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SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

973-983-0888
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No: o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No: o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

     As of November 3, 2003, there were outstanding 17,537,320 shares of Common Stock, $.01 par value.

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PARTY CITY CORPORATION AND SUBSIDIARY

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share information)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

     The condensed consolidated financial statements are unaudited. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments (consisting only of normal recurring accruals) necessary to present fairly the financial position of the Company as of September 27, 2003 and September 28, 2002 and the results of operations and cash flows for the quarters ended September 27, 2003 and September 28, 2002. Because of the seasonality of the party goods industry, operating results of the Company on a quarterly basis may not be indicative of operating results for the full fiscal year.

     These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended June 28, 2003, which are included in the Company’s Annual Report on Form 10-K with respect to such period filed with the Securities and Exchange Commission on September 26, 2003. All significant intercompany accounts and transactions have been eliminated. The June 28, 2003 consolidated balance sheet amounts are derived from the Company’s audited consolidated financial statements.

     Our Fiscal Year (“Fiscal Year”) refers to the 52 or 53 weeks, as applicable, ending the Saturday nearest to June 30, unless otherwise noted. The year ended July 3, 2004 (“Fiscal 2004”) is a 53 week year as compared to the years ended June 28, 2003 (“Fiscal 2003”) and June 29, 2002 (“Fiscal 2002”), which were 52 week years.

     Certain reclassifications have been made to the consolidated financial statements in prior periods to conform to the current period presentation.

2. Stock-Based Compensation

     The Company periodically grants stock options to employees. Pursuant to Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, the Company accounts for stock-based employee compensation arrangements using the intrinsic value method. Accordingly, no compensation expense has been recorded in the condensed consolidated financial statements with respect to option grants. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure, an Amendment of SFAS No. 123”. If compensation cost for the Company’s stock option plans had been determined in accordance with the fair value method prescribed by SFAS No. 123 the Company’s net loss would have been (in thousands, except per share data):

     The weighted average fair value of options granted during the first quarter of Fiscal 2004 and 2003 was $3.94 and $7.92, respectively.

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3. Earnings Per Share

     The following table sets forth the computations of basic and diluted loss per share (in thousands, except per share amounts):

4. Financing Agreements

     In January 2003, the Company entered into a $65 million revolving credit facility (“Loan Agreement”) with Wells Fargo Retail Finance, LLC, as the arranger, collateral agent and administrative agent, and Fleet Retail Finance, Inc., as the documentation agent. Under the terms of the Loan Agreement, the Company may borrow amounts based on a percentage of its eligible inventory and credit card receivables, subject to certain borrowing conditions and customary sub-limits, reserves and other limitations. Interest on advances is charged, at the Company’s option, (i) at the adjusted Eurodollar rate plus the applicable margin, which was set initially at 1.50% and is currently at 1.25%, per annum or (ii) at the prime rate less the applicable margin, which was initially set at and is currently 0.25% per annum. The term of the Loan Agreement is through April 30, 2006 and is secured by a lien on substantially all of the Company’s assets. The Company had a standby letter of credit of $3.1 million outstanding at September 27, 2003. At September 27, 2003 and November 3, 2003, the Company had $15.2 million and no borrowings outstanding under the Loan Agreement, respectively. The Company had $35.2 million available to be borrowed under the Loan Agreement at November 3, 2003.

5. Stockholders’ Equity

Shares Outstanding

     The Company’s authorized capital stock is 25,000,000 shares of its common stock, $0.01 par value per share. Shares of common stock issued and outstanding were 17,425,070 and 17,010,465 at September 27, 2003 and September 28, 2002, respectively.

Stock Repurchase

     In September 2001, the Board of Directors authorized the Company to repurchase up to $15 million of its outstanding common stock. The stock repurchases are made at the discretion of management. There was no stock repurchase activity for the first quarter of Fiscal 2004 or Fiscal 2003. As of September 27, 2003, the Company had purchased 747,012 shares for an aggregate amount of $5.9 million or 39.6% of the total amount to be purchased.

Warrants

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     There were no warrant exercises in the first quarter of Fiscal 2004. In the first quarter of Fiscal 2003, 688,000 warrants to purchase the Company’s common stock were exercised. This included an exercise of 458,667 warrants for which proceeds of $490,774 were received and a cashless exercise of the remaining 229,333 warrants for which the warrant holders received 213,792 shares of common stock. The remaining 15,541 shares were surrendered in connection with this exercise. These 15,541 shares of the Company’s common stock had a market value of $245,386 at the time of surrender.

6. Legal Proceedings

     A lawsuit was filed on September 25, 2001 against Party City in Los Angeles Superior Court by an assistant manager in one of the Company’s California stores for himself and on behalf of other members of an alleged class of Party City store managers (the “Class”) who claim the Company misclassified the Class members as exempt from California overtime wage and hour laws. The Class members seek the disgorgement of overtime wages allegedly owed by the Company to them but not paid and they also seek punitive damages and statutory penalties. If a class is certified, liability is found, and a judgment is entered, such a judgment may adversely affect the Company.

     In addition to the foregoing, from time to time the Company is involved in routine litigation incidental to the conduct of the business. The Company is aware of no other material existing or threatened litigation to which the Company is or may be a party.

7. Segment Information

     The following table contains key financial information of the Company’s business segments (in thousands):

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8. Acquisitions and Dispositions of Stores

     During Fiscal 2003, the Company acquired two stores from a franchisee. The aggregate consideration paid in connection with this acquisition was $1,603,000. The consolidated balance sheets include allocations of the purchase price related to this transaction of approximately $1,002,000 in goodwill, $195,000 in fixed assets and $406,000 in inventory.

     In Fiscal 2002, the Company completed the acquisition of thirteen stores in the Seattle, Washington market from Paper Warehouse, Inc. The conversion of these locations to the Party City store format was completed and all stores were opened by the first quarter of Fiscal 2003. Additional goodwill of $154,000 was recorded in Fiscal 2003 related to the completion of the conversion of these locations.

     The acquisitions have been accounted for under the purchase method of accounting. The results of operations of the acquired stores are included in the financial statements from the date the stores were opened.

     The were no changes in the carrying amount of goodwill of $18.6 million for the three months ended September 27, 2003.

     Assuming the stores acquired during the quarter ended September 28, 2002 were acquired on June 30, 2002, the beginning of Fiscal 2003, the pro forma results would have been as follows (in thousands, except per share amounts):

9. Guarantees

     In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” The Interpretation elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002.

     The Company has unconditionally guaranteed the lease payments of 24 leases associated with franchise stores and locations sublet. The majority of the guarantees were given when the Company sold stores in 1999 as part of its restructuring. The guarantees continue until the leases, which range from 2004 through 2011, expire. The maximum amount of the guarantees may vary, but is limited to the sum of the total amount due under the lease. As of September 27, 2003, the maximum amount of the guarantees was approximately $19.5 million.

10. Recent Accounting Standards

     In January 2003, the FASB issued FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities”. FIN 46 addresses how to identify variable interest entities and provides guidance as to how a company may assess its interests in a variable interest entity for purposes of deciding whether consolidation of that entity is required. FIN 46 is effective for all variable interest entities created after January 31, 2003. The Company is required to adopt the provisions of FIN 46 for any variable interest entity created prior to February 1, 2003 by the end of the current fiscal year. The Company is reviewing the provisions of this interpretation and currently does not expect its implementation to have a material effect on its financial position, results of operations or cash flows.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies and Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the appropriate application of certain accounting policies, many of which require estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the consolidated financial statements.

     We believe our application of accounting policies, and the estimates inherently required by the policies, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change. Historically, we have found the application of accounting policies to be appropriate, and actual results generally do not differ materially from those determined using necessary estimates.

     Our accounting policies are more fully described in Note 1 to the consolidated financial statements contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on September 26, 2003. We have identified certain critical accounting policies that are described below.

     Merchandise inventory. Inventory is valued using the cost method which values inventory at the lower of the actual cost or market, at the individual item level. Cost is determined using the weighted average method. Inventory levels are reviewed to identify slow-moving and closeout merchandise that will no longer be carried. Market is determined by the estimated net realizable value, based upon the merchandise selling price.

     Finite long-lived assets. In the evaluation of the fair value and future benefits of finite long-lived assets, we perform an analysis of the anticipated undiscounted future net cash flows of the related finite long-lived assets. If the carrying value of the related asset exceeds the undiscounted cash flows, the carrying value is reduced to its fair value. Various factors including future sales growth and profit margins are included in this analysis. To the extent these future projections or strategies change, the conclusion regarding impairment may differ from the current estimates.

     Insurance accruals. Our consolidated balance sheets include liabilities with respect to self-insured workers’ compensation and general liability claims. We estimate the required liability of such claims on a discounted basis, utilizing an actuarial method, based upon various assumptions, which include, but are not limited to, our historical loss experience, projected loss development factors, actual payroll and other data. The required liability is also subject to adjustment in the future based upon the changes in claims experience, including changes in the number of incidents (frequency) and changes in the ultimate cost per incident (severity).

     Goodwill. We evaluate goodwill annually or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flows. In making this assessment, management relies on a number of factors including operating results, business plans, economic projections, anticipated future cash flows and marketplace data. A change in these underlying assumptions may cause a change in the results of the tests and, as such, could cause fair value to be less than the carrying value. In such event, we would then be required to record a charge, which would impact earnings.

     Sales Returns. We estimate future sales returns and, when material, record a provision in the period that the related sales are recorded based on historical information. Should actual returns differ from our estimates, we would be required to revise estimated sales returns.

     Store Closure Costs. We will record estimated store closure costs, such as fixed asset write-offs, estimated lease commitment costs net of estimated sublease income and other miscellaneous store closing costs, when the liability is incurred. Such estimates may be subject to change should actual costs differ.

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Results of Operations

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     A reconciliation of EBITDA to net loss follows for the periods indicated:

     Because we also consider EBITDA useful as a liquidity measure, we present the following reconciliation of EBITDA to our cash flow used in operating activities:

     We use EBITDA to determine our executive compensation which bases incentive compensation payments on our EBITDA performance measured against budget. EBITDA is also widely used by us and others in our industry to evaluate and price potential acquisitions.

     EBITDA has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:

     •     EBITDA does not reflect our current expenditures, or future requirements, for capital expenditures or contractual commitments;

     •     EBITDA does not reflect changes in, or cash requirements for, our working capital needs;

     •     EBITDA does not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debts;

     •     Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA does not reflect any cash requirements for such replacements;

     •     Other companies in our industry may calculate EBITDA differently than we do, limiting its usefulness as a comparative measure.

     Because of these limitations, EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using EBITDA only supplementally. See the Statements of Cash Flow included in our financial statements.

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General

     Net Sales. Net sales include same store sales and new store sales. Same store sales include sales for those stores that were in operation for a full period in both the current month and the corresponding month for the prior year. New store sales include sales in the current fiscal year from stores opened during the previous fiscal year before they are considered same stores and new stores opened in the current fiscal year.

     Cost of sales. Cost of sales includes the cost of merchandise, freight to the stores and store occupancy costs. Store occupancy costs include rent, common area maintenance, real estate taxes, repairs and maintenance, depreciation, insurance and utilities.

     Store operating and selling expenses. Store operating and selling expenses consist of selling and store management payroll, employee benefits, medical insurance, employment taxes, advertising, pre-opening expenses which are expensed when incurred and other store level expenses.

     General and administrative expenses. General and administrative expenses include payroll and employee benefits, employment taxes, management information systems, marketing, insurance, legal and other corporate level expenses. Corporate level expenses are primarily attributable to our corporate office in Rockaway, New Jersey.

     Franchising. Franchise revenue is composed of the initial franchise fees, which are recorded as revenue when a franchise store opens, and ongoing royalty fees, generally 4.0% of the store’s net sales.

     Interest expense. Interest and debt expense includes interest relating to our senior notes and credit facility. Interest also includes amortization of financing intangibles, bank service charges and interest on capital lease obligations.

Quarter Ended September 27, 2003 Compared to Quarter Ended September 28, 2002

          Retail. Net sales from company-owned stores increased 12.6% to $102.6 million in the first quarter of Fiscal 2004 from $91.1 million in the same period last year. The first quarter of Fiscal 2004 results include 242 stores that were open at the beginning of Fiscal 2004 and six stores opened during the first quarter. Of the 12.6% increase in sales, 3.9% resulted from a same store sales increase and the remaining 8.7% relates to the stores that have not been open for one year. The same store sales increase was due to a 2.5% increase in the dollar amount of the average sale and an increase of 1.4% in the number of transactions.

     Gross profit, which is net sales minus cost of goods sold and occupancy costs, increased 6.0% to $28.3 million in first quarter of Fiscal 2004 from $26.7 million in the same period last year. The increase in the first quarter of Fiscal 2004 was due to increased sales volume. Gross margin was 27.6% and 29.3% of sales for the first quarter of Fiscal 2004 and Fiscal 2003, respectively. The decrease in gross margin percent was related primarily to a high level of promotional activity in July and August, and the continued emphasis on the clearance of discontinued merchandise as part of the Company’s strategic focus.

     Store operating and selling expenses increased 9.2% to $25.9 million for the first quarter of Fiscal 2004 from $23.7 million in the same period last year. The increase in store operating expenses is primarily attributable to increased expenses related to the additional stores opened since the same period last year. Store operating expenses were 25.2% of sales for the first quarter of Fiscal 2004 compared with 26.0% of sales in the same period last year due to a decrease in store opening expenses and a decrease in grand-opening advertising.

     Pre-opening expenses of $303,000 were recorded in the first quarter of Fiscal 2004 for six new stores opened during the first quarter of Fiscal 2004 and three stores projected to be opened later in the fiscal year. Pre-opening expenses of $409,000 were recorded in the first quarter of Fiscal 2003 related to 11 new stores opened during the quarter and for eight stores projected to be opened later in the fiscal year.