<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Under Section 13 or 15(d) of the Securities
Exchange Act of 1934
For Quarter Ended September 30, 1997
[ ] Transition period pursuant to Section 13 or 15(d) of the
Securities Exchange Act
Commission File Number [ ]
------------------
DISCOVERY ZONE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 36-3877601
(State of Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
565 Taxter Road, Fifth Floor
Elmsford, New York 10523
(Address of principal executive offices) (Zip Code)
(Registrant's telephone number, including area code) (914) 345-4500
110 E. Broward Blvd.
Ft. Lauderdale, Florida 33301
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [ ] No [X]
- -
Common stock outstanding as of September 30, 1997: 4,000,000 shares
<PAGE>
DISCOVERY ZONE, INC.
PART 1--FINANCIAL INFORMATION
Page No.
--------
ITEM 1. FINANCIAL STATEMENTS
Unaudited Condensed Consolidated Statements of
Operations - Two Months ended September 30, 1997,
One Month ended July 31, 1997 and Three Months
ended September 30, 1996 2
Unaudited Condensed Consolidated Statements of
Operations - Two Months ended September 30, 1997,
Seven Months ended July 31, 1997 and Nine Months
ended September 30, 1996 3
Condensed Consolidated Balance Sheets -
September 30, 1997 (unaudited) and December 31, 1996 4
Unaudited Consolidated Condensed Statements of
Cash Flows - Two Months Ended September 30, 1997,
Seven Months Ended July 31, 1997 and Nine Months
Ended September 30, 1996 5
Notes to Unaudited Condensed Consolidated
Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 14
PART II--OTHER INFORMATION
Page
ITEM 1. LEGAL PROCEEDINGS 22
ITEM 2. CHANGES IN SECURITIES 22
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 22
ITEM 5. OTHER INFORMATION 22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 23
2
<PAGE>
PART 1--FINANCIAL STATEMENTS
ITEM 1. FINANCIAL STATEMENTS
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SUCCESSOR PREDECESSOR
COMPANY COMPANY
--------------- ------------------------------
TWO MONTHS THREE MONTHS
ENDED ONE MONTH ENDED
SEPTEMBER 30, ENDED SEPTEMBER 30,
1997 JULY 31, 1997 1996
--------------- ------------- ---------------
<S> <C> <C> <C>
NET REVENUE................................. $ 19,914 $ 10,786 $ 39,788
COST OF GOODS SOLD.......................... 3,057 1,537 7,856
STORE OPERATING EXPENSES.................... 16,879 8,765 32,059
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSE................................... 3,872 1,579 8,336
DEPRECIATION AND AMORTIZATION............... 3,981 1,705 5,572
------- ------------- ---------------
OPERATING LOSS.............................. (7,875) (2,800) (14,035)
OTHER INCOME (EXPENSES):
Interest expense (see Note 1)............. (2,468) (1,430) (497)
Interest income........................... 529 73 13
Other, net................................ 69 41 65
------- ------------- ---------------
Total other expense, net................ (1,870) (1,316) (419)
------- ------------- ---------------
LOSS BEFORE REORGANIZATION COSTS AND
EXTRAORDINARY ITEM........................ (9,745) (4,116) (14,454)
REORGANIZATION COSTS........................ -- (8,060) (4,310)
------- ------------- ---------------
LOSS BEFORE EXTRAORDINARY ITEM.............. (9,745) (12,176) (18,764)
EXTRAORDINARY ITEM-GAIN ON DISCHARGE OF
DEBT...................................... -- 332,165 --
------- ------------- ---------------
NET INCOME (LOSS)........................... (9,745) 319,989 (18,764)
ACCRETION OF CONVERTIBLE REDEEMABLE
PREFERRED STOCK TO REDEMPTION VALUE....... (39) -- --
------- ------------- ---------------
NET INCOME (LOSS) APPLICABLE TO COMMON
SHAREHOLDERS.............................. $ (9,784) $ 319,989 $ (18,764)
------- ------------- ---------------
------- ------------- ---------------
Per common and common equivalent share:
Loss before extraordinary item............ $ (2.45) $ (0.21) $ (0.33)
Extraordinary item-gain on discharge of
debt.................................... -- 5.76 --
------- ------------- ---------------
Net income (loss)......................... $ (2.45) $ 5.55 $ (0.33)
------- ------------- ---------------
------- ------------- ---------------
Weighted average number of common and common
equivalent shares outstanding............. 4,000 57,705 57,705
------- ------------- ---------------
------- ------------- ---------------
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SUCCESSOR PREDECESSOR
COMPANY COMPANY
--------------- --------------------------------
TWO MONTHS NINE MONTHS
ENDED SEVEN MONTHS ENDED
SEPTEMBER 30, ENDED SEPTEMBER 30,
1997 JULY 31, 1997 1996
--------------- --------------- ---------------
<S> <C> <C> <C>
NET REVENUE................................ $ 19,914 $ 82,537 $ 147,848
COST OF GOODS SOLD......................... 3,057 14,136 27,059
STORE OPERATING EXPENSES................... 16,879 60,192 112,741
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSE.................................. 3,872 10,235 33,230
DEPRECIATION AND AMORTIZATION.............. 3,981 11,920 16,204
------- --------------- ---------------
OPERATING LOSS............................. (7,875) (13,946) (41,386)
OTHER INCOME (EXPENSES):
Interest expense (see Note 1)............ (2,468) (3,957) (4,978)
Interest income.......................... 529 86 53
Other, net............................... 69 73 382
------- --------------- ---------------
Total other expense, net............... (1,870) (3,798) (4,543)
------- --------------- ---------------
LOSS BEFORE REORGANIZATION COSTS AND
EXTRAORDINARY ITEM....................... (9,745) (17,744) (45,929)
REORGANIZATION COSTS....................... -- (12,165) (12,436)
------- --------------- ---------------
LOSS BEFORE EXTRAORDINARY ITEM............. (9,745) (29,909) (58,365)
EXTRAORDINARY ITEM-GAIN ON DISCHARGE OF
DEBT..................................... -- 332,165 --
------- --------------- ---------------
NET INCOME (LOSS).......................... (9,745) $ 302,256 $ (58,365)
ACCRETION OF CONVERTIBLE REDEEMABLE
PREFERRED STOCK TO REDEMPTION VALUE...... (39) -- --
------- --------------- ---------------
NET INCOME (LOSS) APPLICABLE TO COMMON
SHAREHOLDERS............................. $ (9,784) $ 302,256 $ (58,365)
------- --------------- ---------------
------- --------------- ---------------
Per common and common equivalent share:
Loss before extraordinary item........... $ (2.45) $ (0.52) $ (1.01)
Extraordinary item-gain on discharge of
debt................................... -- 5.76 --
------- --------------- ---------------
Net income (loss)........................ $ (2.45) $ 5.24 $ (1.01)
------- --------------- ---------------
------- --------------- ---------------
Weighted average number of common and
common equivalent shares outstanding..... 4,000 57,705 57,698
------- --------------- ---------------
------- --------------- ---------------
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
SUCCESSOR PREDECESSOR
COMPANY COMPANY
--------------- --------------
SEPTEMBER 30, DECEMBER 31,
1997 1996
--------------- --------------
(UNAUDITED)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 30,240 $ 3,326
Restricted cash and investments........................... 12,856 --
Receivables, net.......................................... 757 1,338
Inventories............................................... 1,132 2,038
Prepaid expenses and other current assets................. 7,513 2,784
--------------- --------------
TOTAL CURRENT ASSETS.................................... 52,498 9,486
RESTRICTED CASH AND INVESTMENTS............................. 8,850 --
PROPERTY AND EQUIPMENT, net................................. 118,853 110,381
LAND HELD FOR SALE.......................................... 3,635 3,635
OTHER ASSETS................................................ 6,335 2,284
--------------- --------------
TOTAL ASSETS............................................ $ 190,171 $ 125,786
--------------- --------------
--------------- --------------
LIABILITIES AND EQUITY (DEFICIT)
LIABILITIES NOT SUBJECT TO COMPROMISE:
CURRENT LIABILITIES:
Accounts payable and accrued liabilities.................. $ 20,501 $ 15,321
Due to affiliate.......................................... -- 903
Accrued interest.......................................... 2,089 614
Current portion of long-term debt......................... 1,395 --
Debtor-in-possession credit facility...................... -- 22,448
--------------- --------------
TOTAL CURRENT LIABILITIES............................... 23,985 39,286
LONG-TERM DEBT.............................................. 86,903 4,666
OTHER LONG-TERM LIABILITIES................................. 5,050 498
LIABILITIES SUBJECT TO COMPROMISE........................... -- 344,908
CONVERTIBLE REDEEMABLE PREFERRED STOCK...................... 13,839 --
COMMITMENTS AND CONTINGENCIES
NON-REDEEMABLE PREFERRED STOCK, COMMON STOCK AND OTHER
EQUITY (DEFICIT):
Preferred Stock (Predecessor Company)- $.01 par value;
10,000,000 shares authorized, no shares outstanding..... -- --
Common Stock (Predecessor Company)- $.01 par value;
100,000,000 shares authorized, 57,705,470 shares issued
and 57,645,925 shares outstanding at December 31,
1996.................................................... -- 577
Common Stock (Successor Company)- $.01 par value;
10,000,000 shares authorized, 4,000,000 shares issued
and outstanding at September 30, 1997................... 40 --
Treasury stock (Predecessor Company)- 59,545 shares at
cost.................................................... -- (588)
Additional paid-in capital................................ 70,160 291,925
Cumulative translation adjustment......................... (22) 62
Accumulated deficit....................................... (9,784) (555,548)
--------------- --------------
TOTAL NON-REDEEMABLE PREFERRED STOCK, COMMON STOCK AND
OTHER EQUITY (DEFICIT)................................ 60,394 (263,572)
--------------- --------------
TOTAL LIABILITIES AND EQUITY (DEFICIT).................. $ 190,171 $ 125,786
--------------- --------------
--------------- --------------
</TABLE>
The accompanying notes are an integral part of these statements.
5
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
SUCCESSOR PREDECESSOR
COMPANY COMPANY
------------- ----------------------------
TWO MONTHS SEVEN MONTHS NINE MONTHS
ENDED ENDED ENDED
SEPTEMBER 30, JULY 31, SEPTEMBER 30,
1997 1997 1996
------------- ------------- -------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).................................................... $ (9,745) $ 302,256 $ (58,365)
Adjustments to reconcile net income (loss) to net cash (used in)
provided by operating activities before reorganization costs:
Reorganization costs............................................. -- 12,165 12,436
Extraordinary item-gain on discharge of debt..................... -- (332,165) --
Accretion of preferred stock..................................... 39
Depreciation and amortization.................................... 3,981 11,920 16,204
Interest on subordinated convertible debt........................ -- -- 1,383
Loss on disposal of property and equipment....................... -- -- 1,010
Changes in operating assets and liabilities:
Receivables, net............................................... 139 442 724
Inventories.................................................... 182 724 2,433
Prepaid expenses and other assets.............................. (3,339) (962) (7,442)
Accounts payable and accrued liabilities....................... (3,293) 5,667 3,073
Net cash (used in) provided by operating activities before
reorganization costs............................................... (12,036) 47 (28,544)
Reorganization costs................................................. -- (12,165) (12,436)
Adjustments to reconcile reorganization costs to cash used by
reorganization costs:
Loss on asset disposals.......................................... -- -- 2,873
Write-off of deferred debt costs................................. -- -- 4,340
Accrued bankruptcy expenses...................................... -- -- --
Proceeds from sale of property and equipment..................... -- -- 1,753
------------- ------------- -------------
Net cash used by reorganization costs................................ -- (12,165) (3,470)
------------- ------------- -------------
Net cash used in operating activities................................ (12,036) (12,118) (32,014)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment.................................. (262) (567) (1,717)
Proceeds from sale of property and equipment......................... -- 99 6,477
------------- ------------- -------------
Net cash (used in) provided by investing activities.................. (262) (468) 4,760
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from debtor-in-possession credit facilities............. $ -- $ -- $ 15,724
Net repayment of debtor-in-possession credit facilities.............. -- (22,448) --
Proceeds from short-term borrowings.................................. -- -- 7,500
Repayment of short-term borrowings................................... -- -- (7,500)
Advances from affiliate, net......................................... -- -- 10,730
Proceeds from the exercise of options and warrants................... -- -- 282
Proceeds from Senior Secured Notes with Warrants..................... -- 85,000 --
Proceeds from Redeemable Convertible Preferred Stock................. -- 13,800 --
Payment of financing costs........................................... -- (2,800) --
Escrow of restricted cash............................................ -- (21,754) --
------------- ------------- -------------
Net cash provided by financing activities............................ -- 51,798 26,736
------------- ------------- -------------
Net (decrease) increase in cash and cash equivalents................. (12,298) 39,212 (518)
Cash and cash equivalents, beginning of period....................... 42,538 3,326 5,949
------------- ------------- -------------
Cash and cash equivalents, end of period............................. $ 30,240 $ 42,538 $ 5,431
------------- ------------- -------------
------------- ------------- -------------
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest............................................... $ 291 $ 3,957 $ 633
------------- ------------- -------------
------------- ------------- -------------
Cash paid for professional fees in connection with Chapter 11
Proceeding......................................................... $ 143 $ 3,128 $ 2,419
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
The accompanying notes are an integral part of these statements.
6
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED)
(1) ORGANIZATION AND BASIS OF PRESENTATION
Discovery Zone, Inc. (the "Company") is the leading owner and operator of
pay-for-play children's entertainment centers ("FunCenters") in North America
with a national network of 206 FunCenters in 39 states, Puerto Rico and Canada.
The Company also operates two entertainment centers targeting adult customers,
under the "Block Party" name.
The accompanying unaudited condensed consolidated financial statements of
the Company have been prepared in accordance with generally accepted accounting
principles for interim financial information and pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in annual financial statements prepared
in accordance with generally accepted accounting principles have been condensed
or omitted pursuant to those rules and regulations. However, the Company
believes that the disclosures contained herein are adequate to make the
information presented not misleading. It is suggested that these condensed
consolidated financial statements be read in conjunction with the Company's 1996
consolidated financial statements and notes thereto included in the Company's
registration statement on Form S-4.
Discovery Zone, Inc. and its nineteen domestic subsidiaries (collectively,
the "Group") emerged from bankruptcy on July 29, 1997. The Group had originally
filed voluntary petitions for relief under Chapter 11 of the United States
Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court
for the District of Delaware (the "Bankruptcy Court") on March 25, 1996 (the
"Petition Date"). While under Chapter 11, certain claims against the Group at
the Petition Date were stayed while the Company continued its operations as a
Debtor-in-Possession. These claims are reflected in the Company's consolidated
balance sheet as Liabilities Subject to Compromise as of December 31, 1996. On
July 18, 1997, the Bankruptcy Court approved the Company's Joint Plan of
Reorganization with Birch Holdings LLC ("Birch"), which became effective on July
29, 1997 (the "Effective Date" or "Emergence Date").
As a result of the reorganization proceedings, the unaudited condensed
consolidated financial statements and notes thereto were subject to material
uncertainties, the outcome of which were not then determinable. The Company's
unaudited condensed consolidated financial statements for periods prior to the
Effective Date were prepared on a going concern basis and do not include any
adjustments for the effect of any changes which were made in connection with the
Company's recapitalization or operations resulting from a plan of
reorganization.
The unaudited condensed consolidated financial statements reflect accounting
principles and practices set forth in American Institute of Certified Public
Accountants Statement of Position ("SOP") 90-7, "Financial Reporting by Entities
in Reorganization Under the Bankruptcy Code," which provides guidance for
financial reporting by entities that have filed voluntary petitions for relief
under, and have reorganized in accordance with, the Bankruptcy Code.
In accordance with SOP 90-7, the Company did not accrue interest on its
prepetition interest bearing obligations during bankruptcy as it was unlikely
such interest would be paid under the Plan. The amount of such unaccrued
contractual interest during the seven-month period ended July 31, 1997 and the
nine-month period ended September 30, 1996 was approximately $9,176,000 and
$7,963,000, respectively.
The preparation of consolidated 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 consolidated
financial statements and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from those estimates.
7
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(1) ORGANIZATION AND BASIS OF PRESENTATION (CONTINUED)
The financial statements reflect, in the opinion of management, all
adjustments, which are of a normal recurring nature, and those adjustments
required to adopt fresh-start reporting as described below which are necessary
to present fairly the Company's financial position and results of operations.
Capitalized terms have the meanings defined throughout the Notes to Condensed
Consolidated Financial Statements.
The Company's FunCenters typically experience seasonal fluctuations in their
revenues, with generally higher revenues occurring in the first quarter of the
year due to the fact that many of the Company's facilities are located in cold
weather regions where children are unable to play outside during this time of
the year. Operating results of interim periods are not necessarily indicative of
results that may be expected for the year ending December 31, 1997.
(2) JOINT PLAN OR REORGANIZATION AND EXIT FINANCING
In November 1996, the Company filed with the Bankruptcy Court a Joint Plan
of Reorganization (the "Plan") with Birch which set forth a plan for repaying or
otherwise compensating the Company's creditors in order of relative seniority of
their respective claims while seeking to maintain the Company as a going
concern. On July 18, 1997, the Plan was approved by the requisite number of
creditors in each class and confirmed by the Bankruptcy Court. The Plan became
effective on July 29, 1997 and the Company emerged from bankruptcy as of that
date.
The plan provided for (i) the payment in full of certain administrative
claims against the Company (those claims which arose after the Petition Date);
(ii) conversion of substantially all of the Company's liabilities subject to
compromise (excluding taxes payable, lease assumption payments and certain other
pre-petition liabilities permitted under the Plan) to an equity interest in the
Company, and (iii) cancellation of all of the prepetition equity interests in
the Company, all as more fully described in the Plan. Birch had purchased
certain of these prepetition claims from the original banks providing a credit
facility to the Company, resulting in ownership of 55.7% of the common stock of
the reorganized Company ("Common Stock").
Pursuant to the Plan, substantially all the Company's prepetition unsecured
liabilities were converted to equity in exchange for units consisting of nine
shares of Common Stock and a ten-year warrant to purchase one share of Common
Stock at a price of $17.55 (the "Ten Year Warrants"). Such unsecured creditors
will receive 4,000,000 shares of Common Stock and 444,444 shares of Common Stock
have been reserved for issuance in connection with the warrants. As a result of
the transactions which occurred on the Effective Date, indebtedness of
$332,165,000 was discharged, resulting in a gain, reflected as an extraordinary
item in the accompanying condensed consolidated statements of operations, of
approximately $332,165,000. This gain is not recognized for tax purposes to the
extent the Company was insolvent at the date of discharge. However, the
Company's net operating loss carryforwards were reduced by the amount of the
gain.
In connection with its emergence from bankruptcy, the Company raised $100
million through the issuance of $15 million of Convertible Redeemable Preferred
Stock ("Preferred Stock") and $85 million of 13.5% Senior Secured Notes with
Warrants, resulting in $93.8 million of net proceeds to the Company after
deducting related offering costs (the "Exit Financing"). The proceeds were used
to repay the Company's debtor-in-possession credit facilities (see Note 5) and
certain bankruptcy administrative claims and reorganization costs incurred in
connection with the Company's emergence from bankruptcy and to fund the Bond
Interest Escrow Account, which is reflected as Restricted Cash and Investments
in the accompanying condensed consolidated financial statements. The Senior
Secured Note holders also
8
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(2) JOINT PLAN OR REORGANIZATION AND EXIT FINANCING (CONTINUED)
received warrants (the "Warrants") to purchase 805,154 shares of Common Stock at
$.01 per share exercisable through August 1, 2007, which represent approximately
12.5% of the fully diluted shares of Common Stock after giving effect to the
exercise of the Warrants and the Ten Year Warrants and conversion of the
Preferred Stock. A portion of the proceeds from the Senior Secured Notes was
allocated to the Warrants (See Note 6).
The Preferred Stock is convertible at any time into 1,191,626 shares of
Common Stock at an effective conversion price of $12.59 per common share,
representing approximately 18.5% of the fully diluted shares of Common Stock
after giving effect to the exercise of the Warrants and the Ten Year Warrants.
The terms of the Preferred Stock include a liquidation preference, the right to
receive dividends, if paid, voting rights, Board of Directors representation and
redemption upon (i) the earlier to occur of a merger, the sale of substantially
all the Common Stock or assets of the Company or other change of control, or
(ii) 180 days prior written notice from any holder at any time 62 months after
the Effective Date.
As part of the Plan, a stock option plan was established. Pursuant to
certain executive employment contracts, options to purchase shares of Common
Stock have been granted to senior executives of the Company at an exercise price
of $11.88 per share. A total of 715,692 shares of Common Stock have been
reserved for issuance under the Company's stock option plan.
(3) FRESH START REPORTING
Upon emergence from its Chapter 11 proceedings, the Company adopted fresh
start reporting pursuant to the provisions of SOP 90-7. In accordance with SOP
90-7, assets and liabilities have been restated as of July 31, 1997 to reflect
the reorganization value of the Company, which approximates their fair value at
the Emergence Date. In addition, the accumulated deficit of the Company through
the Emergence Date has been eliminated and the debt and capital structure of the
Company has been recast pursuant to the provisions of the Plan. Thus, the
condensed consolidated balance sheet as of September 30, 1997 reflects a new
reporting entity (the "Successor Company") and is not comparable to prior
periods (the "Predecessor Company"). Furthermore, the accompanying condensed
consolidated statements of operations and cash flows of the Predecessor Company
reflect operations prior to the Company's emergence from bankruptcy and the
effect of adopting fresh-start reporting and are thus not comparable with the
results of operations and cash flows of the Successor Company.
The reorganization value of the Company's common equity of approximately
$70,200,000 was determined by the Company with the assistance of financial
advisors by reliance on various valuation methods, including discounted
projected cash flow analyses, price/earnings ratios, and other applicable ratios
and economic and industry information relevant to the operations of the Company,
and through negotiations with the various parties in interest. While the
estimated reorganization value of the Company has been preliminarily allocated
to specific asset categories pursuant to fresh-start reporting, the effects of
such are subject to further refinement or adjustment.
9
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(3) FRESH START REPORTING (CONTINUED)
The effects of the Plan, the Exit Financing, and fresh-start reporting on
the Company's condensed consolidated balance sheet at July 31, 1997 are as
follows (in thousands):
<TABLE>
<CAPTION>
PRE- EXIT FRESH-START
EMERGENCE DISCHARGE OF FINANCING ADJUSTMENTS REORGANIZED
BALANCE SHEET DEBT (1) (2) (3) BALANCE SHEET
------------- ------------ ----------- ----------- -------------
<S> <C> <C> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents.................. $ 1,712 $ (33,811) $ 74,637 $ 42,538
Restricted cash and investments............ 391 10,302 10,693
Receivables, net........................... 896 896
Inventories................................ 1,314 1,314
Prepaid expenses and other current
assets................................... 3,804 (569) 697 3,932
------------- ------------ ----------- ----------- -------------
TOTAL CURRENT ASSETS................... 8,117 (33,811) 84,370 697 59,373
RESTRICTED CASH AND INVESTMENTS.............. -- 11,061 11,061
PROPERTY AND EQUIPMENT, net.................. 98,929 23,591 122,520
LAND HELD FOR SALE........................... 3,635 3,635
OTHER ASSETS................................. 2,233 5,000 (704) 6,529
------------- ------------ ----------- ----------- -------------
TOTAL ASSETS........................... 112,914 (33,811) 100,431 23,584 $ 203,118
------------- ------------ ----------- ----------- -------------
------------- ------------ ----------- ----------- -------------
LIABILITIES AND EQUITY (DEFICIT)
LIABILITIES NOT SUBJECT TO COMPROMISE:
CURRENT LIABILITIES:
Accounts payable........................... $ 7,095 $ 7,095
Accrued liabilities........................ 9,698 (1,368) 1,631 8,783 18,744
Current portion of long-term debt.......... 186 186
Debtor-in-possession credit facility....... 30,895 (30,895) --
------------- ------------ ----------- ----------- -------------
TOTAL CURRENT LIABILITIES.............. 47,874 (32,263) 1,631 8,783 26,025
LONG-TERM DEBT............................... 4,681 5,000 77,950 87,631
OTHER LONG-TERM LIABILITIES.................. 450 5,012 5,462
LIABILITIES SUBJECT TO COMPROMISE............ 344,070 (338,713) (5,357) --
CONVERTIBLE REDEEMABLE PREFERRED STOCK....... -- 13,800 13,800
COMMON STOCK AND OTHER EQUITY (DEFICIT):
Common Stock (Predecessor Company)......... 577 (577) --
Common Stock (Successor Company)........... -- 40 40
Treasury stock (Predecessor Company)....... (588) 588 --
Additional paid-in capital................. 291,925 7,050 (228,815) 70,160
Cumulative translation adjustment.......... 32 (32) --
Accumulated deficit........................ (576,107) 332,165 243,942 --
------------- ------------ ----------- ----------- -------------
TOTAL COMMON STOCK AND OTHER EQUITY
(DEFICIT)............................ (284,161) 332,165 (7,050) 15,146 70,200
------------- ------------ ----------- ----------- -------------
------------- ------------ ----------- ----------- -------------
TOTAL LIABILITIES AND EQUITY
(DEFICIT)............................ $ 112,914 $ (33,811) $ 100,431 $ 23,584 $ 203,118
------------- ------------ ----------- ----------- -------------
------------- ------------ ----------- ----------- -------------
</TABLE>
- ------------------------
(1) To record the discharge or reclassification of prepetition obligations
(liabilities subject to compromise) and debtor-in-possession credit
facilities pursuant to the Plan.
(FOOTNOTES CONTINUED ON NEXT PAGE)
10
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(3) FRESH START REPORTING (CONTINUED)
(2) To record the Exit Financing and related costs.
(3) To record assets and liabilities at their fair value pursuant to fresh-start
reporting and eliminate the existing accumulated deficit.
(4) DEBTOR-IN-POSSESSION CREDIT FACILITIES
At July 29, 1997, the Company had outstanding borrowings under its
debtor-in-possession credit facility with Perry Partners L.P. ("Perry Partners")
(the "Replacement Credit Facility") of $27,808,000. Those borrowings bore
interest at prime plus 3.5% (11.75% at July 29, 1997) payable monthly. The
Replacement Credit Facility also required payment of certain fees as defined in
the agreement as an amount to be determined such that Perry Partners earned an
internal rate of return, determined on an annualized basis, of 21% on all
borrowings (which return took into account all interest and fees). At the
Effective Date, additional fees and interest of $1,800,000 over interest accrued
at the stated rate were owed. Outstanding borrowings under the facility were
repaid upon the Company's emergence from bankruptcy with the proceeds of the
Exit Financing. (See Note 2).
In June and July 1997, the U.S. Bankruptcy Court issued orders permitting
the Company to borrow $5 million from Birch as permitted under the existing
Replacement Credit Facility. The facility bore interest at prime plus 3.5% and
required the payment of certain additional fees to Birch at such time as the
Company exited bankruptcy protection. The loan was unsecured; however,
borrowings under the loan agreement had superpriority administrative claim
status with respect to payment of administrative expenses under the Plan. The
Company borrowed $2.5 million under this facility which was repaid with interest
and fees of $82,000 upon emergence from bankruptcy with the proceeds from the
Exit Financing.
11
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(5) LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
<TABLE>
<CAPTION>
SUCCESSOR PREDECESSOR
COMPANY COMPANY
--------------- ---------------
SEPTEMBER 30, DECEMBER 31,
1997 1996
--------------- ---------------
(UNAUDITED)
<S> <C> <C>
13.5% Senior Secured Notes due 2002, net of unamortized
discount of $6,860 (1)..................................... $ 78,140 $ --
Secured Rejection Note (2).................................. 4,416 4,666
Secured Rent Deferral Notes (2)............................. 332 --
Prepetition Tax Claims (3).................................. 5,000 --
Other notes payable......................................... 410 --
--------------- ------
88,298 4,666
Less current portion........................................ (1,395) --
--------------- ------
Long-term debt.............................................. $ 86,903 $ 4,666
--------------- ------
--------------- ------
</TABLE>
- ------------------------
(1) In connection with its exit financing to emerge from bankruptcy, the Company
issued $85,000,000 of 13.5% Senior Secured Notes due August 1, 2002 (the
"Notes") and the Warrants. A value of approximately $7,050,000 was allocated
to the Warrants based upon their estimated fair value at the time of the
issuance, representing the original issue discount on the Notes. The Notes
are secured by substantially all the assets of the Company and interest is
payable quarterly beginning November 1, 1997. A separate interest escrow
account was established with the trustee to fund interest payments through
August 1, 1999. The interest escrow account balance totaled $21,706,000,
consisting of treasury securities and accrued interest thereon, at September
30, 1997.
The Notes contain restrictions on additional indebtedness and cross-default
provisions with other obligations of the Company. Among other things, the
Company is permitted to have outstanding up to $10 million of senior secured
indebtedness and up to $5 million of new indebtedness arising from sale and
leaseback transactions, capital lease obligations, or purchase money
obligations.
(2) In conjunction with its emergence from bankruptcy, the Company completed the
documentation of the notes and mortgages securing McDonald's Corporations'
("McDonald's") damage claims as approved by the Bankruptcy Court in November
1996 pursuant to the McDonald's Stipulation (see Note 7 to the annual
audited financial statements).
McDonald's claim for damages arising from rejected leases totaled
approximately $4,416,000 at the Emergence Date and is evidenced by a
six-year note payable requiring annual principal payments of approximately
$736,000 (the "Secured Rejection Note"). The Secured Rejection Note bears
interest at 12% payable annually.
The Company's obligations to repay certain rent deferrals granted by
McDonald's pursuant to the McDonald's Stipulation are evidenced by nine
notes due upon the expiration of each initial sublease term (the "Secured
Rent Deferral Notes"). The rent deferrals total currently $398,196 per year
and, when combined with the initial Emergence Date principal balance of
approximately $266,000, will
12
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(5) LONG-TERM DEBT (CONTINUED)
total approximately $2,567,000 over the next eight years. The notes bear
interest at 12% per annum payable at maturity and have maturity dates
ranging from August 31, 2002 to December 31, 2004.
The Secured Rejection Note and the Secured Rent Deferral Notes are secured
by first mortgages or deeds of trust on fourteen properties owned by the
Company including three undeveloped parcels of land with a book value of
$2,747,000 at September 30, 1997, which are included in Land Held for Sale
in the Company's Consolidated Balance Sheet. The notes contain certain
cross-default provisions including cross-defaults among themselves, with the
McDonald's subleases and with other indebtedness of the Company in excess of
$2.5 million.
(3) The prepetition tax claims (the "Tax Claims") represent taxes assessed prior
to the Company filing for bankruptcy and have an estimated aggregate
principal amount of $5 million. The Tax Claims have maturities of up to six
years from the original date of assessment and require payment of principal
amounts in equal annual installments. The majority of the Tax Claims accrue
simple interest at 10% per annum payable with each annual principal
installment. The remainder accrue interest at 12% per annum.
(6) EARNINGS (LOSS) PER COMMON SHARE
Earnings (loss) per common and common equivalent shares is calculated based
upon the weighted average number of common and common equivalent shares
outstanding during the periods presented. Common equivalents outstanding during
the period and common shares issuable upon assumed conversion of the Preferred
Stock have not been included in the computation of earnings (loss) per share as
their effect is antidilutive for all relevant periods presented. Shares of
Common Stock to be issued to unsecured creditors pursuant to the Plan have been
reflected as outstanding as of the Effective Date for purposes of calculating
the weighted average common and common equivalent shares outstanding in the
accompanying unaudited condensed consolidated statement of operations for the
two-month period ended September 30, 1997.
(7) LEGAL MATTERS
From time to time, the Company is a party to a number of lawsuits and other
legal matters, including claims relating to injuries which allegedly occurred at
the Company's facilities and to alleged employment discrimination. A portion of
these claims may be covered by insurance. Management has estimated the potential
liabilities resulting from such claims which arose subsequent to the Petition
Date and which are not covered by insurance to be approximately $2,790,000 at
September 30, 1997 and $1,849,000 at December 31, 1996. These amounts were
recorded in accrued liabilities and other long-term liabilities in the
accompanying condensed consolidated balance sheets. Because these amounts
represent estimates, it is reasonably possible that a change in these estimates
may occur in the future.
(8) RELATED PARTY TRANSACTIONS
On May 7, 1997, the Bankruptcy Court issued an order providing for the
settlement of all of Viacom Inc.'s ("Viacom") prepetition general unsecured
claims against the Group and all claims which the Group or any holders of claims
against the Group may hold against Viacom. Under the agreement and subsequent
Bankruptcy Court order, Viacom received no property for its prepetition
unsecured claims
13
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(8) RELATED PARTY TRANSACTIONS (CONTINUED)
under the Plan. In exchange for this treatment, the Group (i) satisfied in full
a claim which Iwerks Studios, Inc. held against the Group, and which was
guaranteed by Blockbuster Entertainment Group ("Blockbuster"), an affiliate of
Viacom, in the amount of $61,500, (ii) assumed approximately thirty leases of
the Group, which were guaranteed by Viacom, and assign them to Blockbuster and
(iii) paid Viacom's postpetition administrative claims for expenses advanced by
Viacom on behalf of the Group of approximately $991,000 and obligations incurred
under the Management Services Agreement ("MSA") between the Company and Viacom
subject to any setoff paid on behalf of Viacom. In connection with this
settlement, the MSA was terminated.
As required under the Plan, the Company reimbursed Wellspring $1,078,000 for
its out-of-pocket expenses incurred in connection with sponsoring the Plan.
An officer of Griffin Bacal, Inc., the Company's advertising agency, serves
as a director of the Successor Company. The Company paid $7,021,000 to Griffin
Bacal for media and creative services during the nine months ended September 30,
1997.
(9) SUBSEQUENT EVENTS
During the fourth quarter of 1997, the Company began Phase One of its
capital plan to renovate its FunCenters, add new attractions, and broaden their
entertainment offerings, including the addition of designated areas for
lasertag, arts and crafts, stage events and promotional activities. The Company
estimates that approximately 75% of its FunCenters will be renovated pursuant to
this plan by March 31, 1998 at a cost of approximately $15 million. The Company
also expects to complete the conversion of its food service operations to offer
Pizza Hut products in approximately 80% of its FunCenters by year end.
Approximately $2,274,000 of prepaid expenses and other current assets represent
deposits or advances made in anticipation of these changes.
14
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION AND ANALYSIS RELATES TO THE COMPANY'S HISTORICAL
FINANCIAL RESULTS OF OPERATIONS AND FINANCIAL CONDITION, WITHOUT GIVING PRO
FORMA EFFECT TO THE RESTRUCTURING OF THE COMPANY WHICH OCCURRED IN CONNECTION
WITH THE PLAN OF REORGANIZATION AND THE IMPLEMENTATION OF THE TURNAROUND PLAN,
EXCEPT TO THE EXTENT THAT SUCH RESTRUCTURING HAD OCCURRED PRIOR TO THE END OF
THE PERIODS DISCUSSED. AS A RESULT, MANAGEMENT DOES NOT BELIEVE THAT RESULTS OF
OPERATIONS IN FUTURE PERIODS WILL BE COMPARABLE TO PRIOR PERIODS. THIS
DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE COMPANY'S
CONSOLIDATED CONDENSED FINANCIAL STATEMENTS AND THE NOTES THERETO APPEARING
ELSEWHERE IN THIS REPORT ON FORM 10-Q.
OVERVIEW
The Company is the leading owner and operator of pay-for-play children's
entertainment centers in North America, with a national network of 206
FunCenters in 39 states, Puerto Rico and Canada targeted at children ages two to
12 and two Block Party Stores which target adult customers. The Company was
established in 1989 and grew from 28 FunCenters in 1991 to 336 company-owned and
franchised FunCenters by the end of 1995, primarily as a result of acquisitions
of competitors and construction of new FunCenters financed with bank debt and
public offerings of debt and equity securities. This rapid expansion resulted in
a loss of control over costs and quality at both the store and corporate levels
which diminished customer service, reduced store operating margins and caused
selling, general and administrative expenses to increase dramatically.
15
<PAGE>
The Company emerged from Chapter 11 on July 29, 1997 (the "Effective
Date"). The Company generates revenue primarily from the operation of 206
FunCenters. FunCenter revenues are derived from: (i) admission charges; (ii)
food and beverage sales; (iii) redemption game and other concession revenue; and
(iv) birthday party fees. The Company's revenues are subject to significant
quarterly variations based upon several factors, including seasonal changes in
weather, holidays and the school calendar. The Company experienced negative
comparable store sales while operating in Chapter 11 and this trend has
continued since the Effective Date. Among other factors, comparable store
revenues declined because (i) the Company shortened FunCenter operating hours by
approximately 18% to curtail operations during unprofitable time periods, (ii)
the Company reduced its marketing expenditures (see below) and (iii) the Company
did not update its product offering during the Company's reorganization in
bankruptcy.
The Company believes that growth in its revenues will eventually result from
enhanced entertainment value provided by new product offerings, improvement in
food and beverage offerings, increased utilization of FunCenters during weekdays
and other off-peak times and, to a lesser extent, from the construction or
acquisition of new FunCenters. The Company expects to renovate approximately 75%
of its FunCenters by March 31, 1998, convert approximately 80% of its FunCenters
to permit the sale of Pizza Hut menu items and relaunch the brand during the
first quarter of 1998. Management expects that, as a result of these efforts,
revenues will increase on a comparable store basis.
The Company's operating expenses at the store level consist primarily of
food and beverage costs, the cost of game merchandise, labor costs, occupancy
and maintenance expense. As a substantial portion of store operating expenses,
including occupancy costs, facility maintenance and core staffing requirements
are fixed, the Company has a high degree of operating leverage. The Company has
reduced its rent expense through renegotiation of certain store leases and has
generated additional annual cost savings at the store level through cost
management measures and improved financial controls implemented in connection
with Phase 1 of its Turnaround Plan.
The Company's selling, general and administrative expenses include
salaries, bankruptcy-related costs, corporate and regional management
expenses and other administrative, promotional and advertising expenses. In
connection with the Turnaround Plan, the Company expects its annual selling,
general and administrative expenses in 1997 to be approximately $20 million
less than in 1996.
The Company accrued substantial restructuring costs, including costs related
to the relocation of the Company's headquarters, the termination of certain
managers and employees and the rejection of certain store leases.
A portion of these restructuring costs were discharged in
connection with the Plan of Reorganization and other amounts were repaid with
the proceeds of the offering of the Private Notes and the Convertible Preferred
Stock.
16
<PAGE>
RESULTS OF OPERATIONS
COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996.
Upon emergence from Chapter 11, the Company adopted Fresh
Start Accounting. See "Changes in Method of Accounting." Thus the Company's
balance sheets and statements of operations and cash flows after the Effective
Date reflect a new reporting Company (the "Successor Company") and are not
comparable to periods prior to the Effective Date (the "Predecessor Company").
The three months ended September 30, 1997 include the results of the
Predecessor Company for the month ended July 31, 1997 and the Successor Company
for the two months ended September 30, 1997. The principal differences between
these periods relate to reporting changes regarding the Company's capital
structure and indebtedness and the revaluation of the Company's long-term
assets, which primarily affect depreciation and amortization expense and
interest expense in the Company's results of operations.
REVENUE. Total revenue was $30.7 million versus $39.8 million during the
three months ended September 30, 1997 and 1996, respectively. The decline during
the 1997 period as compared to the 1996 period was attributable to a reduction
in the number of FunCenters in operation and a reduction in average sales per
FunCenter. The decrease in average sales per FunCenter was primarily due to
disruptions in the business associated with the Company's bankruptcy filing,
reduced and ineffective marketing programs and a lack of new attractions at the
FunCenters.
COST OF GOODS SOLD. Costs of goods sold, which consists primarily of the
cost of food, redemption merchandise and other product sales, was $4.6 million
in the three months ended September 30, 1997 as compared with $7.9 million in
the three months ended September 30, 1996. As a percentage of revenue, costs of
goods sold declined from 19.8% in the 1996 period to 15.0% in the 1997 period.
This reduction was primarily attributable to simplified product offerings and
better cost management during the 1997 period.
STORE OPERATING EXPENSES. Store operating expenses, which consist primarily
of compensation and benefits for FunCenter operating personnel, occupancy
expenses and facility repair and maintenance expenses were $25.6 million in the
three months ended September 30, 1997 as compared with $32.0 million in the
three months ended September 30, 1996. As a percentage of total revenues, store
operating expenses increased from 80.4% in the 1996 period to 83.3% in the 1997
period due to the decrease in revenue in spite of a $6.4 million decline in
total store operating expenses. The decline in dollars was due to the
implementation of labor planning, lower rent from renegotiated leases,
reductions in central reservation expenses and other cost savings generated
through Phase 1 of the Company's Turnaround Plan.
17
<PAGE>
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses were $5.5 million versus $8.3 million in the three
months ended September 30, 1997 and 1996, respectively. As a percentage of
revenue, selling, general and administrative expenses declined from 20.9% in the
1996 period to 17.9% in the 1997 period. The decrease reflects the reduction in
corporate staff, and related expenses and lower marketing expenses, combined
with a general reduction in spending due to a reduction in the number of
FunCenters, as implemented in Phase 1 of the Company's Turnaround Plan.
DEPRECIATION AND AMORTIZATION EXPENSE. Depreciation and amortization
expense was $5.7 million for the three months ended September 30, 1997 as
compared with $5.6 million for the three months ended September 30, 1996. The
decline resulted primarily from a reduction in the number of FunCenters in
operation, offset by an increase during the two months ended September 30, 1997
attributable to an increase in the Company's plant and equipment as a result of
adopting Fresh Start Accounting for the Successor Company.
INTEREST EXPENSE. Interest expense consisted of accrued interest on (i)
the outstanding LYONS, the Company's subordinated convertible debt and
borrowings under the Company's Pre-petition credit facility (collectively,
the "Pre-petition Indebtedness") through March 25, 1996, (ii) borrowings
under the DIP Facilities, and (iii) after the Effective Date, borrowings
under the Private Notes, the McDonald's Notes and the Pre-petition Taxes
Payable obligations, and was $602,000 for the three months ended September
30, 1997 as compared with $13,000 for the three months ended September 30,
1996. These amounts do not reflect interest on the Pre-petition Indebtedness
which was suspended during the Company's reorganization under Chapter 11. Had
these payments not been suspended, interest expense would have been $5.2
million and $4.4 million for the 1997 and 1996 periods, respectively.
REORGANIZATION COSTS. Reorganization costs of $8.0 million and $4.3 million
were incurred by the Company during its reorganization under Chapter 11 for
the three months ended September 30, 1997 and 1996, respectively, including
$200,000 and $2.4 million incurred for professional fees in the 1996 and 1997
periods, respectively. The remainder was primarily attributable to losses on
asset disposals associated with the closing of FunCenters and expenses
associated with the Plan of Reorganization.
EXTRAORDINARY ITEM. In July 1997, the Company recognized an extraordinary
gain of $332.2 million resulting from the cancellation of indebtedness
pursuant to the Plan.
18
<PAGE>
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996.
The nine months ended September 30, 1997 include the results of the
Predecessor Company for the seven months ended July 31, 1997 and the Successor
Company for the two months ended September 30, 1997. The principal differences
between these periods relate to reporting changes regarding the Company's
capital structure and indebtedness and the revaluation of the Company's
long-term assets, which primarily affect depreciation and amortization expense
and interest expense in the Company's results of operations.
REVENUE. Total revenue was $102.4 million versus $147.8 million during the
nine months ended September 30, 1997 and 1996, respectively. The decline during
the 1997 period as compared to the 1996 period was attributable to a reduction
in the number of FunCenters in operation and a reduction in average sales per
FunCenter. The decrease in average sales per FunCenter was primarily due to
disruptions in the business associated with the Company's bankruptcy filing,
reduced and ineffective marketing programs and a lack of new attractions at the
FunCenters.
COST OF GOODS SOLD. Costs of goods sold which consists primarily of the
cost of food, redemption merchandise and other product sales, was $17.2 million
in the nine months ended September 30, 1997 as compared with $27.0 million in
the nine months ended September 30, 1996. As a percentage of revenue, costs of
goods sold declined from 18.3% in the 1996 period to 16.8% in the 1997 period.
This reduction was primarily attributable to simplified product offerings and
better cost management during the 1997 period.
STORE OPERATING EXPENSES. Store operating expenses, which consist primarily
of compensation and benefits for FunCenter operating personnel, occupancy
expenses and facility repair and maintenance expenses, were $77.1 million in the
nine months ended September 30, 1997 as compared with $112.8 million during the
nine months ended September 30, 1996. As a percentage of total revenues, store
operating expenses declined from 81.8% in the 1996 period to 76.8% in the 1997
period. The decline as a percentage of revenue is due to the implementation of
labor planning, lower rent from renegotiated leases, reductions in central
reservation expenses and other cost savings generated through Phase 1 of the
Company's Turnaround Plan.
19
<PAGE>
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses were $14.1 million versus $33.2 million in the nine
months ended September 30, 1997 and 1996, respectively. As a percentage
of revenue, selling, general and administrative expenses declined
from 22.5% in the 1996 period to 13.7% in the 1997 period. The decrease reflects
the reduction in corporate staff, and related expenses and lower marketing
expenses, combined with a general reduction in spending due to a reduction in
the number of FunCenters, as implemented in Phase 1 of the Company's Turnaround
Plan.
DEPRECIATION AND AMORTIZATION EXPENSE. Depreciation and amortization
expense was $15.9 million for the nine months ended September 30, 1997 as
compared with $16.2 million for the nine months ended September 30, 1996. The
decline resulted primarily from a reduction in the number of FunCenters in
operation, offset by an increase during the two months ended September 30, 1997,
attributable to an increase in the Company's plant and equipment as a result of
adopting Fresh Start Accounting for the Successor Company.
INTEREST EXPENSE. Interest expense consisted primarily of accrued
interest on (i) the outstanding LYONS, the Company's subordinated convertible
debt and borrowings under the Dip Facilities (collectively, the "Pre-petition
Indebtedness") through March 25, 1996, (ii) borrowings under the DIP
Facilities, and (iii) after the Effective Date, borrowings under the Private
Notes, the McDonald's Notes and the Pre-petition Taxes Payable obligations,
and was $6.4 million versus $5 million during the nine months ended September
30, 1997 and 1996, respectively. These amounts do not reflect interest on the
Pre-petition Indebtedness which was suspended during the Company's
reorganization under Chapter 11. Had these payments not been suspended,
interest expense would have been $15.6 million and $12.9 million for the 1997
and 1996 periods, respectively.
REORGANIZATION COSTS. Reorganization costs of $12.2 million versus $12.4
million were incurred by the Company during its reorganization under Chapter 11
for the nine months ended September 30, 1997 and 1996, respectively,
including $7.1 million and $3.2 million incurred for professional fees in the
1996 and 1997 periods, respectively. The remainder was primarily attributable to
losses on asset disposals associated with the closing of FunCenters and expenses
associated with the Plan of Reorganization.
EXTRAORDINARY ITEM. In July 1997, the Company recognized an extraordinary
gain of $332.2 million resulting from the cancellation of indebtedness
pursuant to the Plan.
20
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
The Company does not have significant receivables or inventory and receives
trade credit based upon negotiated terms in purchasing food products and other
supplies. Therefore, the Company's business has not required significant working
capital to operate. The Company requires cash primarily to finance capital
expenditures to maintain and upgrade existing stores and to fund working capital
needs. Following completion of certain programs to improve operating cash flow
under its Turnaround Plan, the Company will also need cash to build new stores.
Historically, the Company has met these liquidity requirements primarily through
external financings, including through the issuance of debt and equity
securities and borrowings under revolving credit facilities, as well as through
cash flow generated by operating activities. In connection with the Plan of
Reorganization, substantially all of the Company's pre-petition debt facilities
and other obligations to creditors were restructured, repaid or eliminated. See
"Plan of Reorganization."
For the two months ended September 30, 1997 and the seven months ended July
31, 1997, the Company used cash of $12.0 million and generated cash of $47,000,
respectively, from operations before reorganization expenses. This decrease
can be attributed primarily to the Company's net losses and changes in working
capital. The reduction in cash used by operations during the 1997 periods is
primarily attributable to Phase 1 of the Company's Turnaround Plan and the
payment of certain reorganization and transaction costs. The Company generated
cash during the two month period ended September 30, 1997 because it incurred
certain reorganization and transaction costs in July 1997 which were paid after
July 31, 1997.
The Company expects to use cash going forward primarily to finance capital
expenditures and meet its limited working capital requirements. The Company
expects to make between $15 million and $20 million in capital expenditures
during the fourth quarter of 1997 and in 1998 in connection with its capital
improvement program under the Turnaround Plan. Should operating cash flow of
existing FunCenters increase as a result of the Turnaround Plan, the Company
also expects to use cash to build new FunCenters.
While the Company's Private Notes contain restrictions on additional
indebtedness, the Company is permitted to have outstanding up to $10 million of
senior secured indebtedness and up to $5 million of new indebtedness arising
from sale and leaseback transactions, capital lease obligations or purchase
money obligations.
On September 30, 1997, the Company had an unrestricted cash balance of
approximately $30.2 million. The Company also had $21.7 million in cash and in
investments the Escrowed Interest Account on September 30, 1997, which amount is
dedicated to making scheduled payments of interest on the Private Notes and the
Exchange Notes through August 1, 1999. The Company believes that its existing
capital resources will provide sufficient funds to finance the Company's
operations in the ordinary course and to fund its capital expenditures and debt
service requirements. See "Business -- Business Strategy and Turnaround Plan."
21
<PAGE>
DISCOVERY ZONE, INC.
PART II--OTHER INFORMATION
Item 1 - Legal Proceedings
Not Applicable
Item 2 - Changes in Securities
Not Applicable
Item 3 - Defaults upon Senior Securities
Not Applicable
Item 4 - Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5 - Other Information
Not Applicable
22
<PAGE>
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit
Number Description
------- -----------
2.1 Third Amended Joint Plan of Reorganization of the
Registrant, dated March 11, 1997 (incorporated by
reference from the Current Report on Form 8-K of the
Registrant, dated July 9, 1997).
2.2 Agreement and Plan of Merger, dated as of July 28,
1997, between Discovery Zone Children's Amusement Corp.
and the subsidiaries of the Registrant listed therein
(incorporated by reference from the Registration
Statement on Form S-4 (the "Form S-4") of the
Registrant, dated November 19, 1997).
2.3 Agreement and Plan of Merger, dated as of July 29,
1997, between the Registrant and Discovery Zone
Children's Amusement Corporation (incorporated by
reference from the Form S-4 of the Registrant, dated
November 19, 1997).
3.1 Amended and Restated Certificate of Incorporation of
the Registrant (incorporated by reference from the
Form S-4 of the Registrant, dated November 19, 1997).
3.2 Amended and Restated By-laws of the Registrant
(incorporated by reference from the Form S-4 of the
Registrant, dated November 19, 1997).
*4.1 Form of Common Stock Certificate (incorporated by
reference from the Registration Statement on Form 10
of the Registrant, dated November 19, 1997).
23
<PAGE>
Exhibit
Number Description
------- -----------
*10.1 Employment Agreement, dated as of July 21, 1997,
between the Registrant and Scott W. Bernstein
(incorporated by reference from the Form S-4 of the
Registrant, dated November 19, 1997).
*10.2 Employment Agreement, dated as of August 1, 1997,
between the Registrant and Robert G. Rooney
(incorporated by reference from the Form S-4 of the
Registrant, dated November 19, 1997).
*10.3 Employment Agreement, dated as of August 1, 1997,
between the Registrant and Sharon L. Rothstein
(incorporated by reference from the Form S-4 of the
Registrant, dated November 19, 1997).
*27.1 Financial Data Schedule (incorporated by reference from
the Form S-4 of the Registrant, dated November 19,
1997).
- -----------------
* To be filed by amendment
24
<PAGE>
(b) Reports on Form 8-K
1. Current Report on Form 8-K dated July 9, 1997: Items 4, 5
and 7
2. Current Report on Form 8-K dated August 4, 1997: Items 5
and 7
SIGNATURES
Pursuant to the requirements 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.
DISCOVERY ZONE, INC.
(Registrant)
DATE: November 19, 1997 /s/ Scott W. Bernstein
----------------------------------------
Name: Scott W. Bernstein
Title: Chief Executive Officer,
President and Director
25
