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 December 31, 1998, the Company had 207 Company-owned stores and 167 franchise stores in its network.
FINANCING AND RELATED DEVELOPMENTS
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 did not meet certain of its financial and reporting covenants, including those relating to timely filing of consolidated financial statements, minimum levels of profitability, net worth, liquidity, fixed charge coverage and others. Consequently, the Company's debt under the Credit Agreement was subject to acceleration and is classified as a current liability in the consolidated balance sheet at December 31, 1998. The Credit Agreement was secured by all the assets of the Company. Additionally, the Credit Agreement restricted the payment of dividends.
On August 16, 1999, the Company entered 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 agreed not to exercise rights and remedies based upon any existing defaults until June 30, 2000, unless a further event of default occurred. The Company also agreed to reduce its outstanding borrowings from $58.6 million to $15 million by October 30, 1999. The interest rate on its bank debt was increased to 2% over the bank's prime interest rate, and the Company paid a forbearance fee of $580,000.
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. The Warrants were valued at $1,965,000 based on management's estimate using certain fair value methodologies and represent an original issue discount to the C Notes and D Notes. Up to $15 million of the Notes were secured by a first lien that was pari pasu with the liens under the Credit Agreement. The Notes are also secured by a junior 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 after giving effect to the exercise of the Warrants. The proceeds from the $30 million in new financing were used for the purchase of seasonal inventory, payment of amounts due under the Credit Agreement, transaction fees and working capital.
The Company also entered into an Investor Rights Agreement (the "Investor Rights Agreement") with the Investors and Jack Futterman, then the chief executive officer of the Company. In this agreement, the Company granted registration rights with respect to shares of common stock. 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 ("EBITDA") does not meet specified targets. The Company achieved its target EBITDA for the calendar year 1999. 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 Company has amended the restriction that prohibited the Investors from purchasing the Company's stock up to an aggregate amount of $1.5 million of the Company's common stock.
Party City's trade vendors representing approximately $36.4 million of trade debt 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. The trade vendors received promissory notes from Party City totaling approximately $12.2 million representing one-third of their unpaid balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bore interest at a rate of 10% per year and were scheduled to mature on November 15, 1999. Interest on the Trade Notes was due on January 15, 2000, unless the bank debt was refinanced before such date. Separately, certain seasonal trade vendors agreed to provide trade credit to the Company for 30% of purchases for the Halloween, Thanksgiving and year-end holiday seasons. Those vendors received a shared lien on the Company's inventory for the amount of the credit.
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 identified stores for sale to existing franchisees to generate working capital. Eighteen stores with a net book value of approximately $9.8 million were sold to franchisees. In order to facilitate the sale of these stores, franchise fees were negotiated at lower than normal rates for specific periods. The total proceeds from the sales of these stores was approximately $9.9 million. The net proceeds from the sale of stores was required under the Bank Forbearance Agreement to be used to pay down the outstanding borrowings under the Credit Agreement.
On January 14, 2000, the Company replaced the Credit Agreement with a new Loan and Security Agreement (the "Loan Agreement") with Congress Financial Corporation ("Congress"), as lender. Under the terms of the Loan Agreement, the Company may from time to time borrow amounts based on a percentage of its eligible inventory, up to a maximum of $40 million at any time outstanding. Advances bear interest, at the Company's option, (i) at the adjusted Eurodollar rate plus the applicable margin, which was initially 2.75% per annum (subject to possible reduction to an interest rate as low as 2.25% from and after June 30, 2001, based on the Company's pre-tax income and excess availability) or (ii) at the rate of 3/4% per annum above the prime rate. The term of the Loan Agreement is three years, and is secured by a lien on substantially all of the assets of the Company. At September 15, 2000, there was $15.8 million outstanding and approximately $24.2 million was available for borrowing under this revolving credit facility.
On January 14, 2000, Party City also received $7 million in cash proceeds from the sale to certain of its existing Investors (the "Investor Group") of a new series of senior secured notes pursuant to a First Amendment (the "First Amendment") to the Securities Purchase Agreements. Pursuant to the First Amendment, the Company issued $7 million in aggregate principal amount of its 14.0% Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien on substantially all of the Company's assets. The Investor Group, together with other existing Investors and Congress, have entered into an intercreditor agreement. In consideration for waivers and forbearances granted by the Investors to various defaults under the terms of the Company's A Notes, B Notes, C Notes and D Notes, the Company also agreed to amend and restate the terms of the Warrants held by the Investors to acquire 6,880,000 shares of the Company's Common Stock. The amended and restated Warrants (the "Amended Warrants") provide for an exercise price of $1.07 per share and were issued upon surrender of the Warrants which had an exercise price of $3.00 per share. The Amended Warrants were valued at $3,156,000 based on management's estimate using certain
fair value methodologies and represent an original issue discount to the C Notes and D Notes. This discount is being amortized using the effective interest method. The effective yield is 28.6% and 28.9% on the C Notes and D Notes, respectively.
The Company used the proceeds from the sale of the E Notes and initial amounts borrowed under the Loan Agreement (i) to pay off all amounts owed under the Credit Agreement, (ii) to pay all amounts owed on the Trade Notes, and (iii) to pay the remaining amounts owed to various seasonal trade vendors for credit extended for inventory purchased by the Company for the 1999 Halloween, Thanksgiving and year-end holiday seasons. All the remaining unpaid vendor balances that were originally due May 1, 1999, were satisfied by individual arrangements with such vendors.
GENERAL
The Company is a specialty retailer of party supplies through its network of discount stores. At December 31, 1998, the Company owned and operated 207 Company-owned stores in the United States and its franchisees operated an additional 167 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 10,000 square feet to 12,000 square feet. These stores offer a broad selection of merchandise (branded 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 fragmented, 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 had estimated retail sales of $11.5 billion 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 fourth calendar 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 increasingly attractive destination shopping locations for party supplies. In addition, the Company 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 continue to expand 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. 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 14,000 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 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, using the buying power of its Company-owned and franchise stores, obtains 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, an important selling season for the Company, each store increases significantly the number of sales associates in the store 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.
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 expanding its position as a category-dominant retailer of party supplies merchandise. The Company intends to focus its efforts to create the necessary 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 December 31, 1998, there were 374 Party City stores open in the United States, Canada, Puerto Rico, Portugal and Spain. Of these, 207 were Company-owned and 167 were operated by the Company's independent franchisees. The following table shows the growth in the Company's network of stores during the last five years.
The Company typically seeks sites for new stores that are stand-alone buildings or which 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, demographics, traffic count, complementary retailers, storefront 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. All Company-owned stores are in leased locations.
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 the widest selection of party supplies; this helps ensure that the Company will reduce the possibility of missed sale opportunities.
Party City stores range in size from 6,750 to 15,876 square feet with a typical store size between 10,000 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 broad selection in each product category.
Product Categories.
The typical Party City store offers a broad selection of merchandise consisting of over 14,000 SKUs divided into the following categories:
Halloween. An important merchandising concept for Party City stores is to provide an extensive selection of costumes for Halloween through its "Halloween Costume Warehouse(R)" 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 system, is often able to obtain supplies 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.
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.
Party Favors. The Company maintains a party favors department which 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.
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.
Balloons. The Company maintains a balloon department which carries a wide selection of basic and decorative latex balloons in many sizes, qualities, colors and package sizes. The mylar balloon department consists of numerous sizes, shapes and designs relating to birthday, seasonal, anniversary and other themes.
Baby Shower. The Company maintains a baby shower department, which includes tableware, decorations, balloons, favors, centerpieces and garlands.
Bridal/Wedding/Anniversary. This product category includes personalized invitations, tableware, balloons, favors, place setting cards, confetti, honeycomb bells and personalized ribbons. Personalized invitation books, which contain numerous samples of customizable event invitations, are carried from the leading invitation stationers at discounted prices.
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 (both solid and printed), glossy printed bags, solid gift wrap, printed gift wrap and foil gift wrap.
Greeting Cards. This product category includes greeting cards from a quality national card vendor at everyday low prices.
General. The Company carries a wide range of other products, including decorative tableware, solid tableware, plastic and paper table covers, cutlery, crepe paper, cups and tumblers. Party City stores carry private label items, as well as its typical branded merchandise.
Product Selection, Purchasing and Suppliers.
The Company's management continuously reviews new and existing product selections to provide the widest and 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 had two suppliers which in total constituted 24% of the Company's purchases for the year ended December 31, 1998. The loss of either one or both 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. Pursuant to the terms of the Company's franchise agreements, franchise stores must adhere to these guidelines. 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 Party City 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, store managers 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 new franchisees go through a comprehensive 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 franchise 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.
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 will assist customers in selecting a costume, which provides the sales associates with a cross-selling opportunity to suggest various accessories and other complementary products. Also, at Halloween the associates utilize two-way radios, which the Company believes help stock personnel to quickly fill requested items, thus expediting sales and reducing lost business caused by slow service.
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, highly motivated employees who are committed to providing excellent customer service.
COMPANY-OWNED STORES
At December 31, 1998, there were 207 Company-owned Party City stores, including 81 stores opened in 1998 and nine franchise stores purchased by the Company in 1998 at December 31, 1998, the Company's stores are located in the following States:
Of the leases for the stores listed above, one expires in 1999, four expire in 2001, five in 2002 and the balance in 2003 or thereafter.
FRANCHISE OPERATIONS
Until opening its first Company-owned store in January 1994, the Company operated exclusively as a franchisor. As of December 31, 1998, the Company was the franchisor for 167 Party City 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. At December 31, 1998, the Company's 167 franchise stores are located in the following states and foreign countries:
The Company receives revenue from its franchisees, including an initial one-time fee ($35,000 at December 31, 1998) and an ongoing royalty fee (4.0% of net sales for new franchisees, payable monthly at December 31, 1998). 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 the Party City store concept. The Company does not offer financing for a franchisee's initial investment. A franchisee's start-up costs include the franchise fee, rent, leasehold improvements, equipment and furniture, initial inventory, opening promotion, signs, other deposits, insurance, training expenses and professional fees.
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.
Although such locations are generally obtained and secured by the franchisee, pursuant to the franchise agreement entered into with franchisees, all site locations must be approved by the Company. As franchisor, Party City also supplies valuable and proprietary information pertaining to the operation of the Party City Super 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 December 31, 1998 the Company had seven 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. If stores are not opened pursuant to the schedule, the territory agreement may be terminated. The following areas are governed by territory agreements: North Carolina; Louisiana/Alabama; Phoenix, AZ and Santa Fe/Albuquerque, NM; 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. 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 system 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 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, which require that employers provide reasonable accommodation for employees with disabilities and that stores be accessible to customers with disabilities.
EMPLOYEES
As of December 31, 1998, the Company employed approximately 1,750 full-time and 2,960 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.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 1998, the Company leased all of its 207 stores. The Company maintains its headquarters at 400 Commons Way, Rockaway, New Jersey 07866. At December 31, 1998, the Company occupied approximately 12,201 square feet of office space for its headquarters under a lease expiring in 2005.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
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. In October 1999, plaintiffs filed an amended class action complaint and in February 2000, plaintiffs filed a second amended complaint.
The second amended class action complaint alleges, 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 seeks 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.
Defendants have moved to dismiss the second amended complaint on the ground that it fails to state a cause of action. The Court has not yet issued a decision with respect to the motion to dismiss. Because this case is in its early stages, no opinion can be expressed as to its likely outcome.
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/or punitive damages for certain counts. On February 3, 2000, Emil Asch amended its Complaint by adding Ron's: The Party Store, Inc., as an additional plaintiff to the suit. The Amended Complaint asserts the same causes of action against the same defendants and seeks the same damages that were sought in the original Complaint. The Company has answered the Amended Complaint, and discovery is proceeding. At this point, no opinion can be expressed as to the likely outcome of the litigation.
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.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1998.
PART II
ITEM 5.
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.
The following table sets forth the high and low closing sales prices of the common stock through December 31, 1998.
At September 20, 2000, the approximate number of holders of record of the common stock was approximately 5,700.
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. 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 Amended Warrants are exercisable for an aggregate of 6,880,000 shares of Common Stock at an initial exercise price of $1.07 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 Amended Warrants represent approximately 35% of the shares of Common Stock outstanding after giving effect to the exercise of the Amended Warrants. The private placement of the issuance and sale of the Notes and Amended 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.
ITEM 6. SELECTED FINANCIAL DATA
The following Selected Financial Data for each of the years ended December 31, 1994 and 1995 are derived from financial statements of the Company not included herein. The selected Consolidated Balance Sheet as of December 31, 1997 and 1998 and the selected Consolidated Statements of Operations for the three years ended December 31, 1998 are derived from the consolidated financial statements of the Company, included elsewhere in this Annual Report on Form 10-K, which have been audited by Deloitte & Touche LLP, independent public accountants, as stated in their report appearing elsewhere herein. The 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 Annual Report on Form 10-K. On December 18, 1997, the Board of Directors
declared a three-for-two common stock split effective January 16, 1998. The common stock data has been retroactively adjusted for the stock split.
- --------------- (a) 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.
(b) The Company's definition of EBITDA is earnings before interest, taxes, depreciation and amortization.
(c) Excludes borrowings under the Credit Agreement of $46.8 million included in current liabilities at December 31, 1998.
ITEM 7.
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.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
A summary of the Company's new store openings, store acquisitions and store sales is as follows:
Retail. Net sales from Company-owned stores increased 116% to $282.9 million in the year ended December 31, 1998 from $131.0 million in the year ended December 31, 1997. The 1998 results include 117 stores which were open at the beginning of that year plus 81 stores opened during the year and nine stores acquired during the year. Of the total sales increase, 48.8% is attributable to new store openings in 1998. Same store sales increased 11.3% in 1998. Gross profit reflects the cost of goods sold and store occupancy costs including rent, common area maintenance, real estate taxes, repair and maintenance, depreciation and utilities. Gross profit for the year ended December 31, 1998 increased 97.4% to $88.2 million compared to $44.7 million in 1997. The increase in 1998 was primarily due to increased sales volume. Gross margin was 31.2% and 34.1% of sales for the years ended December 31, 1998 and 1997, respectively. The decrease in gross margin was related primarily to increases in the provision for slow-moving inventory of $2.8 million and increased inventory losses of $2.1 million as compared to the loss experience in 1997. Additionally, the gross margin percentage was effected by increased store occupancy costs of $4.0 million without a corresponding increase in sales.
Store operating and selling expenses increased 132% to $74.0 million for the year ended December 31, 1998 compared to $31.9 million in 1997. The increase in store operating expenses is primarily attributable to the increased number of stores operated by the Company during 1998. Store operating expenses were 26.1% and 24.3% of sales for 1998 and 1997, respectively, due to increased store operating payroll costs related to new store openings. Company-owned store profit contribution was $14.2 million for the year ended December 31, 1998, compared to a profit contribution of $12.8 million for 1997.
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 6.1% to $10.8 million in the year ended December 31, 1998 from $10.2 million in 1997. Franchise fees, recognized on 19 store openings during the year ended December 31, 1998 increased 23.4% to $570,000 compared to $462,000 during 1997 recognized on 19 store openings. Franchise same store sales increases for the years ended December 31, 1998 and 1997 were 6.8% and 14.8%, respectively.
Expenses directly related to franchise revenue increased 2.9% to $4.1 million for the year ended December 31, 1998 from $4.0 million for the year ended December 31,1997. This increase is primarily attributable to additional franchise personnel 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 36.0% and 37.4% for the years ended December 31, 1998 and 1997, respectively.
Franchise profit contribution was increased 9.1% to $7.3 million for the year ended December 31, 1998 compared to $6.7 million for the year ended December 31, 1997. The 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. General and administrative expenses increased 126% to $16.0 million in the year ended December 31, 1998 compared to $7.0 million in the year ended December 31, 1997. The increase is primarily attributable to an increase in payroll and related benefits, recruitment and moving of new employees, professional and consulting fees, and increased travel as a result of establishing the organizational infrastructure to allow the Company to build the Company owned store base. As a percentage of sales, general and administrative expenses were 5.6% and 5.4% for the years ended December 31, 1998 and 1997, respectively.
Interest Expense. Interest expense increased to $2.6 million for the year ended December 31, 1998 from interest income of $212,000 in the year ended December 31, 1997. This is attributable to additional borrowings under the Credit Agreement outstanding during the year related to store expansion.
Income Taxes. Income taxes decreased 77.3% to $1.1 million for the year ended December 31, 1998 from $5.0 million for the year ended December 31, 1997. This decrease is related primarily to the decrease in pre-tax earnings of 76.9% for 1998 compared to 1997.
Net Income. Net income decreased 76.7% to $1.8 million or $0.14 per basic and diluted share, in the year ended December 31, 1998 as compared to net income of $7.7 million, or $0.65 per share in the year ended December 31, 1997. All earnings per share data have been retroactively adjusted for the three-for-two stock split that occurred on January 16, 1998.
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 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 a franchise store opens, and ongoing royalty fees, generally 4.0% of the store's net sales. Royalty fees increased 20.1% 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 and 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 sales, general and administrative expenses were 5.4% and 8.1% 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 55.5% 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.
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 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. Comprehensive income is equivalent to the Company's reported net income. The adoption of this statement had no impact on the consolidated financial statements.
Effective January 1, 1998, the Company adopted AICPA Statement of Position (the "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 the 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")." 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 Derivative instruments and Hedging Activities ("SFAS No. 133")." 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 year 2001, the Company is required to adopt SFAS No. 133. The Company has determined that the application of SFAS No. 133 will not have a material impact on its financial position or results of operations.
In November 1999, the SEC issued Staff Accounting Bulletin 101, "Revenue Recognition." This bulletin sets forth the SEC Staff's position regarding the point at which it is appropriate for a Registrant to recognize revenue. The Staff believes that revenue is realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or service has been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. The Company uses the above criteria to determine whether revenue can be recognized, and therefore believes that the issuance of this bulletin does not have a material impact on its consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash used in operating activities was $2.7 million in the year ended December 31, 1998 compared to cash provided by operating activities of $9.0 million and $3.6 million in the years ended December 31, 1997 and December 31, 1996, respectively. The decrease in cash provided by operating activities in 1998 in comparison with 1997 was primarily attributable to increases in merchandise inventories and other current assets as well as increased store and corporate operating expenses, without corresponding increases in accounts payable and accrued expenses as compared to 1997. The increase in cash provided by operating activities in 1997 compared to 1996 was primarily attributable to an increase in net income due to the increased number of stores in operation in 1997.
Cash used in investing activities was $39.1 million, $39.9 million and $4.9 million in the years ended December 31, 1998, 1997 and 1996, respectively. Cash used in investing activities in the year ended December 31, 1998 was spent increasing the existing store base by 81 new stores and in the acquisition of nine stores. The increase in cash used in investing activities in 1997 compared to 1996 was attributable to increased purchases of property and equipment necessary to support the growth in Company-owned stores and the acquisition of 24 franchise stores.
Cash provided by financing activities was $45.4 million, $19.2 and $15.2 for the years ended December 31, 1998, 1997 and 1996 respectively. The cash provided by financing activities in 1998 was primarily attributable to borrowings on the credit facility to finance store expansion. The cash provided by financing
activities in 1997 was primarily attributable to the proceeds of the Company's secondary public offering as well as to borrowings on the credit facility.
See "Business -- Financing and Related Developments" for an explanation of the Company's liquidity issues and subsequent financing developments.
IMPACT OF INFLATION
The Company believes that inflation did not have a material impact on its operations for the periods reported. Significant increases in the 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 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.
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 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 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In 1998, the Company utilized an interest rate swap as part of its cash management strategy. The notional amount is $20 million. The interest rate swap expired in April 1999. At December 1998, the interest rate swap arrangement provided for the payment of interest based on a fixed rate and the receipt interest based upon 3-month LIBOR. As a result, the Company remained subject to a moderate amount of market risk through the maturity of the swap. The Company estimates the fair value of the interest rate swap based upon quoted market price, to be $108,000 at December 31, 1998.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The response to this item is submitted as a separate section of this Report commencing on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
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 Stockholders.
PART IV
ITEM 14.
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 consolidated financial statements of the Company are filed as a separate section of this Report commencing on page.
Independent Auditors' Report -- Deloitte & Touche LLP Consolidated Balance Sheets -- December 31, 1997 and 1998 Consolidated Statements of Operations for the years ended December 31, 1996, 1997 and 1998 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1996, 1997 and 1998 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998 Notes to Consolidated Financial Statements for the years ended December 31, 1996, 1997 and 1998
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.
- --------------- 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 Registration Statement on Form S-8 as filed with the Commission on January 9, 1997.
(3) Incorporated by reference to the Company's Registration Statement on Form S-1 as filed with the Commission on March 6, 1997.
(4) 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.
(5) Incorporated by reference to the Company's Annual Report on Form 10-K as filed with the Commission on March 31, 1998.
(b) Reports on Form 8-K.
None
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 27, 2000.
PARTY CITY CORPORATION
By: /s/ JAMES SHEA ------------------------------------ James Shea, Chief Executive Officer
By: /s/ THOMAS E. LARSON ------------------------------------ Thomas E. Larson, Chief Financial Officer
By: /s/ LINDA M. SILUK ------------------------------------ Linda M. Siluk, Chief Accounting 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.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Party City Corporation 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 1998 and the related consolidated statements of operations, stockholders' equity, and cash flows for each year in the three year period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Party City Corporation and subsidiary as of December 31, 1997 and 1998 and the consolidated results of their operations and their cash flows for each of year in the three year period ended December 31, 1998 in conformity with accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP Parsippany, New Jersey September 27, 2000
PARTY CITY CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT NUMBER OF SHARES)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidated Financial Statements
Party City Corporation (the "Company") is incorporated in the State of Delaware and operates retail party supplies 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 December 31, 1998, the Company had 207 Company-owned stores and 167 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 delayed in issuing its audited financial statements for the year ended December 31, 1998 and was unable to 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 took a complete physical inventory as of July 3, 1999, and completed the reconciliation process necessary to prepare consolidated financial statements for the year ended December 31, 1998. 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.
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 1998 was $48,000 and $166,000 respectively.
Merchandise Inventory
The Company values its inventory at the lower of average cost (which approximates FIFO) or market. Provision for slow moving inventory is charged to operations in the period in which such estimates are determined by management.
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 1998, Ad Fund management fees of $134,000, $210,000 and $278,000, respectively, were collected by the Company and credited to general and administrative expense.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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. 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 follows Statement of Financial Accounting Standards ("SFAS") No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. In evaluating the fair value and future benefits of long-lived assets, the Company performs an analysis of the anticipated undiscounted future net cash flows of the related long-lived assets and reduces their carrying value by the excess, if any, of the result of such calculation. Management believes at this time that the carrying value and useful life of goodwill and fixed assets continues to be appropriate.
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 stores ("goodwill") is being amortized on a straight-line basis over 15 years. At December 31, 1997 and 1998, the cost of goodwill was $14.6 million and $20.8 million, respectively.
Deferred Rent
The Company accounts for scheduled rent increases contained in its leases on a straight-line basis over the noncancelable lease term.
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 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,
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"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, 1997 and 1998, 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 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 obligations to the franchisee and the store is opened, the Company recognizes the deposit as revenue. Information regarding franchise activity follows:
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 $16.0 million for the years ended December 31, 1996, 1997 and 1998, respectively.
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Effect of New Accounting Standards
In June 1997, the Financial Accounting Standards Board ("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. Comprehensive income is equivalent to the Company's reported net income. The adoption of this statement had no impact on the consolidated financial statements.
Effective January 1, 1998, the Company adopted AICPA Statement of Position (the "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")." 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")." 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 year 2001, the Company is required to adopt SFAS No. 133. The Company has determined that the application of SFAS No. 133 will not have a material impact on its financial position or results of operations.
In November 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin 101, "Revenue Recognition." This bulletin sets forth the SEC Staff's position regarding the point at which it is appropriate for a registrant to recognize revenue. The Staff believes that revenue is realizable and earned when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or service has been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. The Company uses the above criteria to determine whether revenue can be recognized, and therefore believes that the issuance of this bulletin does not have a material impact on these financial statements.
Seasonality
The Company's business is subject to substantial seasonal variations. Historically, the Company has realized a significant portion of its net sales 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, store closings and store sales. The Company believes this general pattern will continue in the future.
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Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 slow-moving inventory and a liability for incurred but not reported medical 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 24% of the Company's purchases for the year ended December 31, 1998. 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.
2. 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, a member of the Board of Directors until September 17, 1999 and a significant stockholder of the Company. 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 transaction was approximately $8.2 million. Additionally, the acquisition agreement provides that the Company 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 18, 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.
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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 $14.6 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.
Assuming the stores acquired during the years 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):
The pro forma results 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.
3. OTHER CURRENT ASSETS
Other current assets consist of the following (in thousands):
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4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following (in thousands):
5. OTHER ASSETS
Other assets consist of the following (in thousands):
6. FINANCIAL INSTRUMENTS
In 1998, the Company utilized an interest rate swap as part of its cash management strategy. The notional amount is $20 million. The interest rate swap expired in April 1999. At December 31, 1998, the interest rate swap arrangement provided for the payment of interest based on a fixed rate and the receipt interest based upon 3-month LIBOR. As a result, the Company remained subject to a moderate amount of market risk through the maturity of the swap. The Company estimates the fair value of the interest rate swap, based upon quoted market price, to be $108,000 at December 31, 1998.
7. ACCRUED EXPENSES
Accrued expenses consist of the following (in thousands):
8. 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
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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 was 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 December 31, 1998. The Credit Agreement was secured by all the assets of the Company. Additionally, the Credit Agreement restricted the payment of dividends. See additional discussion in Note 18 to the consolidated financial statements.
9. EARNINGS PER SHARE
The following table sets forth the computations of basic and diluted earnings per share (in thousands, except per share amounts):
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Options to purchase, 60,000, 193,250, and 134,000 common shares at prices ranging from $1.67 to $34.44 per share were outstanding at December 31, 1996, 1997 and 1998, 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 1998. Shares issued and outstanding were 12,300,095 and 12,452,369 at December 31, 1997 and 1998, 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
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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 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:
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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:
Set forth below are the Company's net income and earnings 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):
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11. INCOME TAXES
The provision for income tax expense consists of the following (in thousands):
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.
Significant components of the net deferred tax asset at December 31, 1997 and 1998, respectively, are as follows (in thousands):
The following table reconciles the statutory Federal income tax rate with the effective rate of the Company for the periods ended:
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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 1998, $45,000, $65,000, and $121,000 was expensed under the 401(k) Plan.
13. RELATED PARTY TRANSACTIONS
Steven Mandell, 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. Steven Mandell 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 six of these 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. As of December 31, 1998, a current executive of the Company owned one franchise store.
Royalty fees of $208,000, $24,000 and $58,000 relating to the above are included in the accompanying consolidated financial statements for the years ended December 31, 1996, 1997 and 1998, respectively.
The Company provided bookkeeping and office services for certain of these related parties. The Company charged such parties approximately $94,000, $14,000 and $15,000 for the years ended December 31, 1996, 1997, and 1998 respectively. As of July 3, 1999, all such services were terminated. Personnel and office costs allocated to the affiliate were based upon the percentage of time individuals devoted to services for the affiliate stores and square footage occupied.
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.
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 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, 1997 and 1998, no such contingent rent was paid.
At December 31, 1998, the Company leased 23 motor vehicles. The terms range from 24 to 36 months, and expire by March 2002.
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.
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Future minimum lease payments under outstanding leases at December 31, 1998, are as follows (in thousands):
Rent expense for all operating leases was $3.8 million, $12.0 million and $27.3 million for the years ended December 31, 1996, 1997, and 1998, respectively. The Company is obligated for guarantees, subleases or assigned lease obligations for six of its franchisees through 2008. The aggregate future minimum payments under these leases are approximately $8,902,000.
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; 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. In October 1999, plaintiffs filed an amended class action complaint and in February 2000, plaintiffs filed a second amended complaint.
The second amended class action complaint alleges, 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
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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.
Defendants have moved to dismiss the second amended complaint on the ground that it fails to state a cause of action. The Court has not yet issued a decision with respect to the motion to dismiss. Because this case is in its early stages, no opinion can be expressed as to its likely outcome.
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/or punitive damages for certain counts. On February 3, 2000, Emil Asch amended its Complaint by adding Ron's: The Party Store, Inc., as an additional plaintiff to the suit. The Amended Complaint asserts the same causes of action against the same defendants and seeks the same damages that were sought in the original Complaint. The Company has answered the Amended Complaint, and discovery is proceeding. At this point, no opinion can be expressed as to the likely outcome of the litigation.
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.
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
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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 significant in all periods presented. All assets of the Company are located in North America.
The following table contains key financial information of the Company's business segments (in thousands):
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17. SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
18. SUBSEQUENT EVENTS
On August 16, 1999 the Company entered 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 bank lenders and the Company entered into a Standstill and Forbearance Agreement (the "Bank Forbearance Agreement"). Under the Bank Forbearance Agreement, the Banks agreed not to exercise rights and remedies based upon any existing defaults until June 30, 2000 unless a further event of default occurred. The Company also 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.
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. The Warrants were valued at $1,965,000 based on management's estimate using certain fair value methodologies and represents an original issue discount to the C Notes and the D Notes. 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 junior lien on all of the Company's assets. The Company issued the Warrants in connection with the sale of
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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 after giving effect to the exercise of the Warrants. The proceeds from the $30 million in new financing were used for the purchase of seasonal inventory, payment of amounts due under the Credit Agreement, transaction fees and working capital.
The Company also entered into an Investor Rights Agreement (the "Investor Rights Agreement") with the Investors and Jack Futterman, then the chief executive officer of the Company. In this agreement, the Company granted registration rights with respect to shares of common stock. Under the Investor Rights Agreement, the Investors agreed 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 ("EBITDA") do not meet specified targets. The Company achieved its target EBITDA for the calendar year 1999. 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 Company has amended the restriction that prohibited the Investors from purchasing the Company's stock to permit purchase up to an aggregate amount of $1.5 million of the Company's common stock.
Party City's trade vendors representing approximately $36.4 million of trade debt 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. 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 bore interest at a rate of 10% per year and were scheduled to mature on November 15, 1999. Interest on the Trade Notes was due on January 15, 2000, unless the bank debt was refinanced before such date. Separately, certain seasonal trade vendors agreed to provide trade credit to the Company for 30% of the purchases for the Halloween, Thanksgiving and year-end holiday season. These vendors received a shared lien on the Company's inventory for the amount of the credit.
In June 1999, Steven Mandell, a major stockholder and director of the Company granted an option to acquire 1,000,000 shares of the shareholder's common stock to Jack Futterman. 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.
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 $9.8 million were sold to franchisees. In order to facilitate the sale of these stores, franchise fees were negotiated at lower than normal rates for specific periods. The total proceeds from the sales of these stores was approximately $9.9 million. The net proceeds from the sale of stores was required under the Bank Forbearance Agreement to be used to pay down the outstanding borrowings under the Credit Agreement.
PARTY CITY CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On January 14, 2000, the Company replaced the Credit Agreement with a new Loan and Security Agreement (the "Loan Agreement") with Congress Financial Corporation ("Congress"), as lender. Under the terms of the Loan Agreement, the Company may from time to time borrow amounts based on a percentage of its eligible inventory, up to a maximum of $40 million at any time outstanding. Advances bear interest, at the Company's option, (i) at the adjusted Eurodollar rate plus the applicable margin, which will initially be 2.75% per annum (subject to possible reduction to an interest rate as low as 2.25% from and after June 30, 2001, based on the Company's pre-tax income and excess availability) or (ii) at the rate of 3/4% per annum above the prime rate. The term of the Loan Agreement is three years, and is secured by a lien on substantially all of the assets of the Company. At September 15, 2000, there was $15.8 million outstanding and approximately $24.2 million was available to be borrowed under this revolving credit facility.
On January 14, 2000, Party City also received $7 million in cash proceeds from the sale to certain of its existing Investors (the "Investor Group") of a new series of senior secured notes pursuant to a First Amendment (the "First Amendment") to the Securities Purchase Agreements. Pursuant to the First Amendment, the Company issued $7,000,000 in aggregate principal amount of its 14.0% Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien on substantially all of the Company's assets. The Investor Group, together with other existing Investors and Congress, have entered into an intercreditor agreement. In consideration for waivers and forbearances granted by the Investors to various defaults under the terms of the Company's A Notes, B Notes, C Notes and D Notes, the Company also agreed to amend and restate the terms of the Warrants held by the Investors to acquire 6,880,000 shares of the Company's Common Stock. The amended and restated Warrants (the "Amended Warrants") provide for an exercise price of $1.07 per share and were issued upon surrender of the Warrants which had an exercise price of $3.00 per share. The Amended Warrants were valued at $3,156,000 based on management's estimate using certain fair value methodologies and represent an original issue discount to the C Notes and D Notes. This discount is being amortized using the effective interest method. The effective yield is 28.6% and 28.9% on the C Notes and D Notes, respectively.
The Company used the proceeds from the sale of the E Notes and initial amounts borrowed under the Loan Agreement (i) to pay off all amounts owed under the Credit Agreement, (ii) to pay all amounts owed on the Trade Notes and (iii) to pay the remaining amounts owed to various seasonal trade vendors for credit extended for inventory purchased by the Company for the 1999 Halloween, Thanksgiving and year-end holiday seasons. All the remaining unpaid vendor balances that were originally due May 1, 1999, were satisfied by individual arrangements with such vendors.