UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
[X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the quarter ended March 31, 1998.
[ ] Transition period pursuant to Section 13 or 15(d) of the Securities
Exchange Act for the transition period from __________ to __________.
Commission File Number: 0-21854
DISCOVERY ZONE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 65-0408845
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
565 Taxter Road, 10523
Fifth Floor (Zip Code)
Elmsford, New York
(Address of principal executive offices)
Registrant's telephone number, including area code: (914) 345-4500
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 June 1, 1998: 4,000,000 shares
<PAGE>
DISCOVERY ZONE, INC.
PART 1 -- FINANCIAL INFORMATION
Page No.
--------
ITEM 1. FINANCIAL STATEMENTS
Unaudited Condensed Consolidated Statements of
Operations - Three Months Ended March 31, 1998 and 1997 3
Condensed Consolidated Balance Sheets - March 31, 1998
(unaudited) and December 31, 1997 4
Unaudited Condensed Consolidated Statements of Cash
Flows - Three Months Ended March 31, 1998 and 1997 5
Notes to Unaudited Condensed Consolidated Financial
Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 13
PART II -- OTHER INFORMATION
Page No.
--------
ITEM 1. LEGAL PROCEEDINGS 17
ITEM 2. CHANGES IN SECURITIES 17
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 17
ITEM 5. OTHER INFORMATION 17
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 17
2
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share data)
<TABLE>
<CAPTION>
Successor Company Predecessor Company
------------------ -------------------
Three Months Ended Three Months Ended
March 31, 1998 March 31, 1997
------------------ ----------------
<S> <C> <C>
REVENUE.................................................... $ 40,677 $ 38,794
COST OF GOODS SOLD......................................... 6,417 7,195
STORE OPERATING EXPENSES................................... 28,153 26,486
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE................ 5,722 4,254
DEPRECIATION AND AMORTIZATION.............................. 5,370 5,074
---------- ----------
OPERATING LOSS............................................. (4,985) (4,215)
OTHER INCOME (EXPENSE):
Interest, net............................................. (3,328) (1,176)
Other, net................................................ 39 15
---------- ----------
Total other expense, net.............................. (3,289) (1,161)
---------- ----------
LOSS BEFORE REORGANIZATION ITEMS AND INCOME
TAXES..................................................... (8,274) (5,376)
REORGANIZATION ITEMS:
Professional fees......................................... -- (1,481)
Other, net................................................ -- (54)
---------- ----------
Total reorganization items............................ -- (1,535)
---------- ----------
LOSS BEFORE INCOME TAXES................................... (8,274) (6,911)
INCOME TAXES............................................... 125 --
---------- ----------
NET LOSS................................................... (8,399) (6,911)
ACCRETION OF CONVERTIBLE REDEEMABLE PREFERRED
STOCK TO REDEMPTION VALUE................................. (52) --
---------- ----------
NET LOSS ATTRIBUTABLE TO COMMON SHAREHOLDERS............... $ (8,451) $ (6,911)
========== ==========
Per common share - basic and diluted....................... $ (2.11) $ (0.12)
========== ==========
Weighted average number of common shares outstanding....... 4,000 57,646
========== ==========
</TABLE>
The accompanying notes are an integral part of these statements.
3
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
Successor Company
-----------------
March 31, 1998 December 31, 1997
-------------- -----------------
ASSETS (unaudited)
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents.................................. $ 3,961 $ 8,607
Restricted cash and investments............................ 13,275 13,036
Receivables, net........................................... 889 750
Inventories................................................ 1,339 1,739
Prepaid expenses and other current assets.................. 4,130 5,093
--------- ---------
TOTAL CURRENT ASSETS...................................... 23,594 29,225
RESTRICTED CASH AND INVESTMENTS............................ 3,113 5,981
PROPERTY AND EQUIPMENT, net................................ 135,235 131,352
LAND HELD FOR SALE......................................... 3,635 3,635
OTHER ASSETS, NET.......................................... 6,582 6,398
--------- ---------
TOTAL ASSETS.............................................. $ 172,159 $ 176,591
========= =========
LIABILITIES AND EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable........................................... $ 16,388 $ 13,657
Accrued liabilities........................................ 11,636 11,116
Note payable............................................... 224 304
Current portion of long-term debt.......................... 1,102 1,102
--------- ---------
TOTAL CURRENT LIABILITIES................................. 29,350 26,179
LONG-TERM DEBT............................................. 87,446 87,091
OTHER LONG-TERM LIABILITIES................................ 7,644 7,169
SERIES A CONVERTIBLE PREFERRED STOCK - 1,000 shares
authorized, issued and
outstanding, redemption
value of $15,000.......................................... 13,949 13,897
COMMON STOCK AND OTHER EQUITY:
Common stock - $.01 par value; 10,000,000 shares
authorized, 4,000,000 shares issued and outstanding....... 40 40
Additional paid-in capital................................. 70,011 70,063
Cumulative translation adjustment.......................... 84 118
Accumulated deficit........................................ (36,365) (27,966)
--------- ---------
TOTAL COMMON STOCK AND OTHER EQUITY........................ 33,770 42,255
--------- ---------
TOTAL LIABILITIES AND EQUITY............................... $ 172,159 $ 176,591
========= =========
</TABLE>
The accompanying notes are an integral part of these statements.
4
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
<TABLE>
<CAPTION>
Successor Predecessor
Company Company
-------------- --------------
Three Months Three Months
Ended Ended
March 31, 1998 March 31, 1997
-------------- --------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ................................................................... $ (8,399) $ (6,911)
Adjustments to reconcile net loss to net cash provided in operating
activities before reorganization items:
Reorganization items ...................................................... -- 1,535
Depreciation and amortization ............................................. 5,370 5,074
Amortization of debt discount and other noncash interest charges .......... 525 --
Plan administrative payments .............................................. (20) --
Changes in operating assets and liabilities:
Receivables ............................................................... (139) 375
Inventories ............................................................... 400 478
Prepaid expenses and other current assets ................................. 963 (92)
Restricted cash and investments ........................................... 2,630 --
Accounts payable .......................................................... 3,721 905
Accrued liabilities ....................................................... 1,090 (561)
Other ..................................................................... (495) --
-------- --------
Net cash provided by operating activities before reorganization items ..... 5,646 803
Reorganization items ...................................................... -- (1,535)
Adjustments to reconcile reorganization items to cash used by reorganization
items:
Accrued reorganization expenses ........................................... (152) 409
-------- --------
Net cash provided (used) by reorganization items .......................... (152) (1,126)
-------- --------
Net cash provided (used) by operating activities .......................... 5,494 (323)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment ........................................ (10,243) (182)
-------- --------
Net cash used by investing activities ...................................... (10,243) (182)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from debtor-in-possession credit facilities ................... -- 2,384
Net proceeds from borrowings ............................................... 103 78
-------- --------
Net cash provided by financing activities .................................. 103 2,462
Net increase (decrease) in cash ............................................ (4,646) 1,957
Cash and cash equivalents, beginning of period ............................. 8,607 3,326
-------- --------
Cash and cash equivalents, end of period ................................... $ 3,961 $ 5,283
======== ========
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest ..................................................... $ 2,869 $ 611
======== ========
Cash paid for professional fees in connection with
Chapter 11 Proceeding ..................................................... $ 7 $ 1,126
======== ========
</TABLE>
The accompanying notes are an integral part of these statements.
5
<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 203 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 1997
consolidated financial statements and notes thereto included in the Company's
annual report on Form 10-K.
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. 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 three-month period ended March 31, 1997 was
approximately $3,900,000.
6
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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.
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, 1998.
Certain amounts in the March 31, 1997 Condensed Consolidated Financial
Statements have been reclassified to conform with the March 31, 1998
presentation.
(2) JOINT PLAN OF 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.
7
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 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 balance sheets. The Senior Secured Note
holders also 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 5).
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.
Approximately 3,157,000 shares of Common Stock are reserved for
issuance for the exercise of all warrants, and options and conversion of the
Preferred Stock.
(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 were 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 was eliminated and the debt and capital structure of the
Company was recast pursuant to the provisions of the Plan. Thus, the
accompanying condensed consolidated statements of operations and cash flows for
periods prior to the Company's emergence from bankruptcy (the "Predecessor
Company") are not comparable to the results of operations and cash flows of the
Company subsequent to emergence from bankruptcy and the adoption of fresh-start
reporting (the "Successor Company").
8
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
A reorganization value of the Company's common equity of approximately
$70,200,000 was determined by the Company with the assistance of financial
advisors. These advisors (1) reviewed certain historical information for recent
years and interim periods; (2) reviewed certain internal financial and operating
data including financial projections; (3) met with senior management to discuss
operations and future prospects; (4) reviewed publicly available financial data
and considered the market value of public companies deemed generally comparable
to the Company's operating business; (6) reviewed a five year forecast prepared
by the Company; and (7) conducted such analyses as appropriate. Based upon the
foregoing, the financial advisors developed a range of values for the Company as
of the Effective Date. In developing this valuation estimate the advisors, using
rates of 30% to 35%, discounted the Company's five year forecasted free cash
flows and an estimate of sales proceeds assuming the Company would be sold at
the end of the five-year period within a range of comparable Company multiples.
The difference between the Company's reorganized value and a
revaluation of the Company's assets and liabilities resulted in a reorganization
item of approximately $24,829,000 which is included in property and equipment in
the consolidated balance sheet at December 31, 1997, and March 31, 1998, net of
recorded amortization. This reorganization item will be allocated to specific
property and equipment assets and certain intangible assets after the Company
obtains appraisals of certain assets and completes a review of property and
equipment, all of which are currently in process.
(4) CREDIT FACILITY
On March 31, 1998, the Company entered into a $10 million Senior
Secured Revolving Credit Facility (the "Facility") with Foothill Capital
Corporation, as permitted under the Notes. The Facility bears interest at prime
plus 1%, plus certain fees, and allows for the Company to borrow 133% of
trailing twelve month FunCenter Contribution (as defined therein) for its top
100 performing FunCenters, up to a maximum loan principal amount of $10 million.
The Facility contains restrictions on additional indebtedness, capital
expenditures, and dividends, is secured by substantially all of the Company's
assets and has cross-default provisions with other obligations of the Company.
$2.0 million of the Facility is reserved for resolution of certain disputes in
connection with the Company's renovation program (See Note 8).
9
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(5) LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
<TABLE>
<CAPTION>
Successor Company Successor Company
----------------- -----------------
March 31, 1998 December 31, 1997
-------------- -----------------
(Unaudited)
<S> <C> <C>
13.5% Senior Secured Notes due 2002, net of unamortized
discount of $6,399 and $6,652 at March 31, 1998, and
December 31, 1997, respectively (1)................................ $ 78,601 $ 78,348
Secured Rejection Note (2)............................................. 4,416 4,416
Secured Rent Deferral Notes (2)........................................ 531 429
Prepetition Tax Claims (3)............................................. 5,000 5,000
---------- -----------
88,548 88,193
Less current portion................................................... (1,102) (1,102)
---------- ----------
Long-term debt......................................................... $ 87,446 $ 87,091
---------- ----------
</TABLE>
- -----------
(1) In connection with its exit financing to emerge from bankruptcy, the
Company issued $85,000,000 of 13 1/2% Senior Secured Notes due August 1,
2002 (the "Private 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 Private Notes. The Private 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 approximately
$16,388,000, consisting of treasury securities and accrued interest
thereon, at March 31, 1998.
The Company consummated an offer to exchange $85,000,000 aggregate
principal amount of its 13 1/2% Senior Secured Notes due 2002 (the
"Exchange Notes"), which have been registered under the Securities Act of
1933 pursuant to a Registration Statement on Form S-4, for $85,000,000
aggregate principal amount of the outstanding Private Notes (the Private
Notes together with the Exchange Notes, the "Notes").
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) The McDonald's Secured Rejection Note was $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 bears
interest at 11% 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 total approximately $2,567,000 over the
next seven years. The notes bear interest at 11% per annum payable at
maturity and have maturity dates ranging from August 31, 2002 to December
31, 2004.
10
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 March 31, 1998, 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 share is calculated based upon the weighted
average number of common shares outstanding during the periods presented. Common
equivalents outstanding during the period and common shares issuable upon
assumed conversion of the Preferred Stock and other potentially dilutive
securities have not been included in the computation of diluted 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 shares outstanding in the accompanying
unaudited condensed consolidated statement of operations for the three month
period ended March 31, 1998.
(7) RELATED PARTY TRANSACTIONS
An officer of Griffin Bacal, Inc. ("Griffin Bacal"), the Company's
advertising agency, serves as a director of the Successor Company. The Company
paid approximately $2,567,000 to Griffin Bacal for creative services and as
agent for purchase of media from third parties during the three months ended
March 31, 1998.
(8) COMMITMENTS AND CONTINGENCIES
During the fourth quarter of 1997, the Company began an extensive
FunCenter renovation program to broaden their entertainment offerings and
upgrade their facilities, which was broader in scope and costlier than
originally planned. During the first phase of this program, the Company
renovated approximately 60% of its FunCenters and expects to complete
renovations of an additional 15% of its FunCenters by the end of 1998 subject to
available financing. To date, the Company also completed the conversion of
approximately 80% of its FunCenters to permit the sale of Pizza Hut items and
renovated approximately 25% of its locations to offer new weekday programs under
the "DZU" brand name. Through May 15, 1998, the Company has incurred or
committed approximately $28 million in connection with these programs including
excess billings from general contractors which the Company is disputing, and
approximately $3 million of advance purchases for future renovation phases.
A significant portion of the Company's FunCenters have improved
revenues and operating results as evidenced by increases in comparable store
revenues and EBITDA Margins. However, the Company's renovation programs are
taking longer to implement, and are more costly than anticipated. As a result,
improvements in the Company's operating results are taking longer to realize and
the Company believes that it will require additional capital to continue funding
operations. To the extent the Company is unable to obtain such financing it may
not be able to pay its obligations as
11
<PAGE>
they may come due. The Company is in discussions with a number of investment
banks and potential financial and strategic investors to obtain such financing.
In addition, certain existing shareholders of the Company have indicated a
willingness to participate in any such financing. The Company is also
considering the sale of certain non-core assets to support operations in the
interim, although there can be no assurance that the Company will be successful
in selling such assets or raising the additional financing referred to above.
Under the terms of the Company's Senior Notes and Revolving Credit Facility, the
Company is limited to raising additional capital through the sale of equity.
From time to time, the Company is a party to 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 $3,839,000 at
March 31, 1998 and $3,347,000 at December 31, 1997. These amounts are 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.
In February 1998, the Company entered into a contract for the sale of
property in Littleton, Colorado. The Littleton property consists of two parcels,
of which one is improved with a FunCenter and the other is unimproved land. This
contract provides for the sale of such property for $4.2 million and allows the
Company to lease the FunCenter located thereon at an annual rental of $188,250,
plus scheduled escalations, for up to five years. This sale will reduce the
annual debt service on the McDonald's Note to approximately $130,000 per year.
The Littleton sale is scheduled to close in July, 1998. There can be no
assurances that this sale will ultimately close or close on the aforementioned
terms or time period.
12
<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 condensed consolidated 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
203 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 generates revenue primarily from the operation of the
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 continued
through December 1997. Among other factors, comparable store revenues declined
because the Company (i) shortened FunCenter operating hours by approximately 18%
to curtail operations during unprofitable time periods, (ii) reduced its
marketing expenditures (see below), and (iii) did not update its product
offering while in Chapter 11. The Company also experienced a decline in sales
during the recent renovation of the FunCenters and expects future renovation to
temporarily reduce sales during the renovation period.
The Company has undertaken a series of initiatives to increase
revenues, including offering new products, improving food and beverage offerings
and increasing utilization of FunCenters during weekday and other off-peak
times. During the first quarter of 1998, the Company has experienced favorable
comparable store sales compared to the same period in 1997. Further, per
customer spending on food has increased in those FunCenters offering Pizza Hut
menu items since conversion.
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,
since the Effective Date, has generated additional annual cost savings at the
store level through cost containment measures and improved financial controls.
The Company incurred substantial restructuring costs, including the
costs of relocating the Company's headquarters, terminating certain employees
and rejecting selected store leases. A portion of these costs were discharged in
connection with the Plan and other amounts were repaid with the proceeds of the
offering of the Units and the Convertible Preferred Stock.
Recent Developments
The Company is currently implementing the Turnaround Plan, which
consists of a number of cost-cutting and revenue enhancing initiatives,
including an extensive FunCenter renovation program, a revamped marketing and
promotional campaign and an enhanced hiring and training program for store
managers. At May 31, 1998, the Company had renovated approximately 60% of the
FunCenters, which enables such stores to offer new products that have been
developed by the Company in conjunction with its entertainment and promotional
partners. The Company has experienced significant delays and cost overruns in
completing its renovation program.
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Comparable store revenues during the first quarter of 1998 were up 4%,
as compared to a decline of 22% during the first quarter of 1997. During the
first five months of 1998, comparable store revenues declined 0.7%, compared to
a 16.8% decline in comparable store revenues in the first five months of 1997.
This decline in comparable store revenues for the first five months of 1998
consisted of an 12.7% increase in general admission revenues, offset primarily
by decreases in party and game revenues. During the first five months of 1998,
98 stores (48.5% of total stores) had increased comparable store revenues as
compared to 13 stores (6.4% of total stores) in the 1997 period, and 167 stores
(82.7% of total stores) had increased general admission revenue as compared to
13 stores (6.4% of total stores) in the 1997 period.
In spite of improvements relative to the comparable period of the prior
year, the Company's revenues in the first five months of 1998 were less than
expected due to (i) construction delays in completing its FunCenter renovation
program and related business disruptions, (ii) corresponding delays in launching
certain marketing and promotional programs, (iii) unseasonably warm spring
weather in many parts of the United States, which diminished demand for a
variety of indoor entertainment activities and (iv) transitional staffing and
training expenses associated with the introduction of new entertainment
attractions at FunCenters.
As a result of these factors, the Company expects to report negative
comparable store sales and negative EBITDA (as defined herein) for the second
quarter of 1998. The Company requires additional capital to continue funding its
operations and implementing the Turnaround Plan. See "-- Liquidity and Capital
Resources."
Results of Operations
Comparison of the Three Months Ended March 31, 1998 and 1997
Upon emergence from its Chapter 11 proceeding, the Company adopted
Fresh Start Accounting. Thus the Company's balance sheets and statements of
operations and cash flows after the Effective Date reflect a new reporting
entity (the "Successor Company") and are not comparable to periods prior to the
Effective Date (the "Predecessor Company").
The three months ended March 31, 1997 and 1998 include the results of
the Predecessor Company and the Successor Company, respectively. 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.
The Company reported EBITDA (Earnings before Interest, Taxes,
Depreciation and Amortization) for the period of $833,000, before reorganization
costs and non-cash GAAP rent adjustments which were affected by fresh start
accounting ("GAAP Rent Adjustments"), and $385,000 after such adjustments,
compared to $576,000 before such adjustments, and $(676,000), after such
adjustments, in the prior year period. In addition to the revenue growth
described below, these operating improvements were primarily attributable to
improved expense management at the store level. The combined cost savings and
revenue improvements resulted in comparable store EBITDA before GAAP Rent
Adjustments improving 12.6% during the first quarter of 1998 to $5.4 million.
Comparable Store EBITDA margins before GAAP Rent Adjustments improved from 13.1%
of revenue to 14.2% of revenue.
Revenue. The Company had revenue of $40.7 million during the first
quarter of 1998, an increase of 4.9% over revenue of $38.8 million during the
first quarter of 1997. This increase was comprised of a 4% increase in
comparable store sales during the 1998 period over the 1997 period and $1.3
million of sponsorship revenue during the 1998 period, offset by a decline in
the number of FunCenters open during the 1998 period as compared to the 1997
period. Improvements in comparable store revenue was primarily due to a 24.2%
increase in general admission revenue offset by declines in birthday party and
game revenues. During the 1997 period the Company did not report any sponsorship
revenue. Revenues during the first quarter of 1998 were adversely affected by
the first phase of the Company's renovation program, which resulted in business
disruptions and customer quality issues.
14
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Cost of Goods Sold. Cost of goods sold, which consists primarily of the
cost of food, redemption merchandise and other product sales was $6.4 million
and $7.2 million during the first quarter of 1998 and 1997, respectively. As a
percentage of revenue, cost of goods sold declined from 18.5% in the 1997 period
to 15.8% in the 1998 period. This reduction was primarily attributable to
simplified product offerings, improved cost management and lower costs
associated with the conversion to a new food and supply vendor.
Store Operating Expenses. Store operating expenses, which consist
primarily of compensation and benefits of FunCenter operating personnel,
occupancy expenses and facility repair and maintenance expenses, were $28.2
million and $26.5 million during the first quarter of 1998 and 1997,
respectively. As a percentage of total revenues, store operating expenses
increased from 68.3% in the 1997 period to 69.2% in the 1998 period. This
increase was attributable to increased labor costs associated with the Company's
new product offerings, offset by reductions in central reservation expenses and
other cost savings generated through the Company's cost reduction program and
store closings. During the first quarter of 1998, store operating expenses
included certain non-recurring costs resulting from training and start-up
expenses for new product offerings and disruptions related to the FunCenter
renovation program.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses, which include salaries, corporate and regional
management expenses and other administrative, promotional and advertising
expenses, were $5.7 million and $4.3 million during the first quarter of 1998
and 1997, respectively. This increase was due to an increase in sales and
marketing programs associated with the Company's revitalization plan during the
1998 period as compared to the 1997 period.
Depreciation and Amortization Expense. Depreciation and amortization
expenses were $5.4 million and $5.1 million during the first quarter of 1998 and
1997, respectively. During the 1998 period this expense reflected
depreciation expense related to an increase in the carrying value of the
Company's plant and equipment as a result of its adoption of Fresh Start
Accounting for the Successor Company.
Interest Expense. Interest expense was $3.7 million and $1.2 million
during the first quarter of 1998 and 1997, respectively. Reported interest
expense for the Predecessor Company did not include interest on petition
indebtedness which was suspended during the Company's reorganization under
Chapter 11. Had these interest costs been accrued, reported interest expense for
the 1997 period would have been $5.1 million.
Interest Income. The Company reported interest income of $320,000
during the first quarter of 1998. No interest income was recorded in the first
quarter of 1997. The increase was due to earnings from the Interest Escrow
Account and short-term investment of proceeds from the Company's offering of
Units and Convertible Preferred Stock in the exit financing.
Reorganization Items. Reorganization items of $1.5 million were
incurred by the Company during the first quarter of 1997 during its
reorganization under Chapter 11. These reorganization items primarily consisted
of professional fees.
Liquidity and Capital Resources
The Company does not require significant working capital to operate
because it does not have significant receivables or inventory and utilizes trade
credit in purchasing food products and other supplies. The Company requires cash
primarily to finance capital expenditures to maintain and upgrade existing
stores and to fund operating losses and debt service. Following the
implementation of its business strategy, 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 including certain pre-petition tax claims,
the McDonald's Note and the McDonald's Rent Deferral Secured Notes. Upon
emerging from Chapter 11, the Company issued (a) Units consisting of $85.0
million aggregate principal amount of Notes and Warrants and (b) $15.0 million
of Convertible Redeemable Preferred Stock. The net proceeds of the offerings of
the Units and Convertible Redeemable Preferred Stock totaled $93.8 million. Of
that amount, the Company (i) repaid borrowings, claims and expenses incurred
while under Chapter 11 of $45.5 million, (ii) purchased an aggregate of $21.6
million of securities, consisting of U.S. Treasury Securities, that were placed
in escrow and pledged as security for scheduled interest payments on the Notes
through August 1, 1999, and (iii) applied $26.7 million to finance capital
expenditures, and provide capital for working capital and other general
corporate purposes.
15
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The Company holds for sale certain parcels of undeveloped land which
secure the McDonald's Notes. To the extent such sales occur prior to the due
date for debt services, the net proceeds for such sales would be available to be
applied to such payments.
During the first quarter of 1998 and 1997, the cash provided by
operations was $5.6 million and $800,000, respectively, before reorganizations
items. These sources of cash were comprised of earnings from operations before
interest, taxes, depreciation, amortization and reorganization costs of $385,000
in 1998 and $860,000 in 1997, and other changes in working capital including
payables and accruals in 1998 attributable to the Company's renovation program.
At March 31, 1998, the Company had an unrestricted cash balance of
approximately $3.9 million. The Company also had $16.4 million in cash and
investments in the Escrowed Interest Account as of March 31, 1998, which amount
is dedicated to making scheduled payments of interest on the Exchange Notes
through August 1, 1999.
On March 31, 1998, the Company entered into a $10.0 million Senior
Secured Revolving Credit Facility (the "Senior Facility") as permitted under the
Indenture dated July 22, 1997 (the "Indenture"), among the Company, the
guarantors named therein and State Street Bank and Trust Company, trustee. The
Senior Facility bears interest at prime plus 1% plus certain fees and allows the
Company to borrow 133% of the 12-month trailing FunCenter contribution (as
defined therein) for its 100 top performing FunCenters up to a maximum principal
amount of $10.0 million. As of May 15, 1998, the Company had borrowed $4.5
million and had the ability to borrow an additional $5.5 million, subject to a
$2.0 million reserve for certain contractor disputes. See "Financial Statements
- -- Notes to Unaudited Condensed Consolidated Financial Statements."
The Company is also permitted under the Indenture to incur up to $5.0
million of new indebtedness under sale and leaseback transactions, capital lease
obligations or purchase money obligations.
During the fourth quarter of 1997, the Company began an extensive
FunCenter renovation program designed to broaden their entertainment offerings,
upgrade their facilities and give them a " new look." This renovation program
was much broader in scope and costlier than originally planned. During the first
phase of this program, the Company renovated approximately 60% of its
FunCenters, and expects to complete renovations for an additional 15% of its
FunCenters by the end of 1998, subject to available financing. Through March 31,
1998, the Company also completed the conversion of approximately 80% of its
FunCenters to permit the sale of Pizza Hut menu items and renovated
approximately 25% of its locations to offer new weekday programs under the "DZU"
brand name. Through May 15, 1998, the Company has incurred or committed
approximately $28 million in connection with these programs, including excess
billings from general contractors which the Company is disputing and
approximately $3 million of advance purchases for future renovation phases. The
Company estimates that the cost to complete the renovation of an additional 15%
of its FunCenters, excluding advanced purchases referred to above will be
approximately $2 to $3 million.
A significant portion of the Company's FunCenters have improved
revenues and operating results as evidenced by increases in comparable store
revenues and EBITDA margins. However, the Company's renovation programs are
taking longer to implement, and are more costly than anticipated. As a result,
improvements in the Company's operating results are taking longer to realize and
the Company believes that it will require additional capital to continue funding
operations. To the extent the Company is unable to obtain such financing it may
not be able to pay its obligations as they may come due. The Company is in
discussions with a number of investment banks and potential financial and
strategic investors to obtain such financing. In addition, certain existing
shareholders of the Company have indicated a willingness to participate in any
such financing. The Company is also considering the sale of certain non-core
assets to support operations in the interim, although there can be no assurance
that the Company will be successful in selling such assets or raising the
additional financing referred to above. Under the terms of the Company's Senior
Notes and Revolving Credit Facility, the Company is limited to raising
additional capital through the sale of equity.
Seasonality
The Company's FunCenters experience seasonal fluctuations in their
revenues, with higher revenues occurring in the first quarter of the year due to
the fact that many FunCenters are located in cold weather regions where children
are unable to play outside during this time of year. In 1997, the FunCenters
generated 30% of their revenue in the first quarter versus 25%, 24% and 22% in
the second, third and fourth quarters, respectively. These fluctuations in
revenues are primarily related to the school year and the weather.
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DISCOVERY ZONE, INC.
PART II--OTHER INFORMATION
Item 1. Legal Proceedings
Not Applicable
Item 2. Changes in Securities
The Company consummated an offer to exchange $85,000,000
aggregate principal amount of its 13 1/2% Senior Secured
Notes due 2002, which have been registered under the
Securities Act of 1933 pursuant to a Registration Statement
on Form S-4, for $85,000,000 aggregate principal amount of
the outstanding 13 1/2% Senior Secured Notes due 2002 of the
Company.
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
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit
Exhibit
Number Description
------ -----------
27.1 Financial Data Schedule, for the three months
ended March 31, 1998.
27.2 Financial Data Schedule, for the three months
ended March 31, 1997.
(b) Reports on Form 8-K
Not applicable
17
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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.
DATE: July 1, 1998 DISCOVERY ZONE, INC.
Signature Title
--------- -----
/s/ Scott W. Bernstein Chief Executive Officer,
- ----------------------- President and Director
Scott W. Bernstein
/s/ Robert G. Rooney Senior Vice President, Chief Financial and
- ----------------------- Administrative Officer
Robert G. Rooney
18
