<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
FORM 10-Q/A
- --------------------------------------------------------------------------------
(MARK ONE)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended August 1, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from_____________to ___________
Commission File Number 0-19536
THE RIGHT START, INC.
---------------------
(Exact name of registrant as specified by its charter)
California 95-3971414
---------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organiztion) Identification No.)
5388 Sterling Center Drive, Unit C, Westlake Village, CA 91361
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(Address of principal executive offices) (Zip Code)
(818) 707-7100
---------------
(Registrant's telephone number, including area code)
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
------ ------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common Stock Outstanding as of August 1, 1998 - 10,103,639 shares
<PAGE>
THE RIGHT START, INC.
INDEX TO FORM 10-Q/A
FOR THE THIRTEEN AND TWENTY - SIX WEEK PERIODS
ENDED AUGUST 1, 1998
PART I - FINANCIAL INFORMATION
<TABLE>
<S> <C> <C>
Item 1. Financial Statements (unaudited)
Balance Sheet 3
Statement of Operations 4
Statement of Cash Flows 5
Notes to Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
<CAPTION>
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 14
SIGNATURES 15
</TABLE>
2
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THE RIGHT START, INC.
BALANCE SHEET
(unaudited)
<TABLE>
<CAPTION>
(Restated - Note 4)
August 1, January 31,
1998 1998
------------- -------------
<S> <C> <C>
ASSETS
Current assets:
Cash $ 276,000 $ 240,000
Accounts and other receivables 404,000 405,000
Merchandise inventories 6,132,000 6,602,000
Prepaid catalog expenses 390,000 297,000
Other current assets 1,019,000 1,364,000
------------- -------------
Total current assets 8,221,000 8,908,000
Property, plant and equipment, net 7,737,000 8,115,000
Other non-current assets 73,000 39,000
Deferred income tax benefit 1,400,000 1,400,000
------------- -------------
$ 17,431,000 $ 18,462,000
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses $ 2,024,000 $ 2,372,000
Accrued salaries and bonuses 214,000 380,000
Advance payments on orders 32,000 30,000
Note payable 2,014,000
------------- -------------
Total current liabilities 2,270,000 4,796,000
Note payable long term 3,000,000 3,000,000
Senior subordinated notes due May 6, 2000 4,000
Senior subordinated notes due May 6, 2000 2,770,000 2,734,000
Subordinated convertible debentures due
May 31, 2002 3,000,000 3,000,000
Deferred rent 1,455,000 1,625,000
Shareholders' equity:
Common stock (25,000,000 shares authorized
at no par value; 10,103,639 issued and
outstanding) 22,337,000 22,337,000
Paid in capital 3,850,000
Accumulated deficit (21,255,000) (19,030,000)
------------- -------------
$ 17,431,000 $ 18,462,000
============= =============
</TABLE>
3
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THE RIGHT START, INC.
STATEMENT OF OPERATIONS
(unaudited)
<TABLE>
<CAPTION>
Thirteen weeks ended Twenty-six weeks ended
------------------------------------ -------------------------------------
(Restated - Note 4) (Restated - Note 4)
<S> <C> <C> <C> <C>
August 1, 1998 August 2, 1997 August 1, 1998 August 2, 1997
---------------- ---------------- ---------------- ----------------
Net sales:
Retail $ 7,791,000 $ 8,171,000 $ 15,120,000 $15,585,000
Catalog 964,000 1,782,000 2,676,000 4,304,000
----------- ----------- ------------ -----------
8,755,000 9,953,000 17,796,000 19,889,000
Costs and expenses:
Cost of goods sold 4,571,000 5,314,000 9,156,000 10,231,000
Operating expense 3,836,000 4,560,000 8,049,000 9,668,000
General and administrative expense 855,000 876,000 1,777,000 1,939,000
Pre-opening cost amortization 19,000 160,000 50,000 377,000
Depreciation and amortization expense 326,000 397,000 674,000 791,000
Other (income) expense 39,000 293,000 (113,000) 293,000
----------- ----------- ------------ -----------
9,646,000 11,600,000 19,593,000 23,299,000
----------- ----------- ------------ -----------
Operating loss (891,000) (1,647,000) (1,797,000) (3,410,000)
Interest expense 122,000 285,000 438,000 490,000
----------- ----------- ------------ -----------
Loss before income taxes and
extraordinary item (1,013,000) (1,932,000) (2,235,000) (3,900,000)
Income tax provision 5,000 10,000 17,000 20,000
----------- ----------- ------------ -----------
Loss before extraordinary item (1,018,000) (1,942,000) (2,252,000) (3,920,000)
Extraordinary gain on debt restructuring 27,000
----------- ----------- ------------ -----------
Net loss $(1,018,000) $(1,942,000) $ (2,225,000) $(3,920,000)
=========== =========== ============ ===========
Basic and diluted loss per share $ (0.10) $ (0.23) $ (0.22) $ (0.46)
=========== =========== ============ ===========
Weighted average number of shares
outstanding 10,103,639 8,593,639 10,103,639 8,546,496
=========== =========== ============ ===========
</TABLE>
4
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THE RIGHT START, INC.
STATEMENT OF CASH FLOWS
(unaudited)
<TABLE>
<CAPTION>
Twenty-six weeks ended
--------------------------------------------
(Restated - Note 4)
August 1, 1998 August 2, 1997
--------------------- --------------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (2,225,000) $ (3,920,000)
Adjustments to reconcile net loss
to net cash used in operating activities:
Depreciation and amortization 725,000 1,168,000
Loss on store closings 39,000
Amortization of discount on subordinated notes 40,000 26,000
Changes in assets and liabilities affecting operations 107,000 (743,000)
Extraordinary gain on debt restructuring (27,000)
------------ ------------
Net cash used in operating activities (1,341,000) (3,469,000)
------------ ------------
Cash flows from investing activities:
Additions to property, plant and equipment (459,000) (1,317,000)
------------ ------------
Cash flows from financing activities:
Net borrowings (payments) under revolving line of credit (2,014,000) 527,000
Proceeds from issuance of senior subordinated notes 3,850,000
Proceeds from common stock issued upon
exercise of stock options 1,320,000
Proceeds from issuance of subordinated notes 3,000,000
------------ ------------
Net cash provided by financing activities 1,836,000 4,847,000
------------ ------------
Net increase in cash 36,000 61,000
Cash at beginning of period 240,000 313,000
------------ ------------
Cash at end of period $ 276,000 $ 374,000
============ ============
</TABLE>
5
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THE RIGHT START, INC.
NOTES TO THE FINANCIAL STATEMENTS
NOTE 1: DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
The Right Start, Inc. is a specialty merchant offering unique, high-quality
juvenile products for infants and young children. The Company markets its
products through its retail stores and through The Right Start Catalog.
There have been no changes in the Company's significant accounting policies
as set forth in the Company's financial statements for the year ended January
31, 1998. These unaudited financial statements as of August 1, 1998 and for the
thirteen and twenty-six week periods then ended have been prepared in accordance
with generally accepted accounting principles for interim financial information.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
Certain reclassifications have been made to conform prior year amounts to
current year presentation.
Operating results for the thirteen and twenty-six week periods ended August
1, 1998 are not necessarily indicative of the results that may be expected for
the year ending January 30, 1999.
NOTE 2: RECAPITALIZATION
In order to enhance the Company's liquidity and improve its capital
structure, effective April 13, 1998 the Company completed a private placement of
non-interest bearing senior subordinated notes in an aggregate principal amount
of $3,850,000, together with detachable warrants to purchase an aggregate of
3,850,000 shares of common stock exercisable at $1.00 per share. The new
securities were sold for an aggregate purchase price of $3,850,000 and were
purchased principally by affiliates of the Company. In connection with the sale
of the new securities, the Company entered into an agreement with all of the
holders of the Company's existing subordinated debt securities (the
"Agreement"), representing an aggregate principal amount of $6,000,000.
Pursuant to the Agreement, each holder (of new and old securities) agreed to
exchange all of its subordinated debt securities together with any warrants
issued in connection therewith, for newly issued preferred stock. Ten shares of
newly issued preferred stock will be issued for each $1,000 principal amount of
subordinated debt securities exchanged. The total number of shares to be issued
are 30,000, 30,000 and 38,500 for Preferred Stock Series A, B and C,
respectively. Holders of $3,000,000 principal amount of existing subordinated
debt securities elected to receive Series A Preferred Stock which will have no
fixed dividend rights, will not be convertible into common stock, will be
mandatorily redeemable by the Company in May 2002 and will not accrue dividends
unless the Company is unable to redeem the Series A Preferred Stock at the
required redemption date, at which point dividends would begin to accumulate and
accrue at a rate of $15 per share per annum. Holders of $3,000,000 principal
amount of existing subordinated debt securities elected to receive Series B
Preferred Stock which will have no fixed dividend rights and will be convertible
into common stock at a price per share of $1.50. Holders of the $3,850,000
principal amount of new subordinated debt securities elected to receive Series C
Preferred Stock which will have no fixed dividend rights and will be convertible
into common stock at a price per share of $1.00. The Series B Preferred Stock
and the Series C Preferred Stock were mandatorily redeemable upon the occurrence
of a change of control of the Company, as defined in the Agreement. Pursuant to
a letter agreement dated July 7, 1998, the Company has received consent from all
but one of the parties that will hold Series B Preferred Stock to remove the
mandatory redemption feature of the Series B Preferred Stock upon a change of
control of the Company. Additionally, pursuant to such letter agreement, the
Company has received consent from all of the parties that will hold Series C
Preferred Stock to remove the mandatory redemption feature of the Series C
Preferred Stock upon the occurrence of a change of control of the Company. The
issuance of the shares of preferred stock upon exchange of the subordinated debt
securities is subject to the approval of the Company's shareholders, which
approval the Company expects to obtain at its annual meeting scheduled to be
held in October 1998.
6
<PAGE>
NOTE 2: (CONTINUED)
As the $3.85 million of New Securities were issued in contemplation of the
exchange into convertible preferred stock, the accounting for the New Securities
is analogous to convertible debt. The New Securities will be exchanged for
Series C Preferred Stock which is convertible into common stock at a price per
share of $1.00. As of the date of issue of the New Securities the stock was
trading at $2.00 a share. Since the conversion feature was in the money at the
date of issue of the debt the portion of the debt proceeds equal to the
beneficial conversion feature of $3.85 million was allocated to additional paid
in capital. The resulting debt discount of $3,850,000 is being amortized to
interest expense in the historical accounts over the period from the April
issuance date to the date the debt is first convertible. The date the debt is
first convertible is the exchange date when the debt is exchanged for
convertible preferred stock. Since the exchange transaction is subject to a
proxy vote by the shareholders, the expected date of the shareholder vote,
anticipated to be in October 1998, has been used to determine the amortization
period of six and a half months. No value has been assigned to the warrants
because the requirement to exchange the warrants, together with the debt, for
preferred stock resulted in an assessment that the warrants have no independent
value apart from the exchange transaction.
The exchanges of the subordinated debt securities for the preferred stock
will be recorded at the date of issuance of the preferred stock. The fair value
of each preferred stock series will be determined as of the issuance date of the
stock. The difference between the fair value of the preferred stock series
granted and the carrying amount of the related subordinated debt security's
balance plus accrued interest exchanged will be recognized as a gain or loss on
the extinguishment of debt. If the Series B Preferred Stock conversion feature
is "in the money" at the date of issuance of the preferred stock, a portion of
the fair value of the preferred stock equal to the beneficial conversion feature
will be allocated to additional paid in capital. The beneficial conversion
feature amount allocated to paid in capital will be recognized as a return to
the preferred shareholders immediately through a charge to accumulated deficit
and a credit to preferred stock.
The estimated gain or loss to be recorded on the total proposed
recapitalization is not determinable at this time as the transactions will be
measured and recorded at the date of issuance of the preferred stock.
In connection with the above restructuring, the holders of $6.0 million
principal amount of subordinated debt permanently waived their rights to receive
interest payments and agreed to exchange such debt for preferred stock,
resulting in the elimination of approximately $0.6 million in annual interest
payments. In addition, the proceeds from the Company's private placement of
$3,850,000 were used to pay off the Company's revolving line of credit.
Further, the Company's lender amended the existing loan agreement to provide
more favorable terms which are consistent with management's financial and
operational plans. These plans include the closure of certain unprofitable mall
stores and opening of other store locations.
As a result of the above, management believes that it has sufficient
liquidity to execute its current plan. However, the Company's ability to fund
its operations, open new stores and maintain compliance with its loan agreement
is dependent on its ability to generate sufficient cash flow from operations and
obtain additional financing as described above. Historically, the Company has
incurred losses and expects to continue to incur losses in the near term.
Depending on the success of its business strategy, the Company may continue to
incur losses beyond such period. Losses could negatively affect working capital
and the extension of credit by the Company's suppliers and impact the Company's
operations.
NOTE 3: EXTRAORDINARY GAIN
Effective April 13, 1998, the holders of the Company's $3.0 million
subordinated notes and $3.0 million subordinated convertible debentures agreed
to waive their right to receive any and all interest payments accrued and owing
after February 28, 1998. This modification of terms was accounted for
prospectively, from the effective date, under Statement of Financial Accounting
Standards No. 15 "Accounting by Debtors and Creditors for Troubled Debt
Restructurings" as follows.
The carrying amount of the notes as of April 13, 1998 was not changed as the
carrying amount of the debt did not exceed the total future cash payments of
$3.0 million specified by the new terms. Interest expense was computed using
the interest method to apply a constant effective interest rate to the payable
balance between the modification date of April 13, 1998 and maturity of the
payable in May 2000.
7
<PAGE>
The total future cash payments specified by the new terms of the convertible
debentures of $3.0 million is less than the carrying amount of the liability to
the debenture holders of $3,027,000. Therefore, the carrying amount was reduced
to an amount equal to the total future cash payments specified by the new terms
and the Company recognized a gain on restructuring of payables equal to the
amount of the reduction as of April 13, 1998. No interest expense shall be
recognized on the payable for any period between the modification date of April
13, 1998 and maturity of the payable in May 2002.
NOTE 4: RESTATEMENT OF FINANCIAL STATEMENTS FOR THE TWENTY-SIX WEEK PERIOD ENDED
AUGUST 1, 1998
The Company has restated the financial statements for the twenty-six week
period ended August 1, 1998 to reflect the following: reverse the value assigned
to the warrants of $154,000 which were attached to the $3.85 million of senior
subordinated non-interest bearing notes issued in April 1998 and record the
notes as convertible debt (see Note 2); reverse imputed interest on the non-
interest bearing notes to the extent the transaction is with a principal
shareholder; and amortize debt discount on the senior subordinated non-interest
bearing notes over the period from the April issuance date to the date the notes
are first convertible.
The effect of the restatements on accumulated deficit and net loss as of and
for the twenty-six week period ended August 1, 1998 is as follows:
<TABLE>
<CAPTION>
Net Loss Accumulated Deficit
----------- -------------------
<S> <C> <C>
As previously reported ($2,291,000) ($21,321,000)
Adjustment for the effect of restatements 15,000 15,000
----------- ------------
As adjusted ($1,207,000) ($20,237,000)
</TABLE>
The restatements had no effect on basic and diluted loss per share as previously
reported.
NOTE 5: PER SHARE DATA
Basic per share data is computed by dividing income available to common
shareholders by the weighted average number of common shares outstanding.
Diluted per share data is computed by dividing income available to common
shareholders plus income associated with dilutive securities by the weighted
average number of shares outstanding plus any potential dilution that could
occur if securities or other contracts to issue common stock were exercised or
converted into common stock in each year.
Securities that could potentially dilute basic EPS in the future that were not
included in the computation of diluted EPS because to do so would have been
antidilutive for the periods presented include options outstanding to purchase
644,000 and 652,000 shares of common stock at August 1, 1998 and August 2, 1997,
respectively, debt issued with detachable warrants in May 1997 enabling the
holder to purchase 475,000 shares of common stock at $3.00 per share and
debentures issued in October 1996 convertible into 750,000 shares of common
stock. Additionally, $3,850,000 of subordinated debt was issued with 3,850,000
detachable warrants in April 1998 enabling the holder to purchase 3,850,000
shares of common stock at $1.00 per share. This could potentially dilute basic
EPS in the future.
8
<PAGE>
NOTE 6: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid amounted to $332,000 and $394,000 for the twenty-six weeks
ended August 1, 1998 and August 2, 1997, respectively. Cash paid for income
taxes was $5,000 and $4,000 for the twenty-six weeks ended August 1, 1998 and
August 2, 1997, respectively.
Changes in assets and liabilities which increased (decreased) cash are as
follows:
<TABLE>
<CAPTION>
Twenty-six weeks ended
August 1, 1998 August 2, 1997
--------------- ---------------
<S> <C> <C>
Accounts and other receivables $ 1,000 $ 699,000
Merchandise inventories 470,000 393,000
Prepaid catalog expenses (93,000) (418,000)
Other current assets 295,000 (198,000)
Other non-current assets (34,000) 1,000
Accounts payable and accrued expenses (331,000) (1,413,000)
Accrued salaries and bonuses (166,000) (70,000)
Advance payments on orders 2,000 39,000
Deferred rent (37,000) 224,000
--------- -----------
$ 107,000 $ (743,000)
========= ===========
</TABLE>
9
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS
THIRTEEN WEEKS ENDED AUGUST 1, 1998 COMPARED WITH AUGUST 2, 1997
Net sales for the thirteen weeks ended August 1, 1998 declined 12% to $8.8
million from $10.0 million for the same period last year. For the quarter,
retail net sales declined 5% to $7.8 million as compared to $8.2 million last
year, while catalog net sales decreased 46% to $1.0 million from $1.8 million
last year. Retail sales reflect sales increases due to four store openings
during and since the second quarter of the prior fiscal year offset by eight
closings during the first half of the current fiscal year; the net impact of
store openings and closures is a 3% decline in retail sales. The remaining 2%
decline represents the Company's same-store sales results. The reduction in
catalog net sales is due to the Company's decision to significantly reduce
circulation and operate the catalog at a smaller and more profitable level.
Cost of goods sold decreased $.7 million or 14%, resulting in a gross
margin of 48% as compared to 47% last year. The margin improvement reflects the
introduction of higher margin products and product lines including developmental
toys, books, videos and other media.
Operating expense was $3.8 million in the second quarter of 1998 as
compared to $4.6 million in the second quarter of 1997, representing a 16%
decrease. Retail operating expense decreased 14%, primarily due to reductions
in merchandise warehousing and handling costs and reduced labor costs.
Additionally, catalog operating expense decreased 46% in line with the decrease
in catalog sales.
General and administrative expense decreased 2% to $855,000 during the
second quarter of 1998 from $876,000 during the same period last year. The
Company has continued its trend of significantly reduced general and
administrative expenses. These costs represent the Company's corporate overhead
expenses which are fixed in nature and do not vary directly with changes in
sales.
Depreciation and amortization expense decreased to $326,000 during the
second quarter of 1998 from $397,000 during the same period last year. The 18%
decrease is primarily due to the expense reduction associated with fixed assets
that were written off in conjunction with the closure of eight stores, the
relocation of the Company's distribution facility and the move of the Company's
corporate office. These decreases were offset by the expense associated with
the fixed asset additions for the new stores opened in fiscal 1997.
Other expense is comprised of store closing costs in the second quarter of
fiscal 1998. In the same period of the prior year, other expense represents the
write-off of fixed assets abandoned in conjunction with the relocation of the
Company's distribution facility and severance expense.
Interest expense decreased to $173,000 from $285,000 in the second quarter
of the prior year. The 39% decrease results from a decrease in total
outstanding borrowings offset by the amortization of the discount associated
with the $3.85 million non-interest bearing senior subordinated notes issued
during the first quarter of fiscal 1998. See Liquidity and Capital Resources.
TWENTY-SIX WEEKS ENDED AUGUST 1, 1998 COMPARED WITH AUGUST 2, 1997
Net sales for the twenty-six weeks ended August 1, 1998 declined 11% to
$17.8 million from $19.9 million for the same period last year. Retail net sales
declined 3% to $15.1 million as compared to $15.6 million last year, while
catalog net sales decreased 38% to $2.7 million from $4.3 million last year.
Retail sales reflect sales increases due to six store openings during and since
the second quarter of the prior fiscal year offset by eight closings during the
first half of the current fiscal year; the net impact of store openings and
closures is a 3% increase in retail sales. This is offset by a 6% decline in the
Company's same-store sales results. The reduction in catalog net sales is due to
the Company's decision to significantly reduce circulation and operate the
catalog at a smaller and more profitable level.
Cost of goods sold decreased $1.1 million or 11%, resulting in a gross
margin of 49% as compared to 49% last year. The margin is flat with the prior
year and includes a positive trend toward improvement as
10
<PAGE>
compared to the prior year. This reflects the introduction of higher margin
products and product lines including developmental toys, books, videos and other
media, offset by the impact of certain marketing and promotional programs
introduced in the first quarter of fiscal 1998.
Operating expense was $8.1 million in the first half of 1998 as compared to
$9.7 million in the first half of 1997, representing a 16% decrease. Retail
operating expense decreased 6%, primarily due to reductions in merchandise
warehousing and handling costs and reduced labor costs. Additionally, catalog
operating expense decreased 42% in line with management's plan to operate a
smaller, more profitable catalog.
General and administrative expense decreased 8% to $1,777,000 during the
first half of 1998 from $1,939,000 during the same period last year. The
Company has continued its trend of significantly reduced general and
administrative expenses.
Depreciation and amortization expense decreased to $674,000 during the
first half of 1998 from $791,000 during the same period last year. The 18%
decrease is primarily due to the expense reduction associated with fixed assets
that were written off in conjunction with the closure of eight stores, the
relocation of the Company's distribution facility and the move of the Company's
corporate office. These decreases were offset by the expense associated with
the fixed asset additions for the new stores opened in fiscal 1997.
Other (income) expense is comprised of net revenues generated from store
closings in the first half of fiscal 1998. In the same period of the prior
year, other expense represents the write-off of fixed assets abandoned in
conjunction with the relocation of the Company's distribution facility and
severance expense.
Interest expense remained relatively flat between the first half of fiscal
1998 compared to the first half of fiscal 1998. This results from a first
quarter increase offset by a second quarter decrease in total outstanding
borrowings. See Liquidity and Capital Resources. Included in interest expense
is a non-cash charge of $4,000 related to the amortization of the discount
associated with the $3.85 million of non-interest bearing senior subordinated
notes issued during the first quarter of fiscal 1998.
The Company has a deferred tax asset of $9.4 million, which is reserved by
a valuation allowance of $8.0 million, for a net tax benefit of $1.4 million.
Management expects that the Company will generate at least $4 million of taxable
income within the next 15 years to utilize the net deferred tax asset. The
taxable income will be generated through a combination of improved operating
results and tax planning strategies. Rather than lose the benefit of the
Company's net operating loss ("NOL") carryforward if the Company's operating
results alone are insufficient to realize such tax benefit, the Company could
implement certain tax planning strategies including the sale of the Company's
catalog operation, since such operations generally operate on a break-even
basis. Alternatively, the Company could also sell its catalog operation's
mailing lists in order to generate income to enable the Company to realize its
NOL carryforward. Based on the above operating improvements combined with tax
planning strategies in place, management believes that adequate taxable income
will be generated over the next 15 years in which to utilize the NOL
carryforward.
LIQUIDITY AND CAPITAL RESOURCES
During the first half of Fiscal 1998, the Company's primary sources of
liquidity were from borrowings under its $13 million senior credit facility (the
"Credit Facility") and proceeds from the sale of approximately $3.9 million of
non-interest bearing senior subordinated notes with warrants. The Credit
Facility consists of a $10,000,000 revolving line of credit for working capital
(the "Revolving Line") and a $3,000,000 capital expenditure facility (the "Capex
Line"). Availability under the Revolving Line is subject to a defined borrowing
base. As of August 1, 1998, borrowings of $3,000,000 were outstanding under the
Capex Line. There were no borrowings and approximately $2.8 million available
under the Revolving Line. The Credit Facility terminates on November 19, 1999
and on such date all borrowings thereunder are immediately due and payable.
Borrowings under the Credit Facility are secured by substantially all of the
Company's assets.
The Credit Facility, as amended, requires the Company at all times to
maintain net worth (defined to include equity and subordinated debt) of at least
$8 million. The Credit Facility also limits the Company's earnings before
interest, taxes, depreciation and amortization (EBITDA) to the following loss
amounts: $1.2 million for the three months ended May 2, 1998 and the six months
ended August 1, 1998, $900,000 for the nine
11
<PAGE>
months ended October 31, 1998 and the twelve months ended January 31, 1999 and
$500,000 for the twelve months ended April 30, 1999. Minimum EBITDA of zero is
required for the twelve months ended July 31, 1999 and $400,000 for the twelve
months ended October 31, 1999. In addition, capital expenditures are limited to
$1,750,000 in fiscal years 1998 and 1999.
The Company's ability to fund its operations, open new stores and maintain
compliance with the Credit Facility is dependent on its ability to generate
sufficient cash flow from operations. Historically, the Company has incurred
losses and expects to continue to incur losses in the near term. Depending on
the success of its business strategy, the Company may continue to incur losses
beyond such period. Losses could negatively affect working capital and the
extension of credit by the Company's suppliers and impact the Company's
operations.
In order to enhance the Company's liquidity and improve its capital
structure, effective April 13, 1998 the Company completed a private placement of
non-interest bearing senior subordinated notes in an aggregate principal amount
of $3,850,000, together with detachable warrants to purchase an aggregate of
3,850,000 shares of common stock exercisable at $1.00 per share. The new
securities were sold for an aggregate purchase price of $3,850,000 and were
purchased principally by affiliates of the Company. In connection with the sale
of the new securities, the Company entered into an agreement with all of the
holders of the Company's existing subordinated debt securities, representing an
aggregate principal amount of $6,000,000. Pursuant to the agreement, each
holder (of old and new securities) agreed to exchange all of its subordinated
debt securities together with any warrants issued in connection therewith, for
newly issued preferred stock. Ten shares of newly issued preferred stock will
be issued for each $1,000 principal amount of subordinated debt securities
exchanged. The total number of shares to be issued are 30,000, 30,000 and
38,500 for Preferred Stock Series A, B and C, respectively. Holders of
$3,000,000 principal amount existing subordinated debt securities elected to
receive Series A Preferred Stock which will have no fixed dividend rights, will
not be convertible into common stock, will be mandatorily redeemable by the
Company in May 2002 and will not accrue dividends unless the Company is unable
to redeem the Series A Preferred Stock at the required redemption date, at which
point dividends would begin to accumulate and accrue at a rate of $15 per share
per annum. Holders of $3,000,000 principal amount existing subordinated debt
securities elected to receive Series B Preferred Stock which will have no fixed
dividend rights and will be convertible into common stock at a price per share
of $1.50. Holders of the $3,850,000 principal amount of new subordinated debt
securities elected to receive Series C Preferred Stock which will have no fixed
dividend rights and will be convertible into common stock at a price per share
of $1.00. The Series B Preferred Stock and the Series C Preferred Stock was
mandatorily redeemable upon the occurrence of a change of control of the
Company, as defined in the agreement. Pursuant to a letter agreement dated July
7, 1998, the Company has received consent from all but one of the parties that
will hold Series B Preferred Stock to remove the mandatory redemption feature of
the Series B Preferred Stock upon a change of control of the Company.
Additionally, pursuant to such letter agreement, the Company has received
consent from all of the parties that will hold Series C Preferred Stock to
remove the mandatory redemption feature of the Series C Preferred Stock upon the
occurrence of a change of control of the Company. The issuance of the shares of
preferred stock upon exchange of the subordinated debt securities is subject to
the approval of the Company's shareholders, which approval the Company expects
to obtain at its annual meeting scheduled to be held in October 1998.
As the $3.85 million of New Securities were issued in contemplation of the
exchange into convertible preferred stock, the accounting for the New Securities
is analogous to convertible debt. The New Securities will be exchanged for
Series C preferred stock which is convertible into common stock at a price per
share of $1.00. As of the date of issuance of the New Securities the stock was
trading at $2.00 a share. Since the conversion feature was "in the money" at the
date of issuance of the debt, the portion of the debt proceeds equal to the
beneficial conversion feature of $3.85 million was allocated to additional paid
in capital. The resulting debt discount of $3,850,000 is being amortized to
interest expense in the historical accounts over the period from the April
issuance date to the date the debt is first convertible. The date the debt is
first convertible is the exchange date when the debt is exchanged for
convertible preferred stock. Since the exchange transaction is subject to a
proxy vote by the shareholders, the expected date of the shareholder vote,
anticipated to be in October 1998, has been used to determine the amortization
period of six and a half months. No value has been assigned to the warrants
because the requirement to exchange the warrants, together with the debt, for
preferred stock has resulted in an assessment that the warrants have no
independent value apart from the exchange transaction.
The exchanges of the subordinated debt securities for the preferred stock
will be recorded at the date of issuance of the preferred stock. The fair value
of each preferred stock series will be determined as of the issuance date of the
stock. The difference between the fair value of the preferred stock series
granted and the carrying
12
<PAGE>
amount of the related subordinated debt security's balance plus accrued interest
exchanged will be recognized as a gain or loss on the extinguishment of debt. If
the Series B Preferred Stock conversion feature is "in the money" at the date of
issue of the preferred stock, a portion of the fair value of the preferred stock
equal to the beneficial conversion feature will be allocated to additional paid
in capital. The beneficial conversion feature amount allocated to paid in
capital will be recognized as a return to the preferred shareholders immediately
through a charge to accumulated deficit and a credit to preferred stock.
The estimated gain or loss to be recorded on the total proposed
recapitalization is not determinable at this time as the transactions will be
measured and recorded at the date of issuance of the preferred stock, however,
management does not believe that the transactions will have a material adverse
effect on the Company's financial position or results of operations.
The discount inherent in the $3,850,000 of new securities must be amortized
to interest expense over the period from the April issuance date to the date the
security is first convertible. This treatment is required by generally accepted
accounting principles. In accordance with the agreement, however, no interest
payments will be made and the interest expense recorded serves to increase the
carrying value of the security and shareholders' equity.
In connection with the above restructuring, the holders of $6.0 million
principal amount of subordinated debt permanently waived their rights to receive
interest payments and agreed to exchange such debt for preferred stock,
resulting in the elimination of approximately $0.6 million in annual interest
payments. In addition, the proceeds from the Company's private placement of
$3,850,000 were used to pay off the Company's revolving line of credit.
Further, the Company's lender amended the existing loan agreement to provide
more favorable terms which are consistent with management's financial and
operational plans. These plans include the closure of certain unprofitable mall
stores and opening of other store locations.
OTHER MATTERS
Year 2000
- ---------
The Company is currently working to resolve the potential impact of the
year 2000 on the processing of date-sensitive information by the Company's
computerized information systems. The year 2000 problem is the result of
computer programs being written using two digits (rather that four) to define
the applicable year. Any of the Company's programs that have time-sensitive
software may recognize a date using "00" as the year 1900 rather that the year
2000 which could result in miscalculations or system failures. Based on
preliminary information, costs of addressing potential problems are not
currently expected to have a material adverse impact on the Company's financial
position, results of operations or cash flows in future periods. The Company
plans to devote the necessary resources to resolve all significant year 2000
issues in a timely manner.
New Accounting Pronouncements
- -----------------------------
In April 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-5 "Reporting on the Costs of Start-up
Activities" ("SOP 98-5"). This statement requires that the costs of start-up
activities and organization costs be expensed as incurred. The impact of SOP 98-
5 is not expected to be material to the Company's financial position or results
of operations. Effective October 1, 1997, the Company began expensing all store
pre-opening costs as incurred.
Nasdaq Market Listing
- ---------------------
The Company has received notice from the staff of The Nasdaq Stock Market,
Inc. ("Nasdaq") that it was not in compliance with the Nasdaq's new minimum net
tangible assets requirement of $4 million and that Nasdaq intends to delist the
Company's common stock. In accordance with the Nasdaq's procedures, the Company
has filed an appeal with the Nasdaq's Listings Hearing Department which will
allow the Company to maintain its listed status pending the outcome of the
appeal.
Although the Company currently does not satisfy the Nasdaq's minimum net
tangible asset requirement, the Company expects to regain compliance after its
annual meeting of shareholders when the Company expects to
13
<PAGE>
complete its previously announced recapitalization transaction. Pursuant to the
recapitalization transaction, the holders of all of the Company's subordinated
debt securities have agreed to exchange their debt securities for preferred
stock. Had the recapitalization been completed as of August 1, 1998, the Company
estimates that its net tangible assets would have been approximately $9 million.
The Company is unable to predict whether its appeal will be successful,
notwithstanding the consummation of the recapitalization transaction. If the
Company's appeal is unsuccessful, the Company's common stock would be removed
from listing on the Nasdaq National Market. If the Company's common stock is
delisted from the Nasdaq National Market, it may become more difficult to buy or
sell the common stock or to obtain timely and accurate quotations to buy or
sell.
PART II
ITEM 6. Exhibits and Reports on Form 8-K
The Company filed no Reports of Form 8-K during the second quarter of fiscal
1998.
The following exhibits of The Right Start, Inc. are included herein.
Exhibit
Number
- ------
27 Financial Data Schedule
14
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has caused this report to be signed on its behalf by the undersigned
and thereunto duly authorized.
THE RIGHT START, INC.
Date: October 15, 1998 /s/ JERRY WELCH
------------------------------ -----------------------------
Jerry Welch
Chief Executive Officer
15
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