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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR THE PERIOD FROM JANUARY 1, 1998 TO JULY 3, 1999
COMMISSION FILE NUMBER 0-27826
PARTY CITY CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 22-3033692
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
400 COMMONS WAY, ROCKAWAY, NJ 07866
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (973) 983-0888
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
NONE NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
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 [ ] No [X]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
The aggregate market value of voting stock held by non-affiliates of the
Registrant on September 29, 1999, based on the closing sale price on such date,
was approximately $19,800,000.
The number of outstanding shares of the Registrant's common stock, $0.01
par value, as of September 29, 1999 was 12,455,538.
DOCUMENTS INCORPORATED BY REFERENCE
PORTIONS OF THE REGISTRANT'S PROXY STATEMENT FOR THE 1999 ANNUAL MEETING OF
SHAREHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III.
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PART I
ITEM 1. BUSINESS
Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party goods stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of
July 3, 1999, the Company had 215 Company-owned stores and 178 franchise stores
in its network.
RECENT DEVELOPMENTS
Audited Consolidated Financial Statements
The Company was unable to issue audited financial statements for the year
ended December 31, 1998 and timely file its 1998 Annual Report on Form 10-K with
the Securities and Exchange Commission ("SEC") primarily because of difficulties
associated with taking the year-end physical inventories and the related
reconciliation process. The Company has taken a complete physical inventory as
of July 3, 1999 and prepared consolidated financial statements for the
eighteen-month period from January 1, 1998 to July 3, 1999. As a result of the
failure to file the Form 10-K by March 31, 1999 the Company was in default of
Nasdaq's continued listing requirements. Trading in the Company's Common stock
was halted on May 6, 1999, and the Company was delisted on July 20, 1999.
Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. The
Company continues to use December 31 as its tax year end. The change to a 52-53
week calendar was made to facilitate comparable store sales computations. The
term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June
30, unless otherwise noted.
Financing Agreements
On April 24, 1998, the Company refinanced and replaced its then existing
$20 million loan facility with a $60 million secured revolving line of credit
agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit
Agreement"). Advances under the Credit Agreement originally bore interest, at
the Company's option, at the agent bank's base rate (the higher of the bank's
prime rate or the federal funds rate plus 1/2% per annum) or LIBOR plus an
applicable margin.
The Company's failure to issue its consolidated financial statements on a
timely basis is a default under the Credit Agreement. In addition to this
default, the Company did not meet certain of its financial covenants, including
those relating to minimum levels of profitability, net worth, liquidity, fixed
charge coverage and others. Consequently, the Company's debt was subject to
acceleration and is classified as a current liability in the consolidated
balance sheet at July 3, 1999. Amounts due to the lenders under the Credit
Agreement are secured by all the assets of the Company. Additionally, the Credit
Agreement restricts the payment of dividends.
In August 1999, the Company completed a comprehensive refinancing that
included entering into agreements with its existing bank lenders under the
Credit Agreement (the "Banks"), a new group of investors (the "Investors") and
its trade vendors. The Banks and the Company entered into a Standstill and
Forbearance Agreement (the "Bank Forbearance Agreement"). Under the Bank
Forbearance Agreement, the Banks have agreed not to exercise rights and remedies
based upon any existing defaults until June 30, 2000 unless a further event of
default occurs. The Company has agreed to reduce its outstanding bank borrowings
from the $58.6 million outstanding at July 3, 1999, to $15 million by October
30, 1999, to increase the interest rate on its bank debt to 2% over the bank's
prime interest rate, and to pay a forbearance fee of $580,000. Company
management intends to refinance its outstanding indebtedness to the Banks with
an asset-based lending arrangement. There is no assurance such a lending
arrangement can be obtained. The $15 million anticipated to be outstanding at
October 30, 1999 is due June 30, 2000 unless the Bank Forbearance Agreement is
extended or amended.
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On August 17, 1999, the Company received $30 million in financing from the
"Investors". The Investors purchased senior secured notes and warrants pursuant
to separate securities purchase agreements (the "Securities Purchase
Agreements") each dated as of August 16, 1999. Under these Securities Purchase
Agreements, the Company issued (i) $10 million of its 12.5% Secured Notes due
2003 (the "A Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the
"B Notes"); (iii) $5 million of its 13.0% Secured Notes due 2002 (the "C
Notes"); (iv) $10 million of its 14.0% Secured Notes due 2004 (the "D Notes",
and together with the A Notes, the B Notes and the C Notes, the "Notes"); and
(v) warrants (the "Warrants") to purchase 6,880,000 shares of the Company's
common stock at an initial exercise price of $3.00 per share. Up to $15 million
of the Notes is secured by a first lien that is pari passu with the liens under
the Credit Agreement under certain circumstances and all of the Notes are
secured by a second lien on all of the Company's assets. The Company issued the
Warrants in connection with the sale of the C Notes and the D Notes. The
Warrants may be exercised at any time before the close of business on August 16,
2006. The shares of Common Stock reserved for issuance under the Warrants
represent approximately 35% of the shares of Common Stock outstanding assuming
the exercise of the Warrants.
The Company also entered into an Investor Rights Agreement (the "Investor
Rights Agreement") with the Investors and Jack Futterman. In this agreement, the
Company granted registration rights with respect to shares of Common Stock owned
by the Investors. The Company has agreed to nominate two individuals, designated
by the Investors, to its Board of Directors. Under the Investor Rights
Agreement, the Investors agree that they will not, without the prior written
consent of the Board of Directors, (i) acquire or agree to acquire, publicly
offer or make any public proposal with respect to the possible acquisition of
(a) beneficial ownership of any securities of the Company, (b) any substantial
part of the Company's assets, or (c) any rights or options to acquire any of the
foregoing from any person; (ii) make or in any way participate in any
"solicitation" of "proxies" (as such terms are defined in the rules of the
Securities Exchange Act of 1934, as amended) to vote, or seek to advise or
influence any person with respect to the voting of any voting securities of the
Company; or (iii) make any public announcement with respect to any transaction
between the Company or any of its securities holders and the Investors,
including without limitation, any tender or exchange offer, merger or other
business combination of a material portion of the assets of the Company. These
standstill provisions terminate if the Company's consolidated earnings before
interest, taxes, depreciation and amortization and exclusive of special charges,
as defined in the Investor Rights Agreement, do not meet specified targets.
Party City's trade vendors representing approximately $36.4 million of
trade debt have also entered into an agreement with the Company. Pursuant to a
Vendor Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"),
these trade vendors agreed to forbear from taking any action against Party City
until January 15, 2000, unless an event of default occurs. The trade vendors
have received promissory notes from Party City representing one-third of their
unpaid claims as of May 1, 1999 (the "Trade Notes"). The Trade Notes bear
interest at a rate of 10% per year and mature on November 15, 1999. Interest on
the Trade Notes is due on January 15, 2000, unless the borrowings under the
Credit Agreement are refinanced before then. On January 15, 2000, Company
management believes it will resume normal credit terms with substantially all of
its vendors. Upon such event, management believes the remaining two-thirds of
the unpaid claims as of May 1, 1999 will be satisfied through individual
arrangements with its vendors. However, there can be no assurance that the
Company will successfully conclude these arrangements. Separately, certain
seasonal trade vendors have agreed to extend certain credit to Party City for
30% of purchases for the Halloween, Thanksgiving and end of year holiday
seasons. Vendors that have agreed to extend credit will receive a shared lien
that is pari passu with the liens of the Credit Agreement on the Company's
inventory for the amount of the credit extended.
Also, in connection with these transactions, one outside director of the
Company resigned and two representatives of the Investors joined the Board of
Directors. One of these directors (who was a temporary appointee) is being
replaced.
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The proceeds from the sale of the Notes has been used as follows (in
thousands):
Purchase of seasonal inventory.............................. $20,000
Payment of amounts under the Credit Agreement............... 4,000
Transactions fees........................................... 450
Working capital............................................. 5,550
-------
Total proceeds.................................... $30,000
-------
The Company's unaudited pro forma consolidated balance sheet as of July 3,
1999, after giving effect to the transactions described above is as follows (in
thousands):
JULY 3, PRO FORMA PRO FORMA
1999 ADJUSTMENTS JULY 3, 1999
-------- ----------- ------------
(UNAUDITED) (UNAUDITED)
ASSETS
Cash and cash equivalents......................... $ 11,470 $ 25,550 $ 37,020
Merchandise inventory............................. 47,016 -- 47,016
Other current assets.............................. 29,615 -- 29,615
-------- -------- --------
Total current assets............................ 88,101 25,550 113,651
Property and equipment............................ 50,557 -- 50,557
Goodwill, net..................................... 18,483 -- 18,483
Other assets...................................... 906 450 1,356
-------- -------- --------
Total Assets............................ $158,047 $ 26,000 $184,047
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable -- trade....................... $ 45,114 $(12,133) $ 32,981
Trade Notes..................................... -- 12,133 12,133
Accrued expenses................................ 10,145 -- 10,145
Credit Agreement................................ 58,550 (4,000) 54,550
Other current liabilities....................... 986 -- 986
-------- -------- --------
Total current liabilities............... 114,795 (4,000) 110,795
Long-term Liabilities:
Senior Secured Notes............................ -- 28,200 28,200
Other long-term liabilities..................... 7,318 -- 7,318
Stockholders' equity.............................. 35,934 1,800 37,734
-------- -------- --------
Total liabilities and stockholders
equity................................ $158,047 $ 26,000 $184,047
======== ======== ========
Sales of Company-Owned Stores
In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company began a program to identify stores for sale to existing
franchisees to generate working capital. Eighteen stores with a net book value
of approximately $9,150,000 were sold to franchisees, of which seventeen stores
with a net book value of approximately $8,750,000 were sold subsequent to July
3, 1999. In connection with the sales, normal franchise fees were waived for
negotiated periods up to five years. The total proceeds from the sales of these
stores are approximately $9,883,000, of which $9,683,000 was received subsequent
to July 3, 1999. The net proceeds from the sale of stores is required under the
Bank Forbearance Agreement to be used to pay down the outstanding borrowings
under the Credit Agreement.
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GENERAL
The Company is a specialty retailer of party supplies through its network
of discount stores. At September 20, 1999, the Company owned and operated 198
Company-owned stores in the United States and its franchisees operated an
additional 204 stores in the United States, Puerto Rico, Canada, Portugal and
Spain. The Company, based in Rockaway, New Jersey, believes it is one of the
largest party supplies specialty chains. The Company authorized the first
franchise store in 1989 and opened its first Company-owned store in January
1994.
The Company operates and franchises party supplies stores that generally
range in size from 8,000 square feet to 12,000 square feet. These stores offer a
broad selection of merchandise (brand name as well as private label) for a wide
variety of celebratory occasions, including birthday parties, weddings, and baby
showers as well as seasonal events such as Halloween, Christmas, New Year's Eve,
Graduation, Easter, Valentine's Day, Thanksgiving, St. Patrick's Day, the Super
Bowl and the Fourth of July. Party City seeks to offer customers a "one-stop"
party store that provides a wide selection of merchandise at everyday low
prices. A key element of delivering customer satisfaction is stocking inventory
in sufficient quantities to satisfy customer needs for parties of virtually all
sizes and types.
INDUSTRY OVERVIEW
The retail party supplies business has traditionally been a fragmented one,
with consumers purchasing party-related products from single owner-operated
party supplies stores and designated departments in drug stores, general mass
merchandisers, supermarkets, and department stores of local, regional and
national chains. According to industry sources, the market for party and special
occasion merchandise, comprised of party supplies, greeting cards, gift wrap and
related items is estimated at $11.5 billion in sales in 1998.
The Company believes that the increasing breadth of party supplies
merchandise produced by manufacturers over the past few years has been a driving
factor in the marketplace's acceptance of the party supplies store concept.
Further, the Company believes that the significant revenues experienced by its
Company-owned and franchise stores in the calendar year fourth quarter can be
attributed, to a large extent, to the growth in the number of persons
celebrating Halloween and the increased demand for costumes and party supplies
utilized in such celebrations. The Company has noted the marketplace's
acceptance of other types of superstores and mega-retailers in various
categories such as food, home furnishings and pet supplies, among others. The
success of such superstores and mega-retailers in other industries has prompted
the Company to expand its product lines to include a wider breadth of
merchandise in order to make its stores attractive destination shopping
locations for party supplies. In addition, Company management believes that the
increased breadth of related and integrated merchandise available to customers
in superstores and mega-retailers influences consumers to increase the number of
purchases in a given trip to a retailer. As such, the Company believes that the
broad selection, and relatively low price points, of merchandise offered by its
stores often stimulates customers to purchase additional items on impulse.
BUSINESS STRATEGY
The Company's objective is to maintain its position as a leading
category-dominant national chain of party supplies stores. The Company believes
that it has transformed the party supplies business by introducing increased
product and marketing focus and greater mass merchandising sophistication. In
order to maintain continued store growth, Company management is continuing to
invest in its human resources and management information systems to further
improve the infrastructure necessary to manage continued growth. Key components
of the Company's strategy are:
Offer the Broadest Selection of Merchandise in an Exciting Shopping
Environment. The Company tries to provide party-planners and party-goers with
convenient one-stop shopping for party supplies and offers what it believes is
one of the most extensive selections of party supplies. A typical Party City
store contains approximately 20,000 SKUs. Within its many product categories,
Party City offers a wide variety of patterns, colors and styles. The Company has
been expanding the range of items which it offers in order to create
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consumer loyalty and generate repeat business by striving to maintain a new and
exciting product selection. Further, the Company believes that its broad
selection of merchandise and relatively low price points often stimulates
consumers to purchase additional party supplies on impulse.
Establish Convenient Store Locations. While the Company believes that its
stores typically are destination shopping locations, it seeks to maximize
customer traffic and quickly build the visibility of new stores by situating its
stores in high traffic areas. Site selection criteria include: population
density; demographics; traffic counts; complementary retailers; storefront
visibility and presence (either in a stand-alone building or in a strip or power
shopping center); competition; lease rates; and accessible parking. The Company
believes there is an extensive number of suitable locations available for future
stores.
Maintain Everyday Low Pricing. The Company uses the buying power of its
402 Company-owned and franchise stores network to attempt to obtain volume
discounts from its vendors on most products, allowing the stores to offer a
broad line of high quality merchandise at competitive prices. The Company
reinforces customers' expectations of savings by prominently displaying signs
announcing its everyday low prices. The Company also maintains a lowest price
guaranty policy, to which it suggests its franchisees adhere. This policy
guarantees that Party City will meet and discount the advertised prices of a
competitor's products. The Company believes that this policy has helped foster
the Company's image of offering consumers exceptional value for their money.
Provide Excellent Customer Service. The Company views the quality of its
customers' shopping experience as critical to its continued success. The Company
is committed to making shopping in its stores an enjoyable experience through
the employment of friendly, knowledgeable and energetic sales associates who
provide customers with personalized shopping assistance. At Halloween, the most
important selling season for the Company, each store increases significantly the
number of sales associates to ensure prompt service. Sales associates assist
customers in selecting or finding a certain item, which provides the sales
associates with a cross-selling opportunity to suggest accessories or other
complementary products. The Company believes that the compensation of its store
managers and other personnel is competitive and enables the Company to attract
and retain well-qualified, motivated employees who are committed to providing
excellent customer service.
Human Resources. During the first six months of calendar 1999, Company
management has made human resources one of its key components of the Company's
long-term growth strategy. During calendar 1999, the Company hired several
individuals in key management positions and reassigned other members of
management to effectively define its strategic objectives and target significant
goals for the upcoming fiscal year. While the number of corporate personnel was
decreased in 1999, key additions to the finance and management information
systems groups were made.
EXPANSION PLANS
The Company's long-term goal regarding expansion is to increase its market
share in existing markets and penetrate new markets with a goal of maintaining a
leading position as a category-dominant retailer of party supplies merchandise.
During Fiscal 2000, the Company intends to focus its efforts to create the
necessary
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management infrastructure and control environment to support continued growth.
Over the next few years, the Company intends to balance growth between
Company-owned stores and opening franchise stores to meet its growth objectives.
STORE LOCATIONS
As of September 20, 1999, there were 402 Party City stores open in the
United States, Canada, Puerto Rico, Portugal and Spain. Of these, 198 were
Company-owned and 204 were operated by the Company's independent franchisees.
The following table shows the growth in the Company's network of stores.
YEAR ENDED DECEMBER 31, SIX MONTHS JULY 4, 1999
-------------------------------------------- ENDED TO
1993 1994 1995 1996 1997 1998 JULY 3, 1999 SEPTEMBER 20, 1999
---- ---- ---- ---- ---- ---- ------------ ------------------
COMPANY-OWNED:
Stores open at beginning of
period...................... -- -- 7 16 36 117 207 215
Stores opened................. -- 7 9 20 57 81 9 --
Stores closed................. -- -- -- -- -- -- -- --
Stores acquired from
franchisees................. -- -- -- -- 24 9 -- --
Stores sold to franchisees.... -- -- -- -- -- -- (1) (17)
-- --- --- --- --- --- --- ---
Stores open at end of
period...................... -- 7 16 36 117 207 215 198
FRANCHISE:
Stores open at beginning of
period...................... 32 58 99 132 164 158 167 178
Stores opened................. 26 42 35 32 19 19 11 9
Stores closed................. -- (1) (2) -- (1) (1) (1) --
Stores purchased by the
Company..................... -- -- -- -- (24) (9) -- --
Stores sold by the Company.... -- -- -- -- -- -- 1 17
-- --- --- --- --- --- --- ---
Stores open at end of
period...................... 58 99 132 164 158 167 178 204
-- --- --- --- --- --- --- ---
TOTAL COMPANY AND FRANCHISE
STORES........................ 58 106 148 200 275 374 393 402
The Company typically seeks sites for new stores that are stand-alone
buildings or that are located in a strip or power shopping center near high
traffic routes. The Company seeks to lease sites rather than own the real
estate. Often the site may be a shopping center under construction or renovation
and may be available for occupancy typically in a period ranging from three
months to one year. The Company's site selection criteria include, but are not
limited to: population density and/or demographics; traffic count; complementary
retailers; store-front visibility and presence; competition; lease rates; and
accessible parking. In addition, the Company carefully considers the presence of
existing, and the potential for future, competition in the market when selecting
a site. The Company believes there is an extensive number of suitable locations
available for future sites.
MERCHANDISING
Store Layout.
Party City stores are designed to give the shopper a feeling of excitement
and create a festive atmosphere. The Company's goal is for the customer to be
pleasantly surprised by his or her shopping experience. The Company's strategy
to achieve this goal is to maintain an in-stock position of a wide selection of
party supplies. Party City stores range in size from 6,750 to 15,876 square feet
with a typical store size between 8,000 and 12,000 square feet. The stores are
divided into various sections of different categories of party supplies,
displayed to emphasize the everyday low prices and breadth of merchandise
available. The floor plan is designed to impress the customer with the breadth
of selection in each product category.
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Product Categories.
The typical Party City store offers a broad selection of merchandise
consisting of over 20,000 SKUs divided into the following categories:
Halloween. As a key component of its sales strategy, Party City stores
provide an extensive selection of costumes for Halloween through its
"Halloween Costume Warehouse" department. The stores also carry a broad
array of decorations and accessories for the Halloween season. The Halloween
merchandise is prominently displayed to provide an exciting and fun shopping
experience for customers. The Company, because of the buying power of the
Party City network, is often able to obtain supplies of some of the most
sought after Halloween-related merchandise. The stores display
Halloween-related merchandise throughout the year to position the Company as
the customer's Halloween shopping resource. The Company believes that the
importance of Halloween, among both young children and adults, is growing
significantly.
Seasonal. Customer purchases made for seasonal holiday events compose a
significant part of Party City's business. The seasonal category includes
products which are carried for the Super Bowl, Valentine's Day, St.
Patrick's Day, Passover, Easter, First Communion, Graduation, the Fourth of
July, Christmas, Hanukkah and New Year's Eve. Some of the major items within
this category are tableware, decorations, cutouts, lights and balloons
tailored to the particular event.
Baby Shower. The Company maintains a baby shower department, which includes
tableware, decorations, balloons, favors, centerpieces and garlands.
Balloons. The Company maintains a balloon department, which carries a vast
selection of basic and decorative latex balloons in various sizes,
qualities, colors and package sizes. The balloon department also carries
Mylar balloons in numerous sizes, shapes and designs relating to birthday,
seasonal, anniversary and other themes.
Birthdays. The birthday product category includes a wide assortment of
merchandise to fulfill customer needs for celebrating birthdays, including
special ones such as "first," "sweet sixteen" and other milestone birthdays
such as 40th and 50th birthdays. Some of the products in this category
include invitations, thank you cards, tableware, hats, horns, banners,
cascades, balloons, novelty gifts, pinatas and candies.
Bridal/Wedding/Anniversary. This product category includes personalized
invitations, tableware, balloons, favors, place setting cards, confetti,
honeycomb bells and personalized ribbons. Personalized invitation books
containing numerous samples of customizable event invitations are carried
from the leading invitation stationers at discounted prices.
Candy. The candy product category includes novelty and packaged candy sold
to enhance children's parties or to be used as pinata fillers. Candy is sold
both in individual units and in bulk packaging for customers' convenience.
Catering Supplies. Party City stores offer a broad selection of catering
supplies that consists of trays, platters, foil, bowls, warming racks and
fuel.
Gift Wrap. This product category includes wide assortments of gift bags,
bows, tissue paper, ribbons, printed bags and gift wrap.
Greeting Cards. This product category includes greeting cards from quality
national card vendors at discount prices.
General. The Company carries a range of other products, including
tableware, table covers, cutlery, crepe paper, cups and tumblers. Party City
stores carry private label items, as well as brand name merchandise.
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Party Favors. The Company maintains a party favors department that includes
a broad selection of packaged and bulk favors appealing to different age
groups. The assortment includes different product lines varying in price
points designed to offer customers a variety of purchasing options.
Product Selection, Purchasing and Suppliers.
The Company's management continuously reviews new and existing product
selections to provide the widest, most current assortment of party supplies. In
pursuit of this goal, management attends various industry trade shows including
the National Annual Halloween Trade Show in Rosemont, Illinois and the Toy Fair
in New York. In an effort to keep abreast of new and popular merchandise,
management views presentations given specifically for the Company by its major
vendors. The Company utilizes its inventory tracking system to give the
purchasing staff constant feedback on customers' preferences.
The Company relies on its suppliers for the purchase of its merchandise.
The Company had two suppliers who in the aggregate constituted approximately 21%
of the Company's purchases for the eighteen-month period ended July 3, 1999. The
loss of either of these suppliers would adversely affect the Company's
operations. The Company considers numerous factors in supplier selection,
including price, credit terms, product offerings and quality. The Company
negotiates pricing with suppliers on behalf of all stores in the system (both
Company-owned and franchise) and believes that such buying power enables it to
not only receive the most favorable pricing terms, but, as importantly, to more
readily obtain high demand merchandise, especially popular Halloween costumes.
In order to maintain consistency throughout its store network, the Company
has established an approved list of items that are permitted to be sold in Party
City stores. Franchise stores must adhere to these guidelines according to the
terms of their franchise agreements. The Company establishes a standard store
merchandise layout and presentation format to be followed by Company-owned and
franchise stores. Any layout or format changes developed by the Company are
communicated to the managers of stores on a periodic basis. All of the
merchandise purchased by stores is shipped directly from suppliers to the
stores.
STORE OPERATIONS
Each Party City store is typically managed by a general manager and two
assistant managers. These managers are responsible for all aspects of the
store's day-to-day operations, including employee hiring and training, work
scheduling, inventory control, expense control, maintenance activities and
communications with central office staff. The sales and stocking staff ranges
from three to eight people, except during certain holiday selling seasons when
additional store employees are used. The Company seeks to pay its store managers
toward the higher end of the competitive pay scale in order to hire and retain
experienced and dedicated managers. In addition, managers of Company-owned
stores are eligible for stock option grants under the Company's stock option
plan.
Training. In Company-owned stores, corporate store managers are trained
for a minimum of two weeks prior to the opening of a store. During the store
set-up, a manager receives additional training from the Company's store set-up
team. During the first few days after the initial opening of a store, corporate
headquarters' personnel spend concentrated time in the store overseeing the
operations.
In franchise locations, all franchisees go through a training program
consisting of one week in the classroom and one week in the store to learn the
fundamentals of the store's operation. During the set up of their store, the
franchisee receives additional training from the team leader of the set-up crew
that is dispatched by the Company to assist the franchisee with the store
opening. Shortly after a store opens, a representative from the Company visits
the franchisee and spends several days assisting with the day-to-day operations
of running the store. To ensure efficient operations and that the systems,
policies and processes are being followed, subsequent visits are scheduled on a
regular basis to review what was covered during the initial training.
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CUSTOMER SERVICE
Customer service and shopping convenience are integral components of Party
City's one-stop shopping concept. The Company views the quality of its
customers' shopping experience as critical to its continued success. To this
end, the Company seeks to employ friendly, knowledgeable and energetic sales
associates who provide customers with personalized shopping assistance. For
example, at Halloween, the most important selling season for the Company, each
store increases significantly the number of sales associates in the store. These
employees assist customers in selecting a costume. This provides the sales
associates with a cross-selling opportunity to suggest various accessories and
other complementary products. Also, at Halloween the associates use two-way
radios to help stock personnel quickly fill requested items, expediting sales
and reducing lost business caused by slow service.
Company management believes that the compensation of its store managers and
other personnel is competitive and enables the Company to attract and retain
well-qualified, highly motivated employees who are committed to providing
excellent customer service.
COMPANY-OWNED STORES
Company management believes that a key component in its future growth in
operations will come from Company-owned stores. At September 20, 1999, there
were 198 Company-owned Party City stores, including 81 stores opened in 1998,
nine franchised stores purchased by the Company in 1998, and nine new stores
opened and one store sold in the period from January 1, 1999 to July 3, 1999. In
the period from July 4, 1999 to September 20, 1999, the Company sold an
additional 17 stores to comply with the requirements of its banks under the
Credit Agreement and to improve its liquidity.
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11
The Company's stores are located in the following states:
DECEMBER 31,
------------------------------------ JULY 3, SEPTEMBER 20,
STATE 1994 1995 1996 1997 1998 1999 1999
- ----- ---- ---- ---- ---- ---- ------- -------------
California................. 1 2 8 21 36 37 37
Connecticut................ 1 1 1 3 4 4 4
Florida.................... 2 3 6 11 18 17 16
Illinois................... 1 1 3 8 15 15 15
New York................... 1 2 7 16 33 34 32
Pennsylvania............... 1 1 1 5 8 9 8
Maryland................... -- 1 2 3 4 4 3
Michigan................... -- 4 5 7 7 7 7
Ohio....................... -- 1 1 2 7 7 7
Nevada..................... -- -- 1 2 3 3 3
New Jersey................. -- -- 1 9 14 14 9
Indiana.................... -- -- -- 5 5 5 5
Minnesota.................. -- -- -- 3 5 5 5
Missouri................... -- -- -- 3 3 4 4
Texas...................... -- -- -- 15 22 22 22
Virginia................... -- -- -- 3 5 6 6
Wisconsin.................. -- -- -- 1 1 1 1
Colorado................... -- -- -- -- 2 2 2
Kentucky................... -- -- -- -- 1 1 1
Georgia.................... -- -- -- -- 1 1 --
Kansas..................... -- -- -- -- 1 1 --
Massachusetts.............. -- -- -- -- 3 3 3
North Carolina............. -- -- -- -- 2 2 --
Tennessee.................. -- -- -- -- 4 4 1
Utah....................... -- -- -- -- 1 1 1
Washington................. -- -- -- -- 2 3 3
Louisiana.................. -- -- -- -- -- 3 3
-- -- -- --- --- --- ---
TOTAL............ 7 16 36 117 207 215 198
Of the leases for the stores listed above, five expire in 2001, six expire
in 2002 and the balance expire in 2003 or thereafter. The Company has options to
extend each of such leases for a minimum of five years.
FRANCHISE OPERATIONS
Until opening its first Company-owned store in January 1994, the Company
operated exclusively as a franchisor. As of September 20, 1999, the Company had
204 franchise stores throughout the United States, Puerto Rico, Canada, Portugal
and Spain. A Party City store run by a franchisee utilizes the Company's format,
design specifications, methods, standards, operating procedures, systems and
trademarks.
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12
The Company's franchise stores are located in the following states and
foreign countries:
Alabama.............................................. 6
Arizona.............................................. 7
Arkansas............................................. 1
California........................................... 11
Colorado............................................. 1
Connecticut.......................................... 4
Delaware............................................. 1
Florida.............................................. 15
Georgia.............................................. 19
Hawaii............................................... 1
Illinois............................................. 1
Kansas............................................... 3
Louisiana............................................ 7
Maryland............................................. 6
Mississippi.......................................... 2
Missouri............................................. 1
New Jersey........................................... 24
New Mexico........................................... 3
New York............................................. 12
North Carolina....................................... 14
Ohio................................................. 3
Oregon............................................... 3
Pennsylvania......................................... 8
South Carolina....................................... 4
Tennessee............................................ 8
Texas................................................ 9
Virginia............................................. 5
Puerto Rico.......................................... 4
Canada............................................... 16
Portugal............................................. 1
Spain................................................ 4
---
TOTAL...................................... 204
The Company receives revenue from its franchisees, including an initial
one-time fee (currently at $35,000) and an ongoing royalty fee (currently 4.0%
of net sales for new franchisees, payable monthly). In addition, each franchisee
has a mandated advertising budget, which consists of a minimum of $5,500 to
promote the initial store opening and thereafter the lesser of 3.0% of net sales
or $60,000 per year for local advertising and promotions. Further, the
franchisee must pay an additional 1.0% of net sales to a Party City group
advertising fund to cover common advertising materials related to Ad Fund. The
Company does not offer financing for a franchisee's initial investment.
Franchise start-up expenses include the franchise fee, rent, leasehold
improvements, equipment and furniture, initial inventory, opening promotion,
signs, other deposits, insurance, training expenses and professional fees. In
connection with the sale of 18 stores to franchisees as part of the
Restructuring, the Company agreed to waive franchise royalty fees in respect of
such stores for negotiated periods of up to five years.
Current franchise agreements provide for an assigned area or territory that
typically equals a three-mile radius from the franchisee's store location and
the right to use the Party City logo type and trademark "The Discount Party
Super Store(R)." In most stores, the franchisee or the majority shareholder of a
corporate franchisee devotes full time to the management, operation and
on-premises supervision of the franchise.
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Although such locations are generally obtained and secured by the
franchisee, pursuant to the franchise agreement entered into with franchisees,
the Company must approve all site locations. As franchisor, Party City also
supplies valuable and proprietary information pertaining to the operation of the
Party City store business, as well as advice regarding location, improvements
and promotion. The Company also supplies consultation in the areas of
purchasing, inventory control, pricing, marketing, merchandising, hiring,
training, improvements and new developments in the franchisee's business and
general business operations, as well as the provision of assistance in opening
and initially promoting the store.
As of September 20, 1999, the Company had eight territory agreements with
certain franchisees. These agreements permit the holder of the territory rights
to open a minimum of two and in some cases three or more stores within a stated
time period. The following areas are governed by territory agreements: North
Carolina; Fort Myers/Naples FL; Arkansas; Buffalo/Rochester, NY; Atlanta, GA;
Canada; Spain/Portugal; Puerto Rico.
COMPETITION
The party supplies retailing business is highly competitive. Party City
stores compete with a variety of smaller and larger retailers, including single
owner-operated party supplies stores, specialty party supplies retailers
(including superstores), designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local, regional and
national chains and catalog and Internet stores. Many of these competitors have
substantially greater financial resources than the Company.
Management believes that Party City stores maintain a leading position in
the party supplies business by offering a wider breadth of merchandise, greater
selection within merchandise class and discount prices offered on most items in
the stores. The Company believes that the significant buying power resulting
from the size of the Party City store network is an integral advantage.
TRADEMARKS
The Company has licensed from a wholly owned subsidiary a number of
trademarks and service marks registered with the United States Patent and
Trademark Office, including the marks Party City(R), The Discount Party Super
Store(R) and Halloween Costume Warehouse(R).
GOVERNMENT REGULATION
As a franchisor, the Company must comply with regulations adopted by the
Federal Trade Commission (the "FTC") and with several state laws that regulate
the offer and sale of franchises. The Company also must comply with a number of
state laws that regulate certain substantive aspects of the
franchisor-franchisee relationship. The FTC's Trade Regulation Rule on
Franchising (the "FTC Rule") requires that the Company furnish prospective
franchisees with a franchise offering circular containing information prescribed
by the FTC Rule. State laws that regulate the offer and sale of franchises
require the Company to register before the offer and sale of a franchise can be
made in that state.
State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees and by regulating discrimination among franchisees
with regard to charges, royalties or fees. Those laws also restrict a
franchisor's rights with regard to the termination of a franchise agreement (for
example, by requiring "good cause" to exist as a basis for the termination) by
requiring the franchisor to give advance notice to the franchisee of the
termination and give the franchisee an opportunity to cure any default, and by
requiring the franchisor to repurchase the franchisee's inventory or provide
other compensation. To date, those laws have not precluded the Company from
seeking franchisees in any given area and have not had a material adverse effect
on the Company's operations.
Each Party City store must comply with regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties
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or failures in obtaining the required licenses or approvals can delay and
sometimes prevent the opening of a new store.
Party City stores must comply with federal and state environmental
regulations, but the cost of complying with those regulations has not been
material. More stringent and varied requirements of local governmental bodies
with respect to zoning, land use, and environmental factors can delay, and
sometimes prevent, development of new stores in particular locations.
The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters such as minimum wages,
overtime and other working conditions. The Company and its franchisees also must
comply with the provisions of the Americans with Disabilities Act. The Act
requires that employers provide reasonable accommodation for employees with
disabilities and that stores be accessible to customers with disabilities.
EMPLOYEES
As of September 20, 1999, the Company employed approximately 1,370
full-time and 4,870 part-time employees. The Company considers its relationships
with its employees to be good. None of the Company's employees is covered by a
collective bargaining agreement.
INFLATION AND SEASONALITY
The Company does not believe that its operating results have been
materially affected by inflation during the past year. There can be no
assurance, however, that the Company's operating results will not be affected by
inflation in the future.
The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
and substantially all of its net income for the year during the fourth calendar
quarter of the year, principally due to the sales in October for the Halloween
season and, to a lesser extent, due to holiday sales for Thanksgiving, Christmas
and New Year's. The Company's results of operations may also fluctuate
significantly as a result of a variety of other factors, including the timing of
new store openings. The Company believes this general pattern will continue in
the future.
ITEM 2. PROPERTIES
As of September 20, 1999, the Company leased 198 stores and had signed
leases for four additional stores. The Company leases its headquarters property
in Rockaway, New Jersey. The Company occupies approximately 12,600 square feet
of office space for its headquarters under a lease expiring in 2005.
ITEM 3. LEGAL PROCEEDINGS
Party City of Greenbrook, Inc., et al., v. Party City Corp.
The Company was named as a defendant in a complaint filed with the Supreme
Court of the State of New York, County of New York, on January 16, 1998 (the
"Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung,
Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of
Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in
the suit have existing Party City franchise stores, with the remaining plaintiff
possessing a right of first refusal to develop a Party City store in Watchung,
New Jersey.
The Complaint stated various causes of action, including unjust enrichment,
unfair competition, fraud and misrepresentation, breach of contract,
misappropriation of information and violations of the New Jersey Franchise
Practices Act and the New York State Franchise Sales Act. The crux of the
Complaint was that the Company undertook a course of conduct intentionally
designed to adversely impact the value of the Plaintiffs'
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franchise stores in order to permit the Company to purchase such stores at a
substantially reduced value. The Company settled the lawsuit on June 30, 1999,
at no cost to the Company. In connection with the settlement, the Company agreed
to sell the plaintiff one store at its fair value.
In re Party City Corporation Securities Litigation
The Company has been named as a defendant in the following twelve class
action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David
Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party
City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4)
Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No.
99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven
Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party
City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City
Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel
v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No.
99-CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber,
Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven Mandell
and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief
Executive Officer and former Chief Financial Officer and Executive Vice
President of Operations have also been named as defendants. The complaints have
all been filed in the United States District Court for the District of New
Jersey. The complaints were filed as class actions on behalf of persons who
purchased or acquired Party City common stock during various time periods
between February 1998 and March 19, 1999.
The complaints allege, among other things, violations of sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
thereunder, and seek unspecified damages. The plaintiffs allege that defendants
issued a series of false and misleading statements and failed to disclose
material facts concerning, among other things, the Company's financial
condition, adequacy of internal controls and compliance with certain loan
covenants. The plaintiffs further allege that because of the issuance of a
series of false and misleading statements and/or failure to disclose material
facts, the price of Party City common stock was artificially inflated.
On September 13, 1999, the Court signed an Order appointing lead plaintiffs
and lead counsel to represent the classes alleged in the complaints. The Order
directs plaintiffs to file a consolidated and amended complaint in October 1999.
Emil Asch, Inc. v. Amscan, Inc. et al.
On April 23, 1999, plaintiff Emil Asch, Inc. filed a complaint in the
United States District Court for the Eastern District of New York against the
Company and co-defendants Amscan, Inc., Hallmark, Inc., and Rubie's Costume. The
complaint alleges five violations of the Robinson-Patman Act, which pertains to
price discrimination, unfair competition tortious interference with contractual
relations, and false and deceptive advertising.
Plaintiff seeks damages of $2 million, as well as treble and punitive
damages for certain counts. The Company has answered the Complaint, and
discovery should proceed shortly.
Although the Company's management is unable to express a view on the likely
outcome of these litigations because they are in their early stages, they could
have a material adverse effect on the Company's business and results of
operations.
In addition to the foregoing, the Company is from time to time involved in
routine litigation incidental to the conduct of its business. As of September
30, 1999, the Company is aware of no other material existing or threatened
litigation to which it is or may be a party.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
EXECUTIVE OFFICERS OF THE REGISTRANT
NAME POSITION AGE
- ---- -------- ---
Jack Futterman.......................... Chairman of the Board and Chief Executive Officer 66
Thomas E. Larson........................ Senior Vice President and Chief Financial Officer 52
Gordon Keil............................. Senior Vice President, Franchising and Administration 50
Jack Futterman, 66, has been Chairman of the Board of Directors and Chief
Executive Officer of the Company since June 8, 1999 and has been a Director of
the Company since October 1997. From 1989 until his retirement in 1996, Mr.
Futterman was Chairman and Chief Executive Officer of Pathmark Stores. From 1973
until his appointment as Chairman and Chief Executive Officer, Mr. Futterman
served as Vice President of Supermarkets General (the parent company of Pathmark
Stores) and occupied a number of positions before becoming Chairman and Chief
Executive Officer. A Registered Pharmacist, Mr. Futterman also serves as a
Director of Del Laboratories, Inc. and Hain Food Group as well as several
not-for-profit corporations.
Thomas E. Larson, 52, served as a consultant to the Company from April 1999
through June 1999, when he was named Chief Financial Officer and Senior Vice
President of the Company. From November 1996 to June 1999, Mr. Larson was
co-founder and Chief Financial Officer of Hidden Oaks Technology Corp., a
privately held Internet software development company. From September 1991
through November 1996, Mr. Larson served as Senior Vice President -- Finance for
Ace Cash Express, Inc., a publicly traded Nasdaq retail financial services
company with over 600 locations nationally.
Gordon Keil, 50, is currently the Company's Senior Vice President,
Franchising and Administration, and oversees Franchise Operations, Human
Resources, Real Estate and Legal. Mr. Keil joined the Company in June 1996 as
Chief Operating Officer. Initially, Mr. Keil oversaw Store Operations, Human
Resources and Franchise Relations. He also oversaw Merchandising for part of
1996-1997. Prior to joining the Company in 1996, Mr. Keil had been the founder
and President of Gordon's Stores, Inc., a chain of discount drugstores.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock traded on the Nasdaq National Market under the
symbol "PCTY" until the Company was delisted on July 20, 1999. The Common Stock
now trades on the OTC Bulletin Board, an electronic quotation service for NASD
Market Makers. There can be no assurance that the Common Stock will continue to
trade on the OTC Bulletin Board. It is the Company's intention to again seek to
be listed on Nasdaq if and when the Company satisfies the requirements for
listing.
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The following table sets forth the high and low closing sale prices of the
Common Stock through July 3, 1999.
HIGH LOW
---- ---
1999
Second Quarter.............................................. 4 7/16 2 3/4
First Quarter............................................... 19 1/2 2 1/8
1998
Fourth Quarter.............................................. 21 9 3/16
Third Quarter............................................... 30 19/32 8 11/16
Second Quarter.............................................. 35 1/4 24 3/4
First Quarter............................................... 35 16 3/4
1997
Fourth Quarter.............................................. 21 1/2 15 15/16
Third Quarter............................................... 20 1/16 10 3/4
Second Quarter.............................................. 11 1/8 8 7/8
First Quarter............................................... 11 1/8 10
At September 20, 1999, the approximate number of holders of record of the
Common Stock was approximately 3,500.
DIVIDENDS
Except for the S Corporation distribution of a portion of previously
undistributed earnings to the Company's stockholders in 1994 upon the Company's
election to be taxed as a C Corporation, the Company has never paid cash
dividends on its capital stock and does not intend to pay cash dividends for the
foreseeable future. The Company expects that earnings will be retained for the
continued growth and development of the Company's business. Future dividends, if
any, will depend upon the Company's earnings, financial condition, working
capital requirements, compliance with covenants in agreements to which the
Company is or may be subject, future prospects and other factors deemed relevant
by the Company's Board of Directors. Under various agreements to which the
Company is a party, including the Credit Agreement, the Company is not permitted
to pay any dividends. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."
UNREGISTERED SECURITIES
On August 17, 1999, the Company issued the Notes and the Warrants to the
Investors for an aggregate of $30 million. The Investors were led by Tennenbaum
& Co., LLC, a Los Angeles-based investment firm.
The Warrants are exercisable for an aggregate of 6,880,000 shares of Common
Stock at an initial exercise price of $3.00 per share and may be exercised at
any time before 5:00 p.m. (New York City time) on August 16, 2006. The shares of
Common Stock reserved for issuance under the Warrants represent approximately
35% of the shares of Common Stock outstanding after giving effect to the
exercise of the Warrants. The private placement of the issuance and sale of the
Notes and Warrants to the Investors was exempt from the registration
requirements of the Securities Act of 1933, as amended (the "Securities Act"),
pursuant to Section 4(2) of the Securities Act.
ITEM 6. SELECTED FINANCIAL DATA
The following Selected Financial Data for each of the years ended December
31, 1994 and 1995 and as of December 31, 1996, are derived from the consolidated
financial statements of the Company not included herein. The Selected
Consolidated Balance Sheet data as of December 31, 1997 and July 3, 1999, and
the Selected Consolidated Statements of Operations data for the years ended
December 31, 1996 and 1997 and the period from January 1, 1998 to July 3, 1999,
are derived from the consolidated financial statements of the
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Company, included elsewhere in this Annual Report on Form 10-K. The Consolidated
Statement of Operations for the period from January 1, 1997 to June 30, 1998, is
derived from the consolidated statement of operations for the year ended
December 31, 1997 and the unaudited consolidated statement of operations for the
six months ended June 30, 1998 included in the Company's Form 10-Q for June 30,
1998.
The Balance Sheets as of December 31, 1997 and July 3, 1999, and the
Consolidated Statements of Operations for the years ended December 31, 1996 and
1997 and the period from January 1, 1998 to July 3, 1999 have been audited by
Deloitte & Touche LLP, independent auditors, as stated in their report appearing
elsewhere herein. The Selected Financial Data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements, including
the notes thereto appearing elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA
YEAR ENDED DECEMBER 31, EIGHTEEN MONTHS ENDED
------------------------------------- ----------------------------
1994 1995 1996 1997 JUNE 30, 1998 JULY 3, 1999
------ ------- ------- -------- ------------- ------------
(IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA) (UNAUDITED)
STATEMENT OF OPERATIONS DATA:
Total revenue....................... $8,853 $23,120 $48,591 $141,714 $238,987 $450,843
====== ======= ======= ======== ======== ========
Company-owned stores:
Net sales......................... $3,992 $16,118 $39,144 $131,028 $223,746 $434,272
Cost of goods sold and occupancy
costs.......................... 2,687 10,758 25,937 86,372 151,617 304,619
------ ------- ------- -------- -------- --------
Gross profit...................... 1,305 5,360 13,207 44,656 72,129 129,653
Store operating and selling
expense........................ 1,240 4,255 10,116 31,880 55,991 116,022
------ ------- ------- -------- -------- --------
Company-owned stores profit
contribution................... 65 1,105 3,091 12,776 16,138 13,631
Franchise stores:
Royalty fees...................... 3,836 6,075 8,512 10,224 14,604 15,748
Franchise fees.................... 1,025 927 935 462 637 823
------ ------- ------- -------- -------- --------
Total franchise revenues.......... 4,861 7,002 9,447 10,686 15,241 16,571
Total franchise expense........... 2,050 2,944 3,729 3,998 5,801 6,020
------ ------- ------- -------- -------- --------
Franchise profit contribution..... 2,811 4,058 5,718 6,688 9,440 10,551
General and administrative expense:
Special charges(a)................ -- -- -- -- -- 5,858
Other general and administrative
expenses....................... 1,930 3,024 3,160 7,049 12,664 25,937
------ ------- ------- -------- -------- --------
1,930 3,024 3,160 7,049 12,664 31,795
------ ------- ------- -------- -------- --------
Income (loss) before interest and
income taxes...................... 946 2,139 5,649 12,415 12,914 (7,613)
Interest expense (income), net...... (62) (23) (476) (212) 662 5,014
------ ------- ------- -------- -------- --------
Income (loss) before income taxes... 1,008 2,162 6,125 12,627 12,252 (12,627)
Income taxes (benefit).............. 466 863 2,369 4,957 4,810 (998)
------ ------- ------- -------- -------- --------
Net income (loss)................... $ 542 $ 1,299 $ 3,756 $ 7,670 $ 7,442 $(11,629)
====== ======= ======= ======== ======== ========
Basic earnings (loss) per
share(b).......................... $ 0.16 $ 0.38 $ 0.65 $ 0.63 $ (0.94)
======= ======= ======== ======== ========
Diluted earnings (loss) per
share(b).......................... $ 0.16 $ 0.38 $ 0.64 $ 0.61 $ (0.94)
======= ======= ======== ======== ========
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YEAR ENDED DECEMBER 31, EIGHTEEN MONTHS ENDED
------------------------------------- ----------------------------
1994 1995 1996 1997 JUNE 30, 1998 JULY 3, 1999
------ ------- ------- -------- ------------- ------------
(IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA) (UNAUDITED)
Weighted average shares
outstanding -- Basic.............. 7,513 7,984 9,802 11,879 11,882 12,456
Weighted average shares
outstanding -- Diluted............ 7,513 7,984 9,996 12,171 12,175 12,456
EBITDA(c)........................... $1,045 $ 2,461 $ 6,395 $ 15,209 $ 16,548 $ 10,072
====== ======= ======= ======== ======== ========
OPERATING DATA:
Number of Company-owned stores
(end of period)................ 7 16 36 117 148 215
Increase in Company-owned same
store sales.................... NA 26.6% 17.9% 15.5% 7.4% 4.4%
Number of franchise stores (end of
period)........................ 99 132 164 158 160 178
Increase in franchise same store
sales.......................... 13.1% 10.3% 19.5% 14.8% 10.6% 5.5%
Average sales per Company-owned
store.......................... $ 570 $ 1,510 $ 1,662 $ 1,740 $ 2,416 $ 2,439
Depreciation and amortization..... $ 99 $ 322 $ 746 $ 2,794 $ 3,634 $ 11,827
BALANCE SHEET DATA:
Working capital (deficiency)...... $2,088 $ 1,999 $17,419 $ 13,931 $ 40,805 $(26,694)
Total assets...................... 6,009 10,308 34,603 89,615 119,168 158,047
Bank borrowings and other debt.... 39 72 -- 3,150 40,182 --(d)
Capital lease obligation.......... -- -- -- 1,460 1,072 718
Stockholders' equity.............. 3,232 4,582 23,561 45,783 46,103 35,934
- ---------------
(a) Special charges in 1999 relate to consulting services, accounting fees, bank
fees, legal fees and other expenses related to the Company's default on its
Credit Agreement. The Company engaged the services of a crisis management
consulting firm and numerous other professionals to advise management during
the complex negotiations with the bank, vendors and potential investors.
(b) Until April 1994, the company elected to be taxed as an S Corporation under
the Internal Revenue Code. If the Company had been taxed as a C Corporation
for the year ended December 31, 1994, pro forma income taxes, pro forma net
income and pro forma basic and diluted earnings per share would have been
$410,000, $598,000 and $0.08, respectively.
(c) Earnings before interest, taxes, depreciation and amortization, and
exclusive of special charges, as defined above
(d) Excludes borrowing under the Credit Agreement included in current
liabilities at July 3, 1999.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
The Company's revenues and earnings are generated primarily from its two
business segments -- Retail and Franchising.
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Eighteen-Month Period Ended July 3, 1999 ("1999 Period") Compared to
Eighteen-Month Period Ended June 30, 1998 ("1998 Period")
A summary of the Company's new store openings, store acquisitions and store
sales are as follows:
NEW TOTAL END
STORES STORES STORES STORES BEGINNING OF
OPENED ACQUIRED ADDED SOLD OF PERIOD PERIOD
------ -------- ------ ------ --------- ------
Quarter Ended:
March 31, 1997.................................. 6 6 12 -- 36 48
June 30, 1997................................... 9 -- 9 -- 48 57
September 30, 1997.............................. 29 18 47 -- 57 104
December 31, 1997............................... 13 -- 13 -- 104 117
-- -- -- --
57 24 81 --
Quarter Ended:
March 31, 1998.................................. 12 1 13 -- 117 130
June 30, 1998................................... 15 3 18 -- 130 148
September 30, 1998.............................. 40 5 45 -- 148 193
December 31, 1998............................... 14 -- 14 -- 193 207
-- -- -- --
81 9 90 --
Quarter Ended:
March 31, 1999.................................. 7 -- 7 -- 207 214
July 3, 1999.................................... 2 -- 2 1 214 215
-- -- -- --
9 -- 9 1
Retail. Net sales from Company-owned stores increased 94.1% to $434.2
million for the 1999 Period, from $223.7 million for the 1998 Period. The 1999
Period results include 117 stores which were open at the beginning of that
period plus 98 (net) stores opened during the period. The 1998 Period amount
represents sales from 36 stores which were open at the beginning of the period,
plus 112 stores opened during the period. Of the total sales increase, 89.7% is
attributable to new store openings in the 1999 Period. Same store sales
increased 4.4% in the 1999 Period. Gross profit reflects the cost of goods sold
and store occupancy costs including rent, common area maintenance, real estate
taxes, repairs and maintenance, depreciation and utilities. Gross profit
increased 79.8% to $129.7 million for the 1999 Period compared to $72.1 for the
1998 Period. The increase for the 1999 Period was primarily due to increased
sales volume. Gross margin was 29.9% and 32.2% of sales for the 1999 Period and
1998 Period, respectively. The decrease in gross margin was related primarily to
increases in the provisions for obsolete and slow moving inventory and increases
in store occupancy costs.
Store operating and selling expenses increased 107% to $116.0 million for
the 1999 Period compared to $56.0 million for the 1998 Period. The increase in
store operating expenses is primarily attributable to the increased number of
stores operated by the Company during the 1999 Period. Store operating expenses
were 26.7% and 25.0% of sales for the 1999 Period and 1998 Period, respectively,
due to increased store operating payroll costs related to new store openings.
Company-owned store profit contribution was $13.6 million for the 1999 Period,
compared to a profit contribution of $16.1 million for 1998 Period.
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. Royalty fees increased 7.8% to
$15.7 million for the 1999 Period from $14.6 million for the 1998 Period.
Franchise fees, recognized on 30 store openings during the 1999 Period,
increased 29.2% to $823,000 compared to $637,000 during the 1998 Period, which
represents 26 store openings. Franchise same store sales increased by 5.5% and
10.6% for the 1999 Period and the 1998 Period, respectively.
Expenses directly related to franchise revenue increased 3.4% to $6.0
million for the 1999 Period from $5.8 million for the 1998 Period. This increase
is primarily attributable to additional franchise personnel
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required to operate this portion of the Company's business and the necessary
infrastructure to support such employees. As a percentage of franchise revenue,
franchise expenses were 36.3% and 38.1% for the 1999 Period and 1998 Period,
respectively.
Franchise profit contribution increased 12.8% to $10.6 million for the 1999
Period, compared to $9.4 million for the 1998 Period. The 11.8% increase in
franchise profit contribution is due to the increase in royalty fees and
franchise fees offset in part by an increase in franchise expenses, as discussed
above.
General and Administrative Expenses. The Company's general and
administrative expenses increased 151% to $31.8 million during the 1999 Period,
compared to $12.7 million during the 1998 Period. The increase is attributable
in part to $5.9 million in special charges relating to consulting, accounting,
banking and other expenses resulting from the Company's refinancing
arrangements. In addition, during the 1999 Period, there was an increase in
payroll and related benefits due to a higher overhead structure intended to
support a planned 50-store increase in the number of stores for Fiscal 2000
compared to the 1998 Period. General and administrative expenses increased as a
result of several factors. Payroll and benefits increased $6.2 million, or
85.4%, to $13.5 million in the 1999 Period from $7.3 million in the 1998 Period,
related to additional corporate administrative and support personnel and the
addition of a regional manager supervisory structure. Corporate occupancy
increased 47% to $2.5 million for the 1999 Period from $1.7 million in the 1998
Period, primarily as a result of additional depreciation expense for computer
hardware and software. Also, professional fees, exclusive of special charges of
$5.9 million, increased 242% to $4.1 million in the 1999 Period from $1.2
million in the 1998 Period, primarily related to information systems expenses
for Year 2000 systems remediation and new systems consulting design and
implementation. Due to reductions in planned growth, the number of corporate
staff members decreased by 21% in May 1999 in order to bring administrative
costs in line with more modest growth objectives.
Exclusive of the $5.9 million in special charges discussed above, general
and administrative expenses were 6.0% of sales and 5.7% for the 1999 Period and
1998 Period, respectively.
Interest Expense. Interest expense increased 614% to $5.0 million during
the 1999 Period as compared to the $0.7 million in the comparable 1998 Period.
This increase related primarily to the increase in average borrowings used for
Company expansion during the period, as well as an increase in interest rates
due to provisions of the bank's standstill agreements in effect during the
quarter ended July 3, 1999.
Income Taxes. The income tax benefit was $1.0 million during the 1999
Period compared with the provision for income taxes of $4.8 million recorded
during the 1998 Period. This increase related to the pre-tax loss in the 1999
Period of $12.6 million compared to the pre-tax income of $12.3 million in the
1998 Period. The benefit recorded in the 1999 Period is net of recording a
$572,000 valuation allowance against deferred tax assets. Additionally, the
Company recorded a partial valuation allowance on its part-year federal and
state net operating loss.
Net Loss. As a result of the above factors, net loss was $11.6 million, or
$(0.94) per basic and diluted share, in the 1999 Period as compared to net
income of $7.4 million, or $0.63 and $0.61 per basic and diluted share, in the
comparable 1998 Period.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Retail. Net sales from Company-owned stores increased 234% to $131.0
million in the year ended December 31, 1997 up from $39.1 million in the year
ended December 31, 1996. The 1997 results include 36 stores that were open at
the beginning of that year plus 57 stores opened during the year (of which 19
were opened in September, 10 in October, and three in December) and 24 stores
acquired during the year. The 1996 amount represents sales from 16 stores that
were open at the beginning of the year plus 20 stores opened during the year
(five of which were opened in September and two in October). Of the total sales
increase, 74.4% is attributable to new store openings in 1997. Same store sales
increased 15.5% in 1997. Gross profit reflects the cost of goods sold and store
occupancy costs including rent, common area maintenance, repair and maintenance,
depreciation and utilities. Gross profit for the year ended December 31, 1997
increased 238% to $44.7 million, compared to $13.2 million for the year ended
December 31, 1996. The increase in 1997 was due
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to increased sales volume. Gross margin was 34.1% and 33.7% of sales for the
years ended December 31, 1997 and 1996, respectively.
Store operating and selling expenses increased 216% to $31.9 million for
the year ended December 31, 1997 compared to $10.1 million for 1996. The
increase in store operating expenses is attributable to the increased number of
stores operated by the Company during 1997. Store operating expenses were 24.3%
and 25.8% of sales for the years ended December 31, 1997 and 1996, respectively.
Company-owned store profit contribution increased 313% to $12.8 million for the
year ended December 31, 1997, compared to a profit contribution of $3.1 million
for the comparable 1996 period.
Franchising. Franchise revenue is composed of the initial franchise fees
that are recorded as revenue when the store opens, and ongoing royalty fees,
generally 4.0% of the store's net sales. Royalty fees increased 20.3% to $10.2
million in the year ended December 31, 1997, up from $8.5 million in the
comparable 1996 period. The increase was attributable primarily to sales
increases in stores opened as of December 31, 1996. Franchise same store sales
increases for the years ended December 31, 1997 and 1996 were 14.8% and 19.5%,
respectively. Franchise fees, recognized on 19 store openings during the year
ended December 31, 1997 were $462,000 compared to $935,000 representing 32 store
openings during 1996. The reduction in franchise fees attributed to fewer store
openings was partially offset by the increase in such fees from $30,000 to
$35,000 per store with respect to franchise agreements signed after January 1,
1996.
Expenses directly related to franchise revenue increased 7.2% to $4.0
million for the year ended December 31, 1997 from $3.7 million for the year
ended December 31, 1996. As a percentage of franchise revenue, franchise
expenses were 37.4% and 39.5% for the years ended December 31, 1997 and 1996,
respectively.
Franchise profit contribution was increased 17.0% to $6.7 million for the
year ended December 31, 1997, compared to $5.7 million for the year ended
December 31, 1996. The increase in franchise profit contribution is due to the
increase in royalty fees offset by a decrease in franchise fees and increase in
franchise expenses as discussed above.
General and Administrative Expense. General and administrative expenses
increased 123% to $7.0 million in the year ended December 31, 1997, compared
with $3.1 million in the year ended December 31, 1996. The increase is primarily
attributable to an increase in payroll and related benefits of approximately
$1.8 million as a consequence of establishing the necessary organizational
infrastructure to allow the Company to build its Company-owned store base,
professional fees increases of approximately $226,000 due primarily to increases
in legal and accounting fees, travel expense increases of approximately $730,000
which increased primarily due to the increase in the number of stores. In
addition, the Company had other increases in general and administrative expenses
related to insurance, investor relations expenditures and general corporate
expenses. As a percentage of revenue, general and administrative expenses were
5.0% and 6.5% for the years ended December 31, 1997 and 1996, respectively. This
decrease as a percentage of revenue resulted from increased leverage of general
and administrative expenses over a larger sales base.
Interest Income. Interest income decreased 14.5% to $0.2 million during
the year ended December 31, 1997, as compared to $0.5 million during the year
ended December 31, 1996. This decrease related primarily to the decrease in
average funds available for investment during the period.
Income Taxes. The provision for income tax expense increased 109% to $5.0
million during for the year ended December 31, 1997 as compared to the $2.4
million recorded in 1996. This increase related primarily to the increase in
pre-tax earnings of 106% for the 1997 period over 1996.
Net Income. As a result of the foregoing factors, net income increased
104% to $7.7 million, or $0.65 per basic share and $0.64 per diluted share, in
the year ended December 31, 1997 compared with $3.8 million, or $0.38 per basic
and diluted share in the year ended December 31, 1996.
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ACCOUNTING AND REPORTING CHANGES
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 130 "Reporting
Comprehensive Income," which establishes standards for the reporting and display
of comprehensive income and its components (revenues, expenses, gains and
losses) in a fully set of general-purpose financial statements. This statement
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. The adoption of this statement did not have an impact on the
Company's consolidated financial statements as the Company has no items of
comprehensive income.
Effective January 1, 1998, the Company adopted AICPA Statement of Position
("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of this SOP had no impact on the consolidated
financial statements because the SOP requires the change to be implemented
prospectively.
Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No. 131
establishes standards for the way that business enterprises report information
about operating segments in financial statements and related disclosures about
products and services, geographical areas and major customers. The Company has
adopted this statement and expanded its disclosure of its retail and franchise
segments.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards for derivative instruments and hedging activities. SFAS No.
133 requires an entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and to measure those
instruments at fair value.
For Fiscal 2001, the Company is required to adopt SFAS No. 133, "Accounting
for Derivative Instruments and Hedging Activities." The Company has not yet
determined whether the application of SFAS No. 133 will have a material impact
on its financial position or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash provided by operating activities was $3.6 million, and
$9.0 million in the years ended December 31, 1996 and 1997, respectively. A
total of $1.5 million of cash was used in operations for the 1999 Period. The
increase in cash provided by operating activities in 1997 compared to 1996 was
primarily the result of increased operating contribution for the increased
number of stores in operation during 1997. The decrease in liquidity of $1.5
million relates primarily to increased store and corporate operating expenses in
the 1999 Period, as discussed previously.
Cash used in investing activities was $4.9 million, $39.9 million, and
$47.0 million in the years ended December 31, 1996, 1997 and the 1999 Period,
respectively. The increase in cash used in investing activities in 1997 compared
to 1996 and in the 1999 Period as compared to 1997 was attributable to increased
purchases of property and equipment and store acquisitions.
Cash provided by financing activities was $15.2 million, $19.2 million, and
$56.8 million for the years ended December 31, 1996, 1997 and the 1999 Period,
respectively. Cash provided by financing activities in 1997 was primarily
attributable to the proceeds of the Company's secondary public offering and
borrowings under the Credit Agreement. The cash provided by financing activities
in the 1999 Period was primarily attributable to the proceeds from borrowings
under the revolving credit agreement. See "Business -- Recent Developments" for
an explanation of the cash received as a result of the issuance of the Notes in
August 1999.
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As of July 3, 1999, the Company had a working capital deficiency of $26.7
million, primarily due to the classification of the borrowings under the Credit
Agreement as a current liability. Under the terms of the Bank Forbearance
Agreement, the Company is obligated to reduce its outstanding borrowings under
the Credit Agreement to $15 million by October 30, 1999. In addition, Trade
Notes issued by the Company aggregating approximately $12.1 million mature on
November 15, 1999. On January 15, 2000, Company management believes it will
resume normal credit terms with substantially all of its vendors. At such event,
management believes the remaining two-thirds of the unpaid claims as of May 1,
1999, will be satisfied through individual arrangements with the vendors.
However, there can be no assurances that the Company will successfully conclude
these arrangements.
Based on the Company's cash flow projections, together with its cash on
hand at September 20, 1999, the Company expects to have sufficient liquidity to
fund operations through June 30, 2000.
Company management is evaluating various strategies for improving the
Company's results of operations, operating controls, expansion and franchising
strategies, management information systems needs and other aspects of the
business. These strategies are designed to improve the profitability from
operations and improve management insight into merchandising decisions and
operating controls. Company management plans to make significant capital
expenditures on enhanced information systems over the next several years.
Company management is also seeking replacement financing for the Credit
Agreement. Management has initiated contact with several asset-based lenders to
provide such a facility. If the Company is successful in obtaining an
asset-based lending arrangement, such a facility will assist the Company in
meeting its short-term liquidity needs for the next year. There is no assurance
at this time that the Company will successful in obtaining this financing
facility or how successful its will be in improving operations.
Impact of Inflation
The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in cost of
merchandise purchased, labor, employee benefits and other operating expenses
could have a material adverse effect on the Company's performance.
Seasonality
The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
and substantially all of its cash flow and net income for the year during the
fourth calendar quarter of the year, principally due to the sales in October for
the Halloween season and, to a lesser extent, due to holiday sales for end of
year holidays. The Company's results of operations may also fluctuate
significantly as a result of a variety of other factors, including the timing of
new store openings.
IMPACT OF YEAR 2000 ON THE COMPANY'S COMPUTER OPERATIONS
The Company is preparing for the impact of the arrival of the Year 2000 on
its business. The "Year 2000 Problem" is a term used to describe the problems
created by systems that are unable to accurately interpret dates after December
31, 1999. These problems are derived predominately from the fact that certain
computer hardware and many software programs historically recorded a date's
"year" in a two digit format (i.e., 98 for 1998) and therefore may recognize
"00" as 1900 instead of the year 2000. The Year 2000 Problem creates potential
risks for the Company, including the inability to recognize and properly treat
dates occurring on or after January 1, 2000, which may result in computer system
failures or miscalculations of critical financial or operations information.
In addition to its internal systems, the Company relies heavily on third
parties in operating its business. Such third parties include vendors and
utilities that provide electricity, water, natural gas, transportation,
telephone and banking,
The Company began formulating a plan in 1998 to address the Year 2000
Problem and to ensure that all relevant systems had been subject to a full Year
2000 review and, if necessary, implement remediation, replacement or upgrades.
Under the plan, the Company has focused on (i) internal financial and
operational
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computer systems and (ii) the Year 2000 compliance of all material suppliers and
vendors doing business with the Company. The Company has contacted all outside
suppliers and vendors with which the Company has material relationships and
engaged in discussions which will continue throughout 1999 in furtherance of the
Company's stated goal of minimizing any adverse impact relating to the Year 2000
Problem.
The Company has completed its assessment of all material financial and
operating systems. In connection with this review, the Company upgraded its
financial accounting systems to Year 2000 compliant systems in the first quarter
of 1999. This system is currently being tested to verify Year 2000 compliance,
and such testing should be completed by October 1999. The costs and expenses to
be incurred relating to Year 2000 compliance for these systems is currently not
expected to be material. As of mid-November 1999 all computer operating systems
in use will be upgraded and compliant.
In addition, the Company has assessed all computer hardware, including
servers, microcomputers, POS registers, and peripheral equipment at the store
and corporate levels. Only minor remediation and/or upgrade of these systems has
been required; each will be tested and compliant by November 1, 1999. The Retail
POS software at the store level has been tested and is compliant.
The Company estimates that the total costs and expenses associated with
completing the outlined Year 2000 compliance plan will range from $ 1,500,000 to
$ 1,700,000, of which all but approximately $300,000 has been incurred and
expensed. Company management presently believes that it will substantially
complete its internal Year 2000 compliance program prior to January 1, 2000, and
that there should be no material adverse impact at such time related to Year
2000 Problems associated with the Company's systems or software. Based on
communications with its vendors and suppliers, the Company also believes that
each third party with whom the Company has a material relationship is currently
Year 2000 compliant or scheduled to be Year 2000 compliant by January 1, 2000.
Despite the Company's best efforts, there can be no assurance that (i) the
Company's assessments regarding the Year 2000 Problem are correct; (ii) the
Company will be able to successfully complete its Year 2000 review and implement
such upgrades and/or remediation as is necessary or (iii) third parties or
suppliers with whom the Company does business will avoid Year 2000 Problems
which might adversely affect the Company's business or operations. While the
Company is developing contingency plans to address such failures or unexpected
problems (such plans include identification of alternative suppliers), there can
be no assurance that such contingency plans will be adequate to resolve these
problems. The Company's contingency plan is expected to be completed by October
31, 1999.
The Year 2000 Problems involves substantial risk to the Company. The
Company believes today that the likely worst case scenario regarding the Year
2000 Problem will involve temporary disruptions in the receipt of merchandise
inventory and temporary disruption in the payment of bills. These events may
also cause lost revenue. The foregoing assessment is based on information
currently available to the Company. The Company can provide no assurances that
applications and equipment believed to be Year 2000 compliant will not
experience difficulties, or the Company will not experience difficulties
obtaining resources needed to make modifications to, or replacement of, the
Company's affected systems and equipment. Failure by the Company or third
parties, on which it relies to resolve Year 2000 issues, could have a material
effect on the Company's results of operations.
FORWARD-LOOKING STATEMENTS
This Form 10-K (including the information incorporated herein by reference)
contains forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995. The statements are made a number of times
throughout the document and may be identified by forward-looking terminology as
"estimate," "project," "expect," "believe," "may," "will," "intend" or similar
statements or variations of such terms. Such forward-looking statements involve
certain risks and uncertainties, and include among others, the following: levels
of sales, store traffic, acceptance of product offerings, competitive pressures
from other party supplies retailers, availability of qualified personnel,
availability of suitable future store locations, schedules of store expansion
plans and year 2000 readiness issues relating to the Company's internal systems
and those of third parties, the ability of the Company to refinance its existing
debt on terms acceptable to it and other
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factors. As a result of the foregoing risks and uncertainties, actual results
and performance may differ materially from that projected or suggested herein.
Additional information concerning certain risks and uncertainties that could
cause actual results to differ materially from that projected or suggested may
be identified from time to time in the Company's Securities and Exchange
Commission filings and the Company's public announcements.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The response to this item is submitted as a separate section of this Report
commencing on page F-1.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
In accordance with general instruction G(3) of Form 10-K, the information
called for by Items 10, 11, 12 and 13 of Part III is incorporated by reference
to the Company's definitive Proxy Statement for its 1999 Annual Meeting of
Shareholders.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) List of Documents filed as part of this Annual Report on Form 10-K.
1. The following financial statements of the Company are filed as a
separate section of this Report commencing on page F-1.
Independent Auditors' Report -- Deloitte & Touche LLP
Balance Sheets as of December 31, 1997, and July 3, 1999
Statements of Operations for the years ended December 31, 1996 and 1997,
and the period from January 1, 1998 to July 3, 1999
Statements of Shareholders' Equity for the years ended December 31, 1996
and 1997, and the period from January 1, 1998 to July 3, 1999.
Statements of Cash Flows for the years ended December 31, 1996 and 1997,
and the period from January 1, 1998 to July 3, 1999.
Notes to Financial Statements for the years ended December 31, 1996 and
1997, and the period from January 1, 1998 to July 3, 1999.
2. Financial Statement Schedules -- Not Applicable.
3. List of Exhibits.
The following exhibits are included as a part of this Annual Report on Form
10-K or incorporated herein by reference.
3.1(1) -- Certificate of Incorporation of the Company.
3.2(1) -- Bylaws of the Company.
4.1(1) -- Specimen stock certificate evidencing the Common Stock.
4.2(2) -- Form of Revolving Credit Note.
4.3(3) -- Form of Warrant.
4.4(3) -- Form of A Note.
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4.5(3) -- Form of B Note.
4.6(3) -- Form of C Note.
4.7(3) -- Form of D Note.
4.8(3) -- Form of Securities Purchase Agreement, dated as of August
16, 1999, by and between the Company and each of the
Investors.
10.1(1) -- Form of Unit Franchise Agreement entered into by the Company
and franchisees.
10.2(1) -- Employment Agreement, dated as of January 1, 1994 and
amended as of January 16, 1996, by and between the Company
and Steve Mandell.
10.3(4) -- Amendment to Employment Agreement, dated as of March 5,
1997, by and between the Company and Steven Mandell.
10.4(1) -- Employment Agreement, dated as of January 1, 1994 and
amended as of January 16, 1996, by and between the Company
and Perry Kaplan.
10.5(1) -- Employment Agreement of David Lauber, dated as of June 12,
1995, by and between the Company and David Lauber.
10.6(1) -- Employment Agreement of Lawrence Fine, dated as of October
13, 1995, by and between the Company and Lawrence Fine.
10.7(5) -- Amended Stock Option Plan of the Registrant.
10.8(5) -- Amended and Restated 1994 Stock Option Plan of the Company.
10.9(1) -- Loan and Security Agreement, dated as of August 15, 1995 and
amended as of October 6, 1995, by and between the Company
and Midlantic Bank, N.A.
10.10(4) -- Commitment Letter between PNC Bank and the Company.
10.11(6) -- Asset Purchase Agreement dated as of September 2, 1997 by
and among the Company and Hammond Retailing of Mesquite,
L.C., Hammond Retailing of West Plano, L.C., Hammond
Retailing of Richardson, L.C., Hammond Retailing of
Arlington, L.C., Hammond Retailing of Carrollton, L.C.,
Hammond Retailing of Irving, L.C., Hammond Retailing of
Medallion, L.C., Hammond Retailing of Red Bird LLC, Hammond
Retailing of Vista Ridge, LLC, Hammond Retailing of Pleasant
Grove, LLC, Hammond Retailing of White Rock, LLC, Hammond
Communications, Inc. and Mr. Geoffrey Hammond (without
exhibits or schedules).
10.12(6) -- Letter Agreement by and between the Company and Hammond
Retailing of Plano East, LLC, dated as of July 7, 1997.
10.13(6) -- Third Amendment to Loan and Security Agreement, dated as of
June 16, 1997, by and between the Company and PNC Bank,
National Association.
10.14(7) -- Fourth Amendment to the Loan and Security Agreement, dated
as of March 10, 1998, by and between the Company and PNC
Bank, National Association.
10.15(7) -- $60,000,000 credit facility Commitment Letter, dated as of
March 9, 1998, by and between the Company and PNC Bank N.A.,
as agent, for the Banks.
10.16(7) -- Employment Agreement of David Lauber, dated as of September
23, 1997, by and between the Company and David Lauber.
10.17(2) -- Revolving Credit Facility Credit Agreement, dated as of
April 24, 1998, by and among the Company, the Banks and PNC
Bank, National Association, as Agent.
10.18(8) -- Option Agreement, dated as of June 8, 1999, between Steven
Mandell and Jack Futterman.
10.19(8) -- Stock Pledge Agreement, dated as of June 8, 1999, between
Steven Mandell and Jack Futterman.
10.20(8) -- Employment Agreement, dated as of June 8, 1999, between the
Company and Jack Futterman.
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10.21(3) -- Investor Rights Agreement, dated as of August 16, 1999, by
and among the Company, the Investors and Jack Futterman.
10.22(3) -- Standstill and Forbearance Agreement, dated as of August 16,
1999, by and among the Company, PNC Bank, National
Association, as Agent, and the Banks.
10.23(3) -- Vendor Forbearance and Standstill Agreement, dated as of
August 16, 1999, by and among the Company and the Trade
Vendors.
21.1 -- Subsidiaries.
23.1 -- Consent of Deloitte & Touche LLP.
27.1 -- Financial Data Schedule.
- ---------------
Notes
(1) Incorporated by reference to the Company's Registration Statement as amended
on Form S-1 Number 333-350 as filed with the Commission on January 18, 1996.
(2) Incorporated by reference to the Company's Quarterly Report on Form 10-Q as
filed with the Commission on May 15, 1998.
(3) Incorporated by reference to the Company's Current Report on Form 8-K as
filed with the Commission on August 25, 1999.
(4) Incorporated by reference to the Company's Registration Statement on Form
S-1 as filed with the Commission on March 6, 1997.
(5) Incorporated by reference to the Company's Registration Statement on Form
S-8 as filed with the Commission on January 9, 1997.
(6) Incorporated by reference to the Company's Current Report on Form 8-K as
filed with the Commission on September 12, 1997, as amended November 10,
1997.
(7) Incorporated by reference to the Company's Annual Report on Form 10-K as
filed with the Commission on March 31, 1998.
(8) Incorporated by reference to Amendment No. 1 to Schedule 13D as filed with
the Commission on June 30, 1999.
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(b) Reports on Form 8-K.
None.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on September 30, 1999.
PARTY CITY CORPORATION
By: /s/ JACK FUTTERMAN
------------------------------------
Jack Futterman
Chief Executive Officer
By: /s/ THOMAS E. LARSON
------------------------------------
Thomas E. Larson, Senior Vice
President and
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
---- ----- ----
By: /s/ JACK FUTTERMAN Chief Executive Officer, September 30, 1999
--------------------------------------------- Chairman of the Board
Jack Futterman and Director
By: /s/ THOMAS E. LARSON Senior Vice President and September 30, 1999
--------------------------------------------- Chief Financial Officer
Thomas E. Larson
By: /s/ LINDA M. SILUK Chief Accounting Officer September 30, 1999
---------------------------------------------
Linda M. Siluk
By: /s/ RAYMOND HEMMIG Director September 30, 1999
---------------------------------------------
Raymond Hemmig
By: /s/ MATTHEW R. KAHN Director September 30, 1999
---------------------------------------------
Matthew R. Kahn
By: /s/ HOWARD LEVKOWITZ Director September 30, 1999
---------------------------------------------
Howard Levkowitz
By: /s/ DUAYNE WEINGER Director September 30, 1999
---------------------------------------------
Duayne Weinger
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INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders
Party City Corporation
Rockaway, New Jersey
We have audited the accompanying consolidated balance sheets of Party City
Corporation and subsidiary as of December 31, 1997 and July 3, 1999, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the years ended December 31, 1996 and 1997 and the period from January
1, 1998 to July 3, 1999. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Party City
Corporation and subsidiary as of December 31, 1997, and July 3, 1999, and the
consolidated results of their operations and their cash flows for the years
ended December 31, 1996 and 1997 and for the period from January 1, 1998 to July
3, 1999 in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements for the period from
January 1, 1998 to July 3, 1999, have been prepared assuming that Party City
Corporation will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company's default on its Credit Agreement
and inability to liquidate its trade payables under normal terms raise
substantial doubt about its ability to continue as a going concern. Management's
plans in regard to these matters are also described in Note 1. The consolidated
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
DELOITTE & TOUCHE LLP
SEPTEMBER 29, 1999
PARSIPPANY, NEW JERSEY
F-1
31
PARTY CITY CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
DECEMBER 31, 1997 JULY 3, 1999
----------------- ------------
ASSETS
Current assets:
Cash and cash equivalents................................. $ 3,235 $ 11,470
Merchandise inventory..................................... 39,041 47,016
Refundable income taxes................................... -- 6,848
Advance merchandise payments.............................. -- 9,439
Other current assets...................................... 7,840 13,328
------- --------
Total current assets.............................. 50,116 88,101
Property and equipment, net................................. 24,199 50,557
Goodwill, net............................................... 14,130 18,483
Other assets................................................ 1,170 906
------- --------
Total assets...................................... $89,615 $158,047
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable -- trade................................. $24,927 $ 45,114
Accrued expenses.......................................... 6,994 10,145
Credit Agreement.......................................... -- 58,550
Income taxes payable...................................... 3,080 --
Other current liabilities................................. 1,184 986
------- --------
Total current liabilities......................... 36,185 114,795
Long-term liabilities:
Revolving credit agreement................................ 3,150 --
Deferred rent............................................. 2,987 6,527
Other long-term liabilities............................... 1,510 791
Commitments and contingencies
Stockholders' equity:
Common stock.............................................. 123 125
Additional paid-in capital................................ 32,246 34,024
Retained earnings......................................... 13,414 1,785
------- --------
Total stockholders' equity........................ 45,783 35,934
------- --------
Total liabilities and stockholders' equity........ $89,615 $158,047
======= ========
See accompanying notes to consolidated financial statements.
F-2
32
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED
DECEMBER 31, PERIOD FROM
------------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
------- -------- ---------------
Revenues:
Net sales.............................................. $39,144 $131,028 $434,272
Royalty fees........................................... 8,512 10,224 15,748
Franchise fees......................................... 935 462 823
------- -------- --------
Total revenues................................. 48,591 141,714 450,843
Expenses:
Cost of goods sold and occupancy costs................. 25,937 86,372 304,619
Company-owned stores operating and selling expense..... 10,116 31,880 116,022
Franchise expense...................................... 3,729 3,998 6,020
General and administrative expense..................... 3,160 7,049 31,795
------- -------- --------
Total expenses................................. 42,942 129,299 458,456
------- -------- --------
Income (loss) before interest and income taxes........... 5,649 12,415 (7,613)
Interest expense (income).............................. (476) (212) 5,014
------- -------- --------
Income (loss) before income taxes........................ 6,125 12,627 (12,627)
Provision for income taxes (benefit)................... 2,369 4,957 (998)
------- -------- --------
Net income (loss)........................................ $ 3,756 $ 7,670 $(11,629)
======= ======== ========
Basic earnings (loss) per share........................ $ 0.38 $ 0.65 $ (0.94)
======= ======== ========
Weighted average shares outstanding -- basic........ 9,802 11,749 12,426
======= ======== ========
Diluted earnings (loss) per share...................... $ 0.38 $ 0.64 $ (0.94)
======= ======== ========
Weighted average shares outstanding -- diluted...... 9,996 12,039 12,426
======= ======== ========
See accompanying notes to consolidated financial statements.
F-3
33
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT NUMBER OF SHARES)
COMMON STOCK ADDITIONAL
--------------------- PAID-IN- RETAINED
SHARES AMOUNTS CAPITAL EARNINGS TOTAL
---------- ------- ---------- -------- --------
Balance at January 1, 1996.......... 7,836,000 $ 78 $ 2,515 $ 1,988 $ 4,581
Sale of common shares............... 2,550,000 25 16,975 -- 17,000
Expenses incurred on sale of common
shares............................ -- -- (1,990) -- (1,990)
Exercise of stock options........... 55,001 1 174 -- 175
Tax effect of non-qualified
options........................... -- -- 39 -- 39
Net income.......................... -- -- -- 3,756 3,756
---------- ---- ------- -------- --------
Balance at December 31, 1996........ 10,441,001 104 17,713 5,744 23,561
Sale of common shares............... 1,800,000 18 15,582 -- 15,600
Expenses incurred on sale of common
shares............................ -- -- (1,415) -- (1,415)
Exercise of stock options........... 59,094 1 266 -- 267
Tax effect of non-qualified
options........................... -- -- 100 -- 100
Net income.......................... -- -- -- 7,670 7,670
---------- ---- ------- -------- --------
Balance at December 31, 1997........ 12,300,095 123 32,246 13,414 45,783
Exercise of stock options........... 155,443 2 755 -- 757
Tax effect of non-qualified
options........................... -- -- 1,023 -- 1,023
Net loss............................ -- -- -- (11,629) (11,629)
---------- ---- ------- -------- --------
Balance at July 3, 1999............. 12,455,538 $125 $34,024 $ 1,785 $ 35,934
========== ==== ======= ======== ========
See accompanying notes to consolidated financial statements.
F-4
34
PARTY CITY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED
DECEMBER 31, PERIOD FROM
------------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
------- -------- ---------------
Cash Flow from Operating Activities:
Net income (loss)...................................... $ 3,756 $ 7,670 $(11,629)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization....................... 746 2,794 11,827
Deferred rent....................................... 706 1,813 3,541
Provision for doubtful accounts..................... 6 275 331
Loss on abandonment of property and equipment....... 11 99 234
Deferred tax asset.................................. (152) (543) (3,271)
Changes in assets and liabilities
Merchandise inventory............................... (5,464) (23,853) (3,721)
Refundable income taxes............................. -- -- (6,848)
Advance merchandise payments........................ -- -- (9,439)
Other current assets................................ (1,170) (5,197) (1,976)
Other assets........................................ (5) (335) (308)
Accounts payable.................................... 3,016 19,950 20,187
Accrued expenses.................................... 755 5,013 3,151
Income taxes payable................................ 1,390 1,176 (3,080)
Other current liabilities........................... (37) (11) (198)
Other long-term liabilities......................... -- 197 (296)
------- -------- --------
Net cash provided by (used in) operating
activities..................................... 3,558 9,048 (1,495)
Cash flow from investment activities:
Purchases of property and equipment................. (4,872) (18,272) (36,608)
Stores acquired..................................... -- (21,653) (10,419)
------- -------- --------
Net cash used in investing activities............. (4,872) (39,925) (47,027)
Cash flow from financing activities:
Net proceeds from sale of stock..................... 15,010 14,185 --
Proceeds from exercise of stock options............. 175 267 757
Tax effect of non-qualified stock options........... 38 100 1,023
Net proceeds from Credit Agreement.................. (72) 4,610 55,400
Repayment of capital lease obligation............... -- -- (423)
------- -------- --------
Net cash provided by financing activities.............. 15,151 19,162 56,757
------- -------- --------
Net increase (decrease) in cash and cash equivalents... 13,837 (11,715) 8,235
Cash and cash equivalents, beginning of period......... 1,113 14,950 3,235
------- -------- --------
Cash and cash equivalents, end of period............... $14,950 $ 3,235 $ 11,470
======= ======== ========
Supplemental disclosure of cash flow information:
Income taxes paid................................... $ 1,148 $ 4,219 $ 5,902
Interest paid....................................... 41 294 5,183
See accompanying notes to consolidated financial statements.
F-5
35
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. RECENT DEVELOPMENTS
Consolidated Financial Statements
Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party goods stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. As of
July 3, 1999, the Company had 215 Company-owned stores and 178 franchise stores
in its network. The consolidated financial statements of the Company include the
accounts of the Company and its wholly-owned subsidiary, Party City Michigan,
Inc. All significant intercompany balances and transactions have been
eliminated.
The Company was unable to issue audited financial statements for the year
ended December 31, 1998 and timely file its 1998 Annual Report on Form 10-K with
the Securities and Exchange Commission ("SEC") primarily because of difficulties
associated with taking the year-end physical inventories and the related
reconciliation process. The Company has taken a complete physical inventory as
of July 3, 1999, and prepared consolidated financial statements for the
eighteen-month period from January 1, 1998 to July 3, 1999. As a result of the
failure to file the Form 10-K by March 31, 1999, the Company was in default of
Nasdaq's continued listing requirements. Trading in the Company's common stock
was halted on May 6, 1999, and the Company was delisted on July 20, 1999.
Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. The
Company continues to use December 31 as its tax year end. The change to a 52-53
week calendar was made to facilitate comparable store sales computations. The
term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June
30, unless otherwise noted.
Financing Agreements
On April 24, 1998, the Company refinanced and replaced its then existing
$20 million loan facility with a $60 million secured revolving line of credit
agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit
Agreement"). Advances under the Credit Agreement originally bore interest, at
the Company's option, at the agent bank's base rate (the higher of the bank's
prime rate or the federal funds rate plus 1/2% per annum) or LIBOR plus an
applicable margin. The Company's failure to issue its consolidated financial
statements on a timely basis is a default under the Credit Agreement. In
addition to this default, the Company did not meet certain of its financial
covenants, including those relating to minimum levels of profitability, net
worth, liquidity, fixed charge coverage and others. Consequently, the Company's
debt was subject to acceleration and is classified as a current liability in the
consolidated balance sheet at July 3, 1999. The Credit Agreement is secured by
all the assets of the Company. Additionally, the Credit Agreement restricts the
payment of dividends.
On August 16, 1999 the Company entered in the following agreements with its
existing bank lenders under the Credit Agreement (the "Banks"), a new group of
investors (the "Investors") and its trade vendors. The bank lenders and the
Company entered into a Standstill and Forbearance Agreement (the "Bank
Forbearance Agreement"). Under the Bank Forbearance Agreement, the Banks have
agreed not to exercise rights and remedies based upon any existing defaults
until June 30, 2000 unless a further event of default occurs. The Company has
agreed to reduce its outstanding bank borrowings from the $58.6 million
outstanding at July 3, 1999, to $15 million by October 30, 1999, to increase the
interest rate on its bank debt to 2% over the bank's prime interest rate and to
pay a forbearance fee of $580,000. Company management intends to refinance its
outstanding indebtedness to the Banks with an asset-based lending arrangement.
There
F-6
36
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
is no assurance such a lending arrangement can be obtained. The $15 million
anticipated to be outstanding at October 30, 1999 is due June 30, 2000 unless
the Bank Forbearance Agreement is extended or amended.
On August 17, 1999, the Company received $30 million in financing from the
Investors. The Investors purchased senior secured notes and warrants pursuant to
separate securities purchase agreements (the "Securities Purchase Agreements")
each dated as of August 16, 1999. Under these Securities Purchase Agreements,
the Company issued (i) $10 million of its 12.5% Secured Notes due 2003 (the "A
Notes"); (ii) $5 million of its 13.0% Secured Notes due 2003 (the "B Notes");
(iii) $5 million of its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10
million of its 14.0% Secured Notes due 2004 (the "D Notes", and together with
the A Notes, the B Notes and the C Notes, the "Notes"); and (v) warrants (the
"Warrants") to purchase 6,880,000 shares of the Company's common stock at an
initial exercise price of $3.00 per share. Up to $15 million of the Notes is
secured by a first lien that is pari pasu with the liens under the Credit
Agreement. The Notes are secured by a second lien on all of the Company's
assets. The Company issued the Warrants in connection with the sale of the C
Notes and the D Notes. The Warrants may be exercised before the close of
business on August 16, 2006. The shares of Common Stock reserved for issuance
under the Warrants represent approximately 35% of the shares of Common Stock
outstanding assuming the exercise of the Warrants.
The Company also entered into an Investor Rights Agreement (the "Investor
Rights Agreement") with the Investors and the chief executive officer of the
Company. In this agreement, the Company granted registration rights with respect
to shares of common stock. The Company has agreed to nominate two individuals
designated by the Investors to its Board of Directors. Under the Investor Rights
Agreement, the Investors agree that they will not, without the prior written
consent of the Board of Directors, (i) acquire or agree to acquire, publicly
offer or make any public proposal with respect to the possible acquisition of
(a) beneficial ownership of any securities of the Company, (b) any substantial
part of the Company's assets, or (c) any rights or options to acquire any of the
foregoing from any person; (ii) make or in any way participate in any
"solicitation" of "proxies" (as such terms are defined in the rules of the
Securities Exchange Act of 1934, as amended) to vote, or seek to advise or
influence any person with respect to the voting of any voting securities of the
Company; or (iii) make any public announcement with respect to any transaction
between the Company or any of its securities holders and the Investors,
including without limitation, any tender or exchange offer, merger or other
business combination of a material portion of the assets of the Company. These
standstill provisions terminate if the Company's consolidated earnings before
interest, taxes, depreciation and amortization and exclusive of special charges,
as defined in the Investor Rights Agreement, do not meet specified targets.
Party City's trade vendors representing approximately $36.4 million of
trade debt have also entered into an agreement with the Company. Pursuant to a
Vendor Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"),
these trade vendors agreed to forbear from taking any action against Party City
until January 15, 2000, unless an event of default occurs. The trade vendors
have received promissory notes from Party City representing one-third of their
unpaid balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bear
interest at a rate of 10% per year and mature on November 15, 1999. Interest on
the Trade Notes is due on January 15, 2000, unless the bank debt is refinanced
before then. On January 15, 2000, the Company management believes it will resume
normal credit terms with the substantially all its vendors. Upon such event,
management believes the remaining two-thirds of the unpaid claims as of May 1,
1999, will be satisfied through individual arrangements with its vendors.
However, there can be no assurance that the Company will successfully conclude
these arrangements. Separately, certain seasonal trade vendors have agreed to
extend credit to Party City for 30% of purchases for the Halloween, Thanksgiving
and end of year holiday seasons. Vendors that have agreed to extend credit will
receive a shared lien that is pari passu with the liens of the Credit Agreement
on the Company's inventory for the amount of the credit extended.
F-7
37
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Also, in connection with these transactions, one outside director of the
Company resigned and two representatives of the Investors joined the Board of
Directors.
The proceeds from the $30 million in new financing have been used as
follows (in thousands):
Purchase of seasonal inventory.............................. $20,000
Payment of amounts under the Credit Agreement............... 4,000
Transactions fees........................................... 450
Working capital............................................. 5,550
-------
Total proceeds.................................... $30,000
=======
The Company's unaudited pro forma consolidated balance sheet as of July 3,
1999, after giving effect to the transactions described above, is as follows (in
thousands):
JULY 3, PRO FORMA PRO FORMA
1999 ADJUSTMENTS JULY 3, 1999
-------- ----------- ------------
(UNAUDITED) (UNAUDITED)
ASSETS
Cash and cash equivalents......................... $ 11,470 $ 25,550 $ 37,020
Merchandise inventory............................. 47,016 -- 47,016
Other current assets.............................. 29,615 -- 29,615
-------- -------- --------
Total current assets............................ 88,101 25,550 113,651
Property and equipment............................ 50,557 -- 50,557
Goodwill, net..................................... 18,483 -- 18,483
Other assets...................................... 906 450 1,356
-------- -------- --------
Total Assets............................ $158,047 $ 26,000 $184,047
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable -- trade....................... $ 45,114 $(12,133) $ 32,981
Trade Notes..................................... -- 12,133 12,133
Accrued expenses................................ 10,145 -- 10,145
Credit Agreement................................ 58,550 (4,000) 54,550
Other current liabilities....................... 986 -- 986
-------- -------- --------
Total current liabilities............... 114,795 (4,000) 110,795
Long-term Liabilities:
Senior Secured Notes............................ -- 28,200 28,200
Other long-term liabilities..................... 7,318 -- 7,318
Stockholders' equity.............................. 35,934 1,800 37,734
-------- -------- --------
Total liabilities and stockholders
equity................................ $158,047 $ 26,000 $184,047
======== ======== ========
Sales of Company-Owned Stores
In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company began a program to identify stores for sale to existing
franchisees to generate working capital. Eighteen stores with a net book value
of approximately $9,150,000 were sold to franchisees, of which seventeen stores
with a net book value of approximately $8,750,000 were sold subsequent to July
3, 1999. In connection with the sales, normal franchise fees were
F-8
38
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
waived for negotiated periods up to five years. The total proceeds from the
sales of these stores are approximately $9,883,000, of which $9,683,000 was
received subsequent to July 3, 1999. The net proceeds from the sale of stores is
required under the Bank Forbearance Agreement to be used to pay down the
outstanding borrowings under the Credit Agreement.
Management Plan
In addition to the negotiation of agreements discussed above, Company
management is evaluating various strategies for improving the Company's results
of operations, operating controls, expansion and franchising strategies,
management information systems needs and other aspects of the business. These
strategies are designed to improve the profitability from operations and improve
management insight into merchandising decisions and operating controls. There is
no assurance that the Company will achieve the operating improvements discussed
above.
Company management is also seeking replacement financing for the Credit
Agreement. Management has initiated contact with several asset-based lenders to
provide such a facility. If the Company is successful in obtaining an
asset-based lending arrangement, such a facility will assist the Company in
meeting its short-term liquidity needs for the next year. There is no assurance
at this time that the Company will be successful in obtaining this financing
facility.
The accompanying consolidated financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. The financial
statements do not include any adjustments to the recoverability and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company's ability to continue as a
going concern is dependent on the Company's achieving its minimum operating
plan, obtaining satisfactory financing and establishing normal credit terms with
its vendors. There can be no assurance that the Company will be successful in
negotiating these vendor and financing arrangements on terms that it will
consider acceptable, or at all, or that the terms of such arrangements will not
impair the Company's ability to conduct its business in accordance with its
minimum operating plan.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents
The Company considers its highly liquid investments purchased as part of
daily cash management activities to be cash equivalents.
Fair Value of Financial Instruments
Financial instruments consist of cash equivalents, accounts receivable,
accounts payable and debt obligations. The carrying amounts reported in the
balance sheets of such financial instruments approximate their fair market
values due to their short-term maturity.
Allowance for Doubtful Accounts
The allowance for doubtful accounts on receivables from franchisees at
December 31, 1997 and July 3, 1999 was $48,000 and $379,000 respectively.
Merchandise Inventory
The Company values its inventory at the lower of average cost (which
approximates FIFO) or market. Provision for obsolete and slow moving inventory
is charged to operations in the period in which such estimates are determined by
management.
F-9
39
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Advance Merchandise Payments
In order to continue shipments of merchandise from suppliers while the
Company is in arrears on its trade payables, merchandise purchases are being
made primarily on a cash-in-advance basis as an on-account payment and
classified in current assets. As merchandise inventory attributable to these
on-account payments is received in the stores, an adjustment is made in the
Company's accounting records to reflect the purchase in merchandise inventory
and reduce the advance merchandise payments account. At July 3, 1999, the
Company has approximately $9,439,000 in advance merchandise payments.
Advertising Fund
Pursuant to its franchise agreements, the Company collects 1% of the net
sales of its franchise stores for contribution into the Advertising Fund (the
"Ad Fund"). These amounts are restricted in their use for advertising on behalf
of the franchisees. Receipts and disbursements are not recorded as income or
expense since the Company does not have full discretion over the use of the
funds. The Company also contributes 1% of net sales of its owned stores into the
Ad Fund. To cover the expenses of fund administration, the Company charges the
Ad Fund a management fee equal to 5% of the funds contributed by franchisees.
During 1996, 1997, and the period from January 1, 1998 to July 3, 1999, Ad Fund
management fees of $134,000, $210,000 and $437,000, respectively, were collected
by the Company and credited to general and administrative expense.
Property and Equipment
Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives of
the assets or, where applicable, the terms of the respective leases, whichever
is shorter. Property and equipment placed in service prior to January 1, 1993,
are depreciated using an accelerated method. The difference between the two
methods is not material. The Company uses estimated useful lives of five to
seven years for furniture, fixtures and equipment. Capitalized software costs
are amortized on a straight-line basis over their estimated lives of three to
five years, beginning in the year the assets were placed into service.
Maintenance and repairs are charged directly to expense as incurred. Major
renewals or replacements of fixed assets are capitalized after making the
necessary adjustments to the asset and accumulated depreciation of the items
renewed or replaced.
Impairment of Long-lived Assets and Intangibles
The Company reviews long-lived assets, including intangibles, for
impairment whenever events or changes in circumstances indicate that the
carrying amount of the assets in question may not be recoverable.
Intangibles
Trademarks, which are included in other assets, consist primarily of
capitalized legal costs and are being amortized using the straight-line method
over the estimated useful lives of the assets. The excess of purchase price over
the fair value of the net assets acquired in connection with the purchase of
franchise stores ("goodwill") is being amortized on a straight-line basis over
15 years.
Deferred Rent
The Company accounts for scheduled rent increases contained in its leases
on a straight-line basis over the noncancelable lease term.
F-10
40
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income Taxes
The Company files a consolidated Federal income tax return. Separate state
income tax returns are filed with each state in which the Company conducts
business. The Company accounts for its income taxes using the asset and
liability method. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to the differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the year in which those temporary differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in earnings in the period
that includes the enactment date.
Stock Options
As permitted under Statement of Financial Accounting Standards ("SFAS") No.
123, "Accounting for Stock-Based Compensation", the Company has elected not to
adopt the fair value based method of accounting for its stock-based compensation
plans. The Company will continue to apply the provisions of Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees". The Company has complied with the disclosure requirements of SFAS
No. 123.
Earnings Per Share
Basic earnings per share is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per common share also includes the dilutive effect of potential common
shares (dilutive stock options) outstanding during the period. All earnings per
share data for the years ended December 31, 1996 and 1997, has been
retroactively adjusted for the three-for-two common stock split that occurred on
January 16, 1998.
Revenue Recognition
The Company operates predominately as a retailer through its Company owned
stores. The retail segment recognizes revenue at the point of sale.
The Company's franchise segment generates revenues through franchise fees
and royalties. Revenue from individual franchise sales, recorded as franchise
fees, is recognized by the Company upon completion of the certain initial
services, which normally coincide with the opening of the franchisee's store.
The Company is obligated in accordance with the terms of each franchisee's
respective agreement to provide the following initial services: advice on site
location, store design and layout, training and pre-opening assistance. On an
ongoing basis, the Company provides assistance regarding sources of supply,
pricing, advertising and promotion programs and other defined assistance.
Royalty fees are recorded on a monthly basis as a percentage of the franchisee's
net sales.
Area franchise sales represent agreements with franchisees to open a
specified number of franchises within defined geographic areas and development
periods. The Company's policy is to receive a deposit in advance for each of the
potential stores, based on its standard initial franchise fee at the time the
contract is signed. Upon receipt, the deposit is recorded as deferred revenue.
When the Company satisfies its initial
F-11
41
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
obligations to the franchisee and the store is opened, the Company recognizes
the deposit as revenue. Information regarding franchise activity follows:
NUMBER OF STORES
---------------------------------
YEAR ENDED
DECEMBER 31, PERIOD FROM
-------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
---- ---- ---------------
Franchise stores in operation at beginning of the
period.............................................. 132 164 158
Franchise stores opened during the period............. 32 19 30
Franchise stores acquired during the period........... -- (24) (9)
Stores sold by the Company............................ -- -- 1
Franchise stores closed during the period............. -- (1) (2)
--- --- ---
Franchise stores in operation at the end of the
period.............................................. 164 158 178
=== === ===
Store Opening and Closing Costs
New store opening costs are expensed as incurred. In the event a store is
closed before its lease expires, the estimated lease obligation, less any
sublease rental income, is provided in the period of closing.
Advertising Costs
The costs associated with store advertising are expensed in the period in
which the related promotion and sales occur. Advertising expense was
approximately $2.3 million, $7.0 million and $23.4 for the years ended December
31, 1996 and 1997, and the period from January 1, 1998 to July 3, 1999,
respectively.
Effect of New Accounting Standards
In June 1997, the FASB issued SFAS No. 130 "Reporting Comprehensive
Income," which establishes standards for the reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. This statement requires
that all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. The adoption
of this statement did not have an impact on the Company's consolidated financial
statements as the Company has no items of comprehensive income.
Effective January 1, 1998, the Company adopted AICPA Statement of Position
("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of this SOP had no impact on the consolidated
financial statements because the SOP requires the change to be implemented
prospectively.
Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No. 131
establishes standards for the way that business enterprises report information
about operating segments in financial statements and related disclosures about
products and services, geographical areas and major customers. The Company has
adopted this statement and expanded its disclosure of its retail and franchise
segments.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards for derivative instruments and
F-12
42
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
hedging activities. SFAS No. 133 requires an entity to recognize all derivatives
as either assets or liabilities in the statement of financial position and to
measure those instruments at fair value.
For Fiscal 2001, the Company is required to adopt SFAS No. 133, "Accounting
for Derivative Instruments and Hedging Activities." The Company has not yet
determined whether the application of SFAS No. 133 will have a material impact
on its financial position or results of operations.
Seasonality
The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
and substantially all of its net income for the year during the fourth calendar
quarter of the year, principally due to the sales in October for the Halloween
season and, to a lesser extent, due to sales for end of year holidays. The
Company's results of operations may also fluctuate significantly as a result of
a variety of other factors, including the timing of new store openings. The
Company believes this general pattern will continue in the future.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Significant
estimates include provision for obsolete and slow-moving inventory, liability
for incurred but not reported medical claims and accrued workers compensation
claims.
Concentration
The Company relies on its suppliers for the purchase of its merchandise.
That Company had two suppliers who in the aggregate constituted approximately
21% of the Company's purchases for the eighteen-month period ended July 3, 1999.
The loss of either of these suppliers would adversely affect the Company's
operations.
Reclassifications
Certain reclassifications have been made to the consolidated financial
statements in prior periods to conform to the current period presentation.
3. ACQUISITIONS
1997 Acquisitions
On February 28, 1997, the Company acquired six franchise stores. Four of
the stores acquired were owned by Steven Mandell, then the Company's Chairman
and President through May 1999 and a member of the Board of Directors until
September 17, 1999. Such stores were acquired for an aggregate purchase price of
$5.2 million. The remaining two stores were owned by Perry Kaplan, a former
executive officer and Director of the Company. Such stores were acquired for an
aggregate purchase price of $1.3 million. On August 1, 1997, the Company
acquired three franchise stores; two stores in the Southern California market
and one store in Staten Island, New York. Through these transactions, the
Company acquired certain development rights to the Southern California and
Staten Island, New York markets. The aggregate purchase price of these
transactions was approximately $3.3 million. On August 27, 1997 the Company
acquired two franchise stores in the Chicago market and on September 12, 1997
the Company acquired two franchise stores in Virginia. The aggregate purchase
price of these transactions was approximately $3.9 million. On September 2,
1997, the Company acquired 11 franchise stores in the Dallas/Fort Worth market.
The purchase price of this
F-13
43
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
transaction was approximately $8.2 million. Additionally, the acquisition
agreement provides that the Company has acquired the rights for any future
development in the Dallas/Fort Worth market.
1998 Acquisitions
On March 27, 1998, the Company acquired one franchise store in the Miami,
Florida market. The purchase price of this transaction was approximately $0.3
million. On June 28, 1998, the Company acquired three franchise stores in the
Memphis, Tennessee market. The purchase price of this transaction was
approximately $1.9 million. As discussed in Note 1, in order to meet cash flow
requirements, the Company sold the three Memphis stores to a franchisee in
August 1999. On August 31, 1998, the Company acquired four franchise stores in
the Chicago market from Duayne Weinger, a director of the Company. The purchase
price of this transaction was $3.9 million. On September 23, 1998, the Company
acquired one franchise store in the Houston market. The purchase price of this
store was approximately $0.5 million.
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 of acquisition. Goodwill of $14.1 million in
1997 and $6.2 million in 1998 was recorded in connection with these acquisitions
and is being amortized on a straight-line basis over 15 years.
The pro forma results below are not necessarily indicative of the results
of operations that would have occurred had the transactions been consummated as
indicated nor are they intended to indicate results that may occur in the
future. Assuming the stores acquired during the year ended December 31, 1997 and
1998, were acquired on January 1, 1997, the pro forma results would have been as
follows (in thousands, except per share amounts) (unaudited):
PERIOD FROM
YEAR ENDED JANUARY 1, 1998
DECEMBER 31, 1997 TO JULY 3, 1999
----------------- ---------------
Total revenues........................................ $174,817 $458,422
Net income (loss)..................................... 8,834 (11,048)
Basic earnings (loss) per share....................... $ 0.75 $ (0.89)
Diluted earnings (loss) per share..................... 0.73 (0.89)
4. OTHER CURRENT ASSETS
Other current assets consist of the following (in thousands):
DECEMBER 31, 1997 JULY 3, 1999
----------------- ------------
Restricted cash from advertising fund................... $ 290 $ 68
Receivables from franchisees:
Royalty fees.......................................... 1,069 1,124
Other................................................. 386 977
Deferred income taxes................................... 382 4,225
Prepaid and other assets................................ 5,713 6,934
------ -------
$7,840 $13,328
====== =======
F-14
44
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. OTHER ASSETS
Other assets consist of the following (in thousands):
DECEMBER 31,
1997 JULY 3, 1999
------------ ------------
Deferred income taxes....................................... $ 572 $ --
Other....................................................... 598 906
------ ----
$1,170 $906
====== ====
6. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
DECEMBER 31,
1997 JULY 3, 1999
------------ ------------
Equipment................................................... $ 9,041 $ 24,570
Furniture................................................... 10,974 23,318
Leasehold improvements...................................... 7,550 16,112
Automobiles................................................. 118 102
------- --------
27,683 64,102
Less: accumulated depreciation and amortization............. (3,484) (13,545)
------- --------
$24,199 $ 50,557
======= ========
7. IMPAIRMENT OF LONG-LIVED ASSETS
For the period from January 1, 1998 to July 3, 1999, the Company recorded
an impairment charge of $300,000 relating to goodwill and fixed assets for five
stores. These stores have not achieved expected sales and earnings. The Company
determined that each store's projected cash flow could not support future
amortization of the remaining goodwill and fixed assets and an impairment charge
was warranted. The amount of impairment charge was measured on the basis of
projected discounted cash flows using a discount rate indicative of the
Company's average cost of funds. The Company will continually assess the
recoverability of goodwill and fixed asset balances of all long-lived assets and
intangibles. The impairment charge is applicable to the Company's retail segment
and is included in general and administrative expense in the consolidated
statement of operations. No impairment charge was incurred in the years ended
December 31, 1996 and 1997.
8. ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
DECEMBER 31,
1997 JULY 3, 1999
------------ ------------
Accrued salaries and benefits............................... $2,228 $ 1,819
Sales and use taxes......................................... 1,709 1,741
Other....................................................... 3,057 6,585
------ -------
$6,994 $10,145
====== =======
F-15
45
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. EARNINGS PER SHARE
The following table sets forth the computations of basic and diluted
earnings per share (in thousands, except per share amounts):
YEAR ENDED
DECEMBER 31, PERIOD FROM
----------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
------ ------- ---------------
Net income (loss).................................. $3,756 $ 7,670 $(11,629)
Average shares outstanding......................... 9,802 11,749 12,426
Earnings (loss) per share -- basic................. $ 0.38 $ 0.65 $ (0.94)
Dilutive effect of stock options................... 194 290 (a)
Average common and common equivalent shares
outstanding...................................... 9,996 12,039 12,426
Earnings (loss) per share -- diluted............... $ 0.38 $ 0.64 $ (0.94)
- ---------------
(a) In periods with losses, options were excluded from the computation of
diluted earnings per share because they would be antidilutive.
Options to purchase, 119,250 and 1,026,820 common shares at prices ranging
from $3.84 to $34.44 per share were outstanding at December 31, 1996 and
July 3, 1999, respectively, but were not included in the computation of
dilutive earnings per share because the exercise price of the options
exceeds the average market price.
10. STOCKHOLDERS EQUITY AND STOCK OPTIONS
The Company has 25,000,000 shares authorized of its $.01 par value common
stock at December 31, 1997 and July 3, 1999. Shares issued and outstanding were
12,300,095 and 12,455,538 at December 31, 1997 and July 3, 1999, respectively.
On March 27, 1996, the Company completed an initial public offering ("IPO")
of 2,550,000 shares of common stock, $.01 par value, issued by the Company, at
an IPO price of $6.67 per share. Proceeds to the Company, net of offering
expenses of $1,990,000, were $15,010,000.
On May 8, 1997, the Company completed a secondary public offering of its
common stock. The total offering was for 3,360,000 shares of common stock, of
which 1,800,000 shares were offered by the Company and 1,560,000 were offered by
certain selling stockholders. The offering price was $8.67 per share. Proceeds
to the Company net of offering expenses were $14,185,000. On December 18, 1997,
the Board of Directors declared a three-for-two common stock split effective
January 16, 1998. All common stock and per share data has been retroactively
adjusted for the stock split.
The Company maintains the Amended and Restated 1994 Stock Option Plan (the
"1994 Plan") pursuant to which options may be granted to employees, directors
and consultants for the purchase of the common stock of the Company. On March 6,
1998, the Board of Directors of the Company amended the 1994 Option Plan to
increase the number of shares available for the grant of options under the 1994
Plan from 900,000 shares to 1,800,000 shares. This amendment was ratified by the
Company's stockholders on June 22, 1998.
The 1994 Plan, as amended, permits the Company to grant incentive and
non-qualified stock options to purchase an aggregate of 1,800,000 shares of the
Company's common stock, as adjusted for the three-for-two common stock split
that occurred on January 16, 1998. Such options may be incentive stock options
or non-qualified options. Any employee of the Company or any subsidiary of the
Company is eligible to receive incentive stock options and non-qualified stock
options under the 1994 Plan. Non-qualified stock options may
F-16
46
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
be granted to employees as well as non-employee directors and consultants of the
Company under the 1994 Plan as determined by the Board or the Compensation
Committee.
The term of an option is determined by the Compensation Committee of the
Board. The exercise price of the shares covered by an incentive stock option may
not be less than the fair value of the shares at the time of grant. The exercise
price of the shares covered by a non-qualified option need not be equal to the
fair value of the stock at the date of grant, but may be granted with an
exercise price as determined by the Compensation Committee. The options granted
prior to November 1997 vest one-third each year, over a period of three years.
Options granted after November 1997 vest over four-year and five-year periods,
vesting ratably starting in the second year after the date of grant.
The following tables summarize information about stock option transactions
for the 1994 Plan:
WEIGHTED
AVERAGE EXERCISE
NUMBER OF SHARES PRICE
---------------- ----------------
Balance at January 1, 1996............................ 255,000 2.69
Granted............................................... 422,250 9.59
Exercised............................................. (54,999) 3.18
Canceled.............................................. (88,001) 6.00
---------
Balance at December 31, 1996.......................... 534,250 7.54
Granted............................................... 583,625 12.66
Exercised............................................. (56,600) 4.62
Canceled.............................................. (64,250) 10.59
---------
Balance at December 31, 1997.......................... 997,025 10.51
Granted............................................... 527,500 17.71
Exercised............................................. (155,449) 4.86
Canceled.............................................. (342,250) 18.28
--------- -----
Balance at July 3, 1999............................... 1,026,826 12.47
=========
Options Exercisable at:
December 31, 1996..................................... 142,500
December 31, 1997..................................... 244,650
July 3, 1999.......................................... 448,701
RANGE OF EXERCISE
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------ ---------------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
NUMBER REMAINING AVERAGE NUMBER AVERAGE
OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE
RANGE OF EXERCISE PRICES AT JULY 3, 1999 LIFE PRICE AT JULY 3, 1999 PRICE
- ------------------------ --------------- ----------- -------- --------------- --------
$3.84 to $9.50 183,650 8.31 $ 6.28 89,150 $ 7.00
$9.68 to $10.00 212,750 7.53 10.00 124,500 10.00
$10.17 to $11.00 228,076 7.92 10.60 129,201 10.37
$11.56 to $16.00 225,600 8.38 13.64 69,850 13.99
$16.33 to $34.44 176,750 8.62 22.78 36,000 22.21
- -----------------------------------------------------------------------------------------------------------
$3.84 to $34.44 1,026,826 8.13 12.47 448,701 11.11
F-17
47
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company measures compensation cost under APB No. 25, "Accounting for
Stock Issued to Employees." Accordingly, no compensation cost has been
recognized in connection with the 1994 Plan in the accompanying consolidated
financial statements. In accordance with SFAS No. 123, "Accounting for Stock-
Based Compensation," the fair value of each option grant is estimated on the
date of grant using the Black-Scholes option-pricing model using the following
assumptions for grants in the respective periods:
YEAR ENDED
DECEMBER 31, PERIOD FROM
---------------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
--------- --------- ---------------
Expected volatility............................. 35% 40% 120%
Expected lives.................................. 6.0 years 4.3 years 5.0 years
Risk-free interest rate......................... 6.50% 5.7% 5.5%
Expected dividend yield......................... 0% 0% 0%
Set forth below are the Company's net income (loss) and earnings (loss) per
share presented "as reported" and pro forma as if compensation cost were
recognized in accordance with the provisions of SFAS No. 123 (in thousands,
except per share data):
YEAR ENDED DECEMBER 31, PERIOD FROM
------------------------ JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
-------- -------- ---------------
Net income (loss):
As reported................................... $3,756 $7,670 $(11,629)
Pro-forma..................................... 3,345 6,944 (13,775)
Basic earnings (loss) per share:
As reported................................... $ 0.38 $ 0.65 $ (0.94)
Pro-forma..................................... 0.34 0.59 (1.11)
Diluted earnings (loss) per share:
As reported................................... $ 0.38 $ 0.64 $ (0.94)
Pro-forma..................................... 0.33 0.58 (1.11)
11. INCOME TAXES
The provision for income tax expense consists of the following (in
thousands):
YEAR ENDED
DECEMBER 31, PERIOD FROM
---------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
------ ------ ---------------
Current:
Federal............................................. $1,963 $4,519 $2,031
State............................................... 558 981 242
------ ------ ------
2,521 5,500 2,273
Deferred:
Federal............................................. (128) (464) (3,438)
State............................................... (24) (79) 167
------ ------ ------
(152) (543) (3,271)
------ ------ ------
$2,369 $4,957 $ (998)
====== ====== ======
F-18
48
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying value of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes. In the eighteen-month period
ended July 3, 1999, the Company recorded a valuation allowance on certain of the
Company's deferred tax assets due to uncertainties associated with generating
taxable income needed to recover such assets. Since it is presently uncertain
when the Company would generate sufficient taxable income, the Company
determined it was more likely than not that such deferred tax assets could not
be recovered.
The Company has changed its year end for financial reporting to the 52-53
week year ending closest to June 30 effective the period ended July 3, 1999. The
tax year end remains December 31. The estimated tax loss for the six months
ended July 3, 1999, will be included in the tax year ended December 31, 1999. If
such a loss exists for the tax year ending December 31, 1999, its can be carried
back two years and forward 20 years.
Significant components of the net deferred tax asset at December 31, 1997
and July 3, 1999 are as follows (in thousands):
DECEMBER 31,
1997 JULY 3, 1999
------------ ------------
Current:
Inventory................................................. $ 274 $1,218
Vacation pay accrual...................................... 94 183
Reserves not currently deductible......................... - 401
Amortization of goodwill.................................. - 220
Part year federal net operating loss...................... - 4,225
Deferred state taxes...................................... - 184
Valuation allowance....................................... - (2,206)
Other..................................................... 14 -
------ ------
Net current deferred tax asset......................... $ 382 $4,225
====== ======
Non-current:
Deferred rent............................................. $1,259 $2,525
Start-up costs............................................ 20 (404)
Property and equipment.................................... (672) (2,187)
Deferred state taxes...................................... (35) (184)
Part year federal and state net operating loss............ -- 1,640
AMT credit................................................ -- 347
Valuation allowance....................................... -- (1,737)
------ ------
Non-current deferred tax asset......................... $ 572 $ --
====== ======
The following table reconciles the statutory Federal income tax rate with
the effective rate of the Company for the periods ended:
DECEMBER 31, PERIOD FROM
------------ JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
---- ---- ---------------
Federal statutory rate/(benefit)........................ 34.0% 35.0% (34.0%)
State income taxes net of federal benefit............... 5.6 4.7 2.1
Valuation allowance..................................... -- -- 23.0
Other................................................... (0.9) (0.4) 1.2
---- ---- ------
Effective tax rate/(benefit)............................ 38.7% 39.3% (7.7%)
==== ==== ======
F-19
49
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. EMPLOYEE BENEFIT PLANS
The Company has a defined contribution 401(k) savings plan (the "401(k)
Plan") covering all eligible employees. Participants may defer between 1% and
15% of annual pre-tax compensation subject to statutory limitations. The Company
contributes an amount as determined by the Board of Directors. Such amount has
been established as 50% of the employee's contribution up to $1,000.
For the years ended December 31, 1996, 1997 and the period from January 1,
1998 to July 3, 1999, $45,000, $65,000, and $107,000 were expensed under the
401(k) Plan.
13. RELATED PARTY TRANSACTIONS
The former president of the Company and a major stockholder owned all of
the outstanding shares of two party supplies stores for which no royalty fees
were charged. This officer was also the majority owner of two additional
franchise stores and was a 50% owner of one franchise through 1995. The Company
received royalty fees based on 3.0% of net sales from the majority owned stores.
In addition, a former Director of the Company owned two franchises and was a 50%
owner of one franchise through 1995, for which the franchisee paid royalty fees
of 2.0% of net sales. On February 28, 1997, the Company acquired these six
franchise stores.
Furthermore, another former officer of the Company owned two franchises. On
August 1, 1997, the Company acquired one of these stores. The Company charged
the officer approximately $0 and $19,000 for rent for the years ended December
31, 1996 and 1997. A current executive of the Company owns one franchise store.
Royalty fees of $208,000, $24,000 and $82,000 relating to the above are
included in the accompanying consolidated financial statements for the years
ended December 31, 1996, and 1997 and the period ended July 3, 1999,
respectively.
The Company and its affiliates employed common bookkeeping personnel, for
which the Company charged its affiliates approximately $94,000, $14,000 and
$19,000 for the years ended December 31, 1996 and 1997, and the period ended
July 3, 1999 respectively. As of July 3, 1999, all such services were
terminated. Office expenses allocated from the affiliate to the Company are
based upon the square footage occupied by the Company. Personnel costs allocated
to the affiliate are based upon an analysis of the percentage of time
individuals devote to services for the affiliate stores. Management believes
that both allocation methods are reasonable to determine the appropriate
expenses to be allocated.
On August 31, 1998, the Company acquired four franchise stores in the
Chicago market from a director of the Company at a purchase price of $3.9
million.
In June 1999, a major shareholder and director of the Company granted an
option to acquire 1,000,000 shares of the shareholder's common stock to the
current chief executive officer. The option vested immediately and has an
exercise price of $3.00 a share, the fair value of the common stock at date of
grant. The option expires in June 2004.
14. LEASE COMMITMENTS
Leases
The Company leases real estate in connection with the operation of
corporate retail stores as well as its corporate office. The store leases are
for properties ranging in size from 6,750 to 15,900 square feet. The terms range
from five years to twenty years, and expire by 2016. The leases contain
escalation clauses, renewal
F-20
50
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
options from five years to ten years and obligations for reimbursement of common
area maintenance and real estate taxes. Certain leases contain contingent rent
based upon specified sales volume. For the years ended December 31, 1996 and
1997, and the period from January 1, 1998 to July 3, 1999, no such contingent
rent was paid.
At July 3, 1999, the Company leases 29 motor vehicles. The terms range from
24 to 36 months, and expire by March 2002. Such leases are not being renewed as
they expire.
In August 1997, the Company entered into a five-year capital lease with a
present value of approximately $1.6 million for computer hardware and software.
The Company has the option to purchase the equipment for a nominal cost at the
termination of the lease. The leased hardware and software is included in
property and equipment at a net book value of approximately $1.3 million at July
3, 1999.
Future minimum lease payments under outstanding leases at July 3, 1999, are
as follows (in thousands):
OPERATING
CAPITAL LEASE LEASES
------------- ---------
Fiscal year ending:
2000........................................................ $ 362 $ 33,611
2001........................................................ 362 33,741
2002........................................................ 362 33,929
2003........................................................ -- 33,938
2004........................................................ -- 34,071
Thereafter.................................................. -- 130,603
------ --------
Total minimum lease payments................................ 1,086 $299,893
========
Less amount representing interest........................... (49)
------
Present value of net minimum lease payments................. 1,037
Less current maturities, included in other liabilities...... 319
------
Long-term obligation........................................ $ 718
======
Rent expense for all operating leases was $3,779,000, $11,956,000 and
$30,264,000 for the years ended December 31, 1996 and 1997, and the period from
January 1, 1998 to July 3, 1999, respectively. The Company is obligated for
guarantees, subleases or assigned lease obligations for eight of its franchisees
through 2009. The aggregate future minimum payments under these leases are
approximately $11,736,000.
15. COMMITMENTS AND CONTINGENCIES
Securities Litigation
The Company has been named as a defendant in the following twelve class
action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David
Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party
City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4)
Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No.
99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven
Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party
City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City
Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel
v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-
CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber, Civ.
Action No. 99-CV-2238;
F-21
51
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and (12) Gross v. Party City Corp., Steven Mandell and David Lauber, Civ. Action
No. 99-CV-2355. The Company's former Chief Executive Officer and former Chief
Financial Officer and Executive Vice President of Operations have also been
named as defendants. The complaints have all been filed in the United States
District Court for the District of New Jersey. The complaints were filed as
class actions on behalf of persons who purchased or acquired Party City common
stock during various time periods between February 1998 and March 19, 1999.
The complaints allege, among other things, violations of sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
thereunder, and seek unspecified damages. The plaintiffs allege that defendants
issued a series of false and misleading statements and failed to disclose
material facts concerning, among other things, the Company's financial
condition, adequacy of internal controls and compliance with certain loan
covenants. The plaintiffs further allege that because of the issuance of a
series of false and misleading statements and/or failure to disclose material
facts, the price of Party City common stock was artificially inflated.
On September 13, 1999, the Court signed an Order appointing lead plaintiffs
and lead counsel to represent the classes alleged in the complaints. The Order
directs plaintiffs to file a consolidated and amended complaint in October 1999.
Other
The Company was named as a defendant in a complaint filed with the Supreme
Court of the State of New York, County of New York, on January 16, 1998 (the
"Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung,
Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of
Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in
the suit have existing Party City franchise stores, with the remaining plaintiff
possessing a right of first refusal to develop a Party City store in Watchung,
New Jersey.
The Complaint stated various causes of action, including unjust enrichment,
unfair competition, fraud and misrepresentation, breach of contract,
misappropriation of information and violations of the New Jersey Franchise
Practices Act and the New York State Franchise Sales Act. The crux of the
Complaint was that the Company undertook a course of conduct intentionally
designed to adversely impact the value of the Plaintiffs' franchise stores in
order to permit the Company to purchase such stores at a substantially reduced
value. The Company settled the lawsuit on June 30, 1999, at no cost to the
Company. In connection with the settlement, the Company agreed to sell the
plaintiff one store at its fair value.
On April 23, 1999, plaintiff Emil Asch, Inc. filed a Complaint in the
United States District Court for the Eastern District of New York against the
Company and co-defendants Amscan, Inc., Hallmark, Inc., and Rubie's Costume. The
Complaint alleges five violations of the Robinson-Patman Act, which pertains to
price discrimination, unfair competition tortious interference with contractual
relations, and false and deceptive advertising.
Plaintiff seeks damages of $2 million, as well as treble and punitive
damages for certain counts. The Company has answered the Complaint, and
discovery should proceed shortly.
Although the Company's management is unable to express a view on the likely
outcome of these litigations because they are in their early stages, they could
have a material adverse effect on the Company's business and results of
operations.
In addition to the foregoing, the Company is from time to time involved in
routine litigation incidental to the conduct of its business. The Company is
aware of no other material existing or threatened litigation to which it is or
may be a party.
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52
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Employment Agreements
The Company has entered into employment agreements with its chief executive
officer and the chief financial officer, each for a period of three years. Such
agreements expire May and June 2002, respectively. Under the agreements, the
executives are entitled to specified salaries over the contract periods and
guaranteed bonuses for Fiscal 2000. Future bonuses are provided contingent upon
certain Company and individual performance criteria devised by the Company for
each period. Severance payments are due in the event the executives are
terminated by the Company. The Company's minimum commitment under these
agreements is approximately $3.0 million.
16. SEGMENT INFORMATION
The Company owns, operates and franchises party supplies stores in the
United States and, to a limited extent in Europe. The Company's management
reporting system evaluates performance based on a number of factors; however,
the primary measure of performance is the pre-tax operating profit of each
segment. Accordingly, the Company reports two segments - retail and franchising.
The retail segment generates revenue through the sale of primarily third-party
branded party goods through Company-owned stores. The franchising segment
generates revenue through the charge for initial franchise fees and a royalty on
retail sales. The accounting policies are described in the summary of
significant accounting policies. The Company has no intersegment sales. No
single customer accounts for 10% or more of total revenues. Revenues from Europe
were not greater than $16,000 in any periods presented. All assets of the
Company are located in North America.
F-23
53
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table contains key financial information of the Company's
business segments (in thousands):
YEAR ENDED DECEMBER 31, PERIOD FROM
----------------------- JANUARY 1, 1998
1996 1997 TO JULY 3, 1999
--------- ---------- ---------------
RETAIL:
Net revenue...................................... $39,144 $131,028 $434,272
Operating earnings............................... 3,091 12,776 13,631
Identifiable assets.............................. 32,441 84,939 146,960
Depreciation/amortization........................ 563 2,433 9,492
Capital expenditures............................. 4,356 37,200 39,421
FRANCHISING:
Net revenue...................................... $ 9,447 $ 10,686 $ 16,571
Operating earnings............................... 5,718 6,688 10,551
Identifiable assets.............................. 1,193 1,455 2,101
Depreciation/amortization........................ -- -- --
Capital expenditures............................. -- -- --
CORPORATE/OTHER:
Net revenue...................................... $ -- $ -- $ --
Operating expense................................ (3,160) (7,049) (31,795)
Identifiable assets.............................. 969 3,221 8,986
Depreciation/amortization........................ 183 361 2,335
Capital expenditures............................. 516 2,725 7,606
CONSOLIDATED TOTALS:
Net revenue...................................... $48,591 $141,714 $450,843
Operating earnings (loss)........................ 5,649 12,415 (7,613)
Interest expense (income), net................... (476) (212) 5,014
------- -------- --------
Earnings (loss) before income taxes (benefit).... 6,125 12,627 (12,627)
Income taxes (benefit)........................... 2,369 4,957 (998)
------- -------- --------
Net income (loss)................................ $ 3,756 $ 7,670 $(11,629)
======= ======== ========
Identifiable assets.............................. $34,603 $ 89,615 $158,047
Depreciation/amortization........................ 746 2,794 11,827
Capital expenditures............................. 4,872 39,925 47,027
17. SPECIAL CHARGES AND GENERAL AND ADMINISTRATIVE EXPENSE
As discussed in Note 1, the Company is in default on its Credit Agreement
and also has not been able to liquidate its trade payables in the normal course
of business. Consequently, in April 1999, the Company engaged the services of a
crisis management firm, and several law firms, accounting firms and consultants
to
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54
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
assist Company management with such tasks as: (1) preparing required
projections, (2) contacting additional financing sources, (3) negotiating with
and monitoring efforts by a vendor steering committee, (4) negotiating with
representatives of the bank group, and (5) other nonrecurring consulting
services. Included in general and administrative expense is approximately $5.9
million for these services incurred between March 1999 and July 3, 1999.
Company management believes these costs to be unusual both in scope of
services and magnitude and anticipates similar expenses of approximately $3
million to be required prior to January 31, 2000 to further resolve its
financing issues. Such expenses will be recognized as the related services are
performed.
F-25