UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ . Commission File Number 1-13796 Gray Communications Systems, Inc. (Exact name of registrant as specified in its charter) Georgia 58-0285030 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 126 N. Washington St., Albany, Georgia 31701 (Address of principal executive offices) (Zip code) (912) 888-9390 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report.) 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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. Class A Common Stock, (No Par Value) Class B Common Stock, (No Par Value) - ------------------------------------- ----------------------------------- 4,538,145 shares as of August 13, 1998 3,411,277 shares as of August 13, 1998
INDEX GRAY COMMUNICATIONS SYSTEMS, INC. PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed consolidated balance sheets (unaudited) - June 30, 1998 and December 31, 1997 Condensed consolidated statements of operations (unaudited) Three months ended June 30, 1998 and 1997; Six months ended June 30, 1998 and 1997 Condensed consolidated statement of stockholders' equity (unaudited) - Six months ended June 30, 1998 Condensed consolidated statements of cash flows (unaudited) Six months ended June 30, 1998 and 1997 Notes to condensed consolidated financial statements (unaudited) - June 30, 1998 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K SIGNATURES 2
PART I. FINANCIAL INFORMATION Item 1. Financial Statements GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) <TABLE> <CAPTION> June 30, December 31, 1998 1997 ------------- ------------- <S> <C> <C> CURRENT ASSETS: Cash and cash equivalents $ 2,739,188 $ 2,367,300 Trade accounts receivable, less allowance for doubtful accounts of $1,293,000 and $1,253,000, respectively 20,025,376 19,527,316 Recoverable income taxes 1,897,469 2,132,284 Inventories 1,320,444 846,891 Current portion of program broadcast rights 1,324,251 2,850,023 Other current assets 1,185,291 968,180 ------------- ------------- Total current assets 28,492,019 28,691,994 PROPERTY AND EQUIPMENT: Land 864,695 889,696 Buildings and improvements 12,025,272 11,951,700 Equipment 56,624,691 52,899,547 ------------- ------------- 69,514,658 65,740,943 Allowance for depreciation (26,340,052) (23,635,256) ------------- ------------- 43,174,606 42,105,687 OTHER ASSETS: Deferred loan costs 7,987,427 8,521,356 Goodwill and other intangibles 261,159,342 263,425,447 Other 2,869,399 2,306,143 ------------- ------------- 272,016,168 274,252,946 ------------- ------------- $ 343,682,793 $ 345,050,627 ============= ============= </TABLE> See notes to condensed consolidated financial statements. 3
GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) (continued) <TABLE> <CAPTION> JUNE 30, DECEMBER 31, 1998 1997 ------------- ------------- <S> <C> <C> CURRENT LIABILITIES: Trade accounts payable (includes $1,130,000 and $850,000 payable to Bull Run Corporation, respectively) $ 3,391,969 $ 3,321,903 Employee compensation and benefits 3,839,784 3,239,694 Accrued expenses 2,646,703 2,265,725 Accrued interest 4,713,304 4,533,366 Current portion of program broadcast obligations 1,189,093 2,876,060 Deferred revenue 2,183,695 1,966,166 Current portion of long-term debt 578,881 400,000 ------------- ------------- Total current liabilities 18,543,429 18,602,914 LONG-TERM DEBT 226,322,573 226,676,377 OTHER LONG-TERM LIABILITIES: Program broadcast obligations, less current portion 424,190 617,107 Supplemental employee benefits 1,226,158 1,161,218 Deferred income taxes 1,272,533 1,203,847 Other acquisition related liabilities 4,224,998 4,494,016 ------------- ------------- 7,147,879 7,476,188 Commitments and contingencies STOCKHOLDERS' EQUITY: Serial Preferred Stock, no par value; authorized 20,000,000 shares; issued 2,060 shares ($20,600,000 aggregate liquidation value) 20,600,000 20,600,000 Class A Common Stock, no par value; authorized 15,000,000 shares; issued 5,307,716 shares 10,385,595 10,358,031 Class B Common Stock, no par value; authorized 15,000,000 shares; issued 3,515,364 shares 66,527,502 66,397,804 Retained earnings 4,697,154 6,603,191 ------------- ------------- 102,210,251 103,959,026 Treasury Stock at cost, Class A Common, 769,571 and 781,921 shares, respectively (8,862,142) (9,011,369) Treasury Stock at cost, Class B Common, 105,588 and 166,790 shares, respectively (1,679,197) (2,652,509) ------------- ------------- 91,668,912 92,295,148 ------------- ------------- $ 343,682,793 $ 345,050,627 ============= ============= </TABLE> See notes to condensed consolidated financial statements. 4
GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, -------------------------------- -------------------------------- 1998 1997 1998 1997 ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> OPERATING REVENUES Broadcasting (net of agency commissions) $ 22,689,990 $ 17,782,557 $ 42,201,054 $ 33,767,854 Publishing 7,379,114 6,081,748 13,916,449 11,306,602 Paging 1,991,407 1,634,609 3,924,873 3,184,985 ------------ ------------ ------------ ------------ 32,060,511 25,498,914 60,042,376 48,259,441 EXPENSES Broadcasting 12,661,021 9,604,608 24,779,408 19,299,392 Publishing 5,983,435 4,594,834 11,440,940 8,528,255 Paging 1,327,495 946,629 2,583,100 1,836,923 Corporate and administrative 656,449 740,991 1,316,929 1,374,319 Depreciation and amortization 4,221,723 3,488,301 7,843,307 6,760,244 ------------ ------------ ------------ ------------ 24,850,123 19,375,363 47,963,684 37,799,133 ------------ ------------ ------------ ------------ 7,210,388 6,123,551 12,078,692 10,460,308 Miscellaneous income (expense), net (73,209) 5,930 (314,276) (39,833) ------------ ------------ ------------ ------------ 7,137,179 6,129,481 11,764,416 10,420,475 Interest expense 6,039,258 5,081,505 11,966,739 10,057,198 ------------ ------------ ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES 1,097,921 1,047,976 (202,323) 363,277 Income tax expense 260,814 426,100 443,377 202,500 ------------ ------------ ------------ ------------ NET INCOME (LOSS) 837,107 621,876 (645,700) 160,777 Preferred Dividends 358,998 350,000 717,996 700,000 ------------ ------------ ------------ ------------ NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS $ 478,109 $ 271,876 $ (1,363,696) $ (539,223) ============ ============ ============ ============ AVERAGE OUTSTANDING COMMON SHARES: Basic 7,944,503 7,943,309 7,932,532 7,953,460 Stock compensation awards 399,608 117,932 -0- -0- ------------ ------------ ------------ ------------ Diluted 8,344,111 8,061,241 7,932,532 7,953,460 ============ ============ ============ ============ BASIC EARNINGS (LOSS) PER COMMON SHARE: Net income (loss) available to common stockholders $ 0.06 $ 0.03 $ (0.17) $ (0.07) ============ ============ ============ ============ DILUTED EARNINGS (LOSS) PER COMMON SHARE: Net income (loss) available to common stockholders $ 0.06 $ 0.03 $ (0.17) $ (0.07) ============ ============ ============ ============ </TABLE> See notes to condensed consolidated financial statements. 5
GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (unaudited) <TABLE> <CAPTION> CLASS A CLASS B PREFERRED STOCK COMMON STOCK COMMON STOCK ----------------------- -------------------------- -------------------------- SHARES AMOUNTS SHARES AMOUNTS SHARES AMOUNTS -------- -------------- ----------- -------------- ----------- -------------- <S> <C> <C> <C> <C> <C> <C> Balance at December 31, 1997 2,060 $20,600,000 5,307,716 $10,358,031 3,515,364 $66,397,804 Net loss for the six months ended June 30, 1998 Common Stock dividends ($.04 per share) Preferred stock dividends Income tax expense relating to stock plans 27,564 26,326 Issuance of treasury stock: 401(k) plan 103,372 Non-qualified stock plan Purchase of Class A Common Stock ----- ----------- --------- ----------- --------- ----------- Balance at June 30, 1998 2,600 $20,600,000 5,307,716 $10,385,595 3,515,364 $66,527,502 ===== =========== ========= =========== ========= =========== CLASS A CLASS B TREASURY STOCK TREASURY STOCK ----------------------------- ------------------------------ RETAINED EARNINGS SHARES AMOUNTS SHARES AMOUNTS ------------- ------------ ---------------- ------------- ---------------- Balance at December 31, 1997 $6,603,191 (781,921) $(9,011,369) (166,790) $(2,652,509) Net loss for the six months ended June 30, 1998 (645,700) Common Stock dividends ($.04 per share) (317,400) Preferred stock dividends (717,996) Income tax expense relating to stock plans Issuance of treasury stock: 401(k) plan 8,702 138,389 Non-qualified stock plan (224,941) 22,850 460,290 52,500 834,923 Purchase of Class A Common Stock (10,500) (311,063) ---------- -------- ----------- -------- ----------- Balance at June 30, 1998 $4,697,154 (769,571) $(8,862,142) (105,588) $(1,679,197) ========== ======== =========== ======= =========== TOTAL -------------- Balance at December 31, 1997 $92,295,148 Net loss for the six months ended June 30, 1998 (645,700) Common Stock dividends ($.04 per share) (317,400) Preferred stock dividends (717,996) Income tax expense relating to stock plans 53,890 Issuance of treasury stock: 401(k) plan 241,761 Non-qualified stock plan 1,070,272 Purchase of Class A Common Stock (311,063) ------------ Balance at June 30, 1998 $91,668,912 ============ </TABLE> See notes to condensed consolidated financial statements. 6
GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Six Months Ended June 30, ---------------------------- 1998 1997 ------------ ------------ OPERATING ACTIVITIES Net income (loss) $ (645,700) $ 160,777 Items which did not use (provide) cash: Depreciation 4,175,981 3,646,840 Amortization of intangible assets 3,667,326 3,113,404 Amortization of deferred loan costs 541,723 542,139 Amortization of program broadcast rights 1,899,189 1,619,198 Payments for program broadcast rights (1,954,588) (1,830,304) Supplemental employee benefits (154,657) (117,749) Common stock contributed to 401(k) Plan 241,761 216,819 Deferred income taxes 68,686 2,200,000 (Gain) loss on disposal of assets 348,310 (5,314) Changes in operating assets and liabilities: Receivables, inventories and other current assets (1,012,774) (1,203,550) Accounts payable and other current liabilities 1,260,198 (2,691,321) ------------ ------------ NET CASH PROVIDED BY OPERATING ACTIVITIES 8,435,455 5,650,939 INVESTING ACTIVITIES Purchase of FCC License (829,600) -0- Acquisition of satellite uplink business -0- (4,074,031) Purchases of property and equipment (5,766,160) (6,757,526) Deferred acquisition costs (200,745) (485,303) Payments on purchase liabilities (269,018) (138,599) Deferred costs associated with exchange of television station (859,534) -0- Proceeds from asset sales 182,421 5,314 Other (241,707) (524,815) ------------ ------------ NET CASH USED IN INVESTING ACTIVITIES (7,984,343) (11,974,960) 7
GRAY COMMUNICATIONS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)(continued) <TABLE> <CAPTION> Six Months Ended June 30, -------------------------------------- 1998 1997 ------------ ------------ <S> <C> <C> FINANCING ACTIVITIES Dividends paid (717,400) (712,807) Common Stock transactions 53,890 241,545 Purchase of treasury stock (311,063) (1,119,775) Sale of treasury stock 1,070,272 -0- Proceeds from borrowings of long-term debt 10,200,000 13,500,000 Payments on long-term debt (10,374,923) (6,113,020) ------------ ------------ NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES (79,224) 5,795,943 ------------ ------------ INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 371,888 (528,078) Cash and cash equivalents at beginning of period 2,367,300 1,051,044 ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,739,188 $ 522,966 ============ ============ </TABLE> See notes to condensed consolidated financial statements. 8
GRAY COMMUNICATIONS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE A--BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Gray Communications Systems, Inc. (the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six month period ended June 30, 1998 are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 1997. Certain amounts in the accompanying unaudited condensed consolidated financial statements have been reclassified to conform to the 1998 format. NOTE B--BUSINESS ACQUISITIONS AND DISPOSITION SUBSEQUENT TRANSACTIONS On July 31, 1998, the Company completed the purchase of all of the outstanding capital stock of Busse Broadcasting Corporation ("Busse"). The net purchase price was $112 million plus associated transaction costs. The purchase price includes the assumption of Busse's indebtedness, including its 11 5/8% Senior Secured Notes due 2000. Immediately prior to the Company's acquisition of Busse, Cosmos Broadcasting Corporation acquired WEAU-TV from Busse and exchanged it for WALB-TV, the Company's NBC affiliate in Albany, Georgia. In exchange for WALB-TV, the Company received WEAU-TV, which was valued at $66 million, and approximately $12 million in cash for a total value of $78 million. As a result of these transactions, the Company adds the following television stations to its existing broadcast group: KOLN-TV, the CBS affiliate serving the Lincoln-Hastings-Kearney, Nebraska market; its satellite station KGIN-TV, the CBS affiliate serving Grand Island, Nebraska; and WEAU-TV, an NBC affiliate serving the Eau Claire-La Crosse, Wisconsin market. These transactions also satisfy the Federal Communication Commission's requirement for the Company to divest itself of WALB-TV. The Company will pay Bull Run Corporation, a principal stockholder of the Company, a fee equal to 1% of the transaction values for services performed, of which $780,000 was included in accounts payable at June 30, 1998. Condensed unaudited balance sheets of WALB-TV as of June 30, 1998 and December 31, 1997 are as follows: JUNE 30, DECEMBER 31, 1998 1997 ------ ------ (IN THOUSANDS) Current assets $2,662 $2,379 Property and equipment, net 2,760 1,473 Other assets 95 471 ------ ------ Total assets $5,517 $4,323 ====== ====== Current liabilities $2,027 $ 994 Other liabilities 177 215 Stockholder's equity 3,313 3,114 ------ ------ Total liabilities and stockholder's equity $5,517 $4,323 ====== ====== 9
GRAY COMMUNICATIONS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued) NOTE B--BUSINESS ACQUISITIONS AND DISPOSITION (continued) SUBSEQUENT TRANSACTIONS (CONTINUED) Condensed unaudited income statement data for the three months and six months ended June 30, 1998 and 1997 for WALB-TV is as follows: Three Months Ended Six Months Ended June 30, June 30, ----------------- ----------------- 1998 1997 1998 1997 ------ ------ ------ ------ (in thousands) Broadcasting revenues $3,235 $2,584 $5,658 $4,931 Expenses 1,418 1,162 2,556 2,255 ------ ------ ------ ------ Income before income taxes $1,817 $1,422 $3,102 $2,676 ====== ====== ====== ====== Net income $1,126 $ 883 $1,923 $1,660 ====== ====== ====== ====== Condensed unaudited balance sheets of Busse Broadcasting Corporation (including WEAU-TV) as of June 28, 1998 and December 28, 1997 are as follows: JUNE 28, DECEMBER 28, 1998 1997 ------- ------- (IN THOUSANDS) Current assets $13,473 $14,123 Property and equipment, net 12,555 13,226 Deferred charges and other assets 1,503 1,812 Intangible assets and excess reorganization value 46,827 48,775 ------- ------- Total assets $74,358 $77,936 ======= ======= Current liabilities $ 2,360 $ 4,161 Long term debt 61,168 60,919 Stockholder's equity 10,830 12,856 ------- ------- Total liabilities and stockholder's equity $74,358 $77,936 ======= ======= Condensed unaudited income statement data for the three months and six months ended June 28, 1998 and June 29, 1997 for Busse Broadcasting Corporation (including WEAU-TV) is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED -------------------------- -------------------------- JUNE 28, JUNE 29, JUNE 28, JUNE 29, 1998 1997 1998 1997 -------- -------- -------- -------- (IN THOUSANDS) <S> <C> <C> <C> <C> Broadcasting revenues $ 5,489 $ 5,285 $ 10,216 $ 9,550 Expenses 5,939 6,074 12,242 12,048 -------- -------- -------- -------- Loss before income taxes $ (450) $ (789) $ (2,026) $ (2,498) ======== ======== ======== ======== Net loss available to common stockholders $ (1,656) $ (1,995) $ (4,437) $ (4,909) ======== ======== ======== ======== </TABLE> 10
GRAY COMMUNICATIONS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued) NOTE B--BUSINESS ACQUISITIONS AND DISPOSITION (continued) PRO FORMA FINANCIAL DATA (UNAUDITED) On April 24, 1997, the Company purchased GulfLink Communications, Inc. and on August 1, 1997, the Company purchased the assets of WITN-TV(collectively referred to as the "1997 Acquisitions"). Unaudited pro forma operating data for the three months and six months ended June 30, 1998 and 1997 is presented below and assumes that the acquisition of Busse Broadcasting Corporation ("Busse Acquisition"), the exchange of WALB-TV ("WALB Exchange") and the 1997 Acquisitions were completed on January 1, 1997. This unaudited pro forma operating data does not purport to represent the Company's actual results of operations had the Busse Acquisition, WALB Exchange and the 1997 Acquisitions been completed on January 1, 1997, and should not serve as a forecast of the Company's operating results for any future periods. The pro forma adjustments are based solely upon certain assumptions that management believes are reasonable under the circumstances at this time. Unaudited pro forma operating data for the three months and six months ended June 30, 1998 and 1997, is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, -------------------------- -------------------------- 1998 1997 1998 1997 -------- -------- -------- -------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Revenues, net $ 34,315 $ 30,692 $ 64,600 $ 57,899 Expenses 34,355 30,944 67,466 60,976 -------- -------- -------- -------- Loss before income taxes $ (40) $ (252) $ (2,866) $ (3,077) ======== ======== ======== ======== Net loss available to common stockholders $ (660) $ (517) $ (4,027) $ (2,731) ======== ======== ======== ======== Diluted loss per share available to common stockholders $ (0.08) $ (0.07) $ (0.51) $ (0.34) ======== ======== ======== ======== </TABLE> The pro forma results presented above include adjustments to reflect (i) the incurrence of interest expense to fund the respective acquisitions, (ii) depreciation and amortization of assets acquired, (iii) the elimination of the corporate expense allocation net of additional accounting and administrative expenses and (iv) the income tax effect of such pro forma adjustments. NOTE D--LONG-TERM DEBT In September 1996, the Company entered into the $125.0 million senior credit facility (the "Senior Credit Facility") with KeyBank National Association, NationsBank, N.A. (South), CIBC, Inc., CoreStates Bank, N.A., and the Bank of New York. The Senior Credit Facility included scheduled reductions in the $125.0 million credit limit which commenced on March 31, 1997, interest rates based upon a spread over LIBOR and/or Prime, an unused commitment fee of 0.50% applied to available funds and a maturity date of June 30, 2003. Effective September 17, 1997, the Senior Credit Facility was modified to reinstate the original credit limit of $125.0 million which had been reduced by the scheduled reductions. The modification also reduced the interest rate spread over LIBOR and/or Prime. The modification also extended the maturity date from June 30, 2003 to June 30, 2004. The modification required a one-time fee of $250,000. At June 30, 1998, the Company had approximately $65.6 million outstanding under the Senior Credit Facility, which did not include a letter of credit in the amount of $5.9 million which had been established but not yet drawn upon. On June 30, 1998, the balance available under the Senior Credit Facility was $49.8 million and the interest rate on the balance outstanding was based on a spread over LIBOR and Prime of 2.00% and 0.25%, respectively. As of June 30, 1998, the credit limit of $125.0 million as amended on September 17, 1997 had been reduced by $3.7 million due to scheduled reductions as specified in the Senior Credit Facility. 11
GRAY COMMUNICATIONS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)(continued) NOTE D--LONG-TERM DEBT (continued) On July 31, 1998, the Company amended and restated the Senior Credit Facility to increase its committed availability from $125 million to $200 million. The amendment also provides for an additional $100 million of uncommitted borrowing capacity. The modification also extended the maturity date from June 30, 2004 to June 30, 2005. The modification required a one-time fee of approximately $750,000. Immediately following the acquisition of Busse, the Company exercised its right to satisfy and discharge the Busse 11 5/8% Senior Secured Notes, effectively prefunding the notes at the October 15, 1998 call price of 106 plus accrued interest. The amount necessary to satisfy and discharge the notes was approximately $69.9 million. 12
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations of Gray Communications Systems, Inc. INTRODUCTION The following analysis of the financial condition and results of operations of Gray Communications Systems, Inc. (the "Company") should be read in conjunction with the Company's unaudited Condensed Consolidated Financial Statements and notes thereto included elsewhere herein. The Company derives its revenues from its television broadcasting, publishing and paging operations. On August 1, 1997 the Company purchased substantially all of the assets of WITN-TV ("WITN"), the NBC affiliate serving the Greenville-Washington-New Bern, North Carolina market (the "WITN Acquisition"). On April 24, 1997, the Company purchased GulfLink Communications, Inc. (the "GulfLink Acquisition"), which is in the transportable satellite uplink business, a business in which the Company was already engaged. As a result of the higher operating margins associated with the Company's television broadcasting operations, the profit contribution of these operations as a percentage of revenues, has exceeded, and is expected to continue to exceed, the profit contributions of the Company's publishing and paging operations. Set forth below, for the periods indicated, is certain information concerning the relative contributions of the Company's television broadcasting, publishing and paging operations. Three Months Ended June 30, ----------------------------------------------- 1998 1997 --------------------- ---------------------- Percent of Percent of Amount Total Amount Total ------- ------- ------- --------- (dollars in thousands) Television Broadcasting Revenues $22,690 70.8% $17,783 69.7% Operating income (1) 6,801 86.2 5,520 80.2 Publishing Revenues $ 7,379 23.0% $ 6,082 23.9% Operating income (1) 856 10.9 1,035 15.0 Paging Revenues $ 1,991 6.2% $ 1,634 6.4% Operating income (1) 231 2.9 324 4.8 13
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations of Gray Communications Systems, Inc. (continued) INTRODUCTION (CONTINUED) Six Months Ended June 30, ----------------------------------------------- 1998 1997 --------------------- ---------------------- Percent of Percent of Amount Total Amount Total ------- ------- ------- --------- (dollars in thousands) Television Broadcasting Revenues $42,201 70.3% $33,768 70.0% Operating income (1) 11,137 82.9 9,281 78.3 Publishing Revenues $13,916 23.2% $11,306 23.4% Operating income (1) 1,800 13.4 1,922 16.2 Paging Revenues $ 3,925 6.5% $ 3,185 6.6% Operating income (1) 499 3.7 657 5.5 (1) Represents income before miscellaneous income (expense), allocation of corporate overhead, interest expense and income taxes. The operating revenues of the Company's television stations are derived primarily from broadcast advertising revenues and, to a much lesser extent, from compensation paid by the networks to the stations for broadcasting network programming. The operating revenues of the Company's publishing operations are derived from retail advertising, circulation and classified revenue. Paging revenue is derived primarily from the leasing and sale of pagers. In the Company's broadcasting operations, broadcast advertising is sold for placement either preceding or following a television station's network programming and within local and syndicated programming. Broadcast advertising is sold in time increments and is priced primarily on the basis of a program's popularity among the specific audience an advertiser desires to reach, as measured by Nielsen Media Research ("Nielsen"). In addition, broadcast advertising rates are affected by the number of advertisers competing for the available time, the size and demographic makeup of the market served by the station and the availability of alternative advertising media in the market area. Broadcast advertising rates are the highest during the most desirable viewing hours, with corresponding reductions during other hours. The ratings of a local station affiliated with a major network can be affected by ratings of network programming. Most broadcast advertising contracts are short-term, and generally run only for a few weeks. Approximately 52.0% of the gross revenues of the Company's television stations for the six months ended June 30, 1998 were generated from local advertising, which is sold primarily by a station's sales staff directly to local accounts, and the remainder represented primarily national advertising, which is sold by a station's national advertising sales representative. The stations generally pay commissions to advertising agencies on local, regional and national advertising. The stations also pay commissions to the national sales representative on national advertising. Broadcast advertising revenues are generally highest in the second and fourth quarters each year, due in part to increases in consumer advertising in the spring and retail advertising in the period leading up to and including the holiday season. In addition, broadcast advertising revenues are generally higher during even numbered election 14
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations of Gray Communications Systems, Inc. (continued) INTRODUCTION (CONTINUED) years due to spending by political candidates, which spending typically is heaviest during the fourth quarter. The Company's publishing operations' advertising contracts are generally entered into annually and provide for a commitment as to the volume of advertising to be purchased by an advertiser during the year. The publishing operations' advertising revenues are primarily generated from local advertising. As with the broadcasting operations, the publishing operations' revenues are generally highest in the second and fourth quarters of each year. The Company's paging subscribers either own pagers, thereby paying solely for the use of the Company's paging services, or lease pagers, thereby paying a periodic charge for both the pagers and the paging services. Of the Company's pagers currently in service, approximately 75% are owned and maintained by subscribers with the remainder being leased. The terms of the lease contracts are month-to-month, three months, nine months or twelve months in duration. Paging revenues are generally equally distributed throughout the year. The broadcasting operations' primary operating expenses are employee compensation, related benefits and programming costs. The publishing operations' primary operating expenses are employee compensation, related benefits and newsprint costs. The paging operations' primary operating expenses are employee compensation and telephone and other communications costs. In addition, the broadcasting, publishing and paging operations incur overhead expenses, such as maintenance, supplies, insurance, rent and utilities. A large portion of the operating expenses of the broadcasting, publishing and paging operations is fixed, although the Company has experienced significant variability in its newsprint costs in recent years. MEDIA CASH FLOW The following table sets forth certain operating data for the broadcast, publishing and paging operations for the three months and six months ended June 30, 1998 and 1997: Three Months Ended Six Months Ended June 30, June 30, -------------------- -------------------- 1998 1997 1998 1997 -------- -------- -------- -------- (in thousands) Operating income $ 7,210 $ 6,124 $ 12,079 $ 10,460 Add: Amortization of program license rights 959 822 1,899 1,619 Depreciation and amortization 4,221 3,488 7,843 6,760 Corporate overhead 658 741 1,317 1,374 Non-cash compensation and contributions to the Company's 401(k) plan, paid in common stock 115 95 233 210 Less: Payments for program license liabilities (959) (892) (1,955) (1,830) -------- -------- -------- -------- Media Cash Flow (1) $ 12,204 $ 10,378 $ 21,416 $ 18,593 ======== ======== ======== ======== 15
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations of Gray Communications Systems, Inc. (continued) MEDIA CASH FLOW (CONTINUED) (1) Of Media Cash Flow for the three months ended June 30, 1998 and 1997, $10.1 million and $8.2 million, respectively, was attributable to the Company's broadcasting operations; $1.4 million and $1.5 million, respectively, was attributable to the Company's publishing operations; and $670,000 and $694,000, respectively, was attributable to the Company's paging operations. Of Media Cash Flow for the six months ended June 30, 1998 and 1997, $17.5 million and $14.4 million, respectively, was attributable to the Company's broadcasting operations; $2.5 million and $2.8 million, respectively, was attributable to the Company's publishing operations; and $1.4 million, respectively was attributable to the Company's paging operations. "Media Cash Flow" is defined as operating income, plus depreciation and amortization (including amortization of program license rights), non-cash compensation and corporate overhead, less payments for program license liabilities. The Company has included Media Cash Flow data because such data are commonly used as a measure of performance for media companies and are also used by investors to measure a company's ability to service debt. Media Cash Flow is not, and should not be used as, an indicator or alternative to operating income, net income or cash flow as reflected in the Company's unaudited Condensed Consolidated Financial Statements, and is not a measure of financial performance under generally accepted accounting principles and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with generally accepted accounting principles. As discussed in the INTRODUCTION, the Company completed two broadcasting acquisitions during 1997. The financial results of the Company reflect increases between the three month and six month periods ended June 30, 1998 and 1997 in substantially all broadcast line items. CASH FLOW PROVIDED BY (USED IN) OPERATING, INVESTING AND FINANCING ACTIVITIES The following table sets forth certain cash flow data for the Company for the six months ended June 30, 1998 and 1997. Six Months Ended June 30, ---------------------------- 1998 1997 -------- ------- (in thousands) Cash flows provided by (used in) Operating activities $ 8,435 $ 5,650 Investing activities (7,984) (11,975) Financing activities (79) 5,796 16
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations of Gray Communications Systems, Inc. (continued) BROADCASTING, PUBLISHING AND PAGING REVENUES Set forth below are the principal types of operating revenues earned by the Company's broadcasting, publishing and paging operations for the periods indicated and the percentage contribution of each to the Company's total revenues: <TABLE> <CAPTION> Three Months Ended June 30, ------------------------------------------------------------------------------ 1998 1997 ------------------------------------- ----------------------------------- Amount Percent of Total Amount Percent of Total ----------- ---------------- --------- ---------------- (dollars in thousands) <S> <C> <C> <C> <C> Broadcasting Net revenues: Local $11,167 34.8% $ 9,804 38.5% National 6,530 20.4 5,466 21.4 Network compensation 1,358 4.2 1,148 4.5 Political 1,993 6.2 106 0.4 Production and other 1,643 5.2 1,259 4.9 ------- ----- ------- -------- $22,691 70.8% $17,783 69.7% ======= ===== ======= ======== Publishing Net revenues: Retail advertising $ 3,447 10.8% $ 2,895 11.4% Classified 2,413 7.5 1,850 7.3 Circulation 1,340 4.2 1,227 4.8 Other 179 0.5 110 0.4 ------- ------ ------- -------- $ 7,379 23.0% $ 6,082 23.9% ======= ====== ======= ======== Paging Net revenues: Paging lease and service $ 1,991 6.2% $ 1,634 6.4% ======= ====== ======= ======== $32,061 100.0% $25,499 100.0% ======= ====== ======= ======== </TABLE> 17
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations of Gray Communications Systems, Inc. (continued) BROADCASTING, PUBLISHING AND PAGING REVENUES (CONTINUED) <TABLE> <CAPTION> Six Months Ended June 30, ------------------------------------------------------------------------------ 1998 1997 ------------------------------------- ----------------------------------- Amount Percent of Total Amount Percent of Total ----------- ---------------- --------- ---------------- (dollars in thousands) <S> <C> <C> <C> <C> Broadcasting Net revenues: Local $22,065 36.7% $18,916 39.2% National 12,100 20.2 10,231 21.2 Network compensation 2,573 4.3 2,281 4.7 Political 2,186 3.6 153 0.3 Production and other 3,278 5.5 2,187 4.6 ------- ------- ------- ------- $42,202 70.3% $33,768 70.0% ======= ======= ======= ======= Publishing Net revenues: Retail advertising $ 6,424 10.7% $ 5,384 11.1% Classified 4,498 7.5 3,467 7.2 Circulation 2,619 4.4 2,217 4.6 Other 375 0.6 238 0.5 ------- ------- ------- ------- $13,916 23.2% $11,306 23.4% ======= ======= ======= ======= Paging Net revenues: Paging lease and service $ 3,925 6.5% $ 3,185 6.6% ======= ======= ======= ======= $60,043 100.0% $48,259 100.0% ======= ======= ======= ======= </TABLE> Three Months Ended June 30, 1998 compared to Three Months Ended June 30, 1997 REVENUES. Total revenues for the three months ended June 30, 1998 increased $6.6 million, or 25.7%, over the same period of the prior year, from $25.5 million to $32.0 million. This increase was primarily attributable to the net effect of (i) increased revenues resulting from the WITN Acquisition, (ii) increased political revenue, (iii) increased publishing revenues and (iv) increased paging revenues. The WITN Acquisition accounted for $2.3 million of the revenue increase. Broadcast net revenues increased $4.9 million, or 27.6%, over the same period of the prior year, to $22.7 million from $17.8 million. The WITN Acquisition accounted for $2.3 million of the broadcast net revenue increase. On a pro forma basis, assuming the acquisition of WITN had been effective on January 1, 1997, broadcast net revenues for WITN for the three months ended June 30, 1998 remained constant at $2.3 million when compared to the same period of the prior year. Broadcast net revenues, excluding the WITN Acquisition, increased $2.6 million, or 14.8%, over the same period of the prior year, to $20.4 million from $17.8 million. This increase was due primarily to an increase in political advertising revenue of $1.8 million. Publishing revenues increased $1.3 million, or 21.3%, over the same period of the prior year, to $7.4 million from $6.1 million. The increase in revenues was due primarily to an increase in retail advertising, classified advertising, circulation and other revenue of $553,000, $563,000 $113,000 and $69,000, respectively. The increase in retail advertising and circulation revenue was due primarily to an increase in circulation at the Gwinnett Daily Post 18
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Three Months Ended June 30, 1998 compared to Three Months Ended June 30, 1997 (continued) to 64,000 at June 30, 1998 from 49,000 at June 30, 1997. The increase in retail advertising and classified advertising revenue was due primarily to linage increases. Paging revenue increased $357,000 or 21.8%, over the same period of the prior year, to $2.0 million from $1.6 million. The increase was attributable primarily to an increase in the number of pagers in service. The Company had approximately 78,500 pagers and 58,000 pagers in service at June 30, 1998 and 1997, respectively. OPERATING EXPENSES. Operating expenses for the three months ended June 30, 1998 increased $5.5 million, or 28.3%, over the same period of the prior year, to $24.9 million from $19.4 million, due primarily to the WITN Acquisition, increased expenses at the Company's existing television stations exclusive of WITN and the expense associated with the increase in circulation at the Gwinnett Daily Post. The WITN Acquisition, increased expenses at existing television stations and the cost associated with the increase in circulation at the Gwinnett Daily Post accounted for $1.3 million, $1.8 million and $1.2 million (exclusive of depreciation and amortization), respectively, of the operating expense increase. Broadcast expenses increased $3.1 million, or 31.8%, over the three months ended June 30, 1998, to $12.7 million from $9.6 million. The increase was attributable primarily to the WITN Acquisition and increased expenses at the Company's existing television stations exclusive of WITN. On a pro forma basis, assuming the acquisition of WITN had been effective on January 1, 1997, broadcast expenses for WITN for the three months ended June 30, 1998 as compared to the three months ended June 30, 1997 remained constant at $1.3 million. Broadcast expenses, excluding the results of the WITN Acquisition increased $1.8 million, or 18.5%, to $11.4 million from $9.6 million. This increase was due primarily to an increase in payroll expense, other expense and the GulfLink Acquisition of $800,000, $650,000 and $250,000, respectively. Publishing expenses for the three months ended June 30, 1998 increased $1.4 million, or 30.2%, from the same period of the prior year, to $6.0 million from $4.6 million. This increase resulted primarily from an increase in the expense associated with the increase in circulation at the Gwinnett Daily Post and higher newsprint pricing. Average newsprint costs increased approximately 9.6% while newsprint consumption increased approximately 26.8%. Paging expenses increased $380,000 or 40.1%, over the same period of the prior year, to $1.4 million from $947,000. The increase was attributable primarily to an increase in payroll and other costs associated with an increase in the number of pagers in service. Corporate and administrative expenses decreased $84,000 or 11.3%, over the same period of the prior year, to $656,000 from $741,000. Depreciation of property and equipment and amortization of intangible assets was $4.2 million for the three months ended June 30, 1998, as compared to $3.5 million for the same period of the prior year, an increase of $732,000, or 21.0%. This increase was primarily the result of higher depreciation and amortization costs related to the WITN Acquisition and the GulfLink Acquisition. INTEREST EXPENSE. Interest expense increased $959,000, or 18.9%, to $6.0 million for the three months ended June 30, 1998 from $5.1 million for the three months ended June 30, 1997. This increase was attributable primarily to increased levels of debt resulting from the financing of the WITN Acquisition and the GulfLink Acquisition. INCOME TAX EXPENSE (BENEFIT). Income tax expense decreased $165,000, or 38.8%, to $261,000 for the three months ended June 30, 1998 from $426,000 for the three months ended June 30, 1997. NET INCOME AVAILABLE TO COMMON STOCKHOLDERS. Net income available to common stockholders of the Company was $479,000 for the three months ended June 30, 1998, as compared with net income available to common stockholders of $272,000 for the same period of the prior year, an increase of $207,000. 19
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Six Months Ended June 30, 1998 compared to Six Months Ended June 30, 1997 REVENUES. Total revenues for the six months ended June 30, 1998 increased $11.8 million, or 24.4%, over the same period of the prior year, to $60.0 million from $48.3 million. This increase was primarily attributable to the net effect of (i) increased revenues resulting from the WITN Acquisition and the GulfLink Acquisition, (ii) increased publishing revenues (iii) increased political broadcast revenue and (iv) increased paging revenues. The WITN Acquisition and the GulfLink Acquisition accounted for $4.1 million and $1.0 million, respectively, of the revenue increase. Broadcast net revenues increased $8.4 million, or 25.0%, over the same period of the prior year, to $42.2 million from $33.8 million. The WITN Acquisition and the GulfLink Acquisition accounted for $4.1 million and $1.0 million, respectively, of the broadcast net revenue increase. On a pro forma basis, assuming the acquisition of WITN had been effective on January 1, 1997, broadcast net revenues for WITN for the six months ended June 30, 1998 increased $124,000, or 3.1%, when compared to the same period of the prior year to $4.1 million from 4.0 million. Broadcast net revenues, excluding the WITN Acquisition and the GulfLink Acquisition, increased $3.3 million, or 9.8%, over the same period of the prior year, to $36.7 million from $33.4 million. This increase was due primarily to an increase in political advertising revenue of $2.0 million. Publishing revenues increased $2.6 million, or 23.1%, over the same period of the prior year, to $13.9 million from $11.3 million. The increase in revenues was due primarily to an increase in retail advertising, classified advertising and circulation revenue of $1.0 million, $1.0 million, and $401,000, respectively. The increase in retail advertising and circulation revenue was due primarily to an increase in circulation at the GWINNETT DAILY POST. The increase in classified advertising revenue was due primarily to linage increases. Paging revenue increased $741,000 or 23.3%, over the same period of the prior year, to $3.9 million from $3.2 million. The increase was attributable primarily to an increase in the number of pagers in service. The Company had approximately 78,500 and 58,000 pagers in service at June 30, 1998 and 1997, respectively. OPERATING EXPENSES. Operating expenses for the six months ended June 30, 1998 increased $10.2 million, or 26.9%, over the same period of the prior year, from $37.8 million to $48.0 million, due primarily to the WITN Acquisition, the GulfLink Acquisition, and the expense associated with the increase in circulation at the GWINNETT DAILY POST. The WITN Acquisition, the GulfLink Acquisition and the cost associated with the increase in circulation at the GWINNETT DAILY POST accounted for $2.5 million, $842,000 and $2.7 million (exclusive of depreciation and amortization), respectively, of the operating expense increase. Broadcast expenses increased $5.5 million, or 28.4%, over the six months ended June 30, 1998, to $24.8 million from $19.3 million. The increase was attributable primarily to the WITN Acquisition and GulfLink Acquisition. On a pro forma basis, assuming the acquisition of WITN had been effective on January 1, 1997, broadcast expenses for WITN for the six months ended June 30, 1998 increased $46,000, or 2.0%, over the six months ended June 30, 1997 to $2.5 million from $2.4 million. Broadcast expenses, excluding the results of the WITN Acquisition and the GulfLink Acquisition, increased $2.2 million, or 11.3%, to $21.2 million from $19.0 million. This increase resulted from an increase in payroll expense and other expense of $1.3 million and $780,000, respectively. Publishing expenses for the six months ended June 30, 1998 increased $2.9 million, or 34.2%, from the same period of the prior year, to $11.4 million from $8.5 million. This increase resulted primarily from an increase in the expense associated with the increase in circulation at the GWINNETT DAILY POST and higher newsprint pricing. Average newsprint costs increased approximately 10.2% while newsprint consumption increased approximately 30.0%. Paging expenses increased $746,000 or 40.6%, over the same period of the prior year, to $2.6 million from $1.8 million. The increase was attributable primarily an increase in payroll and other costs associated with an increase in the number of pagers in service. 20
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Six Months Ended June 30, 1998 compared to Six Months Ended June 30, 1997 (continued) Corporate and administrative expenses for the six months ended June 30, 1998 decreased $57,000, or 4.1%, over the same period of the prior year, to $1,317,000 from $1,374,000. Depreciation of property and equipment and amortization of intangible assets for the six months ended June 30, 1998, increased $1.1 million, or 16.0%, over the same period of the prior year, to $7.8 million from $6.7 million. This increase was primarily the result of higher depreciation and amortization costs related to the WITN Acquisition and the GulfLink Acquisition. INTEREST EXPENSE. Interest expense increased $1.9 million, or 19.0%, from $10.1 million for the six months ended June 30, 1997 to $12.0 million for the six months ended June 30, 1998. This increase was attributable primarily to increased levels of debt resulting from the financing of the WITN Acquisition and the GulfLink Acquisition. NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS. Net loss available to common stockholders of the Company was $1.4 million for the six months ended June 30, 1998, as compared with a net loss available to common stockholders of $539,000 for the same period of the prior year, an increase of $824,000. Liquidity and Capital Resources In September 1996, the Company entered into the $125.0 million senior credit facility (the "Senior Credit Facility") with KeyBank National Association, NationsBank, N.A. (South), CIBC, Inc., CoreStates Bank, N.A., and the Bank of New York. The Senior Credit Facility included scheduled reductions in the $125.0 million credit limit which commenced on March 31, 1997, interest rates based upon a spread over LIBOR and/or Prime, an unused commitment fee of 0.50% applied to available funds and a maturity date of June 30, 2003. Effective September 17, 1997, the Senior Credit Facility was modified to reinstate the original credit limit of $125.0 million which had been reduced by the scheduled reductions. The modification also reduced the interest rate spread over LIBOR and/or Prime. The modification also extended the maturity date from June 30, 2003 to June 30, 2004. The modification required a one-time fee of $250,000. At June 30, 1998, the Company had approximately $65.6 million outstanding under the Senior Credit Facility, which did not include a letter of credit in the amount of $5.9 million which had been established but not yet drawn upon. On June 30, 1998, the balance available under the Senior Credit Facility was $49.8 million and the interest rate on the balance outstanding was based on a spread over LIBOR and Prime of 2.00% and 0.25%, respectively. As of June 30, 1998, the credit limit of $125.0 million as amended on September 17, 1997 had been reduced by $3.7 million due to scheduled reductions as specified in the Senior Credit Facility. On July 31, 1998, the Company amended and restated the Senior Credit Facility to increase its committed availability from $125 million to $200 million. The amendment also provides for an additional $100 million of uncommitted borrowing capacity. The modification also extended the maturity date from June 30, 2004 to June 30, 2005. The modification required a one-time fee of approximately $750,000. The Company's working capital was $9.9 million and $10.1 million at June 30, 1998 and December 31, 1997, respectively. The Company's cash provided from operations was $8.4 million and $5.7 million for the six months ended June 30, 1998 and 1997, respectively. Management believes that current cash balances, cash flows from operations and the available funds under its Senior Credit Facility will be adequate to provide for the Company's capital expenditures, debt service, cash dividends and working capital requirements for the forseeable future. The Senior Credit Facility contains certain restrictive provisions, which, among other things, limit additional indebtedness and require minimum levels of cash flows. Additionally, the effective interest rate of the Senior Credit Facility can be changed based upon the Company's maintenance of certain operating ratios as defined in the Senior Credit Facility, not to exceed the lender's prime rate plus 0.5% or LIBOR plus 2.25%. The Senior Credit Facility contains restrictive provisions similar to the provisions of the Company's 10 5/8% Senior Subordinated Notes due 2006. 21
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) The Company's cash used in investing activities was $8.0 million and $12.0 million for the six months ended June 30, 1998 and 1997, respectively. The decreased usage of $4.0 million from 1997 to 1998 was primarily due to the GulfLink Acquisition which was completed on April 24, 1997. The Company will require liquidity for capital expenditures and working capital needs. For the three months ended June 30, 1998 capital expenditures totaled $5.8 million. It is anticipated that significant capital expenditures may be required in the future to implement advanced television ("ATV"), at the Company's television stations. The Federal Communication Commission ("FCC") has determined the technical standards, the channel assignments and a time table for implementation of ATV. Generally, under the FCC's implementation schedule, the Company must apply for ATV construction permits for each of its present television stations by November 1, 1999 and then commence ATV operations by May 1, 2002. Under the current FCC implementation schedule the Company would generally be required to surrender to the government either the current channel or the ATV channel by December 31, 2006 and continue its digital operations thereafter on the retained channel. Recent legislation requires the FCC to extend the December 31, 2006 surrender date with respect to certain stations within a given television market if (i) at least one network affiliate is not broadcasting a digital service in the given market and has exercised "due diligence" in meeting the ATV buildout requirements for that market or (ii) digital to analog converter technology is not generally available in the given market or (iii) 15 percent or more of the television households in a given market do not subscribe to a multichannel video programming distributor that carries the digital service of each local station and those television households do not have at least one advanced television set or at least one digital to analog converter. The foregoing implementation schedule is subject to review by the FCC every two years and may also be subject to future legislation or judicial review, the effect of which cannot be predicted by the Company. The Company is currently studying the ATV channel assignments for its television stations as well as the technical and capital expenditure requirements to implement ATV at these television stations. The Company currently intends to implement ATV at its television stations within the FCC mandated implementation period. The Company cannot presently predict the cost of such implementation but, based upon general industry estimates, currently believes that such costs will be material and will require several million dollars to commence initial ATV operations. The Company's cash used in financing activities was $79,000 for the six months ended June 30, 1998 as compared to cash provided by financing activities of $5.8 million for the six months ended June 30, 1997. The decrease in cash provided by financing activities resulted primarily from decreased net borrowings of long-term debt, decreased cash provided by common stock transactions partially offset by increased funds provided by the sale of commons stock. During the six months ended June 30, 1998, the Company issued 22,850 shares of Class A Common Stock and 61,202 shares of Class B Common Stock from treasury to fulfill obligations under its employee benefit plan, non-employee director stock purchase plan and long-term incentive plan. During the six months ended June 30, 1998, the Company purchased 10,500 shares of Class A Common stock at a cost of $311,063. The Company regularly enters into program contracts for the right to broadcast television programs produced by others and program commitments for the right to broadcast programs in the future. Such programming commitments are generally made to replace expiring or canceled program rights. Payments under such contracts are made in cash or the concession of advertising spots for the program provider to resell, or a combination of both. During the six months ended June 30, 1998, the Company paid $2.0 million for such program broadcast rights. On July 31, 1998, the Company completed the purchase of all of the outstanding capital stock of Busse Broadcasting Corporation ("Busse"). The net purchase price was $112 million plus associated transaction costs. The purchase price includes the assumption of Busse's indebtedness, including its 11 5/8% Senior Secured Notes due 2000. Immediately prior to the Company's acquisition of Busse, Cosmos Broadcasting Corporation acquired WEAU-TV from Busse and exchanged it for WALB-TV, the Company's NBC affiliate in Albany, Georgia. In exchange for WALB-TV, the Company received WEAU-TV, which was valued at $66 million, and approximately 22
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) $12 million in cash for a total value of $78 million. As a result of these transactions, the Company adds the following television stations to its existing broadcast group: KOLN-TV, the CBS affiliate serving the Lincoln-Hastings-Kearney, Nebraska market; its satellite station KGIN-TV, the CBS affiliate serving Grand Island, Nebraska; and WEAU-TV, an NBC affiliate serving the Eau Claire-La Crosse, Wisconsin market. These transactions also satisfy the Federal Communication Commission's requirement for the Company to divest itself of WALB-TV. The Company will pay Bull Run Corporation, a principal stockholder of the Company, a fee equal to 1% of the transaction values for services performed, of which $780,000 was included in accounts payable at June 30, 1998. Immediately following the acquisition of Busse, the Company exercised its right to satisfy and discharge the Busse 11 5/8% Senior Secured Notes, effectively prefunding the notes at the October 15, 1998 call price of 106 plus accrued interest. The amount necessary to satisfy and discharge the notes was approximately $69.9 million which was funded through the Senior Credit Facility. The Company and its subsidiaries file a consolidated federal income tax return and such state or local tax returns as are required. As of June 30, 1998, the Company anticipates that it will generate taxable operating losses for the foreseeable future. Management does not believe that inflation in past years has had a significant impact on the Company's results of operations nor is inflation expected to have a significant effect upon the Company's business in the near future. Cautionary Statements for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act This quarterly report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. When used in this report, the words "believes," "expects," "anticipates," "estimates" and similar words and expressions are generally intended to identify forward-looking statements. Statements that describe the Company's future strategic plans, goals, or objectives are also forward-looking statements. Readers of this Report are cautioned that any forward-looking statements, including those regarding the intent, belief or current expectations of the Company or management, are not guarantees of future performance, results or events and involve risks and uncertainties, and that actual results and events may differ materially from those in the forward-looking statements as a result of various factors including, but not limited to, (i) general economic conditions in the markets in which the Company operates, (ii) competitive pressures in the markets in which the Company operates, (iii) the effect of future legislation or regulatory changes on the Company's operations and (iv) other factors described from time to time in the Company's filings with the Securities and Exchange Commission. The forward-looking statements included in this report are made only as of the date hereof. The Company undertakes no obligation to update such forward-looking statements to reflect subsequent events or circumstances. Impact of Year 2000 Some of the Company's older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that recognize a date using "00" as the year 1900 rather than the year 2000. This could cause a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company has completed an assessment and will have to modify or replace portions of its software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. The Company does not believe that the estimated total Year 2000 project cost will have a material impact upon its financial 23
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Impact of Year 2000 (continued) position. Most of this cost will be realized over the estimated useful lives of the new hardware and software. To date, the Company has not incurred significant expenses associated with the Year 2000 issue. The project is estimated to be completed no later than June 30, 1999, which is prior to any anticipated impact on its operating systems. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company. The costs of the project and the date on which the Company believes it will complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. 24
PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.1 - Amended and Restated Stock Purchase Agreement by and among Busse Broadcasting Corporation, South Street Corporate Recovery Fund I, L.P., Greycliff Leveraged Fund 1993, L.P., South Street Leveraged Corporate Recovery Fund, L.P., South Street Corporate Recovery Fund I (International), L.P. and Gray Communications Systems, Inc. dated as of June 22, 1998 10.2 - Asset Purchase Agreement by and among Busse Broadcasting Corporation, WEAU License, Inc. and Cosmos Broadcasting Corporation dated as of June 22, 1998 10.3 - Exchange Agreement by and among Gray Communications Systems, Inc., WALB-TV, Inc., WALB Licensee Corporation., Cosmos Broadcasting Corporation, Busse Broadcasting Corporation, and WEAU License, Inc. dated as of June 22, 1998 10.4 - Escrow Agreement by and among WALB-TV, Inc. WALB Licensee Corporation, Cosmos Broadcasting Corporation and NationsBank, N. A. dated as of June 22, 1998 10.5 - Amended and Restated Loan Agreement by and among Gray Communications Systems, Inc. as Borrower, NationsBank, NA as Syndication Agent and Administrative Agent, Key Corporate Capital Inc., as Documentation Agent and The Financial Institutions Listed Herein as of July 31, 1998 with NationsBanc Montgomery Securities LLC, as Lead Arranger. 10.6 Asset Purchase Agreement by and among WALB-TV, Inc., WALB-TV Licensee Corp. and Cosmos Broadcasting Corporation dated as of June 22, 1998 27 - Financial Data Schedule (b) Reports on Form 8-K None 25
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. GRAY COMMUNICATIONS SYSTEMS, INC. (Registrant) Date: August 13, 1998 By: /s/ Frederick J. Erickson ------------------------- Frederick J. Erickson Chief Financial Officer