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 September 30, 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 [X] No [ ]
Common stock outstanding as of December 31, 1998: 430,333,492 shares
<PAGE>
DISCOVERY ZONE, INC.
PART 1 -- FINANCIAL INFORMATION
Page No.
--------
ITEM 1. FINANCIAL STATEMENTS
Unaudited Condensed Consolidated Statements of
Operations - Three Months Ended September 30, 1998 and 1997 3
Unaudited Condensed Consolidated Statements of Operations -
Nine Months Ended September 30, 1998 and 1997 4
Condensed Consolidated Balance Sheets - September 30, 1998
(unaudited) and December 31, 1997 5
Unaudited Condensed Consolidated Statements of Cash
Flows - Nine Months Ended September 30, 1998 and 1997 6
Notes to Unaudited Condensed Consolidated Financial
Statements 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 13
AND RESULTS OF OPERATIONS
PART II -- OTHER INFORMATION
Page No.
--------
ITEM 1. LEGAL PROCEEDINGS 19
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS 19
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 21
ITEM 5. OTHER INFORMATION 21
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 21
2
<PAGE>
DISCOVERY ZONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share data)
<TABLE>
<CAPTION>
Predecessor
Successor Company Company
----------------- -------
Three Months Two Months One Month
Ended Ended Ended
September 30, 1998 September 30,1997 July 31, 1997
------------------ ----------------- -------------
<S> <C> <C> <C>
REVENUE ............................................ $ 28,384 $ 20,080 $ 11,241
COST OF GOODS SOLD ................................. 4,724 3,060 1,537
STORE OPERATING EXPENSES ........................... 25,311 16,756 8,715
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSE ........................................ 7,463 4,142 2,084
DEPRECIATION AND AMORTIZATION ...................... 5,884 3,982 1,705
--------- --------- ---------
OPERATING LOSS ..................................... (14,998) (7,860) (2,800)
OTHER INCOME (EXPENSE):
Interest, net .................................. (4,177) (2,644) (649)
Other, net ..................................... 389 34 41
--------- --------- ---------
Total other expense, net .................... (3,788) (2,610) (608)
--------- --------- ---------
LOSS BEFORE REORGANIZATION ITEMS AND
EXTRAORDINARY ITEM ............................. (18,786) (10,470) (3,408)
REORGANIZATION ITEMS:
Professional fees .............................. -- -- (2,477)
Unallocated reorganization value ............... -- -- 24,829
Other, net ..................................... -- -- (6,663)
--------- --------- ---------
Total reorganization items .................. -- -- 15,689
--------- --------- ---------
NET INCOME (LOSS) BEFORE EXTRAORDINARY ITEM ........ (18,786) (10,470) 12,281
EXTRAORDINARY ITEM-GAIN ON DISCHARGE OF
DEBT ........................................... -- -- 332,165
--------- --------- ---------
NET INCOME (LOSS) .................................. (18,786) (10,470) 344,446
ACCRETION OF REDEEMABLE
PREFERRED STOCK TO REDEMPTION VALUE ............ (126) (36) --
DIVIDENDS ON 14.5% CUMULATIVE PREFERRED
STOCK .......................................... (319) -- --
--------- --------- ---------
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON
SHAREHOLDERS ................................... $ (19,231) $ (10,506) $ 344,446
========= ========= =========
Per common share - basic and diluted:
Loss before extraordinary item ................. $ (0.05) $ (2.63) $ 0.21
Extraordinary item-gain on discharge of debt ... -- -- 5.76
--------- --------- ---------
Net income (loss) .............................. $ (0.05) $ (2.63) $ 5.97
========= ========= =========
Weighted average number of common shares outstanding 356,189 4,000 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>
Predecessor
Successor Company Company
----------------- -------
Nine Months Two Months Seven Months
Ended Ended Ended
September 30, 1998 September 30,1997 July 31, 1997
------------------- ------------------ ----------------
<S> <C> <C> <C>
REVENUE ............................................ $ 98,595 $ 20,080 $ 82,537
COST OF GOODS SOLD ................................. 15,895 3,060 14,136
STORE OPERATING EXPENSES ........................... 78,445 16,756 59,267
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSE ........................................ 20,207 4,142 11,160
DEPRECIATION AND AMORTIZATION ...................... 16,654 3,982 11,920
--------- --------- ---------
OPERATING LOSS ..................................... (32,606) (7,860) (13,946)
OTHER INCOME (EXPENSE):
Interest, net .................................. (11,050) (2,644) (3,163)
Other, net ..................................... 442 34 73
--------- --------- ---------
Total other expense, net ..................... (10,608) (2,610) (3,090)
--------- --------- ---------
LOSS BEFORE REORGANIZATION ITEMS, INCOME
TAX PROVISION AND EXTRAORDINARY ITEM ........... (43,214) (10,470) (17,036)
REORGANIZATION ITEMS:
Professional fees .............................. -- -- (6,164)
Unallocated reorganization value ............... -- -- 24,829
Other, net ..................................... -- -- (7,082)
--------- --------- ---------
Total reorganization items ................... -- -- 11,583
--------- --------- ---------
LOSS BEFORE INCOME TAX PROVISION AND
EXTRAORDINARY ITEM ............................. (43,214) (10,470) (5,453)
INCOME TAX PROVISION ............................... (125) -- --
--------- --------- ---------
LOSS BEFORE EXTRAORDINARY ITEM ..................... (43,339) (10,470) (5,453)
EXTRAORDINARY ITEM-GAIN ON DISCHARGE
OF DEBT ........................................ -- -- 332,165
--------- --------- ---------
NET INCOME (LOSS) .................................. (43,339) (10,470) 326,712
ACCRETION OF REDEEMABLE
PREFERRED STOCK TO REDEMPTION VALUE ............ (234) (36) --
DIVIDENDS ON 14.5% CUMULATIVE PREFERRED
STOCK .......................................... (319) -- --
--------- --------- ---------
NET INCOME (LOSS) ATTRIBUTABLE TO COMMON
SHAREHOLDERS ................................... $ (43,892) $ (10,506) $ 326,712
========= ========= =========
Per common share - basic and diluted:
Loss before extraordinary item ................. $ (0.36) $ (2.63) $ (0.09)
Extraordinary item-gain on discharge of debt ... -- -- 5.75
--------- --------- ---------
Net income (loss) .............................. $ (0.36) $ (2.63) $ 5.66
========= ========= =========
Weighted average number of common shares outstanding 122,686 4,000 57,705
========= ========= =========
</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 Company
-----------------
September 30, 1998 December 31, 1997
------------------ -----------------
ASSETS (unaudited)
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 2,527 $ 8,607
Restricted cash and investments 13,868 13,036
Receivables, net 776 750
Inventories 1,891 1,739
Prepaid expenses and other current assets 3,642 5,093
--------- ---------
TOTAL CURRENT ASSETS 22,704 29,225
RESTRICTED CASH AND INVESTMENTS -- 5,981
PROPERTY AND EQUIPMENT, NET 110,220 131,352
LAND HELD FOR SALE 3,635 3,635
TRADEMARK, NET 15,911 --
OTHER ASSETS, NET 8,617 6,398
--------- ---------
TOTAL ASSETS $ 161,087 $ 176,591
========= =========
LIABILITIES AND EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 11,099 $ 13,657
Accrued liabilities 10,724 11,116
Note payable and capital lease obligation 423 304
Current portion of long-term debt 944 1,102
--------- ---------
TOTAL CURRENT LIABILITIES 23,190 26,179
LONG-TERM DEBT 107,343 87,091
OTHER LONG-TERM LIABILITIES 8,393 7,169
SERIES A CONVERTIBLE PREFERRED STOCK - 1,000 shares
authorized, 993 and 1,000 shares issued and
outstanding, and redemption value of $14,000
and $15,000 at September 30, 1998 and
December 31, 1997, respectively 13,122 13,897
14.5% CUMULATIVE PREFERRED STOCK - Series A Senior
Cumulative Preferred - 80,000
shares authorized, issued and outstanding
at September 30, 1998, and Series B Senior Cumulative
Preferred - 340,000 shares authorized, 337,101 shares
issued and outstanding at September 30, 1998 10,510 --
COMMON STOCK AND OTHER EQUITY (DEFICIT):
Common stock - $.01 par value,
10,000,000 shares authorized, 4,000,000 shares
issued and outstanding at December 31, 1997,
and Common Stock - $.00017 par value, 2,400,000,000
shares authorized, 430,333,492
shares issued and outstanding at September 30, 1998 73 40
Additional paid-in capital 69,649 70,063
Cumulative translation adjustment 112 118
Accumulated deficit (71,305) (27,966)
--------- ---------
TOTAL COMMON STOCK AND OTHER EQUITY (1,471) 42,255
(DEFICIT) --------- ---------
TOTAL LIABILITIES AND EQUITY $ 161,087 $ 176,591
========= =========
</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>
Predecessor
Successor Company Company
----------------- -------
Nine Months Two Months Seven Months
Ended Ended Ended
September 30, 1998 September 30,1997 July 31, 1997
------------------ ----------------- -------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (43,339) $ (10,470) $ 326,712
Adjustments to reconcile net income (loss) to net cash used
by operating activities before Reorganization items:
Reorganization items -- -- (11,583)
Extraordinary item--gain on discharge of debt -- -- (332,165)
Depreciation and amortization 16,654 3,982 11,920
Amortization of debt discount and other noncash interest
charges 1,941 383 --
Plan administrative payments (183) -- (1,109)
Changes in operating assets and liabilities:
Receivables (26) (42) 630
Inventories (152) 185 724
Prepaid expenses and other assets (1,451) (4,862) (484)
Restricted cash and investments 7,964 -- --
Accounts payable (94) (1,044) 814
Accrued liabilities 1,319 (921) (3,182)
Other (70) (121) (70)
--------- --------- ---------
Net cash used by operating activities before reorganization items (14,535) (12,910) (7,831)
Reorganization items -- -- 11,583
Adjustments to reconcile reorganization items to cash used
by reorganization items:
Unallocated reorganization value -- -- (24,829)
Accrued reorganization expenses (525) -- 10,118
--------- --------- ---------
Net cash used by reorganization items (525) -- (3,128)
--------- --------- ---------
Net cash used by operating activities after reorganization items (15,060) (12,910) (10,959)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (14,865) (723) (567)
Proceeds from sale of property and equipment -- -- 99
--------- --------- ---------
Net cash used by investing activities (14,865) (723) (468)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net repayment of debtor-in-possession credit facilities -- -- (22,448)
Proceeds from Senior Secured Notes with Warrants -- -- 85,000
Proceeds from Preferred Stock Issuance 9,500 -- 15,000
Proceeds from Senior Collateralized Notes with Warrants 20,000 -- --
Increase in McDonald's Rent Deferral Note -- 66 --
Payment of McDonald's Secured Rejection Note (736) -- --
Payment of financing costs (2,052) -- (4,569)
Escrow of restricted cash (2,815) -- (21,608)
Proceeds from short-term borrowings 139 410 276
Repayment of short-term borrowings (191) -- (158)
Advances from Birch Holdings LLC -- -- 2,500
Repayment of advances from Birch Holdings LLC -- (2,500)
--------- --------- ---------
Net cash provided by financing activities 23,845 476 51,493
--------- --------- ---------
Net increase (decrease) in cash (6,080) (13,157) 40,066
Cash and cash equivalents, beginning of period 8,607 43,392 3,326
--------- --------- ---------
Cash and cash equivalents, end of period $ 2,527 $ 30,235 $ 43,392
========= ========= =========
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest $ 9,185 $ 291 $ 3,340
========= ========= =========
Cash paid for professional fees in connection with
Chapter 11 proceeding $ 1,194 $ 143 $ 3,128
========= ========= =========
</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 199 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/A.
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 protection 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 in 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 incurred prior to the effective date during the three and
nine month periods ended September 30, 1997 was approximately $1,326,000 and
$9,176,000, 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)
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 1997 Condensed Consolidated Financial Statements
have been reclassified to conform with the 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, among other things, 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 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"). The Company
reserved 4,000,000 shares of Common Stock for issuance to such unsecured
creditors and 444,444 shares of Common Stock were reserved for issuance in
connection with the Ten Year Warrants.
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 included in 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 at the
time of issuance represented 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).
8
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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. At the
time of issuance, the Preferred Stock represented 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 are 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 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").
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; (5) considered certain economic and
industry information relevant to the 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 an unallocated
reorganization value of approximately $24,829,000 which was included in property
and equipment in the consolidated balance sheet at December 31, 1997, net of
recorded amortization. During the second quarter of 1998, the Company completed
its allocation of reorganization value as required under fresh start reporting,
pursuant to which approximately $17,226,000 of such amount was attributed to the
Company's trademarks and the balance remained as property and equipment. This
allocation was based on a review of the Company's property and equipment and an
appraisal of the Company's trademarks.
(4) SENIOR COLLATERALIZED NOTES AND 14.5% CUMULATIVE PREFERRED STOCK
On July 17, 1998 the Company completed a $29.5 million financing from
the sale of $10.5 million of 14.5% Cumulative Preferred Stock (the "New
Preferred Stock") resulting in proceeds of $9.5 million (see below) and $20
million of aggregate principal amount of 13.5% Senior Collateralized Notes due
2002 ("New Notes"), both together with warrants to purchase approximately 99.6%
of the fully diluted Common Stock for a nominal purchase price. The offering
resulted in net proceeds to the Company of approximately $27 million after costs
and expenses. The proceeds of the offering (i) were used to repay outstanding
borrowings under the Company's Senior Facility, (ii) were used to purchase $2.8
million of U.S. Treasury Securities that were placed in escrow and pledged as
security for scheduled interest payments through August 1, 1999 on the New Notes
and (iii) are available for working capital, capital expenditures and other
general corporate purposes, including
9
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
previously incurred costs associated with the Company's renovation program and
operating losses. In addition $1 million of existing Preferred Stock was
exchanged for $1 million of New Preferred Stock.
The New Preferred Stock was issued in an aggregate liquidation
preference of $10.5 million, a mandatory redemption date of November 1, 2002 and
accumulates dividends at an annual rate of 14.5%, compounded quarterly.
Purchasers of the New Preferred Stock, which consisted primarily of existing
common and preferred stockholders, also received warrants to purchase an
aggregate of 50.6% of the fully diluted Common Stock for a nominal exercise
price.
The terms of the New Notes are substantially the same as the Company's
existing 13.5% Senior Secured Notes due August 1, 2002 (the "Senior Secured
Notes"), rank pari passu in right of repayment and are due May 1, 2002. The
priority of claims on the collateral securing the Senior Secured Notes are
subordinated to the priority of claims on the collateral securing the New Notes.
Purchasers of the New Notes also received two series of warrants to purchase
approximately 49% of the fully diluted Common Stock for a nominal exercise
price. If the Company redeems the New Notes prior to the end of 1999 and meets
certain other conditions, a portion of these warrants, aggregating approximately
9% of the fully diluted Common Stock, will be redeemed or canceled at no
additional cost to the Company. The Company obtained the required consents to
issue the New Notes from holders of the Senior Secured Notes and to increase the
Senior Facility to $15 million. The Company is obligated to register the New
Notes within six months of issuance.
In connection with this financing, the Company increased the number of
shares of Common Stock authorized for issuance to 2.4 billion and changed its
par value from $.01 per share to $.00017 per share, and a holder of the New
Preferred Stock exercised warrants to purchase 426,333,492 shares of Common
Stock. At September 30, 1998, approximately 1.8 billion shares of Common Stock
were reserved for issuance in connection with the exercise of all warrants,
options and preferred stock conversions.
(5) LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
<TABLE>
<CAPTION>
Successor Company
---------------------------------------
September 30, 1998 December 31, 1997
------------------ -----------------
(Unaudited)
<S> <C> <C>
Senior Secured Revolving Credit Facility (a) $ -- $ --
13.5% Senior Collateralized Notes due 2002 (b) 19,900 --
13.5% Senior Secured Notes due 2002, net of unamortized
discount of $5,864 and $6,652 at September 30, 1998
and December 31, 1997, respectively (c) 79,136 78,348
Secured Rejection Note (d) 3,680 4,416
Secured Rent Deferral Notes (d) 729 429
Prepetition Tax Claims (e) 4,842 5,000
---------- -----------
108,287 88,193
Less current portion (944) (1,102)
--------- ----------
Long-term debt $ 107,343 $ 87,091
---------- -----------
- -----------
</TABLE>
10
<PAGE>
DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(a) On March 31, 1998, the Company entered into a $10 million Senior
Secured Revolving Credit Facility (the "Senior Facility") with Foothill
Capital Corporation as permitted under the Senior Secured Notes (as
defined herein). The Senior 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 Senior 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. Up to $2.0 million of
the Senior Facility is reserved for resolution of certain disputes or
letters of credit in connection with the Company's renovation program
(see Note 8).
(b) During July 1998, the Company issued $20,000,000 of 13.5% Senior
Collateralized Notes due May 1, 2002, (the "Senior Collateralized
Notes") and Warrants. The Senior Collateralized Notes are secured by
substantially all the assets of the Company and interest is payable
quarterly beginning August 1, 1998. A value of $100,000 was allocated
to the warrants based upon their appraised value at the time of
issuance, representing the original issue discount on the Senior
Collateralized Notes. A separate interest escrow was established with
the trustee to fund interest payments through August 1, 1999. The
interest escrow account balance totaled approximately $2,815,000,
consisting of treasury securities and accrued interest thereon, at
September 30, 1998.
The Senior Collateralized Notes contain restrictions on additional
indebtedness and cross-default provisions with other obligations of the
Company.
(c) 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 "Private Senior Secured 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 Senior Secured Notes. The
Private Senior Secured 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 $11,053,000,
consisting of treasury securities and accrued interest thereon, at
September 30, 1998.
The Company consummated an offer to exchange $85,000,000 aggregate
principal amount of its 13.5% Senior Secured Notes due 2002 (the
"Exchange Senior Secured 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 Senior Secured Notes (the Private Senior Secured Notes,
together with the Exchange Senior Secured Notes, the "Senior Secured
Notes").
The Senior Secured 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.
Consents from the holders of the Senior Secured Notes were obtained to
modify certain of these restrictions in connection with the offering of
the Senior Collateralized Notes and 14.5% Cumulative Preferred Stock
discussed in Note 4.
(d) The McDonald's Secured Rejection Note had a principal amount of
$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 currently total
$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.
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, 1998, which are included in
Land Held for Sale in the Company's Consolidated Balance Sheet. The
notes contain certain cross-default provisions, including any
cross-default in excess of $2.5 million, among themselves, with the
McDonald's subleases or with other indebtedness of the Company.
(e) 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.
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DISCOVERY ZONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(6) LOSS PER COMMON SHARE
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 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 two-month period ended
September 30, 1997 and the three and nine month periods ended September 30,
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 $2,465,000 and $6,605,000 to Griffin Bacal for creative
services and as agent for purchase of media from third parties during the three
and nine month periods ended September 30, 1998, respectively.
(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. To date, the Company also
completed the conversion of approximately 75% 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 October 31, 1998,
the Company has incurred or committed to incur approximately $28 million in
connection with these programs, including excess billings from general
contractors which the Company has disputed, of which approximately $3.4
million remains unpaid.
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 $4,337,000 at September 30,
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.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion and analysis relates to DZ's historical
financial results of operations and financial condition. This discussion and
analysis does not give pro forma effect to the restructuring of the Company in
connection with the Plan of Reorganization and the implementation of the
Turnaround Plan, except to the extent that such restructuring 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 periods prior to
such restructuring events. Please read this discussion and analysis in
conjunction with DZ's condensed consolidated financial statements and the notes
thereto appearing elsewhere in this report on Form 10-Q.
Overview
DZ is the leading owner and operator of pay-for-play children's
entertainment centers in North America. DZ has a national network of 199
FunCenters in 39 states, Puerto Rico and Canada targeted at children ages two to
12 and two Block Party Stores which target adult customers.
DZ generates revenue primarily from the operation of the FunCenters.
FunCenters derive revenues from: (i) admission charges; (ii) food and beverage
sales; (iii) redemption game and other concession revenue; and (iv) birthday
party fees. DZ's revenues are subject to significant quarterly variations based
upon several factors, including seasonal changes in weather, holidays and the
school calendar. DZ 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 DZ (a) shortened FunCenter
operating hours by approximately 18% to curtail operations during unprofitable
time periods, (b) reduced its marketing expenditures (see below), and (c) did
not update its product offering while in Chapter 11. DZ also experienced a
decline in sales during its recent renovation of the FunCenters.
DZ'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 emerging from bankruptcy, has generated additional annual cost savings at
the store level on a comparable store basis through cost containment measures
and improved financial controls.
DZ incurred substantial restructuring costs while operating under
Chapter 11, 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 DZ's Plan of Reorganization and
other amounts were repaid with the proceeds of the offering of the Units (as
defined herein) and the Preferred Stock.
DZ is currently implementing its Turnaround Plan. This plan consists of
a number of cost-cutting and revenue enhancing initiatives, including an
extensive FunCenter renovation program to enhance its product offerings,
improved food and beverage offerings, a revamped marketing and promotional
campaign and an enhanced hiring and training program for store managers. Through
October 31,1998, DZ 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, and
converted approximately 75% of its FunCenters to offer Pizza Hut products.
Per-customer spending on food has increased in those FunCenters offering Pizza
Hut menu items since conversion.
Comparable store revenues during the third quarter of 1998 were down
6.3% as compared to a decline of 15.5% during the third quarter of 1997, a
decline of 5.3% in the second quarter of 1998, and an increase of 4% in the
first quarter of 1998. During the first nine months of 1998, comparable store
revenues declined 2% , compared to a 17% decline in comparable store revenues in
the first nine months of 1997. This decline in comparable store revenues for the
first nine months of 1998 consisted of a 5.3% increase in general admission
revenues, offset primarily by decreases in birthday party and game revenues.
During the first nine months of 1998, 81 stores (40.5% of total stores) had
increased comparable store revenues as compared to 8 stores (4% of total stores)
in the 1997 period, and 145 stores (72.5% of total stores) had increased general
admission revenue as compared to nine stores ( 4% of total stores) in the 1997
period.
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In spite of improvements relative to the comparable period of the prior
year, DZ's results of operations in the first nine months of 1998 were less than
expected due to:
o construction delays in completing its FunCenter renovation
program and related business disruptions,
o corresponding delays in launching certain marketing and
promotional programs,
o unseasonably warm weather in many parts of the United
States, which diminished demand for a variety of indoor
entertainment activities, and
o transitional staffing and training expenses associated with
the introduction of new entertainment attractions at
FunCenters.
As a result of these factors, DZ experienced negative comparable store
sales and negative EBITDA (as defined herein) for the second and third quarters
of 1998. DZ required additional capital to continue funding its operations and
implementing the Turnaround Plan and consummated a $29.5 million financing on
July 17, 1998. See "Liquidity and Capital Resources."
Results of Operations
Upon emergence from Chapter 11, DZ adopted Fresh Start Accounting. Thus
DZ's balance sheets and statements of operations and cash flows after emerging
from bankruptcy reflect a new reporting entity (the "Successor Company") and are
not comparable to periods prior to such date (the "Predecessor Company").
The three and nine month periods ended September 30, 1997 include the
results of the Predecessor Company and the Successor Company. The three and nine
month periods ended September 30, 1998 include the results of the Successor
Company only. The principal differences between these periods relate to
reporting changes regarding DZ's capital structure and indebtedness and the
revaluation of DZ's long-term assets, which primarily affect depreciation and
amortization expense and interest expense in DZ's results of operations.
Comparison of the Three Months Ended September 30, 1998 and 1997
Revenue. The Company had revenue of $28.4 million during the third
quarter of 1998, a decrease of 9.4% from revenue of $31.3 million during the
third quarter of 1997. This decrease was comprised of a 6.3% decrease in
comparable store sales during the 1998 period from the 1997 period (as compared
to a 15.5% decline in the 1997 period from the 1996 period) and a decline in the
number of FunCenters open during the 1998 period as compared to the 1997 period.
Revenues during the third quarter of 1998 were adversely affected due to the
factors set forth in "Overview."
Cost of Goods Sold. Cost of goods sold, which consists primarily of the
cost of food, redemption merchandise and other product sales, was $4.7 million
and $4.6 million during the third quarter of 1998 and 1997, respectively. As a
percentage of revenue, cost of goods sold increased from 14.7% for the 1997
period to 16.6% for the 1998 period due to an increase in costs associated with
certain new product offerings. These increases were offset by cost reductions
attributable to simplified product offerings, improved cost management and lower
costs associated with conversion to a new food supplier.
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 $25.3
million and $25.5 million during the third quarter of 1998 and 1997,
respectively ($24.9 million and $25.8 million, respectively, before GAAP Rent
Adjustments). DZ attributes this decrease to reductions in central reservation
expenses and other cost savings generated through its cost reduction program and
store closings, offset by increased labor costs associated with its new product
offerings.
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 $7.5 million and $6.2 million during the third quarter of 1998
and 1997, respectively. This increase was primarily attributable to an increase
in general and administrative expenses during the 1998 period as compared to the
1997 period.
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Depreciation and Amortization Expense. Depreciation and amortization
expenses were $5.9 million and $5.7 million during the third quarter of 1998 and
1997, respectively. This increase primarily reflected depreciation and
amortization expense related to an increase in the carrying value of the
Company's trademarks and property and equipment as a result of its adoption of
Fresh Start Accounting for the Successor Company.
Interest Expense. Interest expense was $4.4 million and $3.9 million
during the third quarter of 1998 and 1997, respectively. Reported interest
expense for the Predecessor Company did not include interest on pre-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 $5.9 million.
Interest Income. The Company reported interest income of $272,000
during the third quarter of 1998, and $616,000 in the third quarter of 1997. The
decrease was due to a reduction in the remaining proceeds from DZ's offering of
Units and Convertible Preferred Stock in the exit financing.
Reorganization Items. Reorganization items of $15.7 million (increase
to income) were incurred by the Company during its reorganization under Chapter
11 for the third quarter of 1997, including $2.5 million incurred for
professional fees. Included in reorganization items for the third quarter of
1997 was an increase in net income of $24.8 million, which resulted from the
difference between the Company's reorganized value and a revaluation of the
Company's assets and liabilities. See Note 4 to the Company's 1997 Audited
Financial Statements. The remainder was primarily attributable to losses on
asset disposals associated with the closing of FunCenters, the write-off of
deferred financing costs on certain pre-petition indebtedness and expenses
associated with the Company's Plan of Reorganization.
EBITDA. DZ reported negative EBITDA (Earnings before Interest, Taxes,
Depreciation and Amortization) for the third quarter of 1998 of $8.7 million
before reorganization items and non-cash GAAP rent adjustments which were
affected by Fresh Start Accounting ("GAAP Rent Adjustments"), and $9.1 million
after such adjustments, compared to negative EBITDA of $5.4 million before such
adjustments, and $5.1 million after such adjustments, in the comparable prior
year period. This decline was primarily attributable to lower revenue and
increased general and administrative costs.
Comparison of the Nine Months Ended September 30, 1998 and 1997
Revenue. DZ had revenue of $98.6 million during the first nine months
of 1998, a decrease of 3.9% from revenue of $102.6 million during the first nine
months of 1997. This decrease included a 2% decrease in comparable store sales
during the 1998 period compared to the 1997 period (as compared to a 17% decline
in the 1997 period compared to the 1996 period) and a reduction of revenue
attributable to fewer FunCenters being open during the 1998 period as compared
to the 1997 period, offset in part by $1.1 million of additional sponsorship
revenue during the 1998 period. Changes in comparable store revenue were
primarily due to an increase in general admission revenue offset by declines in
birthday party and game revenues. Revenues during the first nine months of 1998
were adversely affected by the factors set forth in "Overview."
Cost of Goods Sold. Cost of goods sold, which consists primarily of the
cost of food, redemption merchandise and other product sales, was $15.9 million
and $17.2 million during the first nine months of 1998 and 1997, respectively.
As a percentage of revenue, cost of goods sold declined from 16.7% in the 1997
period to 16.1% in the 1998 period. DZ attributes this decline to simplified
product offerings, improved cost management and lower costs associated with
conversion to a new food supplier, offset by increases due to new product
offerings.
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 $78.5
million and $76.0 million during the first nine months of 1998 and 1997,
respectively ($77.2 million and $76.9 million, respectively, before GAAP Rent
Adjustments). As a percentage of total revenues, store operating expenses
increased from 74.0 % in the 1997 period to 79.5 % in the 1998 period. DZ
attributes this increase to increased labor costs associated with certain new
product offerings, offset by reductions in central reservation expenses and
other cost savings generated through DZ's cost reduction program and store
closings. During the first nine months 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 $20.2 million and $15.3 million during the first nine months of
1998 and 1997, respectively. This increase was primarily attributable to an
increase in sales and marketing programs associated with the Company's
revitalization plan and to increases in general and administrative costs during
the 1998 period as compared to the 1997 period.
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Depreciation and Amortization Expense. Depreciation and amortization
expenses were $16.7 million and $15.9 million during the first nine months of
1998 and 1997, respectively. This increase primarily reflected depreciation and
amortization expense related to an increase in the carrying value of the
Company's trademarks and property and equipment as a result of its adoption of
Fresh Start Accounting for the Successor Company.
Interest Expense. Interest expense was $11.9 million and $6.4 million
in the first nine months of 1998 and 1997, respectively. Reported interest
expense for the Predecessor Company did not include interest on pre-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 $15.6 million.
Interest Income. The Company reported interest income of $863,000
during the first nine months of 1998, compared to $616,000 during the first nine
months of 1997. The increase was due to earnings from the Interest Escrow
Account and short-term investment of proceeds from DZ's offering of Units and
Convertible Preferred Stock in the exit financing.
Reorganization Items. Reorganization items of $11.6 million (increase
to income) were incurred by the Company during its reorganization under Chapter
11 for the nine months ended September 30, 1997, including $6.2 million incurred
for professional fees. Included in reorganization items for the nine months
ended September 30, 1997 was an increase in net income of $24.8 million which
resulted from the difference between the Company's reorganized value and a
revaluation of the Company's assets and liabilities. See Note 4 to the Company's
1997 Audited Financial Statements. The remainder was primarily attributable to
losses on asset disposals associated with the closing of FunCenters, the
write-off of deferred financing costs on certain pre-petition indebtedness and
expenses associated with the Company's Plan of Reorganization.
EBITDA. DZ reported negative EBITDA for the first nine months of 1998
of $14.7 million, before reorganization items and non-cash GAAP rent adjustments
which were affected by Fresh Start Accounting ("GAAP Rent Adjustments"), and
$15.9 million after such adjustments, compared to negative EBITDA of $6.8
million before such adjustments, and $5.9 million after such adjustments, in the
comparable prior year period. This decline was primarily attributable to lower
revenue during the third quarter of 1998 as compared to the prior year period
and increased expenditures for sales and marketing programs.
Liquidity and Capital Resources
DZ 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 fund operating losses and debt service payments and to finance capital
expenditures to maintain and upgrade existing stores. Following the
implementation of its Turnaround Plan, the Company also expects to need cash to
build new stores. Historically, DZ has met these liquidity requirements
primarily through external financing, 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
DZ'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, DZ issued (a) units (the "Units") consisting of $85.0
million aggregate principal amount of Senior Secured Notes and Warrants and (b)
$15.0 million of Preferred Stock. The net proceeds of the offerings of the Units
and Preferred Stock totaled $93.8 million. Of that amount, DZ (i) repaid
borrowings, claims and expenses incurred 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 (the "Escrowed Interest
Account") and pledged as security for scheduled interest payments on the Senior
Secured Notes through August 1, 1999, and (iii) applied $26.7 million to finance
capital expenditures and to provide capital for working capital and other
general corporate purposes.
On March 31, 1998, the Company entered into a $10.0 million Senior
Secured Revolving Credit Facility with Foothill Capital Corporation (the "Senior
Facility") as permitted under the Indenture (the "Secured Notes Indenture"),
dated as of July 22, 1997, 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.
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The Company is permitted under the Secured Notes Indenture to incur up
to $5.0 million of additional indebtedness under sale and leaseback
transactions, capital lease obligations or purchase money obligations. In July
1998, the Company received the consent of holders of the Senior Secured Notes to
increase the Senior Facility to $15 million, although there can be no assurance
that it will be able to enter into a new or amended credit facility providing
for such an increase.
On July 17, 1998 the Company completed a $29.5 million financing from
the sale of $10.5 million of 14.5% Cumulative Preferred Stock (the "New
Preferred Stock") and $20 million of aggregate principal amount of 13.5% Senior
Collateralized Notes due 2002 (the "New Notes"), both together with warrants to
purchase approximately 99.6% of the fully diluted common stock of the Company
for a nominal purchase price. The offerings resulted in net proceeds to the
Company of approximately $27 million after costs and expenses. These net
proceeds (i) were used to repay outstanding borrowings under the Company's
Senior Facility, (ii) were used to purchase $2.8 million of U.S. Treasury
Securities that were placed in escrow and pledged as security for scheduled
interest payments on the New Notes through August 1, 1999 and (iii) are
available for working capital, capital expenditures and other general corporate
purposes, including previously incurred costs associated with the Company's
renovation program and operating losses. As part of this transaction, $1 million
of existing Preferred Stock was exchanged for $1 million of New Preferred Stock.
DZ holds for sale certain parcels of undeveloped land which secure the
McDonald's Senior Secured Notes. To the extent such sales occur prior to the due
date for related debt service payments, the net proceeds from such sales will be
applied to principal and will reduce prospective interest payments.
During the fourth quarter of 1997, the Company began an extensive
FunCenter renovation program designed to broaden FunCenter 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. Through October 31, 1998, the Company also completed the conversion
of approximately 75% 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 October 31, 1998, the Company has
incurred or committed approximately $28 million in connection with these
programs, including excess billings from general contractors which the Company
has disputed, of which approximately $3.4 million remains unpaid.
During the nine months ended September 30, 1998 and 1997, cash used in
operations was $14.5 million and $20.5 million, respectively, before
reorganizations items. The decrease in cash used in operations during the 1998
period was primarily attributable to decreases in prepaid expenses and other
assets, such as prepaid insurance and post-petition vendor deposits, in the 1998
period compared to the 1997 period. As of November 10, 1998, the Company had
$6.4 million of borrowings outstanding under the Senior Facility and had an
ability to borrow an additional $3.6 million, subject to a $0.7 million reserve
for certain contractor disputes and subject to $0.5 million of outstanding
letters of credit. See "Financial Statements--Senior Secured Notes to Unaudited
Condensed Consolidated Financial Statements."
At September 30, 1998, the Company had an unrestricted cash balance of
approximately $2.5 million and no outstanding borrowings under the Senior
Facility. The Company repaid all outstanding amounts under the Senior Facility
in July 1998 using the proceeds from the offerings of the New Notes and the New
Preferred Stock (each as defined herein). The Company also had $13.9 million in
cash and investments in the Escrowed Interest Account as of September 30, 1998.
This balance is dedicated to making scheduled payments of interest on the Senior
Secured Notes and the Senior Collateralized Notes through August 1, 1999.
Historically, the cash necessary to fund the Company's capital
expenditures, working capital and operating losses has been provided by the
Company's financing activities, including proceeds from offerings of debt and
equity securities, equipment financing and the Senior Facility. The Company has
historically experienced significant operating losses during the fourth quarter
due to the seasonality of its business. Given its current level of cash flows
and its expected cash flows in the fourth quarter, the Company has substantially
reduced the level of capital expenditures. If the Company continues to generate
negative operating cash flow, this will adversely impact its ability to
implement the Turnaround Plan. Moreover, if the Company cannot generate positive
cash flow from operations in an amount necessary to satisfy its debt service
obligations, meet its working capital and capital expenditure requirements and
fund operating losses, the Company will require additional financing. The
Company is currently in discussions to increase the amount available under the
Senior Facility by up to $5 million, which, under the terms of the Indentures,
is the maximum amount permitted to be borrowed under a senior credit facility.
There can be no assurance that such additional financing will be available.
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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.
Impact of Year 2000
The Year 2000 issue is the result of computer programs that were
written using two digits rather than four to define an applicable year. At the
turn of the century, the Company's computer equipment and software and devices
with imbedded technology that are time-sensitive may recognize a date using "00"
as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices, or
engage in similar normal business activities.
The Company has undertaken various initiatives intended to ensure that
its computer equipment and software will function properly with respect to dates
in the Year 2000 and thereafter. For this purpose, the term "computer equipment
and software" includes systems that are commonly thought of as IT systems,
including accounting, data processing, and telephone/PBX systems, cash
registers, scanning equipment, and other miscellaneous systems, as well as
systems that are not commonly thought of as IT systems, such as alarm systems,
fax machines, or other miscellaneous systems. Both IT and non-IT systems may
contain imbedded technology, which complicates the Company's Year 2000
identification, assessment, remediation, and testing efforts. The Company has
completed an assessment of this situation and, during the third quarter of 1998,
began implementing a plan to modify or replace certain portions of its software
and hardware. The Company expects to complete its remediation effort by June 30,
1999.
The Company has both internally developed software and hardware and
software purchased or licensed from third party vendors who have upgrade
releases available to address the issue. The Company has also communicated with
its key suppliers to determine the extent to which Year 2000 issues affect
services provided to the Company.
The Company believes that, in addition to its existing staff, the cost
of its Year 2000 identification, assessment, remediation and testing efforts
will be approximately $300,000, consisting primarily of previously planned
hardware and software upgrades.
The Company believes that with modifications to existing software and
hardware and upgrades to existing third- party vendor software, the Year 2000
issue will not pose significant operational problems for its computer equipment
and software. However, if such modifications are not made or are not completed
timely, the Year 2000 issues could have a material impact on the Company's
ability to operate.
The Company has begun, but not yet completed, developing an analysis of
operational problems and costs, including loss of revenues, that would be
reasonably likely to result should the Company and certain third parties not
complete efforts necessary to achieve Year 2000 compliance in a timely manner. A
contingency plan has not been developed for dealing with the most reasonably
expected worst case scenario and such scenario has not yet been clearly
identified. The Company currently plans to complete such analysis and
contingency planning by March 31, 1999.
18
<PAGE>
DISCOVERY ZONE, INC.
PART II--OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Not Applicable
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Changes in Securities
In connection with its offering of New Notes and New
Preferred Stock (the "Offering"), the Company obtained the
consent from holders of a majority in aggregate principal
amount of the Senior Secured Notes to amend certain provisions
and waive certain covenants of the Secured Notes Indenture and
to enter into a supplemental indenture thereto. The Offering
closed on July 17, 1998.
Waivers
The Company received the following waivers which were
necessary to permit the Offering, including:
(i) a waiver of the "Limitation on Incurrance of
Additional Indebtedness and Issuance of Preferred
Stock" covenant to permit the Company to issue up to
$20 million of New Notes without meeting the tests
currently required by such covenant for the
incurrence of additional indebtedness;
(ii) a waiver of the "Limitation on Liens" covenant to
permit the Company to incur additional liens on
collateral securing the Senior Secured Notes in
connection with the issuance of the New Notes (which
liens are senior in priority to the liens on the
collateral securing the Senior Secured Notes);
(iii) a waiver of the "Impairment of Security Interest"
covenant to permit the Company to enter into an
indenture, an intercreditor agreement and certain
related agreements with respect to the New Notes
pursuant to which the holders of New Notes were
granted security interests in and liens on certain
collateral securing the New Notes;
(iv) a waiver of certain provisions of the Secured Notes
Indenture providing that the trustee thereunder could
execute a new intercreditor agreement providing for
liens on the New Notes that are senior in priority of
payment to the Senior Secured Notes, that the New
Notes be fully secured and that holders of the New
Notes be permitted to apply for, and that holders of
Senior Notes not object to, any application for
adequate protection in favor of the holders of the
New Notes in the event of a bankruptcy filing by the
Company.
Amendments
The Company obtained the necessary consents to amend certain
provisions of the Indenture to permit the Offering, including:
(i) amendments to the "Limitation on Restricted Payments"
covenant permitting the Company (A) to redeem and
repurchase the New Notes under certain circumstances,
such as upon a change of control and following certain
asset sales, in each case on terms substantially similar
to the corresponding provisions of the Secured Note
Indenture; (B) at the Company's option, upon the closing
of certain public equity offerings by the Company, to
redeem up to 100% of the original principal amount of
the New Notes and to apply the proceeds of such
offerings to pay accrued and unpaid dividends on the New
Preferred Stock upon the conversion thereof into Common
Stock; and (C) to redeem or repurchase
19
<PAGE>
the warrants issued in connection with any such public
equity offerings under certain circumstances;
(ii) an amendment to the definition of "Permitted
Indebtedness" to permit the Company to incur up to
$20 million of additional indebtedness in connection
with the issuance of the New Notes;
(iii) an amendment to the "Limitation on the Incurrance of
Additional Indebtedness and Issuance of Preferred
Stock" covenant to permit certain subsidiaries of the
Company to guarantee the New Notes;
(iv) an amendment to the definition of "Permitted Liens"
to permit the Company, in connection with the
issuance of the New Notes, to incur additional liens
on the collateral securing the Senior Secured Notes;
(v) an amendment to the definitions of "Permitted
Investments" to permit the Company to make investments
in the New Notes;
(vi) amendments to the "Limitations on Impairment of
Security Interests" covenant, the "Grant of Security
Interest" covenant, the "Execution of Intercreditor
Agreement" covenant, the "Release of Collateral"
covenant, the "Specified Release of Collateral"
covenant, the "Authorization of Actions to Be Taken
by the Trustee Under the Collateral Agreements"
covenant and the "Subordination of Security Interest"
covenant, in each case to permit the Trustee to enter
into an intercreditor agreement with respect to the
New Notes;
(vii) amendments to the "Limitation on Merger,
Consolidation and Sale of Assets" covenant and the
"Successor Corporation Substituted" covenant, in each
case to the extent necessary to require that any
successor corporation to the Company as a result of a
merger, consolidation, sale of assets or other
transaction involving the Company, assume the
Company's obligations under the intercreditor
agreement with respect to the New Notes;
(viii) an amendment to the "Limitation on Incurrence of
Additional Indebtedness and Issuance of Preferred
Stock" covenant to permit the Company to incur
additional secured indebtedness under an amended or
additional Senior Facility secured by a first priority
security interest in and lien upon, among other things,
the collateral securing the Senior Secured Notes;
(ix) an amendment to the "Limitation on Liens" covenant to
permit the Company to incur additional liens (which
liens will be senior in priority to liens securing
collateral under the Senior Secured Notes) in
connection with an amended or additional Senior
Facility;
(x) an amendment to the "Impairment of Security Interests"
covenant to permit the Company and the trustee with
respect to the Senior Secured Notes to enter into an
intercreditor agreement and certain related agreements
in connection with the incurrance of any additional
senior secured indebtedness pursuant to which the new
lenders thereunder will be granted a security interest
and lien on the collateral securing the Senior Secured
Notes that will be senior in priority to the security
interests and liens securing collateral under the
Existing Notes;
(xi) amendments to the definitions of "Eligible Credit
Facility," "Intercreditor Agreement" and "Permitted
Indebtedness" to permit the Company to incur up to $5
million of additional senior secured indebtedness under
the "Limitation on the Incurrance of Additional
Indebtedness and Issuance of Preferred Stock" covenant;
and
(xii) an amendment to the "Merger, Consolidation and Sale of
Assets" and the "Successor Corporation Substituted"
covenants, in each case to the extent necessary to
require that any successor corporation to the Company
as a result of a merger, consolidation, sale of assets
or other transaction involving the Company, assume the
Company's obligations in
20
<PAGE>
connection with any intercreditor agreement entered
into in connection with any additional senior secured
indebtedness; and
(xiii) various amendments to the provisions of "Grant of
Security Interest" covenant, the "Execution of
Intercreditor Agreement" covenant, the "Release of
Collateral" covenant, the "Specified Release of
Collateral" covenant; the "Authorization of Actions to
be Taken by the Trustee under the Collateral
Agreements" covenants and "Subordination of Security
Interest" covenants to permit the trustee with respect
to the Senior Secured Notes to enter into an
intercreditor agreement with respect to the Senior
Secured Notes.
Use of Proceeds
The Company used approximately $2.8 million of the proceeds
from the offerings of New Notes and New Preferred Stock to
purchase a portfolio of securities, consisting of U.S.
government securities, that were pledged as security for the
scheduled interest payments on the New Notes through August 1,
1999. The Company used approximately $8.0 million of such
proceeds to repay outstanding borrowings under the Senior
Facility. The Company is using the remaining net proceeds of
the Offering to finance capital expenditures and to pay
certain obligations incurred by the Company in connection with
its store renovation program and for general corporate
purposes, including funding operating losses and changes in
working capital. Pending such uses, the proceeds from such
offerings will be invested in investment grade short-term
interest-bearing securities or money market funds.
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On July 14, 1998, a majority of the stockholders of the
Company authorized the Company by written consent to amend the
Company's Amended and Restated Certificate of Incorporation
to, among other things, (i) increase the authorized share
capital of the Company to 2,400,000,000 shares, consisting of
2,200,000,000 shares of Class A Voting Common Stock, par value
$.00017 per share, 190,000,000 shares of Class B Nonvoting
Common Stock, par value $.00017 per share and 10,000,000
shares of Preferred Stock, par value $.01 per share and (ii)
modify certain corporate governance provisions thereunder with
respect to the size and composition of the Board of Directors
and the ability of the Board of Directors to authorize any
filing for bankruptcy.
Item 5. OTHER INFORMATION
Not Applicable
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit Description
Number
------- -----------
**3.1 Restated Certificate of Incorporation of the Company
**3.2 Amended and Restated By-laws of the Company.
*4.1 First Supplemental Indenture, dated as of July 17,
1998, among the Company, the guarantors named
therein and State Street Bank and Trust Company.
*4.2 Indenture, dated as of July 17, 1998, among the
Company, as issuer, Discovery Zone (Canada)
Limited, Discovery Zone (Puerto Rico), Inc. and
Discovery Zone Licensing, Inc. as guarantors (the
"Subsidiary Guarantors") and Firstar Bank of
Minnesota, N.A., as trustee.
21
<PAGE>
*4.3 Registration Rights Agreement, dated as of July 17,
1998, between the Company and the Initial Purchaser.
*4.4 Warrant Agreement, dated as of July 17, 1998, between
the Company and Firstar Bank of Minnesota, N.A., as
warrant agent (the "Warrant Agent"), relating to the
Series A Preferred Units.
*4.5 Warrant Agreement, dated as of July 17, 1998, between
the Company and the Warrant Agent, relating to the
Series B Preferred Units.
**4.6 Warrant Agreement,dated as of July 17, 1998, between
the Company and the Warrant Agent, relating to the
Series A Note Warrants and the Series B Note
Warrants.
*4.7 Escrow and Security Agreement, dated as of July 17,
1998, between the Company, as pledgor, and Firstar
Bank of Minnesota, N.A., as trustee and security
agent.
*4.8 Pledge Agreement, dated as of July 17, 1998, between
the Company and Firstar Bank of Minnesota, N.A., as
collateral agent (the "Collateral Agent").
*4.9 Subsidiary Pledge Agreement, dated as of July 17,
1998, between the Subsidiary Guarantors and the
Collateral Agent.
**4.10 Security Agreement, dated as of July 17, 1998,
between the Company and the Collateral Agent.
**4.11 Subsidiary Security Agreement, dated as of July, 17,
1998, between the Company and the Collateral Agent.
**4.12 Collateral Assignment of Patents, Trademarks and
Copyrights, dated as of July 17, 1998, among the
Company, as assignor, the Subsidiary Guarantors, as
assignors and Firstar Bank of Minnesota, N.A., as
assignee.
*4.13 Intercreditor Agreement, dated as of July 17, 1998,
between Foothill Capital Corporation and the Firstar
Bank of Minnesota, N.A., as trustee and collateral
agent.
*4.14 Intercreditor Agreement, dated as of July 17, 1998,
between Firstar Bank of Minnesota, N.A., as
collateral agent, and State Street Bank and Trust
Company, as collateral agent.
**10.1 Purchase Agreement, dated as of July 13, 1998, among
the Company, Birch Holdings L.L.C., Birch Acquisition
L.L.C., Wafra Acquisition Fund 6, L.P. and Wafra Fund
Management Ltd., relating to the Series A Preferred
Units.
**10.2 Purchase Agreement, dated as of July 13, 1998, among
the Company, Birch Acquisition L.L.C., DZ Investors
L.L.C. and Jefferies & Company, Inc., relating to the
Series B Preferred Units.
27.1 Financial Data Schedule for the nine months ended
September 30, 1998.
27.2 Financial Data Schedule for the nine months ended
September 30, 1997.
* Incorporated by reference to the Company's Registration
Statement on Form S-4 filed on September 30, 1998.
** Incorporated by reference to the Company's Registration
Statement on Form S-4 filed on December 23, 1998.
(b) Reports on Form 8-K
Current Report on Form 8-K, dated July 17, 1998; Item 5
Current Report on Form 8-K, dated October 26, 1998; Items 5, 6
and 7.
22
<PAGE>
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: January 12, 1999 DISCOVERY ZONE, INC.
Signature Title
--------- -----
/s/ Chet Obieleski Chief Executive Officer, Chief Operating
- --------------------------- Officer, President and Director
Chet Obieleski
/s/ Robert G. Rooney Senior Vice President, Chief Financial and
- --------------------------- Administrator Officer
Robert G. Rooney
23
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