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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
AMENDMENT NO. 3
(Mark One)
(X) Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 (No fee required effective October 7, 1996)
For the fiscal year ended January 31, 1998
( ) Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 (No fee required)
Commission file no. 0-19536
THE RIGHT START, INC.
(Exact name of registrant as specified in its charter)
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<S> <C>
California 95-3971414
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
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5388 Sterling Center Dr., Unit C., Westlake Village, California 91361
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code
(818) 707-7100
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Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, no
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par value
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 and 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 __
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K/A or any amendment to
this Form 10-K/A. [ ]
As of April 15, 1998, approximately 3,134,963 shares of the Registrant's Common
Stock held by non-affiliates were outstanding and the aggregate market value of
such shares was approximately $6,662,000.
As of April 15, 1998 there were outstanding 10,103,639 shares of Common Stock,
no par value, with no treasury stock.
Portions of the Registrant's definitive Proxy Statement for the Annual Meeting
of Stockholders to be held in December 1998 (the "Proxy Statement") are
incorporated by reference into Part III hereof.
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The Company has prepared this Amendment No. 3 to Form 10-K/A to reflect the
following: (i) to change the Company's meeting date for its annual meeting of
shareholders to December 15, 1998; (ii) to revise the information reported under
"Property" to reflect the new location of the Company's headquarters; (iii) to
revise a typographical error contained in Item 12, Security Ownership of Certain
Beneficial Owners and Management, on the line reporting "All executive officers
and directors as a group (twelve persons); (iv) to conform certain disclosure
contained in this Form 10-K, to disclosure contained in the Company's proxy
statement for its annual meeting of shareholders; (v) to revise certain date and
note references contained in The Report of Independent Accountants and (vi) to
amend the Valuation Reserves Schedule on page F-19 to provide certain additional
information.
This Annual Report on Form 10-K/A contains "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Discussions
containing such forward-looking statements may be found in the material set
forth under Item 1. Business and Item 7. Management's Discussion and Analysis,
as well as within this Annual Report generally (including any document
incorporated by reference herein). Also, documents subsequently filed by the
Company with the Securities and Exchange Commission may contain forward-looking
statements. Actual results could differ materially from those projected in the
forward-looking statements as a result of the risk factors identified herein or
in other public filings by the Company, including but not limited to, the
Company's Registration Statement on Form S-3 (File No. 333-08175).
PART I
ITEM 1. BUSINESS
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GENERAL
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The Right Start, Inc. ("The Right Start" or "the Company") is a leading
merchant offering unique, high-quality products for infants and young children.
The Company markets its products through 40 retail stores and through The Right
Start Catalog. The Company is a market leader offering approximately 800 items
targeting infants and children from pre-birth up to age four. Products offered
are carefully selected to meet parents' baby care needs in such categories as
Nursery, Baby's Health, Feeding, Travel, Developmental and Apparel.
HISTORY
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The Company was formed in 1985 to capitalize upon growing trends towards
the use of mail order catalogs and the demand for high quality infants' and
children's goods. Until the formation of the Company, new parents' alternatives
were low-service mass merchant stores or sparsely-stocked, high-priced infant
and children specialty stores. To counter this, The Right Start carefully
screened infant and toddler products in order to identify those considered to be
the "best of the best," that is, the safest, most durable, best designed and
best valued items.
The Right Start then expanded its distribution channel beyond The Right
Start Catalog and into specialty retail sales through The Right Start stores.
Based on the results of the retail stores, the Company's strategy evolved to
include a reduction in The Right Start Catalog circulation and plans for a major
retail expansion.
Management has always made customer service the Company's highest priority.
By offering to its customers sales associates with extensive product knowledge,
carefully selected and tested products, fast shipment
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that is generally less than 48 hours from receipt of catalog orders, and a 24
hour a day/365 day a year ordering capacity, The Right Start is able to
differentiate itself from its competitors.
RETAIL OPERATIONS
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At January 31, 1998, the Company had 43 stores in operation with 38 of
these located in major regional malls throughout the United States. The
remaining five stores are in Southern California: four in street locations and
one in an outlet mall. The stores' product mix includes a wide variety of items
to meet the needs of the parents of infants and small children, all presented
within a store designed to provide a safe, baby-friendly environment for the
shopping ease of new parents. The Company recently increased its offering to
include an expanded selection of infant care products, apparel and developmental
items.
The number of stores open reflects the rapid growth that the Company
experienced in 1996 and early 1997, wherein 24 mall stores were opened. After
studying the results of both the mall and street locations, management concluded
that street locations represented a much more appropriate format for future
retail growth. These locations are more convenient to access and shop for the
Company's customers, many of whom are shopping with infants and small children.
Further, street locations are more cost efficient to build and operate.
Accordingly, the Company has adopted a store opening plan which calls for the
opening of six or more street-location stores in 1998.
In addition to reevaluating store location strategy, in 1997 the Company
determined that certain existing mall locations were not performing at an
acceptable level and implemented a store closing plan. Nine stores were
identified for closure and the Company is in the process of closing those of the
nine that have not already closed.
THE RIGHT START CATALOG
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The Right Start Catalog offers a mail order alternative for The Right Start
customers. This division of the Company represents the business on which the
Company was founded over twelve years ago, and it continues to offer a quality
selection of Right Start products through nationally distributed mail order
catalogs. Several attractive glossy issues are mailed each year, targeting the
Company's principal customers: educated, first-time parents from 23-40 years
old, with average annual income in excess of $60,000.
ADVERTISING AND MARKETING
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The Right Start positions its mall stores in premier locations of top malls
in order to capitalize on the malls' ability to attract a high volume of
customers. Accordingly, minimal promotional advertising is done for these
stores. For street locations, additional marketing programs are done to
establish an awareness of the stores in the local markets. These programs
include direct mail pieces and local newspaper advertising. In addition, the
stores' point of sale system provides a strong marketing database. Customers'
names and addresses are captured and are then used for promotional mailings and
other follow up. Further, the Right Start Catalog provides effective marketing
support for the stores. Catalogs are distributed in existing and future retail
markets to a targeted customer base.
The Company reaches its catalog customers through extensive mailings of The
Right Start Catalog to qualified segments of the Company's own customer list and
selected rented lists. In order to achieve this efficiently, the customer list
is segmented by frequency, recency and size of purchase. Rented lists are
evaluated based on historical performance in The Right Start mailings and
availability of names meeting the Company's customer profile.
PURCHASING
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The Right Start purchases products from over 300 vendors. No single vendor
represents more than 4% of overall sales. In total, the Company imports
approximately 13% of the products offered and this source is expected to grow in
the next year as the Company expands its private label and import programs.
Imported items have
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historically had higher gross profit margins and tend to provide more
opportunities for the Company to offer a large selection of unique goods.
RECENT DEVELOPMENTS
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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 (the "New Notes"), together with detachable warrants to
purchase an aggregate of 3,850,000 shares of common stock exercisable at $1.00
per share (the "New Warrants" and together with the New Notes, the "1998 New
Securities"). The 1998 New Securities were sold for an aggregate purchase price
of $3,850,000 and were purchased primarily by affiliates of the Company. In
connection with the sale of the 1998 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 agreed to exchange all of its subordinated debt
securities together with any warrants issued in connection therewith, for two
series of preferred stock. Ten shares of preferred stock per series 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 Series A Preferred Stock, Series B Preferred Stock and Series C
Preferred Stock, 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 and 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 (the "Series
A Preferred Stock"). Holders of $3,000,000 principal amount of existing
subordinated debt securities elected to receive Series B convertible preferred
stock which will have no fixed dividend rights and will be convertible into
common stock at a price per share of $1.50 (the "Series B Preferred Stock").
Holders of the $3,850,000 principal amount of 1998 New Securities elected to
receive Series C convertible 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 C Preferred Stock"). The Series B Preferred Stock and the Series C
Preferred Stock were mandatorily redeemable upon the occurrance 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 the Series B Preferred Stock in order to eliminate
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 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 approval of the Company's
shareholders, which approval the Company expects to obtain at its annual meeting
scheduled to be held in December 1998.
EMPLOYEES
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As of April 26, 1998, the Company employed 321 employees, approximately 55
percent of whom were part-time. During the retail holiday season, additional
temporary employees are hired. The Company's employees have not entered into
any collective bargaining agreements nor are they represented by union. The
Company considers its employee relations to be good.
COMPETITION
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The retail market for infant and toddler products is very competitive.
Significant competition currently comes from "big box" concept children's stores
which are becoming more and more prevalent. This type of operation offers
customers an extensive variety of products for children and is typically located
in up to 50,000 square feet of retail space, generally in lower real estate cost
locations. In addition, many national and regional mass merchants offer infant
and toddler products in conjunction with a full line of hard and soft goods.
The Right Start distinguishes itself from its competition by offering only
select, high-quality products in each category in a small, service-intense
environment.
There are a variety of general and specialty catalogs selling infants' and
children's items in competition with The Right Start Catalog. The Company
considers its primary catalog competition, however, to be "One Step
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Ahead," "Kids Club" by Perfectly Safe, and "Sensational Beginnings." These
catalogs emerged several years after The Right Start Catalog and directly
compete by offering a very similar product line at comparable price points to
the same target market.
TRADEMARKS
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The Company has registered and continues to register, when deemed
appropriate, certain U.S. trademarks and trade names, including "The Right Start
Catalog." The Company considers these trademarks and tradenames to be readily
identifiable with, and valuable to, its business.
ITEM 2. PROPERTIES
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At January 31, 1998, The Right Start operated 43 retail stores in 16
states. The Company leases each of its retail locations under operating leases
with lease terms ranging from six to ten years, including provisions for early
termination in most locations if certain sales levels are not achieved. At
certain locations, the Company has options to extend the term of the lease. In
most cases, rent provisions include a fixed minimum rent plus a contingent
percentage rent based on net sales of the store in excess of a certain
threshold.
The Company has moved its corporate offices to a new location in Westlake
Village, California, where the Company is leasing office space as a sub-tenant
under an 18 month lease. The space being leased is approximately 13,000 square
feet.
ITEM 3. LEGAL PROCEEDINGS
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The Company is a party to various legal actions arising in the ordinary
course of business. In the opinion of management, any claims which may occur
are adequately covered by insurance or are without merit. The Company believes
that the ultimate outcome of these matters will not have a material adverse
effect on the Company's financial position or results of operations.
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS
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Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDERS' MATTERS
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The Company's common stock is traded on the Nasdaq National Market system
under the symbol RTST. The Company's stock is held of record by approximately
126 registered shareholders as of April 15, 1998. The following table sets
forth the range of high and low bid prices on the Nasdaq National Market for the
Common Stock for the periods indicated.
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Bid Price
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High Low
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Fiscal 1997
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First Quarter $5.50 $2.13
Second Quarter 3.38 2.25
Third Quarter 3.50 2.38
Fourth Quarter 2.69 1.75
Transition Period
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First Quarter 6.88 4.25
Second Quarter 5.63 4.56
Third Quarter (1) 6.38 5.00
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(1) Covers the period from December 1, 1996 to February 1, 1997, the date to
which the Company changed its fiscal year end.
The Company has not paid dividends on its common stock and presently
intends to continue this policy. In addition, the Company's credit agreement
contains a number of financial covenants which may, among other things, limit
the Company's ability to pay dividends.
ITEM 6. SELECTED FINANCIAL DATA - (Dollars in thousands except share data)
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Fiscal Year Transition Period Fiscal Year
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1997 1996 1995 1994
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EARNINGS DATA
Revenues:
Net Sales $ 38,521 $ 27,211 $ 40,368 $ 44,573 $ 49,204
Other revenues 877 1,168 1,311
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38,521 27,211 41,245 45,741 50,515
Net income (loss) (9,241) (5,378) (3,899) (2,106) 176
Basic and diluted earnings (1.01) (0.67) (0.60) (0.33) 0.03
(loss) per share
SHARE DATA
Weighted average
shares outstanding 9,188,172 8,006,190 6,536,813 6,300,000 6,637,142
BALANCE SHEET DATA
Current assets $ 8,908 $ 11,704 $ 8,353 $ 9,660 $ 12,002
Total assets 18,462 22,982 17,475 14,632 18,221
Current liabilities 4,796 8,457 4,649 3,690 4,979
Long-term debt 8,734 5,643
Shareholders' equity 3,307 7,172 11,902 10,694 12,800
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
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OF OPERATION
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RESULTS OF OPERATIONS
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This discussion should be read in conjunction with the information
contained in the Financial Statements and accompanying Notes thereto of the
Company appearing elsewhere in this Form 10-K/A.
Transition Period results have been presented and discussed to provide the
reader with an understanding of the Company's financial condition and results of
operations. Comparisons have been made, based on the significant operating
factors in each period, between the current fiscal year and the comparable
unaudited 52-week period of the prior year and between the Transition Period and
the comparable period of Fiscal 1996.
FISCAL 1997 COMPARED WITH TRANSITION PERIOD
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Revenues for Fiscal 1997 were $38.5 million compared to $27.2 million for
the Transition Period ($41.2 million for the 52-week period ended February 1,
1997). Retail net sales were $31.1 million in Fiscal 1997 and $19.6 million in
the Transition Period ($26.8 million for the 52-week period ended February 1,
1997); catalog net
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sales were $7.4 million in Fiscal 1997 and $7.6 million in the Transition Period
($14.4 million for the 52-week period ended February 1, 1997). Retail net sales
declined 14% between Fiscal 1997 and the 52-week period ended February 1, 1997,
reflecting the partial year impact of three new stores opened in early Fiscal
1997 and three new stores opened at the end of the year, offset by same-store
sales declines of 21%. The Company attributes its some-store sales declines to
the elimination of various marketing activities, promotional offers and heavy
couponing which enhanced sales but negatively impacted margins and operating
expenses.
The 49% decline in catalog net sales between Fiscal 1997 and the 52-week
period ended February 1, 1997 reflects the continued downsizing of the Company's
catalog circulation. Circulation was down 40% between Fiscal 1997 and the 52-
week period ended February 1, 1997. This reflects the Company's plan to reduce
the mailings of the catalog to operate it at a more profitable level.
Cost of goods sold represented 50% of net sales in Fiscal 1997 and 53% in
the Transition Period (54% in the 52-week period ended February 1, 1997). The
Company has achieved better gross margins in Fiscal 1997, continuing the
favorable trend in gross margin that began in the Transition Period. At the
same time, average inventory turns have increased from two times in the
Transition Period to three times in Fiscal 1997. This reflects the ongoing
effort to right size inventory levels and minimize the need for markdowns.
Operating expenses increased as a percentage of net sales to 50% or $19.2
million in Fiscal 1997 compared to 46% in the Transition Period or $12.6 million
($20.0 million or 48% of net sales in the 52-week period ended February 1,
1997). Included in operating expenses in Fiscal 1997 and the Transition Period
are retail occupancy costs of $5.9 million or 15% of sales and $2.9 million or
11% of sales, respectively ($3.8 million or 9% of sales in the 52-week period
ended February 1, 1997). The remaining $13.3 million or 35% of sales and $9.7
million or 36% of sales, respectively ($16.2 million or 40% of sales in the 52-
week period ended February 1, 1997), are payroll and other operating expenses.
These costs have decreased as a percentage of sales, reflecting management's on-
going attention to cost reductions. The burden of fixed occupancy costs in
light of the decline in same-store-sales had a negative impact on the Company's
results for Fiscal 1997. This fact is a major part of the Company's decision to
focus its retail expansion plans on street locations, wherein occupancy and
other fixed operating costs are substantially lower than in mall locations.
General and administrative expenses were $3.9 million in Fiscal 1997
compared to $2.9 million in the Transition Period ($4.5 million for the 52-week
period ended February 1, 1997). The Company experienced a 13% decline in
general and administrative expenses between Fiscal 1997 and the 52-week period
ended February 1, 1997. This decline reflects the impact of payroll and other
overhead cost reductions made in connection with the Company's ongoing efforts
to reduce expenses.
Pre-opening cost amortization was $.7 million in Fiscal 1997 and $.5
million in the Transition Period ($.7 million for the 52-week period ended
February 1, 1997). In Fiscal 1997, three stores were opened in the first half
of the year (the period through which the Company's policy of deferring pre-
opening costs was in effect) compared to twenty-one stores opened in the 52-week
period ended February 1, 1997. Due to the timing of the previous year's
openings, the majority of the amortization related to these openings was
recognized in fiscal 1997. The increased months' amortization offset by
reductions in pre-opening costs beginning in the Transition Period resulted in
relatively flat amortization expense for the comparable periods. In the third
quarter of Fiscal 1997, the Company changed its method of accounting for pre-
opening costs and began expensing them in the first full month of the store's
operations. Previously, the Company deferred pre-opening costs and amortized
them over twelve months.
Depreciation and amortization expense increased to $1.6 million in Fiscal
1997 compared to $.8 million in the Transition Period ($1.2 million for the 52-
week period ended February 1, 1997). The increase results from a full-year
impact of the addition of build-outs and equipment for the new stores opened
during the Transition Period and the partial-year impact of stores opened during
Fiscal 1997.
Other non-recurring expenses incurred in Fiscal 1997 include $1.3 million
of fixed assets and leasehold improvements written off in conjunction with
planned store closures, $.4 million in fixed assets and leasehold improvements
written off in conjunction with the Company's corporate office and distribution
center moves and $.2
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million of severance expense. In December 1997, the Company's Board of Directors
approved management's plan to close seven poor performing retail stores. Six of
these stores were closed as of July 1998 and such closures generated positive
cash flow for the Company resulting from the recovery of the value of certain of
the leases through either landlords or future tenants of the leased space.
Interest expense, net increased from $.2 million in the Transition Period
and for the 52-week period ended February 1, 1997 to $1.1 million in Fiscal
1997. This reflects the interest charge on the Company's borrowings under its
credit facility and subordinated debt issuances which funded operating losses
and growth.
The Company has a deferred tax asset of $8.5 million, which is reserved by
a valuation allowance of $7.1 million, for a net tax benefit of $1.4 million.
Management expects that the Company will generate $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 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.
TRANSITION PERIOD COMPARED WITH FISCAL 1996
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Revenues for the Transition Period were $27.2 million compared to $26.5
million for the comparable period of Fiscal 1996. Catalog net sales for the
Transition Period were $7.6 million and were $16.6 million for the comparable
period of Fiscal 1996. The 54% decline in catalog net sales was a result of a
significant decrease in catalog circulation. The decrease in circulation
reflects management's efforts to discontinue the summer sale catalog which
generated very low margin sales and eliminate circulation to unprofitable
mailing lists.
Retail net sales were $19.6 million for the Transition Period compared to
$9.9 million for the comparable period of Fiscal 1996. The increase in retail
net sales was a result of the Company's retail expansion; 37 stores were open at
February 1, 1997 as compared to 22 at June 1, 1996. Further, the Transition
Period includes the benefit of a full period's results for the eleven stores
opened in Fiscal 1996. Same-store sales were flat for the Transition Period.
Cost of goods sold represented 53% of net sales in the Transition Period
and 54% of net sales in both Fiscal 1996 and the 33-week period ended February
3, 1996. The improvement in gross margin reflected the net positive impact of
steadily improved margins beginning in Fall 1996, offset by lower margins
generated at the beginning of the Transition Period due to heavy promotional
activity to improve the Company's inventory position. The margin improvement
was attributed to better management of inventory levels and the elimination of
excessive mark-down promotions.
Operating expense was $12.6 million, or 46% of net sales, in the Transition
Period compared to $18.3 million, or 45% of net sales, in Fiscal 1996. The
increase was primarily attributed to the addition of senior retail operations
management and increased telemarketing costs for the catalog.
General and administrative expense in the Transition Period was $2.9
million compared to $4.3 million in Fiscal 1996 ($2.0 million in the 33-week
period ended February 3, 1996). The increase between the 33 week periods
reflected the investment made in executive and senior management in the
merchandising areas to support the Company's new retail stores and implement the
Company's merchandising strategy.
The Transition Period included $528,000 in pre-opening cost amortization
compared to $418,000 in Fiscal 1996 ($265,000 in the 33-week period ended
February 3, 1996). The increase resulted from the retail expansion
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over the last two years. The Company amortized its new store opening costs over
the first twelve months of each store's operations.
Depreciation and amortization was $833,000 during the Transition Period as
compared to $938,000 in Fiscal 1996. ($581,000 in the 33-week period ended
February 3, 1996). The increase was due to the increase in property and
equipment resulting from the construction of new stores and installation of the
Company's new information system.
Non-recurring expense of $851,000 incurred during the Transition Period
were primarily attributed to the following: The Company's former President
resigned in October 1996 resulting in a $280,000 severance charge; the Company
prepaid its line of credit upon funding of its new credit facility resulting in
$145,000 of prepayment charges; and the Company had taken action to close two
unprofitable retail store locations, which has resulted in a write-off of
$425,000 in non-recoverable assets.
The Company recognized $207,000 of income tax expense for the Transition
Period. This charge resulted from management's revaluation of the deferred tax
asset. In evaluating the deferred tax asset, management considered the
Company's plans and projections and available tax planning strategies.
FISCAL 1996 COMPARED WITH FISCAL 1995
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Revenues for fiscal 1996 were $41.2 million compared to $44.8 million in
1995. Catalog net sales declined $13.5 million or 37% reflecting the December
1994 sale of Children's Wear Digest (CWD) and reduced response rates and
circulation on The Right Start Catalog. CWD was a wholly owned subsidiary of
the Company selling children's apparel by catalog.
Retail net sales increased over 100% from $7.8 million to $17.1 million.
The increase resulted from an increase in store openings and an increase in
same-store-sales for existing stores. Twenty-two stores were open at the end of
fiscal 1996 as compared to eleven at the end of fiscal 1995. Eight stores were
opened during fiscal 1995.
Cost of goods sold decreased 8.7% or $2.0 million to $21.6 million in
fiscal 1996. The decrease is primarily due to the decrease in net sales.
Additionally, the Company's margins were negatively impacted in fiscal 1996 by
inventory write-downs and shrinkage.
Operating expense decreased $.6 million or 3% from $18.9 million in fiscal
1995 to $18.3 million in fiscal 1996. The decrease represents a $3.4 million
decrease in catalog production costs offset by retail and other operating
expense increases. The decrease in catalog production costs resulted from the
decrease in The Right Start Catalog circulation. Retail operating expenses
increased due to the additional payroll and occupancy costs associated with the
new store openings.
General and administrative expense increased to $4.3 million in fiscal 1996
from $3.0 million in fiscal 1995. This increase includes approximately $600,000
in one-time charges related to hiring and relocation expenses for new key
management personnel and consulting fees related to the restructuring of the
catalog operations. The remaining increase reflected the investment in the
Company's infrastructure to position it to manage the accelerated store opening
plans.
Pre-opening cost amortization increased $304,000 in fiscal 1996 as compared
to fiscal 1995. The fiscal 1996 increase reflected the impact of both fiscal
1995 and 1996 store openings.
Depreciation and amortization increased $193,000 in fiscal 1996 as more
assets were employed in the retail operations due to new store openings.
Other non-recurring expense of $450,000 represents the severance charge
associated with the resignation of the Company's former chief executive officer.
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The Company recognized $927,000 of income tax benefit for the year ended
June 1, 1996, net of a valuation allowance provided against the deferred tax
asset in the fourth quarter of the fiscal year. In evaluating the deferred tax
asset, management considered the Company's plans and projections and available
tax planning strategies.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
During Fiscal 1997, 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 $3.0 million of subordinated debentures with
warrants. These sources financed the Company's operations and capital
expenditures. Capital expenditures of approximately $2.0 million were incurred
in new store openings and refurbishing several of the Company's older stores.
Cash used in funding operating capital (defined as the net change in assets and
liabilities affecting operations) was $1.3 million. The primary use of funds
was in the reduction of accounts payable and accrued expenses, offset by a
decrease in inventory levels and accounts receivable. Decreased inventory
purchases and the settlement of certain large accrued expenses resulted in the
liability reduction and corresponding use of cash.
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 and was $3.1 million as of January 31, 1998. As of
January 31, 1998, borrowings of $2,014,000 and $3,000,000 were outstanding under
the Revolving Line and the Capex Line, respectively, and $1,081,000 was
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 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 and obtain additional financing as
described below. 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 (the "New Notes"), together with detachable warrants to
purchase an aggregate of 3,850,000 shares of common stock exercisable at $1.00
per share (the "New Warrants" and together with the New Notes, the "1998 New
Securities"). The 1998 New Securities were sold for an aggregate purchase price
of $3,850,000 and were purchased primarily by affiliates of the Company. In
connection with the sale of the 1998 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 agreed to exchange all of its subordinated debt
securities together with any warrants issued in connection therewith, for two
series of preferred stock. Ten shares of preferred stock per series 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 Series A Preferred Stock, Series B Preferred Stock and Series C
Preferred Stock, respectively. Holders of $3,000,000 principal amount of
existing subordinated debt securities elected to receive Series A Preferred
Stock
10
<PAGE>
which will have no fixed dividend rights, will not be convertible into common
stock and 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 (the "Series A
Preferred Stock"). Holders of $3,000,000 principal amount of existing
subordinated debt securities elected to receive Series B convertible preferred
stock which will have no fixed dividend rights and will be convertible into
common stock at a price per share of $1.50 (the "Series B Preferred Stock").
Holders of the $3,850,000 principal amount of 1998 New Securities elected to
receive Series C convertible 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 C Preferred Stock"). The Series B Preferred Stock and the Series C
Preferred Stock were mandatorily redeemable upon the occurrance 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 approval of the Company's shareholders, which approval the Company expects to
obtain at its annual meeting scheduled to be held in December 1998.
As the $3.85 million of 1998 New Securities were issued in contemplation of
the exchange into convertible preferred stock, the accounting for the 1998 New
Securities is analogous to convertible debt. The 1998 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 1998 New Securities,
the Company's common stock was trading at $2.00 per 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 was used to determine the amortization period of seven
months. For the periods ended May 2, 1998 and August 1, 1998, the interest
amortization is $0 and $4,000, which has been deemed immaterial. No value has
been assigned to the warrants because of the requirement to exchange the
warrants, together with the debt, for preferred stock that 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 convertible 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.
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 of the 1998 New Securities were used to pay off the Company's
revolving line of credit. Further, the Company's lender amended the Company's
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.
11
<PAGE>
SEASONALITY
- -----------
The Company's business is not as significantly impacted by seasonal
fluctuations, as compared to many other specialty retail and catalog operations.
The Right Start's products are for the most part need-driven and the customer is
often the end user of the product. However, the Company does experience
increased sales during the Christmas holiday season.
IMPACT OF INFLATION
- -------------------
The impact of inflation on results of operations has not been significant.
OTHER MATTERS
- -------------
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 than 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 than 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.
FUTURE ACCOUNTING REQUIREMENTS
- ------------------------------
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) which requires that the costs of start-up activities and
organization costs be expensed as incurred. The impact of the adoption of SOP
98-5 is not expected to be material to the Company's financial position or
results of operations. Effective October 1, 1997 and as disclosed in Note 1,
the Company began expensing all store pre-opening costs as incurred.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ------- -------------------------------------------
The financial statements and supplementary data of the Company are as set
forth in accordance with the index included herein on page 23.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
- ------- ---------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------
Not applicable.
12
<PAGE>
PART III
<TABLE>
<CAPTION>
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- -------- --------------------------------------------------
DIRECTORS
- ---------
The directors of the Company are as follows:
Name Age Director Since Business Experience
---- --- -------------- -------------------
<S> <C> <C> <C>
Andrew Feshbach 37 1995 Mr. Feshbach is a Vice President of Fortune Financial, President
of Big Dog Sportswear and an Executive Vice President of Fortune
Fashions. Previously, Mr. Feshbach was a partner in Maiden Lane,
a merchant bank, and a Vice President in the Mergers and
Acquisitions Group of Bear Stearns.
Robert R. Hollman 54 1995 Mr. Hollman has been President and Chief Executive Officer of
Topa Management Company since 1971 and President and Chief
Executive Officer of Topa Savings Bank since 1989. He has also
been a Director and Officer of Topa Equities, Ltd., the parent
company of Topa Savings Bank, since 1969.
Fred Kayne 60 1995 Mr. Kayne is President and Chairman of Fortune Financial, where
he is responsible for directing all of its investment activities.
Mr. Kayne is also President of Fortune Fashions and Chairman of
Big Dog Sportswear. Mr. Kayne was a partner of Bear, Stearns &
Co. Inc. until its initial public offering in 1985 after which he
was a Managing Director and a member of the Board of Directors
until he resigned in 1986. Fred Kayne and Richard A. Kayne are
brothers.
Richard A. Kayne 53 1995 Mr. Kayne currently serves as President and Chief Executive
Officer of Kayne Anderson Investment Management, Inc., and its
broker dealer affiliate, K.A. Associates, Inc. Mr. Kayne has
been with Kayne Anderson Investment Management, Inc. since 1985
when it was founded by Mr. Kayne and John E. Anderson. He is
also a Director of Foremost Corporation of America and Glacier
Water Services, Inc. Richard A. Kayne and Fred Kayne are
brothers.
Jerry R. Welch 47 1995 See "Business Experience of Executive Officers" below.
Howard M. Zelikow 64 1995 Mr. Zelikow has been a management and financial consultant doing
business at ZKA Associates since 1987 and has been a Managing
Director of Kayne Anderson Investment Management, Inc. since
1988. Mr. Zelikow has been a director of Financial Security
Assurance Holdings Ltd. since 1996 and has served as a director
of Queensway Financial Holdings Limited since 1993. Mr. Zelikow
was Executive Vice President and Chief Financial Officer of The
Progressive Corporation from 1976 through 1987. Mr. Zelikow was
a director of Victoria Financial Corporation from 1991 to 1995, a
director of Capital Guaranty Corporation from 1994 to 1995, and a
director of Nobel Insurance Limited from 1989 to 1993.
</TABLE>
13
<PAGE>
The Directors of the Company serve until their successors are elected and
duly qualified at next year's Annual Meeting of Shareholders, which is to be
held on or about June 28, 1999. During the fiscal year ended January 31, 1998,
the Company's Audit Committee consisted of Messrs. Feshbach, Hollman and Zelikow
and the Company's Compensation Committee consisted of Messrs. Richard Kayne and
Fred Kayne. The Board of Directors does not have a standing Nominating
Committee. The Audit Committee reviews and reports to the Board of Directors
with respect to various auditing and accounting matters, including the selection
of the Company's independent accountants. The Compensation Committee reviews the
Company's general compensation strategy and reviews and reports to the Board of
Directors with respect to compensation of officers and employee benefit
programs.
EXECUTIVE OFFICERS
- ------------------
The executive officers of the Company (the "Named Executive Officers") are
as follows:
<TABLE>
<CAPTION>
Name Age Position Officer Since
---- --- -------- -------------
<S> <C> <C> <C> <C>
Jerry R. Welch 47 Chairman of the Board, President and Chief Executive Officer 1996
Gina M. Shauer 35 Chief Financial Officer and Secretary 1994
Ronald J. Blumenthal 52 Senior Vice President 1994
Michele Iglesias 31 Vice President-Human Resources 1996
Gerald E. Mitchell 43 Vice President-Merchandising 1996
Marilyn Platfoot 44 Vice President-Retail Operations 1996
Richard Pollock 46 Vice President-Logistics 1996
</TABLE>
All officers serve at the discretion of the Board of Directors.
BUSINESS EXPERIENCE OF EXECUTIVE OFFICERS
- -----------------------------------------
JERRY R. WELCH became Chief Executive Officer of the Company in March 1996,
assumed the position of President in September 1996 and has served as Chairman
of the Board since August 1995. Mr. Welch also serves as a Managing Director of
Kayne Anderson Investment Management, Inc. and has served in such capacity since
January 1993. Mr. Welch is also the Chairman of the Board and Chief Executive
Officer of Glacier Water Services, Inc. and has served in such capacities since
April 1993 and September 1994, respectively.
GINA M. SHAUER became Chief Financial Officer of the Company in May 1994
and Secretary in August 1995. Ms Shauer served as a Senior Manager with Price
Waterhouse in Woodland Hills, California from January 1986 until April 1994.
RONALD J. BLUMENTHAL became Senior Vice President of the Company in
September 1996 and served as Vice President-Retail Operations from December 1993
to September 1996. Prior to joining the Company, Mr. Blumenthal served as Vice
President of Store Operations for Cost Plus Imports, from 1990 until 1993, and
for Jos. A. Bank Clothiers from 1985 until 1990, where he also served as Vice
President, Real Estate.
MICHELE IGLESIAS became Vice President - Human Resources of the Company in
December 1996 and served as Director of Human Resources from February 1994 to
December 1996. Ms. Iglesias' previous experience includes other human resources
management positions.
14
<PAGE>
GERALD E. MITCHELL became Vice President-Merchandising of the Company in
July 1996. Mr. Mitchell previously served as Vice President-Merchandising for
Discovery Channel Stores in Dallas, Texas.
MARILYN PLATFOOT became Vice President-Retail Operations of the Company in
April 1996. Ms. Platfoot previously served as Western Regional Manager for
Brookstone Stores from 1992 to 1996. Prior to that, Ms. Platfoot spent 13 years
with the Foxmoor Casual chain, ultimately serving as West Coast Regional
Manager.
RICHARD POLLOCK became Vice President-Logistics of the Company in September
1996 and served as Director of Logistics from June to September 1996. Prior to
joining the Company, Mr. Pollock served as Regional Operations Manager with USCO
Distribution Services and has held several senior level distribution positions.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
- --------------------------------------------------------------------
Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act") requires the Company's executive officers, directors and persons
who own more than 10% of the Company's common stock to file reports of ownership
on Forms 3, 4 and 5 with the Commission. Executive officers, directors and 10%
stockholders are required by the Commission to furnish the Company with copies
of all Forms 3, 4 and 5 as filed.
Based solely on the Company's review of the copies of such forms it has
received, the Company believes that all of its executive officers, directors and
greater than 10% beneficial owners complied with all the filing requirements
applicable to them with respect to transactions during the fiscal year ended
January 31, 1998, except for the following: Fred Kayne did not timely file one
report covering a transaction in which he purchased 224,000 shares of the
Company's common stock. Mr. Ronald J. Blumenthal, Ms. Michele Iglesias, Mr.
Gerald E. Mitchell, Ms. Marilyn Platfoot, Mr. Richard Pollock, Ms. Gina M.
Shauer and Mr. Jerry R. Welch each did not timely file one report with respect
to each of their annual stock option grants.
ITEM 11. EXECUTIVE COMPENSATION
- -------- ----------------------
EXECUTIVE COMPENSATION
- ----------------------
The following table sets forth summary information concerning compensation
paid or accrued by the Company for services rendered during the fiscal year
ended January 31, 1998, the transition period from June 2, 1996 to February 1,
1997 and the fiscal year ended June 1, 1996 to the Company's Chief Executive
Officer and the other executive officers who received compensation (on an
annualized basis) of at least $100,000 during the periods.
15
<PAGE>
SUMMARY COMPENSATION TABLE
- --------------------------
<TABLE>
<CAPTION> Long Term Compensation
Annual Compensation -----------------------
Fiscal ------------------- Other Annual Securities Underlying
Name and Principal Position Year-End Salary Bonuses Compensation (1) Options (#)
- ---------------------------------------- -------- --------- ------- ---------------- -----------------------
<S> <C> <C> <C> <C> <C>
Jerry R. Welch (2) 1998 $ -0- $ -0- $ -0- 14,765
Chairman of the Board, President 1997 $ -0- $ -0- $ -0- 9,217
and Chief Executive Officer 1996 $ -0- $ -0- $ -0- 10,317 (3)
Ronald J. Blumenthal 1998 $135,000 -0- -0- 15,000
Senior Vice President - Marketing 1997 $ 90,965 -0- -0- -0-
1996 $110,161 29,000 4,058 50,000
Gerald E. Mitchell 1998 155,000 -0- 8,048 15,000
Vice President - Merchandising 1997 80,481 -0- 3,875 75,000
Marilyn Platfoot 1998 115,000 -0- -0- 15,000
Vice President Retail Operations 1997 72,981 -0- -0- -0-
1996 6,365 -0- -0- 25,000
Gina M. Shauer 1998 105,000 -0- -0- 10,000
Chief Financial Officer and Secretary 1997 66,635 -0- 750 -0-
1996 94,138 -0- 1,300 20,000
</TABLE>
(1) Amounts shown include Company contributions under the Company's Employee
Stock Ownership Plan and the Company's Employee Stock Purchase Plan, as
applicable for the listed executives.
(2) Mr. Welch receives no compensation for serving as Chief Executive Officer
or President.
(3) Granted under the 1995 Non-Employee Director Plan prior to Mr. Welch
becoming President and Chief Executive Officer.
DIRECTORS' FEES
- ---------------
All of the Company's non-employee directors receive directors' fees of
$3,000 per quarter. All of the members of the Board of Directors have elected,
in lieu of such compensation, to receive options to purchase common stock of the
Company at the fair market value on the date the options are granted.
16
<PAGE>
OPTION GRANTS IN THE FISCAL YEAR ENDED JANUARY 31, 1998
- -------------------------------------------------------
The following table provides certain information regarding stock options
granted to the Named Executive Officers during the fiscal year ended January 31,
1998.
<TABLE>
<CAPTION>
NAME INDIVIDUAL GRANTS % OF TOTAL EXERCISE OR EXPIRATION POTENTIAL REALIZABLE VALUE AT
- --------------- ------------------- OPTIONS BASE PRICE DATE ASSUMED ANNUAL RATES OF STOCK
GRANTED TO ($/SHARE) ---------- PRICE APPRECIATION FOR
EMPLOYEES IN ------------ OPTION TERM
FISCAL YEAR -------------------------------
-------------
<S> <C> <C> <C> <C> <C> <C>
NUMBER OF 5% ($) 10% ($)
SECURITIES ------- --------
UNDERLYING OPTIONS
GRANTED
(#) (1)
------
Jerry Welch 3,000 2.4% 2.50 7/22/07 $12,353 $ 20,303
Jerry Welch 11,765 9.6% 2.50 7/22/02 37,747 48,393
Gerald Mitchell 15,000 12.2% 2.50 7/22/07 61,763 101,514
Ron Blumenthal 15,000 12.2% 2.50 7/22/07 61,763 101,514
Marilyn Platfoot 15,000 12.2% 2.50 7/22/07 61,763 101,514
Gina Shauer 10,000 8.1% 2.50 7/22/07 41,175 67,676
Richard Pollock 10,000 8.1% 2.50 7/22/07 41,175 67,676
Michele Iglesias 10,000 8.1% 2.50 7/22/07 41,175 67,676
</TABLE>
___________________
(1) Named Executive Officers receive options pursuant to the Company's stock
compensation plans described elsewhere herein. The material terms of that
program related to recipients, grant timing, number of options, option
price and duration are determined by the Board of Directors, subject to
certain limitations.
17
<PAGE>
The following table provides certain information regarding the exercise of
stock options held by the Named Executive Officers during the fiscal year ended
January 31, 1998 and the number and value of options held as of the end of such
fiscal year.
<TABLE>
<CAPTION>
NAME VALUE NUMBER OF SECURITIES VALUE OF UNEXERCISED
- ------------ REALIZED ($) (1) UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
OPTIONS AT FISCAL YEAR END (#) AT FISCAL YEAR END ($) (1)
SHARES ACQUIRED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
ON EXERCISE (#) ------------ -------------
----------------
<S> <C> <C> <C> <C> <C> <C>
Jerry Welch -0- -0- 19,534 14,765 -0- -0-
Ron -0- -0- 33,334 56,666 -0- -0-
Blumenthal
Gerald -0- -0- 37,500 52,500 -0- -0-
Mitchell
Marilyn -0- -0- 8,333 31,667 -0- -0-
Platfoot
Gina Shauer -0- -0- 23,334 31,666 -0- -0-
</TABLE>
_________________________
(1) On January 29, 1998 (the last day the Company's common stock was traded in
the fiscal year ended January 31, 1998), the closing sale price of the
Company's common stock on the Nasdaq National Market System was $1.75 per
share.
STOCK COMPENSATION PROGRAMS
- ---------------------------
1991 Employee Stock Option Plan
In October 1991, the Company adopted the 1991 Employee Stock Option Plan
(the "1991 Plan"), as amended to cover an aggregate of 575,000 shares of the
Company's common stock, in order to provide a means of encouraging certain
officers and employees of the Company to obtain a proprietary interest in the
enterprise and thereby create an additional incentive for such persons to
further the Company's growth and development. The information regarding the 1991
Plan provided herein is qualified in its entirety by the full text of such plan,
copies of which have been filed with the Securities and Exchange Commission.
Options granted vest over periods of up to five years (depending on the terms of
the individual grant) commencing on the grant date and expire 10 years
thereafter. Options for 389,982 shares were outstanding as of January 31, 1998,
125,717 of which were exercisable.
On May 5, 1998, the Compensation Committee granted options to purchase an
aggregate of 880,000 shares of the Company's common stock (the "New Option
Shares") to certain executive officers and employees of the Company (each a
"grantee") at an exercise price of $1.75 per share, the closing sale price per
share of the Company's common stock on the date of grant. Grant of the New
Option Shares is subject to shareholder approval to increase the number of
shares of the Company's common stock that may be issued under the 1991 Plan. The
Compensation Committee has also determined that grant of the New Option Shares
to a grantee is conditioned upon such grantee's canceling all of his or her
existing outstanding options to purchase the Company's common stock. The
Compensation Committee may from time to time modify or amend the 1991 Plan as it
deems necessary or desirable, but generally may not change an option already
granted thereunder without the written consent of the holder of such option (or
stock issued on exercise thereof). Of the 880,000 New Option Shares granted,
600,000 option shares were granted to executive officers of the Company in the
following amounts: Gerald Mitchell (125,000 option shares), Ron Blumenthal
(75,000 option shares), Marilyn Platfoot (125,000 option shares), Gina Shauer
(100,000 option shares), Richard Pollock (100,000 option shares), and Michele
Iglesias (75,000 option shares). The remaining 280,000 New Option Shares were
granted to non-executive employees of the Company.
18
<PAGE>
The Board of Directors of the Company has proposed an amendment to the 1991
Plan to increase the maximum number of shares of common stock issuable under
such plan from 575,000 to 1,150,000 shares, subject to the approval of the
shareholders of the Company as provided in the Company's 1998 annual proxy
statement.
1995 Non-Employee Directors Plan
In October 1995, the Company adopted the 1995 Non-Employee Director Plan
(the "1995 Plan"), as amended to cover an aggregate of 250,000 shares of common
stock. The information regarding the 1995 Plan provided herein is qualified in
its entirety by the full text of such plan, copies of which have been filed with
the Securities and Exchange Commission. The 1995 Plan provides for the annual
issuance, to each non-employee director, of options to purchase 3,000 shares of
common stock. In addition, each director is entitled to make an election to
receive, in lieu of directors' fees, additional options to purchase common
stock. The amount of additional options is determined based on an independent
valuation such that the value of the options issued is equivalent to the fees
that the director would be otherwise entitled to receive. Options issued under
this plan vest on the anniversary date of their grant and upon termination of
Board membership. 191,029 options were issued under the plan, 117,204 of which
were exercisable as of January 31, 1998.
The Board of Directors of the Company has proposed an amendment to the 1995
Plan to increase the maximum number of shares of common stock issuable under
such plan from 250,000 to 350,000 shares, subject to the approval of the
shareholders of the Company as provided in the Company's 1998 annual proxy
statement.
Company Employee Stock Purchase Plan
The Company matches employees' contributions to the Company Employee Stock
Purchase Plan at a rate of 50%. The Company's contributions amounted to
$24,000, $21,000 and $28,000 in fiscal 1998, the transition period ended
February 1, 1997 and fiscal 1996, respectively.
Company Employee Stock Ownership Plan
The Company Employee Stock Ownership Plan is funded exclusively by
discretionary contributions determined by the Board of Directors. No
contributions were authorized for fiscal 1998 or the transition period ended
February 1, 1997. The Board of Directors authorized contributions of $70,000 in
fiscal 1996.
COMPENSATION COMMITTEES INTERLOCKS AND INSIDER PARTICIPATION
Richard Kayne and Fred Kayne are each members of the Company's Compensation
Committee and have participated in transactions requiring disclosure under the
Item 13: Certain Relationships and Related Transactions.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- -------- --------------------------------------------------------------
The following table sets forth certain information, as of May 4, 1998, with
respect to all those known by the Company to be the beneficial owners of more
than 5% of its outstanding common stock, each director who owns shares of common
stock, each Named Executive Officer, and all directors and executive officers of
the Company as a group. The following table also sets forth certain information
on a pro forma basis which information gives effect to the Recapitalization (as
defined in Item 13 below), as if the Recapitalization had been approved by the
Company's shareholders and fully consummated on May 4, 1998.
19
<PAGE>
<TABLE>
<CAPTION>
Pro forma for Recapitalization
--------------------------------
Name and Address of Beneficial Owner Amount and Percent of Amount and Percent of
- --------------------------------------------------- Nature of Class Nature of Class
Beneficial ----------- Beneficial -------------
Ownership (1) Ownership (1)
-------------- ----------------
<S> <C> <C> <C> <C>
Richard A. Kayne (2) 4,365,958 42.4% 8,533,854 59.7%
KAIM Non-Traditional, L.P.
1800 Avenue of the Stars
Second Floor
Los Angeles, CA 90067
Cahill, Warnock Strategic Partners Fund, L.P. (3) 988,333 8.9% 746,667 6.9%
One South Street, Suite 2150
Baltimore, MD 21202
Travelers Group Inc. (4) 783,043 7.7% 771,376 7.6%
388 Greenwich Street
New York, NY 10013
Fred Kayne (5) 914,493 9.0% 1,391,577 13.0%
Fortune Fashions
6501 Flotilla Street
Commerce, CA 90040
Albert O. Nicholas 625,000 6.2% 625,000 6.2%
Nicholas Co., Inc.
700 North Water Street
Milwaukee, WI 53202
Howard Kaplan 610,000 6.0% 610,000 6.0%
99 Chauncy Street
Boston, MA 02111
Gerald E. Mitchell (6) 66,750 * 66,750 *
5388 Sterling Center Drive, Unit C
Westlake Village, CA 91361
Gina M. Shauer (7) 27,392 * 27,392 *
5388 Sterling Center Drive, Unit C
Westlake Village, CA 91361
Andrew Feshbach (8) 19,534 * 19,534 *
Big Dog Sportswear
121 Gray Avenue, Suite 300
Santa Barbara, CA 93101
Robert R. Hollman (8) 19,534 * 19,534 *
Topa Management
1800 Avenue of the Stars
Suite 1400
Los Angeles, CA 90067
</TABLE>
20
<PAGE>
<TABLE>
<CAPTION>
Pro forma for Recapitalization
--------------------------------
Name and Address of Beneficial Owner Amount and Percent of Amount and Percent of
- --------------------------------------------------- Nature of Class Nature of Class
Beneficial ----------- Beneficial -------------
Ownership (1) Ownership (1)
-------------- ----------------
<S> <C> <C> <C> <C>
Jerry R. Welch (8)(9) 19,534 * 19,534 *
Kayne Anderson Investment Management, Inc.
1800 Avenue of the Stars
Second Floor
Los Angeles, CA 90067
Howard M. Zelikow (8)(9) 19,534 * 19,534 *
Kayne Anderson Investment Management, Inc.
1800 Avenue of the Stars
Second Floor
Los Angeles, CA 90067
Ronald J. Blumenthal (10) 55,608 * 55,608 *
5388 Sterling Center Drive, Unit C
Westlake Village, CA 91361
All executive officers and directors 5,551,794 49.3% 10,196,774 67.6%
as a group (twelve persons) (11)
</TABLE>
_________________________
* Less than one percent.
(1) Except as otherwise noted below, the persons named in the table have sole
voting power and investment power with respect to all shares of common
stock shown as beneficially owned by them, subject to community property
laws where applicable.
(2) The 4,365,958 shares include (i) 199,034 shares held directly by Mr. Kayne
(including 19,534 shares which may be acquired within 60 days upon exercise
of options) and (ii) 4,166,924 shares held by managed accounts of KAIM Non-
Traditional, L.P. ("KAIM, LP"), a registered investment adviser (including
190,000 shares which may be acquired within 60 days upon exercise of 1997
Warrants). Mr. Kayne has sole voting and dispositive power over the shares
he holds directly. He has shared voting and dispositive power along with
Kayne Anderson Investment Management, Inc. ("KAIM, Inc."), the general
partner of KAIM, LP, over the remaining shares. (Mr. Kayne is the
President, Chief Executive Officer and a Director of KAIM, Inc., and the
principal shareholder of its parent company.) The shares held by managed
accounts of KAIM, LP include the following shares held by investment funds
for which KAIM, LP serves as general partner or manager: 1,481,703 shares
held by Kayne Anderson Non- Traditional Investments, L.P.; 1,081,651 shares
held by ARBCO Associates, L.P.; 1,023,158 shares held of Offense Group
Associates, L.P.; 315,412 shares held by Opportunity Associates, L.P.; and
75,000 shares held by Kayne Anderson Offshore Limited. KAIM disclaims
beneficial ownership of the shares reported, except those shares
attributable to it by virtue of its general partner interests in the
limited partnerships holding such shares. Mr. Kayne disclaims beneficial
ownership of the shares reported, except those shares held by him directly
or attributable to him by virtue of his limited and general partner
interests in such limited partnerships and by virtue of his indirect
interest in the interest of KAIM in such limited partnerships. The
foregoing is based on information provided by Mr. Kayne and KAIM, L.P. to
the Company as of May 4, 1998.
21
<PAGE>
(3) David L. Warnock and Edward L. Cahill are each managing members of Cahill,
Warnock & Company, LLC ("CW") and general partners of Cahill, Warnock
Strategic Partners, L.P. ("CWSP"). CWSP and CW are the general partners,
respectively, of Cahill, Warnock Strategic Partners Fund, L.P. ("SPF") and
Strategic Associates, L.P. ("SA"). SPF owns 1996 Debentures currently
convertible into 710,500 shares of common stock and 150,100 currently
exercisable 1997 Warrants to purchase common stock. SA owns 1996 Debentures
currently convertible into 39,500 shares of common stock and 8,233
currently exercisable 1997 Warrants to purchase common stock. Each of
Messrs. Warnock and Cahill, CW, CWSP, SPF and SA may be deemed to
beneficially own 988,333 shares of common stock. Messrs. Warnock and
Cahill, CW and CWSP disclaim beneficial ownership with respect to the
shares held by SPF and SA. SPF disclaims beneficial ownership with respect
to the shares underlying the 1996 Debentures and the 1997 Warrants held by
SA. SA disclaims beneficial ownership with respect to the shares underlying
the 1996 Debentures and the 1997 Warrants held by SPF. The shares reported
above and in the table exclude 9,217 currently exercisable options to
purchase common stock held by Mr. Warnock.
(4) The amount and nature of beneficial ownership of 783,043 shares has been
taken from an Amendment No. 2 to Schedule 13G filed on January 23, 1998,
which states that (i) Primerica Life Insurance Company, Travelers Insurance
Holdings Inc. and The Travelers Insurance Company each report beneficial
ownership of 631,376 shares and (ii) The Travelers Insurance Group Inc.,
PFS Services, Inc., Associated Madison Companies, Inc. and Travelers Group
Inc. each report beneficial ownership of 783,043 shares. The amount
reported in the table and in clause (ii) above includes currently
exercisable 1997 Warrants to purchase 31,667 shares of common stock.
(5) Includes 855,376 shares, 39,583 shares underlying the 1997 Warrants and
19,534 currently exercisable options to purchase common stock.
(6) Includes 9,000 shares, currently exercisable options to purchase 48,750
shares of common stock and 9,000 shares held by the Company's Employee
Stock Purchase Plan for the benefit of Mr. Mitchell.
(7) Includes 291 shares, currently exercisable options to purchase 26,667
shares of common stock and 434 shares held by the Company's Employee Stock
Ownership Plan for the benefit of Ms. Shauer.
(8) All shares consist of currently exercisable options to purchase common
stock.
(9) Messrs. Welch and Zelikow are Managing Directors of Kayne Anderson
Investment Management, Inc.; however, they disclaim beneficial ownership
with respect to shares held by KAIM or any of its affiliates.
(10) Includes currently exercisable stock options to purchase 55,000 shares of
common stock and 608 shares held by the Company's Employee Stock Ownership
Plan for the benefit of Mr. Blumenthal.
(11) Includes common stock and options beneficially owned by executive officers
and directors, including 21,667 with respect to Ms. Platfoot, 9,312 with
respect to Ms. Iglesias and 12,478 with respect to Mr. Pollock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------- ----------------------------------------------
In May 1997, certain investors, including Cahill Warnock Strategic Partners
Fund, L.P. ("SPF") ($948,000), Strategic Associates, L.P. ("SA") ($52,000), Fred
Kayne ($250,000) and KAIM Non-Traditional, L.P. ("KAIM") ($1,200,000) purchased
an aggregate principal amount of $3,000,000 of the Company's 11.5% Senior
Subordinated Notes due 2000 and warrants to purchase an aggregate of 475,000
shares of the Company's common stock at an exercise price of $3.00 per share,
subject to adjustment under certain circumstances.
In September 1997, certain investors, including SPF (75,800 shares), SA
(4,200 shares), Fred Kayne (224,000 shares) and affiliates of KAIM (800,000
shares), purchased an aggregate of 1,510,000 shares of the Company's common
stock at a price of $2.50 per share.
22
<PAGE>
During the fiscal year ended January 31, 1998, Kayne Anderson Investment
Management, Inc. provided management, consulting and advisory services to the
Company for which it received a fee of $100,000.
In April 1998, each of the holders, including SPF ($3,749,000), SA ($210,000),
Fred Kayne ($250,000) and KAIM ($1,200,000), of (a) the Company's Convertible
Debentures dated October 11, 1996, as amended on May 30, 1997, in the aggregate
principal amount of $3,000,000 (the "1996 Debentures") and (b) the Company's
11.5% Senior Subordinated Notes due May 6, 2000 in the aggregate principal
amount of $3,000,000 (the "'1997 Notes") and warrants to purchase 475,000 shares
of the Company's common stock issued in connection with the 1997 Notes (the
"1997 Warrants" and together with the 1997 Notes, the "1997 Securities") entered
into a Letter Agreement dated April 6, 1998 and an Amendment to Letter Agreement
dated April 13, 1998, and substantially all such holders have entered into a
Letter Agreement dated July 7, 1998 (collectively, the "Amended Letter
Agreement") setting forth a plan of recapitalization (the "Recapitalization").
The Recapitalization consists of the following: (a) the issuance of $3,850,000
aggregate principal amount of the Company's non-interest bearing Senior
Subordinated Notes due May 6, 2000 (the "New Notes") and detachable warrants to
purchase 3,850,000 shares of the Company's common stock (the "New Warrants," and
together with the New Notes, the "1998 New Securities") to, among others, Fred
Kayne ($350,000) and affiliates of KAIM ($3,383,333), (b) a waiver by the
holders of all of their rights to interest payments accrued and owing on the
1996 Debentures and the 1997 Notes on or after February 28, 1998, (c) an
agreement by the holders to exchange the 1996 Debentures and the 1997 Securities
for either Series A or Series B Preferred Stock within two-hundred forty days
after the issuance of the 1998 New Securities and (d) an agreement by the
holders to exchange the 1998 New Securities for Series C Preferred Stock
simultaneous with the exchange of the 1996 Debentures and the 1997 Securities
for Series A and/or B Preferred Stock.
PART IV
<TABLE>
<CAPTION>
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
- -------- ----------------------------------------------------------------
(a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT.
<S> <C>
Page
----
(1) Financial Statements:
Report of Independent Accountants................................................................ F-1
Consolidated Balance Sheet -- January 31, 1998 and February 1, 1997.............................. F-2
Consolidated Statement of Operations - Periods Ended
January 31, 1998, February 1, 1997, June 1, 1996 and May 31, 1995................................ F-3
Consolidated Statement of Changes in Shareholders' Equity -- Periods Ended
January 31, 1998, February 1, 1997, June 1, 1996 and May 31, 1995................................ F-4
Consolidated Statement of Cash Flows -- Periods Ended January 31, 1998,
February 1, 1997, June 1, 1996 and May 31, 1995.................................................. F-5
Notes to Consolidated Financial Statements....................................................... F-6
(2) FINANCIAL STATEMENT SCHEDULES:
Valuation Reserves............................................................................... F-19
</TABLE>
23
<PAGE>
All other financial statement schedules are omitted because they are either
not applicable or the required information is shown in the financial statements
or notes thereto.
(3) LISTING OF EXHIBITS
The following exhibits are filed as part of, or incorporated by reference
into, this annual report:
<TABLE>
<CAPTION>
INDEX TO EXHIBITS
Exhibit
Number
- ------
<S> <C>
3.1 Amended and Restated Articles of Incorporation of the Company, dated
August 12, 1991/(1)/
3.1.1 Amendment to Articles of Incorporation, dated August 20, 1991/(1)/
3.1.2 Form of Amendment to Articles of Incorporation, dated August 24,
1991/(1)/
3.2 Bylaws of the Company, as amended/(2)/
3.3 Specimen Certificate of the Common Stock (without par value)/(1)/
10.1 1991 Key Employee Stock Option Plan/(3)/
10.2 Form of Indemnification Agreement between Registrant and its directors
and executive officers/(3)/
10.3 Asset Purchase Agreement for Acquisition of the Assets of Small People,
Inc. and Jimash Corporation by Right Start Subsidiary I, Inc./(4)/
10.4 1995 Non-employee Directors Option Plan/(5)/
10.5 Registration Rights Agreement dated August 3, 1995 between The Right
Start, Inc. and Kayne Anderson Non-Traditional Investments LP, ARBCO
Associates LP, Offense Group Associates LP, Opportunity Associates LP,
Fred Kayne, Albert O. Nicholas and Primerica Life Insurance
Company/(5)/
10.6 Asset Purchase Agreement dated as of July 29, 1996 by and between
Blasiar, Inc. (DBA Alert Communications Company) and The Right Start,
Inc./(5)/
10.7 Convertible Debenture Purchase Agreement between The Right Start, Inc.
and Cahill Warnock Strategic Partners, LP dated as of October 11,
1996/(6)/
10.7.1 First Amendment to Convertible Debenture Purchase Agreement between The
Right Start, Inc. and Cahill Warnock Strategic Partners, LP dated as of
May 30, 1997/(11)/
10.8 Convertible Debenture Purchase Agreement between The Right Start, Inc.
and Strategic Associates, LP dated as of October 11, 1996/(6)/
10.8.1 First Amendment to Convertible Debenture Purchase Agreement between The
Right Start, Inc. and Strategic Associates, LP dated as of May 30,
1997/(11)/
10.9 Registration Rights Agreement dated October 11, 1996 between The Right
Start, Inc. and Strategic Associates, L.P./(7)/
10.10 Registration Rights Agreement dated October 11, 1996 between The Right
Start, Inc. and Cahill, Warnock Strategic Partners Fund, L.P./(7)/
</(TABLE>
24
<PAGE>
</TABLE>
<TABLE>
<CAPTION>
<S> <C>
10.11 Loan and Security Agreement dated as of November 14, 1996 between The
Right Start, Inc. and Heller Financial, Inc./(6)/
10.12 First Amendment to Loan and Security Agreement and Limited Waiver and
Consent/(8)/
10.13 Second Amendment to Loan and Security Agreement and Limited Waiver and
Consent/(9)/
10.14 Third Amendment to Loan and Security Agreement and Limited Waiver and
Consent/(9)/
10.15 Fourth Amendment to Loan and Security Agreement and Limited Waiver and
Consent*
10.16 Registration Rights Agreement dated May 6, 1997 between The Right
Start, Inc. and certain Kayne Anderson funds, Cahill, Warnock Strategic
Partners Fund, L.P., Strategic Associates, L.P., The Travelers
Indemnity Company and certain other investors named therein/(7)/
10.17 Registration Rights Agreement dated September 4, 1997 between The Right
Start, Inc. and certain Kayne Anderson funds, Cahill, Warnock Strategic
Partners Fund, L.P., The Travelers Indemnity Company and certain other
investors named therein/(7)/
10.18 The Right Start, Inc. Letter Agreement dated as of April 6, 1998/(10)/
10.19 The Right Start, Inc. Amendment to Letter Agreement dated as of April
13, 1998/(10)/
10.20 The Right Start, Inc. Securities Purchase Agreement dated as of May 6,
1997 between the Company and certain investors listed therein with
respect to the Company's 11.5% senior subordinated notes due May 6,
2000 and warrants to purchase the Company's common stock/(12)/
10.21 The Right Start, Inc. Securities Purchase Agreement dated as of April
13, 1998 between the Company and certain investors listed therein with
respect to the Company's Senior Subordinated Notes due May 6, 2000 and
warrants to purchase the Company's common stock/(10)/
10.22 Registration Rights Agreement dated April 13, 1998 between The Right
Start, Inc. and the investors named therein/(7)/
10.23 The Right Start, Inc. Securities Purchase Agreement dated September 4,
1997 between the Company and the investors named therein with respect
to 1,510,000 shares of the Company's common stock/(9)/
23.1 Consent of Independent Accountants
27.1 Financial Data Schedule*
</TABLE>
_________________________
(1) Previously filed as an Exhibit to the Company's Registration Statement of
Form S-1 dated August 29, 1991.
(2) Previously filed as an Exhibit to Amendment Number 2 to the Company's
Registration Statement on Form S-1 dated October 3, 1991.
(3) Previously filed as an Exhibit to Amendment Number 1 to the Company's
Registration Statement on Form S-1 dated September 11, 1991
(4) Previously filed as an Exhibit to the Company's 10-K dated May 26, 1993.
25
<PAGE>
(5) Previously filed as an Exhibit to the Company's 10-K dated June 1, 1996.
(6) Previously filed as an Exhibit to the Company's 10-Q for the period ended
November 30, 1996.
(7) Previously filed as an Exhibit to the Company's 10-K dated January 31,
1998.
(8) Previously filed as an Exhibit to the Company's 10-K for the transition
period from June 2, 1996 to February 1, 1997.
(9) Previously filed as an Exhibit to the Company's 10-Q for the period ended
August 2, 1997.
(10) Previously filed as an Exhibit to the Company's 8-K dated April 23, 1998.
(11) Previously filed as an Exhibit to the Company's 10-Q for the period ended
May 3, 1997.
(12) Previously filed as an Exhibit to the Company's 8-K dated May 6, 1997.
* Previously filed as an Exhibit to this Form 10-K.
(b) REPORTS ON FORM 8-K
There were no Reports on Form 8-K filed during the last quarter of Fiscal
1997.
(c) A list of exhibits included as part of this report is set forth in Part IV
of this Annual Report on Form 10-K above and is hereby incorporated by
reference herein.
(d) Not applicable
26
<PAGE>
SIGNATURES
Pursuant to the requirement of Sections 13 and 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.
THE RIGHT START, INC.
Dated: December 8, 1998 /s/ Gina M. Shauer
----------------------------------
Gina M. Shauer
Chief Financial Officer (Principal
Financial and Accounting Officer)
27
<PAGE>
THE RIGHT START, INC.
REPORT AND CONSOLIDATED
FINANCIAL STATEMENTS
JANUARY 31, 1998 AND FEBRUARY 1, 1997
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
---------------------------------
To the Board of Directors and
Shareholders of The Right Start, Inc.
In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a) (1) and (2) on page 23 present fairly, in all
material respects, the financial position of The Right Start, Inc. and its
subsidiary at January 31, 1998 and February 1, 1997, and the results of their
operations and their cash flows for the fiscal year ended January 31, 1998, the
thirty-three weeks ended February 1, 1997 and the fiscal years ended June 1,
1996 and May 31, 1995, in conformity with generally accepted accounting
principles. 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 of these statements in
accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.
As discussed in Note 16, the consolidated financial statements have been
restated to move other expenses to a component of loss from operations.
PricewaterhouseCoopers LLP
Los Angeles, California
March 6, 1998, except as to
Notes 10 and 16 which are as of
September 1, 1998 and Note 15
which is as of October 13, 1998
F-1
<PAGE>
THE RIGHT START, INC.
CONSOLIDATED BALANCE SHEET
--------------------------
<TABLE>
<CAPTION>
January 31, February 1,
1998 1997
----------- -----------
<S> <C> <C>
ASSETS
- ------
Current assets:
Cash $ 240,000 $ 313,000
Accounts receivable 328,000 938,000
Note receivable 77,000 200,000
Merchandise inventories 6,602,000 7,664,000
Prepaid catalog expenses 297,000 782,000
Deferred pre-opening costs, net 50,000 543,000
Other current assets 1,314,000 1,264,000
----------- -----------
8,908,000 11,704,000
----------- -----------
Property, plant and equipment, net 8,115,000 9,841,000
Other assets 39,000 37,000
Deferred income tax benefit 1,400,000 1,400,000
----------- -----------
9,554,000 11,278,000
----------- -----------
$18,462,000 $22,982,000
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
Current liabilities:
Accounts payable and accrued expenses $ 2,372,000 $ 6,076,000
Accrued salaries and bonuses 380,000 517,000
Advance payments on orders 30,000 31,000
Revolving line of credit 2,014,000 1,833,000
----------- -----------
4,796,000 8,457,000
----------- -----------
Note payable 3,000,000 2,643,000
Senior subordinated notes, net of unamortized
discount of $266,000 2,734,000
Subordinated convertible debentures 3,000,000 3,000,000
Deferred rent 1,625,000 1,710,000
Commitments and contingencies
Shareholders' equity:
Common stock (25,000,000 shares authorized,
no par value; 10,103,639 and 8,153,639 shares
issued and outstanding, respectively) 22,337,000 16,961,000
Accumulated deficit (19,030,000) (9,789,000)
----------- -----------
3,307,000 7,172,000
----------- -----------
$18,462,000 $22,982,000
=========== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
F-2
<PAGE>
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
------------------------------------
<TABLE>
<CAPTION>
Fiscal Year Thirty-three Fiscal Year Ended
Ended Weeks Ended --------------------------
January 31, February 1, June 1, May 31,
1998 1997 1996 1995
----------- ----------- ----------- -----------
(Restated- (Restated- (Restated-
Note 16) Note 16) Note 16)
<S> <C> <C> <C> <C>
Net Sales:
Retail $31,107,000 $19,576,000 $17,075,000 $ 7,783,000
Catalog 7,414,000 7,635,000 23,293,000 36,790,000
Other revenues 877,000 214,000
----------- ----------- ----------- -----------
38,521,000 27,211,000 41,245,000 44,787,000
----------- ----------- ----------- -----------
Costs and expenses:
Cost of goods sold 19,244,000 14,417,000 21,605,000 23,654,000
Operating expense 19,212,000 12,608,000 18,282,000 18,925,000
General and administrative expense 3,912,000 2,941,000 4,341,000 3,008,000
Pre-opening cost amortization 711,000 528,000 418,000 114,000
Depreciation and amortization 1,608,000 833,000 938,000 745,000
Other expenses 1,905,000 851,000 450,000
----------- ----------- ----------- -----------
46,592,000 32,178,000 46,034,000 46,446,000
----------- ----------- ----------- -----------
Operating loss (8,071,000) (4,967,000) (4,789,000) (1,659,000)
Interest expense (income), net 1,143,000 204,000 37,000 (43,000)
Loss on sale of Children's Wear Digest 1,744,000
----------- ----------- ----------- -----------
Loss before income taxes (9,214,000) (5,171,000) (4,826,000) (3,360,000)
Income tax provision (benefit) 27,000 207,000 (927,000) (1,254,000)
----------- ----------- ----------- -----------
Net loss $(9,241,000) $(5,378,000) $(3,899,000) $(2,106,000)
=========== =========== =========== ===========
Basic and diluted loss per share $ (1.01) $ (0.67) $ (0.60) $ (0.33)
=========== =========== =========== ===========
Weighted average number of
shares outstanding 9,188,172 8,006,190 6,536,813 6,300,000
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE>
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF CHANGES IN
SHAREHOLDERS' EQUITY
--------------------
<TABLE>
<CAPTION>
Common Stock
------------------------- Retained Earnings
Shares Amount (Accumulated Deficit)
---------- ----------- ---------------------
<S> <C> <C> <C>
Balance May 25, 1994 6,300,000 $11,206,000 $1,594,000
Net loss (2,106,000)
---------- ----------- ------------
Balance at May 31, 1995 6,300,000 11,206,000 (512,000)
Issuance of shares pursuant
to a rights offering 1,578,806 4,906,000
Issuance of shares pursuant
to the exercise of stock options 60,500 201,000
Net loss (3,899,000)
---------- ----------- ------------
Balance at June 1, 1996 7,939,306 16,313,000 (4,411,000)
Issuance of shares pursuant
to the exercise of stock options 214,333 648,000
---------- ----------- ------------
Net loss (5,378,000)
---------- ----------- ------------
Balance at February 1, 1997 8,153,639 16,961,000 (9,789,000)
Issuance of shares pursuant
to the exercise of stock options 440,000 1,320,000
Issuance of shares pursuant to a
private placement 1,510,000 3,705,000
Issuance of common stock warrants
in conjunction with sale of senior
subordinated notes 351,000
Net loss (9,241,000)
---------- ----------- ------------
Balance at January 31, 1998 10,103,639 $22,337,000 ($19,030,000)
========== =========== ============
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
------------------------------------
<TABLE>
<CAPTION>
Fiscal Year Thirty-three Fiscal Year Ended
Ended Weeks Ended ---------------------------
January 31, February 1, June 1, May 31,
1998 1997 1996 1995
------------ ------------ ----------- -------------
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Net loss $(9,241,000) $(5,378,000) $(3,899,000) $(2,106,000)
Adjustments to reconcile net income
to net cash used in operating activities:
Depreciation and amortization 1,608,000 833,000 938,000 745,000
Pre-opening cost amortization 711,000 528,000 418,000 114,000
Amortization of discount on senior
subordinated notes 85,000 1,744,000
Loss on sale of Children's Wear Digest
Loss on store closings 1,580,000
Change in assets and liabilities
affecting operations (1,316,000) (957,000) 506,000 (2,256,000)
----------- ----------- ----------- -----------
Net cash used in operating activities (6,573,000) (4,974,000) (2,037,000) (1,759,000)
----------- ----------- ----------- -----------
Cash flows from investing activities:
Additions to property, plant and equipment (2,063,000) (3,607,000) (4,165,000) (2,417,000)
Proceeds from sale of marketable securities 1,461,000
Proceeds from sale of Children's Wear Digest 2,437,000
Payment for Children's Wear Digest acquisition (399,000)
Proceeds from sale of telemarketing center 298,000
----------- ----------- ----------- -----------
Net cash provided by (used in) investing
activities (2,063,000) (3,309,000) (4,165,000) 1,082,000
----------- ----------- ----------- -----------
Cash flows from financing activities:
Net proceeds from borrowings under
revolving line of credit 181,000 1,833,000
Proceeds from note payable, long term 357,000 2,643,000
Proceeds from sale of convertible
subordinated debentures 3,000,000
Proceeds from private placement of
common stock 3,705,000
Proceeds from common stock issued
upon exercise of stock options 1,320,000 648,000 201,000
Proceeds from common stock issued
pursuant a rights offering 4,906,000
Proceeds from sale of senior subordinated
notes 3,000,000
----------- ----------- -----------
Cash provided by financing activities 8,563,000 8,124,000 5,107,000
---------- ---------- -----------
Net decrease in cash (73,000) (159,000) (1,095,000) (677,000)
Cash at beginning of period 313,000 472,000 1,567,000 2,244,000
---------- ---------- ----------- ----------
Cash at end of period $ 240,000 $ 313,000 $ 472,000 $1,567,000
========== ========== =========== ==========
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
THE RIGHT START, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
NOTE 1 - THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES:
- ------------------------------------------------------------
The Company
- -----------
The Right Start, Inc. (the Company) is a specialty merchant of infants' and
children's products throughout the United States. In 1991, the Company
completed the sale of 2,300,000 shares of its common stock in an initial public
offering. Prior to that, it was a wholly owned subsidiary of American
Recreation Centers, Inc. (ARC). ARC maintained majority ownership of the
Company through July 1995. In August 1995, an investment group led by Kayne,
Anderson Investment Management, Inc. (KAIM) acquired the 3,937,000 shares of
common stock owned by ARC.
The Company's financial statements also include the accounts of its wholly owned
subsidiary, Children's Wear Digest (CWD) through the date the Company sold CWD
(see Note 6). All material intercompany balances and transactions have been
eliminated.
Fiscal Year
- -----------
The Company has a fiscal year consisting of fifty-two or fifty-three weeks
ending on the Saturday closest to the last day in January. Effective January
1997, the Company changed its fiscal year which had been the fifty-two or fifty-
three weeks ending on the Saturday closest to the last day in May. The change
in year end resulted in a thirty-three week transition period from June 2, 1996
to February 1, 1997 ("the Transition Period"). The fiscal years ended January
31, 1998 ("Fiscal 1997") and June 1, 1996 ("Fiscal 1996") were fifty-two week
periods; the fiscal year ended May 31, 1995 ("Fiscal 1995") was a fifty-three
week period. See Note 14.
Revenue Recognition
- -------------------
Retail sales are recorded at time of sale or when goods are delivered. Catalog
sales are recorded at the time of shipment. The Company provides for estimated
returns at the time of the sale.
Merchandise Inventories
- -----------------------
Merchandise inventories consist of products purchased for resale and are stated
at the lower of cost or market value. Cost is determined on a first-in, first-
out basis.
Prepaid Catalog Expenses
- ------------------------
Prepaid catalog expenses consist of the costs to produce, print and distribute
catalogs. These costs are amortized over the expected sales life of each
catalog which does not exceed four months. Catalog production expenses of
$2,753,000, $1,844,000, $6,061,000 and $9,457,000 were recorded in Fiscal 1997,
the Transition Period, Fiscal 1996 and Fiscal 1995, respectively.
Property, Plant and Equipment
- -----------------------------
Property, plant and equipment are stated at cost less accumulated depreciation.
Depreciation is provided using the straight-line method based upon the estimated
useful lives of the assets, generally three to ten years. Amortization of
leasehold improvements is based upon the term of the lease or the estimated
useful life of the leasehold improvements, whichever is shorter.
F-6
<PAGE>
NOTE 1 - (Continued) :
- -------------------
Store Opening Costs
- -------------------
Effective October 1, 1997, the Company changed the way costs incurred in opening
stores are recognized. Previously, these costs had been deferred and amortized
over 12 months commencing with the store opening. After the effective date, any
pre-opening costs incurred for new stores were charged to expense as incurred.
The impact of this change was not significant to the Company's results of
operations or financial position.
Deferred Rent
- -------------
The Company recognizes rent expense on a straight-line basis over the life of
the underlying lease. The benefit from tenant allowances and landlord
concessions are recorded as deferred rent and recognized over the lease term.
Income Taxes
- ------------
The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standard No. 109 (FAS 109), "Accounting for Income Taxes." FAS 109
requires an asset and liability approach under which deferred tax liabilities
and assets are recognized for the expected future tax consequences of temporary
differences between the carrying amounts and the tax bases of other assets and
liabilities.
During the periods that the Company was majority owned by ARC, the Company
provided for income taxes as a separate taxpayer. State income taxes were
settled pursuant to an informal tax sharing agreement and the Company filed a
separate federal income tax return.
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
652,011, 979,921, 1,047,402 and 1,042,000 shares of common stock at January 31,
1998, February 1, 1997, June 1, 1996 and May 31, 1995, 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, Note 15
describes debt issued with detachable warrants in April 1998 which could
potentially dilute basic EPS in the future.
Stock-Based Compensation
- ------------------------
Compensation cost attributable to stock option plans is recognized based on the
difference, if any, between the closing market price of the stock on the date of
grant over the exercise price of the option. The Company has not issued any
stock options with an exercise price less than the closing market price of the
stock on the date of grant.
Reclassifications
- -----------------
Certain reclassifications have been made to conform prior period amounts to
current year presentation.
Use of Estimates
- ----------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
F-7
<PAGE>
NOTE 2 - PROPERTY, PLANT AND EQUIPMENT, NET :
- --------------------------------------------
<TABLE>
<CAPTION>
January 31, February 1,
1998 1997
----------- -----------
<S> <C> <C>
Property, plant and equipment, at cost:
Machinery, furniture and equipment $3,669,000 $3,728,000
Leaseholds and leasehold improvements 6,683,000 7,676,000
Construction in progress 551,000
Computer software 821,000 693,000
---------- ----------
11,173,000 12,648,000
Accumulated depreciation
and amortization (3,058,000) (2,807,000)
---------- -----------
$8,115,000 $ 9,841,000
========== ===========
</TABLE>
Depreciation and amortization expense for property, plant and equipment amounted
to $1,608,000, $833,000, $935,000 and $645,000 for Fiscal 1997, the Transition
Period, Fiscal 1996 and Fiscal 1995, respectively.
NOTE 3 - CREDIT AGREEMENTS:
- --------------------------
In November 1996, the Company entered into an agreement with a financial
institution for a $13 million credit facility (the Credit Facility). The $13
million facility consists of a $3 million capital expenditure facility and a $10
million revolving credit line for working capital (the Revolver). Availability
under the Revolver is subject to a defined borrowing base. As of January 31,
1998, $2,014,000 and $1,081,000 were outstanding and available, respectively,
under the Revolver based on a defined borrowing base of $3.1 million as of
January 31, 1998. The Credit Facility is for a period of three years and is
secured by substantially all 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 April 30, 1998 and the six months ended July 31, 1998,
$900,000 for the nine 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. Interest
accrues on the revolving line of credit at prime plus 1% and at prime plus 1
1/2% on the capital expenditure facility. At January 31, 1998, the bank's prime
rate of interest was 8.50%. The Company's weighted average interest rate on
short-term borrowings was 9.48% and 9.42% for Fiscal 1997 and the Transition
Period, respectively.
Effective May 6, 1997, the Company sold subordinated notes and warrants to
purchase common stock, certain of the purchasers of which are affiliates of the
Company. The subordinated notes bear interest at 11.5% and are due in full on
May 6, 2000. Warrants to purchase an aggregate of 475,000 shares of common
stock at $3.00 per share were issued in connection with the subordinated notes.
Proceeds from the sale of the subordinated notes and warrants were allocated to
the debt security and the warrants based on the fair value of the securities at
the date of issuance. The value assigned to the warrants was $351,000. The
resulting debt discount is being amortized over the term of the notes.
Subsequent to year end, the holders of the notes agreed to exchange the notes
and warrants in connection with a capital restructuring. See Note 15.
The Company issued and sold subordinated convertible debentures in the aggregate
principal amount of $3 million effective October 11, 1996. The terms of such
debentures, as amended, permit the holders to convert the principal amount into
750,000 shares of the Company's common stock at $4.00 per share at any time
prior to May 31, 2002, the due date of the debentures. The debentures bear
interest at a rate of 8% per annum. The holders of the debentures agreed to
exchange the debentures in conjunction with a capital restructuring in April
1998. See Note 15.
F-8
<PAGE>
NOTE 4 - INCOME TAXES:
- ---------------------
The provision (benefit) for income taxes is comprised of the following:
<TABLE>
<CAPTION>
Fiscal Year Thirty-three Fiscal Year Ended
Ended Weeks Ended ---------------------------
January 31, February 1, June 1, May 31,
1998 1997 1996 1995
----------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Current provision:
Federal $ 1,000 ($424,000)
State $ 27,000
Deferred provision (benefit):
Federal (928,000) (725,000)
State (105,000)
Adjustment to valuation allowance $ 207,000
----------- ----------- ---------- -----------
$27,000 $207,000 ($927,000) ($1,254,000)
=========== =========== ========== ===========
</TABLE>
The Company's effective income tax rate differed from the federal statutory rate
as follows:
<TABLE>
<CAPTION>
Fiscal Year Thirty-three Fiscal Year Ended
Ended Weeks Ended -------------------
January 31, February 1, June 1, May 31,
1998 1997 1996 1995
---- ---- ---- ----
<S> <C> <C> <C> <C>
Federal statutory rate 34% 34% 34% 34%
State income taxes, net of federal benefit 3 1 3 2
Stock options 4
Valuation allowance (39) (45) (19)
Other 2 2 1 1
---- ---- ---- ----
Effective tax rate 0% (4)% 19% 37%
==== ==== ==== ====
</TABLE>
F-9
<PAGE>
NOTE 4 - (Continued) :
- -------------------
Deferred tax liabilities (assets) are comprised of the following:
<TABLE>
<CAPTION>
January 31, February 1, June 1,
1998 1997 1996
----------- ----------- ----------
<S> <C> <C> <C>
Depreciation and amortization $200,000 $236,000 $112,000
Pre-opening costs 21,000 225,000 220,000
Other 64,000 68,000 11,000
----------- ----------- -----------
Deferred tax liabilities 285,000 529,000 343,000
----------- ----------- -----------
Net operating loss carryforward (6,799,000) (4,157,000) (2,256,000)
Deferred rent (839,000) (708,000) (380,000)
Writedown of fixed assets (633,000)
Other reserves (396,000) (234,000) (141,000)
Other tax carryforwards (68,000) (67,000) (70,000)
Sales returns (29,000) (43,000) (43,000)
----------- ----------- -----------
Deferred tax assets (8,764,000) (5,209,000) (2,890,000)
----------- ----------- -----------
Valuation allowance 7,079,000 3,280,000 940,000
----------- ----------- -----------
Net deferred tax asset ($1,400,000) ($1,400,000) ($1,607,000)
=========== =========== ===========
</TABLE>
The Company's deferred tax asset is net of a valuation allowance of $7,079,000.
In evaluating the deferred tax asset, management considered the Company's
projections and available tax planning strategies. The Company's plan projects
taxable income in future years which will enable the deferred tax asset to be
realized. Available tax planning strategies include the sale of certain of the
Company's assets which have little or no tax basis.
The Company has federal and state net operating loss carryforwards at January
31, 1998 of $18,499,000 and $6,844,000, respectively. These carryforwards will
expire in fiscal years ending 2002 through 2012.
NOTE 5 - SALE OF TELEMARKETING CENTER:
- -------------------------------------
In July 1996, the Company sold its phone center operations to a telemarketing
services provider for approximately $500,000, $250,000 of which was in cash and
the remainder of which was in a two-year note secured by the assets of the phone
center. There was no gain or loss on the sale.
NOTE 6 - CHILDREN'S WEAR DIGEST :
- -------------------------------
Pursuant to an asset purchase agreement dated December 30, 1994 (the Agreement)
and a letter of intent agreement entered in November 1994, the Company and its
wholly owned subsidiary, Children's Wear Digest, Inc. (CWD), sold substantially
all of the assets of CWD to Small People, Inc. (SPI). A significant owner of
SPI was the president of CWD until his resignation effective December 30, 1994
and was also the owner of CWD at the time of its purchase by the Company. Under
the terms of the Agreement, CWD sold certain assets, consisting primarily of
inventory, fixed assets and intangible assets, in exchange for cash of
approximately $2,437,000. The transaction resulted in a loss of $1,744,000.
F-10
<PAGE>
NOTE 6 - (Continued):
- -------------------
In connection with the Agreement, the parties also entered into a separate
Telemarketing Agreement, a Confidentiality and Noncompetition Agreement, and
termination agreements related to certain employment and management contracts
between CWD and its former owners which were entered when the Company purchased
CWD in September 1992. The acquisition was accounted for as a purchase and the
resultant goodwill was amortized over its estimated useful life.
NOTE 7 - EMPLOYEE BENEFITS AND STOCK OPTIONS:
- --------------------------------------------
On March 15, 1991, two now former executives were granted options to acquire up
to 900,000 shares of the Company's common stock under a non-qualified stock
option plan. The options were granted at fair market value of $3.33 per share.
Three hundred thousand options were exercisable at the date of grant. These
options expire June 1, 2001. In conjunction with the August 1995 renegotiation
of the employment contracts with these two executives, certain option terms
were amended. Each executive's holdings became 388,000 options exercisable at
$3.00 per share, the fair market value at the time of reissuance. At January
31, 1998, 81,000 shares were outstanding under this plan.
One of the executives covered by this plan was the Company's chief executive
officer who resigned in March 1996. The other executive covered by this plan
was the Company's president who resigned in October 1996. The employment
contracts for these individuals called for severance payments in aggregate of
approximately $930,000. A significant portion of each individual's severance
represented the cash surrender value of a life insurance policy and the
remainder was paid out through December 1997.
The Company adopted the 1991 Employee Stock Option Plan, covering an aggregate
of 450,000 shares of the Company's common stock, in October 1991. Options
granted vest either 20% or 33% (depending on the terms of the individual grant)
each year commencing on grant date and expire 10 years thereafter. In August
1995, those holding options under the 1991 Employee Stock Option Plan were given
the right to cancel their options (the Existing Options) and have an equal
number of options (the New Options) reissued to them at the fair market value of
$3.00 per share. The vesting period on the Existing Options is 20% each year
and the New Options vest 33% each year, both from date of grant. At January 31,
1998 there were no Existing Options outstanding. Options for 379,982 shares
were outstanding as of January 31, 1998, 125,717 of which were exercisable.
In October 1995, the Company adopted the 1995 Non-Employee Directors Option
Plan. This Plan provides for the annual issuance, to each non-employee
director, of options to purchase 3,000 shares of common stock. In addition,
each director is entitled to make an election to receive, in lieu of directors'
fees of $12,000 per year, additional options to purchase common stock. The
amount of additional options is determined based on an independent valuation
such that the fair value of the options issued is equivalent to the fees that
the director would be otherwise entitled to receive on an annual basis. Options
issued under this plan vest on the anniversary date of their grant and upon
termination of Board membership. These options expire five years from the date
of grant. 191,029 options were issued under this plan at exercise prices which
range from $2.50 to $5.13 and were equal to the closing price of the Company's
stock on the date of grant. No compensation cost was recognized in income in
connection with options granted under the Non-Employee Directors Option Plan.
117,204 of the options issued under this plan are exercisable at January 31,
1998.
In 1993, the Company adopted an employee stock ownership plan (ESOP) and
employee stock purchase plan (ESPP) for the benefit of its employees. The ESOP
is funded exclusively by discretionary contributions determined by the Board of
Directors. The Board of Directors authorized contributions to the ESOP of
$70,000 and $50,000 in Fiscal 1996 and Fiscal 1995, respectively. The Company
matches employees' contributions to the ESPP at a rate of 50%. The Company's
contributions to the ESPP amounted to $24,000, $21,000, $28,000 and $58,000 in
Fiscal 1997, the Transition Period, Fiscal 1996 and Fiscal 1995, respectively.
F-11
<PAGE>
NOTE 7 - (Continued) :
- -------------------
The following table summarizes option activity through January 31, 1998:
<TABLE>
<CAPTION>
Weighted
Average
Exercise Price
--------------
<S> <C> <C>
Outstanding at May 25, 1994 1,084,500 $3.56
Granted 2,500 2.50
Canceled (45,000) 4.64
---------
Outstanding at May 31, 1995 1,042,000 3.49
Granted 306,902 4.27
Canceled (241,000) 3.10
Exercised (60,500) 3.19
---------
Outstanding at June 1, 1996 1,047,402 3.40
Granted 163,519 5.27
Canceled (16,667) 3.42
Exercised (214,333) 3.02
---------
Outstanding at February 1, 1997 979,921 3.70
Granted 196,590 2.50
Canceled (84,500) 4.04
Exercised (440,000) 3.00
---------
Outstanding at January 31, 1998 652,011 3.81
=========
</TABLE>
The Company has adopted Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" ("FAS 123"). In accordance with the provisions of FAS
123, the Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations in accounting for its plans and does not
recognize compensation expense for its stock-based compensation plans based on
the fair market value method prescribed by FAS 123. If the Company had elected
to recognize compensation expense based upon the fair value at the grant date
for awards under these plans consistent with the methodology prescribed by FAS
123, the Company's net loss and loss per share would be increased to the pro
forma amounts indicated below:
<TABLE>
<CAPTION>
Fiscal Thirty-three Fiscal
Year Ended Weeks Ended Year Ended
January 31, February 1, June 1,
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Net loss:
As reported ($9,241,000) ($5,378,000) ($3,899,000)
Pro forma (9,640,000) (5,839,000) (4,068,000)
Basic and diluted loss per share:
As reported ($1.01) ($0.67) ($0.60)
Pro forma (1.05) (0.73) (0.62)
</TABLE>
These pro forma amounts may not be representative of future disclosures since
the estimated fair value of stock
F-12
<PAGE>
NOTE 7 - (Continued):
- -------------------
options is amortized to expense over the vesting period, and additional options
may be granted in future years. The fair value for these options was estimated
at the date of grant using the Black-Scholes options-pricing model with the
following weighted-average assumptions for Fiscal 1997, the Transition Period
and Fiscal 1996, respectively: dividend yields of zero percent; expected
monthly volatility of 79.34, 73.25 and 70.97 percent; risk free interest rates
of 6.00, 6.36 and 6.10 percent; and expected life of four years for all periods.
The weighted average fair value of options granted during Fiscal 1997, the
Transition Period and Fiscal 1996 for which the exercise price equals the market
price on the grant date was $2.50, $3.10 and $2.39, respectively.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of employee stock options.
The following table summarizes information concerning currently outstanding and
exercisable stock options:
<TABLE>
<S> <C>
Range of exercise prices $2.50 - $6.50
Number of outstanding options 652,011
Weighted average remaining contractual life 6.7 years
Weighted average exercise price $ 3.81
Number of options exercisable 323,921
Weighted average price of exercisable options $ 4.17
</TABLE>
NOTE 8 - RELATED PARTY TRANSACTIONS:
- ------------------------------------
KAIM provides certain management services to the Company and charges the Company
for such services. Management fees of $100,000, $66,667 and $83,333 were
incurred in Fiscal 1997, the Transition Period, and Fiscal 1996, respectively.
ARC incurred certain expenses on behalf of the Company and charged the Company
for such expenses. These expenses include amounts allocated on an actual basis
for income taxes, insurance premiums, telephone charges and professional fees.
Corporate office overhead charges of $27,000 in Fiscal 1995 were allocated on
the basis of estimated corporate staff effort on behalf of the Company.
The Company provided telemarketing services through July 1996, to K.A.
Industries, a related party to Kayne Anderson. Revenues generated from this
service amount to $40,000 for the Transition Period and $365,000 for Fiscal
1996. Management believes that the terms of this agreement were no less
favorable than those that would have been negotiated with an unrelated third
party.
F-13
<PAGE>
NOTE 9 - OPERATING LEASES:
- --------------------------
The Company leases real property and equipment under non-cancelable agreements
expiring from 1998 through 2007. Certain retail store lease agreements provide
for contingent rental payments if the store's net sales exceed stated levels
("percentage rents"). A majority of the leases contain escalation clauses
which provide for increases in base rental for increases in future operating
cost and renewal options at fair market rental rates. The Company's minimum
rental commitments are as follows:
<TABLE>
<CAPTION>
Fiscal Year Ending
------------------
<S> <C>
1999 $3,582,000
2000 3,377,000
2001 3,254,000
2002 3,217,000
2003 3,038,000
Thereafter 8,435,000
-----------
$24,903,000
===========
</TABLE>
Net rental expense under operating leases was $3,802,000, $1,929,000, $1,959,000
and $1,166,000 for Fiscal 1997, the Transition Period, Fiscal 1996 and Fiscal
1995, respectively. No percentage rents were incurred in Fiscal 1997 and Fiscal
1995; percentage rents incurred in the Transition Period and Fiscal 1996
amounted to $54,000 and $82,000, respectively.
NOTE 10 - STORE CLOSINGS:
- ------------------------
On December 16, 1997, the board approved management's plan to close seven poor
performing retail stores. The Company has written off $1.3 million of the net
carrying value of capitalized leasehold improvements and fixed assets related to
these stores, which is included in other expenses in the consolidated statement
of operations. The revenues from the stores which will be closed were
$4,663,000, $3,003,000, $2,802,000 and $550,000 for Fiscal 1997, the Transition
Period, Fiscal 1996 and Fiscal 1995, respectively. Operating losses from these
stores were $435,000, $215,000, $48,000 and $127,000 for Fiscal 1997, the
Transition Period, Fiscal 1996 and Fiscal 1995, respectively.
On January 28, 1997, the board approved management's plan to close two poor
performing retail stores. The Company has written off $425,000 of the net
carrying value of capitalized leasehold improvements and fixed assets related to
these stores, which is included in other expenses in the consolidated statement
of operations. The revenues from these stores were $802,000, $616,000,
$1,170,000 and $1,112,000 for Fiscal 1997, the Transition Period, Fiscal 1996
and Fiscal 1995, respectively. Operating losses from these stores were
$167,000, $225,000, $155,000 and $123,000 for Fiscal 1997, the Transition
Period, Fiscal 1996 and Fiscal 1995, respectively.
NOTE 11 - COMMITMENTS AND CONTINGENCIES:
- ----------------------------------------
The Company is not party to any material legal actions.
F-14
<PAGE>
NOTE 12 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
- -----------------------------------------------------------
Changes in assets and liabilities which increased (decreased) cash and
equivalents are as follows:
<TABLE>
<CAPTION>
Fiscal Year Thirty-three Fiscal Year Ended
Ended Weeks Ended ----------------------
January 31, February 1, June 1, May 31,
1998 1997 1996 1995
----------- ---------- --------- ---------
<S> <C> <C> <C> <C>
Accounts receivable $ 610,000 ($329,000) ($126,000) $ 300,000
Note receivable 123,000 (200,000)
Merchandise inventories 1,062,000 (2,400,000) (122,000) (724,000)
Prepaid catalog expenses 485,000 (69,000) 268,000 731,000
Income taxes receivable 472,000 (280,000)
Other current assets (50,000) (500,000) (835,000) (699,000)
Deferred pre-opening costs (218,000) (540,000)
Other noncurrent assets (2,000) 113,000 142,000 (42,000)
Accounts payable and accrued expenses (3,503,000) 2,100,000 753,000 (522,000)
Accrued salaries and bonuses (137,000) (13,000) 292,000 (84,000)
Advance payments on orders (1,000) (112,000) (15,000) (112,000)
Amounts due to ARC (71,000) (58,000)
Deferred income taxes 207,000 (928,000) (830,000)
Other liabilities (97,000) (17,000)
Deferred rent 315,000 786,000 773,000 81,000
----------- ---------- --------- -----------
($1,316,000) ($957,000) $506,000 ($2,256,000)
=========== ========== ========= ===========
</TABLE>
Cash paid for income taxes was $5,000 and $7,000 for Fiscal 1997 and the
Transition Period, respectively. Cash paid for interest was $954,000, $193,000,
$73,000 and $30,000 for Fiscal 1997, the Transition Period, Fiscal 1996 and
Fiscal 1995, respectively. Non-cash investing activity consists of a $250,000
note received upon the sale of the phone center operations in the Transition
Period (see Note 5).
NOTE 13 - 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) which requires that the costs of start-up activities and organization
costs be expensed as incurred. The impact of the adoption of SOP 98-5 is not
expected to be material to the Company's financial position or results of
operations. Effective October 1, 1997 and as disclosed in Note 1, the Company
began expensing all store pre-opening costs as incurred.
F-15
<PAGE>
NOTE 14 - COMPARABLE PRIOR PERIOD DATA (Unaudited):
- --------------------------------------------------
As described in Note 1, the Company changed its fiscal year end effective
January 1, 1997, resulting in a thirty-three week transition period ending
February 1, 1997. Comparable results of operations for the thirty-three weeks
ended February 3, 1996 are as follows:
<TABLE>
<S> <C>
Net sales:
Catalog $ 16,573,000
Retail 9,894,000
Other revenues 749,000
-----------
27,216,000
Costs of goods sold 13,864,000
Other expenses, net 14,632,000
-----------
Loss before income taxes (1,280,000)
Income tax benefit 523,000
-----------
Net loss $ (757,000)
===========
Basic and diluted loss per share $ ( 0.12)
===========
Weighted average number of shares outstanding 6,302,534
</TABLE>
NOTE 15 - SUBSEQUENT EVENT:
- ---------------------------
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
convertible 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 convertible 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 receive 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.
F-16
<PAGE>
NOTE 15 - (Continued):
- --------------------
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 September 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. As of the date of issue of the new securities the stock was
trading at $2 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 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 convertible preferred stock series B
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.
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 $.6 million in annual interest
expense. 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.
F-17
<PAGE>
NOTE 16 - RESTATEMENT:
- ---------------------
Other expenses for the fiscal year ended January 31, 1998, thirty-three weeks
ended February 1, 1997 and fiscal year ended June 1, 1996, consisting primarily
of fixed assets and leasehold improvements written off in conjunction with
planned store closures and severance resulting from the resignation of the
Company's former President and Chief Executive Officer as described in Notes 10
and 7, have been reclassified from other non-operating expense to the operating
costs and expenses category in the consolidated statements of operations. The
affect of this restatement was to increase operating loss by $1,905,000,
$851,000 and $450,000 for the fiscal year ended January 31, 1998, thirty-three
weeks ended February 1, 1997 and fiscal year ended June 1, 1996, respectively.
This restatement had no effect on loss before income taxes, net loss or basic
and diluted loss per share or on the Company's financial position or cash flows.
F-18
<PAGE>
THE RIGHT START, INC.
SCHEDULE II - VALUATION RESERVES
<TABLE>
<CAPTION>
Additional
Balance at charged Balance at
beginning to costs end
Classification of period and expenses Deductions of period
- ---------------------------------- ----------- ------------- ------------ ------------
<S> <C> <C> <C> <C>
Fiscal year ended January 31, 1998
- ----------------------------------
Allowance for deferred tax asset $ 3,280,000 $ 3,799,000 $ 7,079,000
Inventory reserve 81,000 425,000 $385,000 121,000
Allowance for sales returns 103,000 34,000 69,000
----------- ----------- -------- -----------
$ 3,464,000 $ 4,224,000 $419,000 $ 7,269,000
=========== =========== ======== ===========
Thirty-three weeks ended February 1, 1997
- -----------------------------------------
Allowance for deferred tax asset $ 940,000 $ 2,340,000 $ 3,280,000
Inventory reserve 86,000 267,000 $272,000 81,000
Allowance for sales returns 103,000 103,000
----------- ----------- -------- -----------
$ 1,129,000 $ 2,607,000 $272,000 $ 3,464,000
=========== =========== ======== ===========
Fiscal year ended June 1, 1996
- ------------------------------
Allowance for deferred tax asset $ 940,000 $ 940,000
Inventory reserve 490,000 $404,000 86,000
Allowance for sales returns $ 103,000 103,000
----------- ----------- -------- -----------
$ 103,000 $ 1,430,000 $404,000 $ 1,129,000
=========== =========== ======== ===========
Fiscal year ended May 31, 1995
- ------------------------------
Allowance for sales returns $ 226,000 $123,000 $ 103,000
----------- ----------- -------- -----------
$ 226,000 $123,000 $ 103,000
=========== =========== ======== ===========
</TABLE>
F-19
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
----------------------------------
We hereby consent to the incorporation by reference in the Prospectus
constituting part of the Registration Statement on Form S-3 (No. 333-08157) and
in the Registration Statements on Form S-8 (No. 333-21749 and No. 333-21747) of
The Right Start, Inc. of our report dated March 6, 1998, except as to Notes 10
and 16 which are as of September 1, 1998 and Note 15 which is as of October 13,
1998 appearing on page F-1 of this Form 10-K/A.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Los Angeles, California
December 7, 1998
