trade Commission proceedings to infringe Fuji patents. If such a suit was filed against the Company, it could have a significantly harmful impact on its financial condition, results of operations and liquidity. The Company is unable to determine the probability or likelihood of such an action. The Company is also involved in various routine legal proceedings in the ordinary course of its business. NOTE M - SUBSEQUENT EVENTS The Company has agreed in principle, to acquire substantially all of the assets of PhotoAccess Technologies Corporation in exchange for 1.2 million shares of PhotoWorks Common Stock and the assumption of approximately $150,000 in liabilities. It is anticipated that a definitive agreement will be executed in the near term. The transaction will broaden PhotoWorks' revenue and customer base, while providing advanced digital technology and an experienced team of engineers to continue to support the Company's digital and online initiatives. Page 10 of 20 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 that relate to future events, product or service offerings, or the future financial performance of the Company. 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 Company 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 ability to generate cash to fund operating activities or obtain additional funding, effective execution of product launches or marketing programs, pricing and other activities by competitors, economic and industry factors, system performance problems due to technical difficulties, and other risks, including those described in the Company's Annual Report on Form 10-K and those described 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 a full-service photography services company dedicated to providing its customers with innovative and inspiring ways to create, share and preserve their photographic memories, primarily through online and mail-order channels. The PhotoWorks(R) service provides image printing and online image storage and management services for both digital and film based camera users, primarily in the United States, which allows customers to store and organize photos online, share them with friends and family, and order prints, photo albums, and photo related products. The Company incurred a net loss of $930,000 ($.06 per share) during the first six months of fiscal 2004, compared to a net loss of $2,498,000 ($.15 per share) for the first six months of 2003. Although revenues for the first six months of fiscal 2004 declined by approximately 31% compared to the same period for fiscal 2003, the Company reduced its net loss through improved operating efficiencies and lower operating costs. Operating results may fluctuate in the future due to changes in the mix of sales, marketing and promotional activities, introductions of new products, research and development requirements, actions by competitors, price increases or decreases by suppliers, conditions in the direct-to-consumer market and the photofinishing industry in general, national and global economic and political conditions, and other factors. Demand for the Company's services is generally seasonal, producing the highest volumes in the first and fourth quarters of the fiscal year. However, seasonality of demand may be offset by changes in the effectiveness of marketing programs, the introduction of new services and products, actions by competitors and other factors. Operating results are 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 product development and marketing expenditures. Critical Accounting Policies Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenue, and expenses. Management's estimates and judgments are based upon the Company's historical experience, knowledge of economic and market factors, and various other factors that are believed to be relevant given the circumstances. Significant policies, methodologies, estimates, and the factors used therein, are reviewed on at least a quarterly basis with the Company's Audit Committee. Actual results may differ from these estimates. Page 11 of 20 The following is a discussion of the estimates included in the Company's financial statements that encompass matters of uncertainty, whereby different estimates could have reasonably been made or changes in such estimates could have a material impact on the financial statements of the Company. Reserve for Obsolete Inventory We regularly assess the valuation of our inventory and write down those inventories that are obsolete, or in excess of forecasted usage, to their estimated realizable value. A reserve for obsolescence is recorded against inventory for any film or paper inventories that are nearing their expiration dates. Additional reserves are recorded for slow-moving or discontinued stock to the extent it is estimated the materials may go unused based on historical inventory turnover, planned changes in marketing promotions or other anticipated changes in product mix over the next year, seasonality, or other factors. Estimates of future usage are based on estimates of future sales and product mix. If actual sales or product mix differs from our estimates, we may need to record additional reserves for obsolete inventory. Revenue Recognition We recognize revenue when products are shipped or services are delivered. PhotoWorks provides its customers with a 100% satisfaction guarantee. The majority of the Company's products and services will not be returned but customers can request a refund if not satisfied. During fiscal year 2003, refunds were less than 1% of net revenues. An allowance is recorded for expected future returns. During the fourth quarter of fiscal 2003, we launched our Pick Your Prints service for film processing orders. Under this service, a customer's images are digitized and only the negatives are initially mailed back. As part of the initial transaction, a customer is issued one print credit per image developed, which they can then use to purchase only the photos they want to have printed. Prints are then produced utilizing the digital images. A portion of the initial purchase is deferred equal to the relative fair value of the digital prints. Revenue is recognized upon utilization of the print credits to order the digital prints. As of March 27, 2004, approximately $200,000 was deferred under this program. In November 2004, we began offering a prepaid print credit product, whereby customers can buy online digital print credits to use on future print orders. Amounts received for the purchase of these credits are deferred and revenue is recognized upon fulfillment of digital print orders. As of March 27, 2004, approximately $120,000 was deferred under this program. Deferred Tax Assets We have net deferred tax assets totaling $12,112,000, comprised primarily of net operating loss carryforwards. Due to our recent history of operating losses, the uncertainty of future taxable income, and limitations on the utilization of net operating loss carryforwards under IRC Section 382, we have recorded a valuation allowance of $12,112,000 against our net deferred tax assets. Contingencies We are subject to various legal proceedings and claims (see Part II, Item 1 - Legal Proceedings and Note L of Notes to Consolidated Financial Statements), the outcomes of which are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies, requires that estimated amounts relating to a contingency should be recorded if it is probable that a liability or gain has been incurred and the amount can be reasonably estimated. Disclosure of a loss contingency is required if there is at least a reasonable possibility that a loss may have been incurred. We evaluate, among other factors, the degree of probability of the outcome and the ability to make a reasonable estimate of the amounts. Page 12 of 20 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.

Second Quarter Ended Six Months Ended --------------------- --------------------- March 27, March 29, March 27, March 29, 2004 2003 2004 2003 ================================================================================ Net revenues 100.0% 100.0% 100.0% 100.0% Cost of goods and services 81.4 84.3 75.3 80.5 ----- ----- ----- ----- Gross profit 18.6 15.7 24.7 19.5 Operating expenses: Marketing 12.3 7.5 11.0 9.5 Research and development 9.6 11.0 8.7 8.4 General and administrative 8.3 20.6 14.3 18.7 ----- ----- ----- ----- Total operating expenses 30.2 39.1 34.0 36.6 ----- ----- ----- ----- Loss from operations (11.6) (23.4) (9.3) (17.1) Total other expense (.8) (.5) (.7) (.4) Loss before income taxes (12.4) (23.9) (10.0) (17.5) Benefit from income taxes 2.2 1.6 1.0 .7 ----- ----- ----- ----- Net loss (10.2)% (22.3)% (9.0)% (16.8)% ===== ===== ===== =====

Net revenues for the second quarter of fiscal 2004 were $4,553,000, compared to net revenues of $6,500,000 in the second quarter of fiscal 2003. For the six months ended March 27, 2004, net revenues were $10,308,000 compared to $14,853,000 for the same period of fiscal 2003. The decline in net revenues was primarily due to continued lower film processing volumes, partially offset by growth in digital printing services. Digital revenues in the second quarter of fiscal 2004 increased 5.0% to $606,000 compared to $578,000 in the second quarter of fiscal 2003. Year to date revenues from digital products and services increased 16.7% to $1,551,000 compared to $1,329,000 for the same period of fiscal 2003. In addition, net revenues in fiscal 2003 included approximately $609,000 from sales generated at retail stores, which were closed by the end of fiscal 2003 in order to focus resources on digital and online initiatives. Net revenues in fiscal 2004 are expected to continue to be lower than fiscal 2003 due to lower film processing volumes. Cost of goods and services consists of labor, processing materials and supplies, shipping and handling costs and fixed operating costs related to the Company's services and products. Gross profit in the second quarter of fiscal 2004 increased to 18.6% of net revenues compared to 15.7% of net revenues in the second quarter of fiscal 2003. For the first six months of fiscal 2004, gross profit increased to 24.7% compared to 19.5% for the same period of fiscal 2003. The increases were primarily due to lower labor and materials costs and closing lower margin retail stores, as well as a shift in the product mix towards digital products and services. Net revenues from digital products increased to 15.0% of total net revenues year to date, compared to 8.9% in the prior year. Margins on certain digital print services also increased due to higher selling prices in the first and second quarters of fiscal 2004 as compared to the first two quarters of fiscal 2003. Gross profit fluctuates due to the seasonal nature of revenues when measured against relatively fixed overhead costs associated with equipment and facilities. Page 13 of 20 Marketing expenses in the second quarter of fiscal 2004 were $562,000 compared to $493,000 in the second quarter of fiscal 2003. For the first six months of fiscal 2004, marketing expenses decreased to $1,139,000 compared to $1,412,000 for the same period in fiscal 2003. Marketing expenditures in fiscal 2004 have been focused on new marketing programs designed to test acquisition and customer reactivation strategies through targeted mail and email campaigns. Marketing expenses will fluctuate due to the timing and magnitude of promotional activities and product and service introductions. Research and development expenses decreased to $435,000 for the second quarter of fiscal 2004 compared to $715,000 in the second quarter of fiscal 2003. For the first six months of fiscal 2004, research and development expenses decreased to $900,000 as compared to $1,251,000 for the same period of fiscal 2003. Research and development expenses consist primarily of costs incurred in developing online products and services for digital image management and print services, and creating equipment necessary to provide customers with new digital photographic services and products. General and administrative expenses decreased to $377,000 for the second quarter of fiscal 2004 compared to $1,339,000 for the second quarter of fiscal 2003. For the six months ended March 27, 2004, general and administrative expenses decreased to $1,470,000 compared to $2,774,000 for the same period of fiscal 2003. During the second quarter of fiscal 2004, PhotoWorks, Inc. and one of its service providers reached a settlement agreement regarding disputed fees for services provided to PhotoWorks resulting in a reduction of administrative expenses of $738,000. In addition, the quarter and year to date expenses were lower due to reduced staffing and professional service costs. General and administrative expenses consist of costs related to management information systems, computer operations, human resource functions, finance, legal, accounting, investor relations and general corporate activities. In January 2004, the Company initiated a reduction in force, representing approximately 18% of its workforce and affecting all areas of the Company. The Company recorded a charge of approximately $182,000 related to the workforce reduction in the quarter ended March 27, 2004. During the second quarter of fiscal 2004, an adjustment was made to reflect refundable tax credits available from fiscal 2001 and 2002. The adjustment resulted in an additional tax benefit of $100,000, which is recorded as income tax receivable. Liquidity and Capital Resources As of May 1, 2004, the Company's principal source of liquidity included approximately $2,416,000 in cash and cash equivalents. The Company's current ratio as of March 27, 2004 was 1.50 compared to 1.46 at the end of fiscal 2003. During the first six months of fiscal 2004, the Company used cash from operating activities of $2,157,000, due primarily to the net operating loss and payments on accounts payable and accrued compensation. Based on current operating projections, the Company anticipates that existing cash and cash equivalents and projected future cash flows from operations will be sufficient to fund its operations, including the purchase of assets of PhotoAccess Technologies and any capital expenditures (See Note M - Subsequent Events of Notes to Consolidated Financial Statements in Part I above), through at least the next twelve months. However, if the Company does not meet its projections or generate sufficient cash from operations to satisfy its ongoing expenses, the Company will be required to seek external sources of financing or refinance its obligations. There can be no assurance that the Company will be able to obtain adequate financing in the future. Controls and Procedures At the end of the period covered by this report, as part of our quarterly review, we evaluated, under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Accounting Officer, the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based upon that evaluation, the Chief Executive Officer and the Chief Accounting Officer concluded that our disclosure controls and procedures are effective to timely alert them to any material information relating to the Company (including its consolidated subsidiaries) that must be included in our periodic SEC filings. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation. Page 14 of 20 PART II -- OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS For an update concerning the legal proceedings, see Note L of Notes to Consolidated Financial Statements in Part I above. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS On February 3, 2004, the Company held its annual meeting of shareholders. The shareholders acted on the following matters at the annual meeting. The following individual was elected to the Company's Board of Directors, to hold office for a three-year term and until his respective successor is duly elected and qualified. The number of votes for and withheld are listed below: For Withheld --- -------- Philippe Sanchez 18,211,621 86,823 The following individuals were elected by the Preferred shareholders to the Company's Board of Directors, to hold office for a three-year term and until their respective successors are duly elected and qualified. The number of votes for and withheld are listed below: For Withheld --- -------- Ross Chapin 3,136,842 0 Paul Goodrich 3,136,842 0 The proposal for an amendment to the Company's 1999 Stock Incentive Compensation Plan to increase by 500,000 the aggregate number of shares of Common Stock available for issuance under the plan was approved. The proposal received the following votes: For 7,471,994 Against 463,233 Abstain 30,577 Broker non votes 10,332,640 ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. 10.1 Lease Termination Agreement dated April 19, 2004 with Immunex Corporation. 31.1 Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley Act of 2002 31.2 Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley Act of 2002 32 Certification of Principal Executive Officers pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906 of the Sarbannes-Oxley Act of 2002 Page 15 of 20 (b) Reports on Form 8-K. Form 8-K dated January 21, 2004 - Item 12 - Results of Operations and Financial Condition for first quarter ended December 27, 2003. Form 8-K dated February 18, 2004 - Item 5 - Other events related to settlement agreement with vendor providing services to PhotoWorks, Inc. Page 16 of 20 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: May 11, 2004 /s/ Philippe Sanchez ---------------------------------------- Philippe Sanchez President and Chief Executive Officer (Principal Executive Officer) /s/ Loran Cashmore Bond ---------------------------------------- Loran Cashmore Bond Vice President Administration Treasurer/Chief Accounting Officer Page 17 of 20 INDEX TO EXHIBITS PHOTOWORKS, INC. Quarterly Report on Form 10-Q For The Quarter Ended March 27, 2004 Exhibit Description 3.1 Third Amended and Restated Articles of Incorporation dated January 27, 1998. (Incorporated by reference to Form 10-K/A for the year ended September 25, 1999, filed January 14, 2000.) 3.2 Articles of Amendment to Articles of Incorporation dated January 25, 2000. (Incorporated by reference from Form 10-Q for the quarter ended December 25, 1999.) 3.3 Articles of Amendment to Articles of Incorporation of PhotoWorks, Inc. dated February 9, 2000 (Incorporated by reference to Exhibit 3.1 filed with the Company's 8-K filed February 16, 2000) 3.4 Articles of Amendment to Articles of Incorporation of PhotoWorks, Inc. dated April 24, 2001 (Incorporated by reference to Exhibit 3.1 filed with the Company's 8-K filed April 27, 2001) 3.5 Articles of Correction to Articles of Incorporation of PhotoWorks, Inc. dated April 25, 2001 (Incorporated by reference to Exhibit 3.2 filed with the Company's 8-K filed April 27, 2001) 3.6 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) 3.7 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) 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* Lease Termination Agreement dated April 19, 2004 with Immunex Corporation. 31.1* Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley Act of 2002 31.2* Certification Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbannes-Oxley Act of 2002 32* Certification of Principal Executive Officers pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906 of the Sarbannes-Oxley Act of 2002 * Filed herewith Page 18 of 20