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Author: koch Three stars, 500 posts CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 197  
Subject: Liquidity Date: 6/14/2001 10:25 PM
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Hi, Fools,

I have spoken previously (#163 http://boards.fool.com/Message.asp?mid=14846875 ) about KARE's cash trouble. I do not hold a position in KARE, and I am certainly not rooting against them. However, I have just read bits of their most recent 10-Q (source: www.freeedgar.com ) and it certainly didn't change my mind. I have copied the section, "Liquidity and Capital Resources" at the bottom of this message. There are at least two parts of it that I feel are downright sneaky, and about which I am curious how other Fools feel.

First, the company states, "...free cash flow, defined as net income plus non-cash items,
decreased by $536,816 to $1,271,090 for the three months ended March 31, 2001..." What? So, the company is allowed to simply redefine free cash flow, in order to make it seem like cash is just pouring in, well above stated earnings? Here's how The Motley Fool would calculate KARE's free cash flow (http://www.fool.com/portfolios/rulemaker/1999/rulemaker991210.htm ):

For three months ending March 31, 2001:
Net cash provided by (used in) operating activities (1,532,591)
...
Capital expenditures (167,134)
Free Cash Flow = (1,699,725)

Note, that the company has defined free cash flow as "Earnings plus depreciation plus amortization," specifically leaving out accounts receivable and payable, which are critical. That makes a difference of minus $1.7 million, which is more than enough to illustrate that KARE was not free cash flow positive. Am I missing something, or does this seem completely dishonest? Please correct me if I am wrong, but I am of the strong opinion that KARE is currently burning cash fairly quickly. (To be more fair, I think managment has previously used this misleading definition of free cash flow, e.g. last year's corresponding 10-Q. However, I cannot find a similar definition elsewhere, http://moneycentral.msn.com/investor/glossary/glossary.asp?TermID=186 , http://www.duke.edu/~charvey/Classes/wpg/bfglosf.htm )

The above discussion of free cash flow is important for my second problem with Managment's discussion in the 10-Q. They state, "The aggregate outstanding balance under the credit facility may not exceed 3.5 times consolidated EBITDA (as defined in the loan agreement), determined quarterly on a four quarter trailing basis. Based on the March 31, 2001 financial statements, the aggregate balance available will be $39.0 million, effective May 15, 2001." Now, as of March 31, 2001, they owed $39.5 million, and had $0.2 million in cash. Given the negative cash flow, it is a complete mystery to me how they claim to be in compliance with the $39.0 million limit.

So, let's see here. It takes a non-standard calculation of cash flow in order to say that the company is making money. Furthermore, the company has maxed out its revolving credit facility (the equivalent of a credit card), which is "secured by substantially all of the assets of the Company." I think this is perhaps the apotheosis of a red flag (http://www.m-w.com/cgi-bin/dictionary?apotheosis I have waited 6 years to use that word). I read a short story last night last night by Faulkner called "Turnabout." In the end, a WWII pilot dives his plane towards the enemy headquarters. Unusually inspired, he keeps diving much longer than required, until he can see between the shingles on the roof. He pulls up at the last minute and his copilot releases the bomb, earning them great exhiliration and some kind of medals. But the narrator points out that had the mission failed, and had the pilot survived, he surely would have been court-martialed for the unauthorized, unneccessary risk. So, the question is, will KARE get the medal or the court-martial? I just don't think it's worth the risk or the dishonesty.

--steve-o

(From latest 10-Q (May, 2001) from www.freeedgar.com . I added bold emphasis. )

Liquidity and Capital Resources

The Company's free cash flow, defined as net income plus non-cash items,
decreased by $536,816 to $1,271,090 for the three months ended March 31, 2001

from $1,807,906 for the three months ended March 31, 2000. The Company's free
cash flow declined primarily because of the decrease in net income between the
periods. The Company finances its business activities primarily from cash
provided by operating activities and from borrowings on its credit facility.
Cash provided by (used in) operating activities for the three months ended March
31, 2001 and 2000 was $(1,532,591) and $209,598, respectively. The decrease in
cash provided by operating activities for the three months ended March 31, 2001
compared to the three months ended March 31, 2000 is due primarily to (1) the
working capital associated with the integration of Fibar and SCS into the
Company, (2) an increase in prepaid assets, such as advertising associated with
trade shows and catalogs and brochures, and (3) a decrease in accounts payable
due to the payment of inventory puchases that were received but not paid at
December 31, 2000.

At March 31, 2001 and December 31, 2000, working capital was $20,609,327 and
$19,068,158, and cash balances were $19,428 and $200,786, respectively. The low
cash balances are due to the Company's practice of applying all excess cash
against the line of credit to minimize interest expense payable on line of
credit balances.

The Company has used its operating cash flow and its credit facility primarily
to expand sales and marketing activities, acquisition and development of new
products, capital expenditures and working capital. Net cash used in investing
activities was $174,667 and $17,812,994 for the three months ended March 31,
2001 and 2000, respectively. The substantial decrease in cash used in investing
activities was due to the acquisition of SCS Interactive in March 2000, compared
to no acquisition activity in the first quarter of 2001.

The Company increased its secured line of credit to $45.0 million on November
17, 2000. The line of credit is secured by substantially all of the assets of
the Company. The line of credit may be used for short-term working capital needs
and future acquisitions. There are no compensating balance requirements and the
credit facility requires compliance with financial loan covenants related to
debt levels compared to annualized cash flows from operations. The aggregate
outstanding balance under the credit facility may not exceed 3.5 times
consolidated EBITDA (as defined in the loan agreement), determined quarterly on
a four quarter trailing basis. Based on the March 31, 2001 financial statements,
the aggregate balance available will be $39.0 million, effective May 15, 2001.

The credit facility terminates and is payable in full on March 1, 2003. Interest
payments are required at least every three months at a fluctuating rate per
annum equal to the applicable "Reserve Adjusted LIBOR Rate" or a commercial
bank's prime rate (8.01% and 8.00% at March 31, 2001). A commitment fee in the
amount of .25% is payable quarterly in arrears based on the average daily unused
portion of the line. There was $39,530,000 outstanding under the credit facility
as of March 31, 2001. As of May 15, 2001, the Company is in compliance with the
mandatory reduction in the credit facility to $39.0 million.
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