SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the fiscal year ended December 31, 1998.
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________
to ________.
Commission File Number: 0-21854
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, FIFTH FLOOR
ELMSFORD, NEW YORK 10523
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (914) 345-4500
Securities registered pursuant to Section 12(b) of the
Securities Act of 1933: None
Securities registered pursuant to Section 12(g) of the Securities Act of 1933:
Common Stock, par value $0.00017 per share
13 1/2% Senior Secured Notes due 2002
13 1/2% Senior Collateralized Notes due 2002
---------------
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 registrant was required to file such reports) and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all
documents and reports required to be filed by Section 12, 13 or 15(d) of the
Securities Exchange Act of 1934 subsequent to the distribution of securities
under a plan confirmed by a court. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [X]
There is no secondary market for the voting stock of Discovery
Zone, Inc.
The aggregate market value of the voting stock held by
non-affiliates of the registrant as of March 30. 1999 was estimated to be
nominal.
As of March 30, 1999, the number of shares of Common Stock
outstanding was 430,333,492.
<PAGE>
PART I
ITEM 1. BUSINESS
Forward-Looking Statements
Some of the information in this report contains forward-looking
statements that involve substantial risks and uncertainties. You can identify
these statements by the use of forward-looking words such as "may," "will,"
"expect," "anticipate," believe," "estimate" or similar words. You should read
statements that contain these words carefully because they discuss our future
expectations, contain projections of our future results of operations or of our
financial condition or state other forward-looking information. We believe that
it is important to communicate our future expectations to our investors.
However, there may be events in the future that management has not predicted
accurately or over which we have no control. These events may include future
operating results, our ability to implement our business strategy, public
interest in new product offerings and potential competition, among other things.
As a result, these forward-looking statements are subject to risks,
uncertainties, and assumptions that may cause actual results to differ
materially from the expectations we describe in such forward-looking
statements. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.
The Company
Discovery Zone, Inc. is a Delaware corporation founded in 1989. The
Company and its consolidated subsidiaries are referred to herein as "DZ" or the
"Company." The Company's principal executive offices are located at 565 Taxter
Road, Fifth Floor, Elmsford, New York 10523.
The Company owns and operates pay-for-play children's entertainment
centers ("FunCenters") in North America, with a national network of 195
FunCenters in 38 states, Canada and Puerto Rico. See "Properties -- FunCenter
Closure Plan." The FunCenters are targeted to appeal to children ages two to 12
and are designed to offer children a unique entertainment experience while
meeting their parents' needs for value and convenience. The Company believes
that it is the first company to develop this concept nationally. As a result,
the Company believes that it has the potential to capitalize on a variety of
favorable demographics in its customer base, including projected growth in the
population of children under the age of 13, which management believes will
increase spending on children's leisure activities.
FunCenters generally are located in strip shopping centers and, to a
lesser extent, in shopping malls. FunCenters typically include:
o "soft play" zones consisting of a series of tubes, slides,
ball bins, climbing mountains, air trampolines, obstacle
courses, ramps and other devices for crawling, jumping,
running, swinging and climbing, all of which have been
designed and constructed with an emphasis on safety;
o "game zones" consisting of games that award tickets redeemable
for prizes;
o food and beverage operations; and
o party rooms for birthdays and other group events.
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" consistent with the
Company's brand repositioning campaign. The Company has renovated approximately
60% of its FunCenters to expand and update its product offerings to include:
1
<PAGE>
o themed laser tag;
o arts and crafts;
o promotional areas featuring changing events; and
o a stage area which features custom DZ programming and kid
Karaoke, and creates a FunCenter focal point for character
appearances and other presentations.
The Company's strategy is to attract kids by featuring a wide variety
of entertainment while appealing to parents with value based pricing. The
Company has also converted approximately 80% of its FunCenters to offer Pizza
Hut brand menu items. See "Business -- Product Improvements."
Recent Developments
In 1998, the Company experienced continued declines in revenues and
attendance in many of its FunCenters. Comparable store revenues and attendance
in 1998 declined 2.4% and 14.5%, respectively, from 1997. This compares to
declines in comparable store revenues and attendance of 15.6% and 17.8%,
respectively, for 1997 versus 1996. Revenue declined at a lower rate than
attendance because of increases in in-store spending for food and games, as well
as increases of 25% to 40% in general admission prices in renovated FunCenters.
The Company believes that in-store spending increased as a result of initiatives
undertaken as part of the Company's Turnaround Plan, described below. The
Company experienced attendance declines of approximately [5]% in those
FunCenters that did not raise general admission prices and which were not
disrupted by renovation activity. In the first three months of 1999, the Company
experienced further declines in same store revenues as compared to the first
three months of 1998, primarily due to continued declines in general admission
attendance. The Company believes that the following factors adversely affected
1998 results:
o construction delays in its FunCenter renovation program
adversely affected customer satisfaction and, in turn, results
of operations, particularly during the first quarter of 1998;
o with respect to renovated FunCenters, construction delays and
poor execution of new product offerings disrupted store
operations, and price increases discouraged repeat visits;
o financial constraints caused the Company to delay and scale
back certain marketing and promotional programs;
o poor price-to-value relationships in the pricing of the
Company's general admission, birthday party and group sales;
and
o unseasonably warm and dry weather in many parts of the United
States diminished demand for a variety of indoor entertainment
activities.
The Company has operated under significant capital constraints since early 1996
due to the bankruptcy process, increased renovation spending and limits on the
Company's ability to raise additional financing due to its highly leveraged
capital structure. These constraints have delayed implementation of its
Turnaround Plan, caused extended periods with little or no marketing activity,
hindered field testing of new products and delayed timely corrective actions.
In the second half of 1998, the Company refined its business strategy
to address these issues and undertook several remedial measures, some of which
have begun to show favorable results in the first quarter of 1999:
2
<PAGE>
o The Company began developing a revised pricing structure to
boost attendance, including a competitively priced birthday
party package and a value oriented annual pass program. In the
period from January 1, 1999 through March 21, 1999, party
attendance increased approximately 18% as compared to a
decline of 28% during the first quarter of 1998, and the
Company's annual pass revenues increased approximately
$670,000 as compared to the same period in 1998. In March
1999, the Company began testing lower general admission prices
in several markets.
o The Company introduced several programs to increase per capita
in-store spending in the first quarter of 1999, including
expanded food and game offerings and a new retail program. In
the period from January 1, 1999 through March 21, 1999,
average in-store spending at FunCenters for food, games and
retail products has increased 12%, 26% and 700%, respectively,
as compared to the prior year period.
o The Company initiated programs to save an additional $10
million per year in operating costs.
In spite of these improvements, the Company's business strategy is
taking longer to implement and is proving to be more costly than originally
anticipated. Currently, the Company does not have, and is not generating from
operations, sufficient cash to meet its obligations as they become due. Due to a
lack of funds, in the fourth quarter of 1998 the Company suspended its
renovation program and stopped making any further renovations to its FunCenters.
As an interim measure, in order to reduce operating costs and conserve cash, the
Company developed a plan in March 1999 to close approximately 25% of its
underperforming FunCenters by the end of the second quarter of 1999, including
some FunCenters that were renovated in connection with the Turnaround Plan.
Historically, the cash necessary to fund the Company's working capital,
operating losses and capital expenditures has been provided by debt or equity
financing. However, the Company has only a minimal amount of borrowing
availability under its Revolving Credit Facility and is severely restricted in
its ability to obtain additional debt or equity financing. On February 8, 1999,
the Company engaged the investment banking firm of Ladenburg, Thalmann & Co. to
assist it in raising additional capital and exploring other strategic
alternatives, including possible investments by one or more strategic partners
or other investors. If the Company is unable to obtain additional debt or equity
financing or arrange a sale of the Company or substantially all of its assets in
the near future, it will have to seek bankruptcy protection. See "Management's
discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
In addition, in their report on the Company's consolidated financial
statements set forth in this annual report, Ernst & Young LLP stated that the
Company's continued operating losses and its need for additional capital to
continue funding operations and meet its obligations as they become due raises
substantial doubt about the Company's ability to continue as a going concern.
History
The Company was founded in 1989 and grew from 28 locations in 1991 to a
peak of 347 locations in 1994. It achieved much of its growth through the
acquisition of its franchisees and other businesses. The Company's rapid
expansion resulted in a loss of control over costs and quality at the store and
corporate levels, which diminished customer service, reduced store operating
margins and caused selling, general and administrative expenses to increase
dramatically. These developments negatively affected the Company's overall
profitability and led to a series of defaults under the Company's primary credit
facility in late 1995 and early 1996. On March 25, 1996, Discovery Zone, Inc.
and all of its domestic subsidiaries filed voluntary petitions for relief under
Chapter 11 of the U.S. Bankruptcy Code. The Company operated under Chapter 11
from March 25, 1996 through July 29, 1997.
During the Company's reorganization under Chapter 11, Birch Holdings,
L.L.C. and its affiliates (collectively, "Birch") and certain unrelated entities
acquired a controlling interest in the Company. Birch recruited a new management
team with backgrounds in the entertainment and consumer marketing industries
and, with these managers, developed a new business strategy for the Company. In
connection with its July 1998 financing, the Company was required by the
investors, to hire a new chief operating officer or a consulting firm approved
by them. See "Business--Financing Arrangements." Accordingly, in August 1998,
the Company retained Carl Marks
3
<PAGE>
Consulting Group, LLC and appointed Chet Obieleski, a representative of Carl
Marks, as the Company's Chief Operating Officer. Scott W. Bernstein, the
Company's President, Chief Executive Officer and a director of the Company,
resigned on November 27, 1998, and Mr. Obieleski assumed the additional
positions of President and Chief Executive Officer. In addition, the Company's
board of directors elected Mr. Obieleski as a director to fill the vacancy
created by Mr. Bernstein's resignation.
Turnaround Plan
Since emerging from bankruptcy, the Company has pursued a new business
strategy, or "Turnaround Plan." The Turnaround Plan is designed to revitalize,
reposition and restore the Company's core business and improve profitability by:
o implementing a broad cost reduction program;
o rebuilding corporate infrastructure and operating
capabilities;
o adding in-store programs featuring entertainment activities
and broader product offerings; and
o refocusing the Company's marketing strategy.
Cost Reduction Program
Closing or Sale of Unprofitable Stores. Beginning in 1995 and
continuing through 1998, the Company implemented a broad cost reduction program
to reduce its expenses relative to revenues and to increase efficiency. This
program resulted in the closing or sale of approximately 140 FunCenters that
were either unprofitable or determined to be unlikely to contribute to future
profits because of uneconomic leases, unfavorable demographics, undesirable size
or market saturation. The Company has now decided to close approximately 50
under-performing FunCenters. See, "Properties -- FunCenter Closure Plan."
Other Cost Reduction Measures. The Company also implemented several
initiatives to reduce annual overhead expenses, including:
o a substantial reduction in corporate and regional management
personnel and related corporate support expenditures;
o the introduction of standard labor planning, purchasing and
inventory control systems;
o changes in game food and beverage operations and vendors;
o a revised birthday party reservation process and risk
management programs; and
o renegotiated store leases with more favorable terms.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Results of Operations."
The Company also established an incentive-based compensation plan tied
to store profitability and service quality measures for its FunCenter and
regional managers to create a stronger sense of ownership and accountability and
to build support for the Company's business strategy.
Product Improvements
Since emerging from Chapter 11, the Company began an extensive
FunCenter renovation program designed to broaden its entertainment offerings,
upgrade its facilities and give such facilities a "new look" consistent with
Discovery Zone's brand repositioning campaign. These renovations typically
included the addition of designated areas for laser tag, arts and crafts, Kids
Karaoke and promotional activities. Through 1998, the Company renovated
approximately 60% of its FunCenters. These renovations were more costly and took
longer to complete than originally anticipated and, due to a lack of funds, the
Company has stopped making any further
4
<PAGE>
renovations. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity."
The Company has created a series of regularly changing activities and
events tied to major entertainment offerings and consumer products that appeal
to children. Laser tag has been themed to the motion pictures and animated
television series "Men in Black" and "Godzilla." In 1998, the Company offered a
hockey skills promotion with the National Hockey League and CCM, a leading
hockey equipment manufacturer, as well as a promotional theme tied to the motion
picture "Lost in Space." During the second half of 1998, the Company conducted a
series of promotions with Fox Kids Worldwide. See "Business -- New Marketing and
Entertainment Strategy."
During 1998 the Company made significant improvements in its game
operations, reducing the average downtime for its games from approximately 30%
in the first quarter of 1999 to 10% in the fourth quarter of 1998 and introduced
a number of revised operating procedures to improve the profitability of its
game operations. Based on a series of tests conducted during 1998, the Company
purchased or leased approximately 700 new games in late 1998. See "Recent
Developments."
In 1997, the Company entered into marketing and product agreements with
Pizza Hut and Pepsi. These agreements provide for joint promotions and, the
Company believes, increase the appeal and quality of its food service
operations. Approximately 80% of FunCenters offer Pizza Hut products. The
Company recently expanded its selection of menu items with new offerings that it
believes will increase appeal to adults. See "Recent Developments."
In addition to the promotional agreements referred to above, during
1997 and 1998, the Company entered into promotional arrangements with Fox Kids
Worldwide, Cartoon Network, Hasbro, Columbia Tri-Star, New Line Cinema, the
Worldwide Wrestling Federation, Welches, Oscar Meyer and the Nabisco Foods
Group. Due to its national market presence and the strength of its brand name,
the Company believes that it has the ability to act as a platform for other
promotional and product "tie-ins" with children's entertainment and consumer
product companies, which should give the Company access to a wide variety of
joint marketing, cross-promotional and in-store entertainment opportunities. The
Company believes that such alliances provide significant marketing support and
themed based promotions to periodically refresh its product offerings and to
stimulate repeat customer visits on a cost-effective basis.
The Company has also sought to increase revenue by better utilizing its
existing facilities. To increase weekday visits, the Company developed
interactive parent-child play programs for preschoolers in 1997. These programs
offer tumbling, climbing, exercising and singing and are now being offered under
the "Discovery Zone University" and "DZU" brand names. During 1998, these
weekday programs were available in approximately 25 FunCenters. The Company does
not currently intend to expand these programs beyond the locations currently
offering them.
Marketing and Entertainment Strategy
Since mid-1997, the Company has implemented a new marketing strategy
consisting of several components:
o Reposition and relaunch "New DZ" brand -- The Company is
reintroducing itself as the "New DZ." Through a combination of
local and national public relations efforts and a revised
advertising campaign, the Company is repositioning itself from
a children's indoor playground to a children's entertainment
center.
5
<PAGE>
o Reorient marketing to regional and local focus -- The Company
is refocusing its marketing efforts on local and regional
marketing and advertising programs with a national "overlay."
o Form strategic marketing partnerships -- The Company has
established cross-promotional alliances with local and
regional businesses, such as supermarkets, convenience stores
and malls, as well as national promoters in the toy,
television, film and consumer product industries.
As part of its ongoing marketing efforts, the Company's strategy is to
target both kids and parents. The core target is ages 6 to 11 and is the primary
focus of in-store entertainment programs. Separately, a specific programming
calendar will be aimed at the younger children, called "DZ Jr." Given the strong
interest and efforts of entertainment companies in both of these markets, the
Company believes this strategy will create broader tie-in opportunities.
Additionally, the Company advertises both its core products and its birthday
party business.
Financing Arrangements
Upon emerging from Chapter 11, the Company issued 85,000 units (the
"1997 Units") consisting of $85.0 million aggregate principal amount of its 13
1/2% Senior Secured Notes due 2002 (the "1997 Notes") and 85,000 warrants (the
"1997 Warrants") to purchase an aggregate of 805,154 shares of the Company's
common stock at an exercise price of $.01 per share. The Company also issued
$15.0 million in convertible preferred stock, par value $.01 per share (the
"Convertible Preferred Stock"). The net proceeds of the offerings of the 1997
Units and Convertible Preferred Stock totaled $93.8 million, of which the
Company used (i) $45.5 million to repay borrowings, claims and expenses incurred
while under Chapter 11, (ii) $21.6 million to purchase U.S. Treasury Securities
that were placed in escrow and pledged as security for scheduled interest
payments on the 1997 Notes through August 1, 1999 and (iii) the remaining
proceeds of $26.7 million for capital expenditures, working capital and other
general corporate purposes.
On March 31, 1998, the Company entered into a new $10.0 million
revolving credit facility with Foothill Capital Corporation (such facility, as
amended from time to time, the "Revolving Credit Facility"), primarily to
finance working capital and for other general corporate purposes. On December
18, 1998, the Company obtained a $2.5 million increase in the Revolving Credit
Facility through March 15, 1999 at which time the line of credit was reduced to
$12.0 million in accordance with its terms. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
On July 17, 1998, the Company completed a $29.5 million financing from
the offering of three series of units (collectively, the "1998 Unit Offerings"):
the 1998 Note Units, the Series A Preferred Stock Units and the Series B
Preferred Stock Units.
o The 1998 Note Units consist of: (i) $20.0 million aggregate
principal amount of 13 1/2% Senior Collateralized Notes due
2002 (the "1998 Notes"), (ii) 340,000 warrants (the "Series A
1998 Note Warrants") to purchase an aggregate of 601,585,205
shares of common stock at an exercise price of $.00017 per
share and (iii) 340,000 redeemable warrants (the "Series B
1998 Note Warrants") to purchase an aggregate of 265,405,238
shares of common stock at an exercise price of $.00017 per
share.
o The Series A Preferred Stock Units consist of: (i) $2.0
million stated value of the Company's 14 1/2% Series A Senior
Cumulative Preferred Stock (the "Series A Cumulative Preferred
Stock") and (ii) 80 warrants (the "Series A Preferred Unit
Warrants") to purchase an aggregate of 170,533,397 shares of
common stock at an exercise price of $.00017 per share.
o The Series B Preferred Stock Units consist of: (i) $8.5
million stated value of the Company's 14 1/2% Series B Junior
Cumulative Preferred Stock (the "Series B Cumulative Preferred
Stock")
6
<PAGE>
and (ii) 340 warrants (the "Series B Preferred Unit Warrants")
to purchase an aggregate of 724,766,937 shares of common stock
at an exercise price of $.00017 per share.
Collectively, all of the warrants issued in the 1998 Unit Offerings
entitle the holders thereof to purchase an aggregate of 99.6% of the Company's
common stock on a fully diluted basis, before giving effect to the issuance of
options under the Company's Stock Incentive Plan.
The 1998 Unit Offerings resulted in net proceeds to the Company of
approximately $27.0 million after costs and expenses which the Company used (i)
to repay outstanding borrowings under the Revolving Credit Facility, (ii) 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 1998 Notes through
August 1, 1999, and (iii) for working capital, capital expenditures and other
general corporate purposes, including the payment of expenses previously
incurred in connection with the Company's renovation program. In addition,
shares of Convertible Preferred Stock with an aggregate stated value of $1
million were tendered to the Company as part of the consideration paid for the
Series A Preferred Stock Units, which shares were thereupon canceled by the
Company.
Industry Overview
Demographics
There are more than 54 million children under the age of 13, with
approximately 35 million children between the ages of five and 13. "Baby Boomer"
families (parents born between 1946 and 1965) are expected to contribute to an
increase in DZ's target market over the next four years. By the year 2000, there
are expected to be approximately 55 million children under the age of 13,
including approximately 36 million between the age of five and 13 (representing
annualized growth rates for these groups of approximately 0.2% and 0.4%,
respectively).
U.S. POPULATION BY AGE GROUP
(IN THOUSANDS)
UNDER 5 5-13 TOTAL UNDER 13
1995 19,591 34,384 53,975
2000 18,987 36,043 55,030
2005 19,127 35,850 54,977
2010 20,012 35,605 55,617
- - -------------
Source: Mid-range of U.S. Bureau of the Census estimates.
Competition
The Company competes against a wide variety of concepts vying for
family leisure time and entertainment spending. These competing concepts
encompass a broad spectrum of entertainment opportunities, including family
entertainment centers, theme parks, movie theaters and other in-home and out of
home entertainment activities. DZ is part of the children's entertainment center
segment of the industry, which includes admissions-based, or pay-for-play,
recreational and soft play centers that target children ages two to 12.
The pay-for-play children's entertainment center industry is highly
fragmented and consists largely of local "mom and pop" stores, small regional
chains and local non-profit organizations that provide pay-for-play indoor soft
play facilities. The Company believes that it pioneered this concept when it
built its first FunCenter in 1989. Several national competitors, such as Leaps
and Bounds, subsequently emerged, and the Company
7
<PAGE>
purchased many such competitors in an attempt to consolidate the market. The
Company's future revenues will depend, in part, upon its ability to respond to
changes in consumer tastes. The performance of individual FunCenters may be
affected by a variety of local factors such as the location of competing
facilities, labor and employee benefit costs and the availability of experienced
management and hourly employees.
Additional competitors may include The Walt Disney Company, which has a
family entertainment concept in two locations and may open additional store
locations, and Jeepers, which owns and operates 15 large indoor entertainment
centers. DZ also competes to some extent against certain children's themed
restaurant chains, which provide ancillary entertainment offerings and
merchandise in addition to food and do not charge admission fees. Such
competitors include CEC Entertainment, Inc., the operator and franchiser of
approximately 350 "Chuck E. Cheese" restaurants in the United States, and, to a
lesser extent, certain franchisees of McDonald's Corporation and other fast food
chains that operate indoor playgrounds at a number of locations. These
restaurants differ from DZ in that they do not charge for admission and are
focused on food as their primary attraction and source of revenue. Certain of
these competitors have longer operating histories, substantially greater name
recognition and/or more extensive financial, technical, marketing, sales and
distribution resources.
To a more limited extent, the Company competes against indoor/outdoor
family entertainment centers, including theme parks and other themed restaurant
chains. These destinations offer an entertainment experience centered around
attractions such as miniature golf, water rides, go-carts and video arcade
games. Theme parks provide a variety of thrill rides, redemption games and other
entertainment attractions. Such facilities generally require more travel and
have higher prices than FunCenters. Themed restaurants have also expanded in
recent years and include chains such as Planet Hollywood and Rainforest Cafe.
The generally older and/or broader age group focus of each of these concepts and
the differing nature of their product offerings limit the extent to which they
compete against the Company.
Current FunCenter Operations
The FunCenters currently are indoor pay-for-play entertainment centers
for children. Adults are not permitted entry without a child. The Company
encourages the participation of parents and other accompanying adults, and play
equipment is constructed to allow them to play along with their children.
A typical FunCenter is approximately 12,000 to 17,000 square feet and
contains the following special features:
o an indoor playground composed of a series of tubes, slides,
ball bins, climbing mountains, air trampolines, obstacle
courses, ramps, stairs and other devices for crawling,
jumping, running, swinging and climbing;
o a separate area for toddlers but on a smaller scale. In
renovated FunCenters, this area is called the "DZ Jr." play
area. Access to this play area is limited to children under a
specified height, which provides younger children their own,
less boisterous play area;
o food and beverage operations which, in most cases, feature a
selection of Pizza Hut food products and Pepsi beverage
products;
o a game zone, featuring activities and games which children are
awarded tickets for play and, to a more limited extent, video
games. Tickets can be redeemed for a variety of small toys and
prizes;
o three to five party rooms, which can be reserved for birthdays
or other group events. FunCenters offer a variety of packages
that combine a celebration in the party room, including cake
and other
8
<PAGE>
and beverage services, with access to the entire FunCenter and
tokens for use in the game zone for each child attending a
party;
o a redemption counter where awards for games are redeemed, as
well as Discovery Zone apparel, toys and products are sold.
Renovated FunCenters typically also contain the following features:
o A laser tag area called "Laser Adventure," featuring a maze of
interactive targets themed to major entertainment properties;
o An arts and craft room called the "Art Factory," featuring
regularly changing arts and crafts projects;
o A 1,000 to 1,400 square foot promotional area called the
"Cage," featuring a series of changing activities and events.
In certain locations, the game zone has been moved to the
Cage;
o A stage area called "DZ Live," featuring custom DZ Video
programming and kid Karaoke. The stage area represents a
FunCenter focal point where the Company can present public
relation appearances, costume characters, storytelling, puppet
shows, a talent contest and other appearances;
Discovery Zone currently targets children 12-years old and younger,
with the highest concentration of visitors being two to eight-years old. With
its revamped product offerings, it hopes to attract a larger portion of the
six-to eleven-year-old market population.
FunCenters are designed and constructed with an emphasis on safety and
security. At each FunCenter, an identification code is stamped on the hand of
each child and matched at the exit with an identical stamp upon the hand of the
accompanying adult. In addition, the entrance and exit at each FunCenter are
monitored for security purposes. At all FunCenters, play area equipment is
equipped with protective cushions and padding, and "coaches" are available to
assist children through play activities. All FunCenters prohibit smoking and
maintain high cleanliness standards.
FunCenters charge a general admission fee for each child, with prices
ranging from $2.99 to $8.99, depending on age and location. The Company also
offers discounted admission fees for groups and birthday parties. Adults
accompanying children are admitted without charge. Typical hours of operation
for FunCenters extend from 11:00 a.m. to 7:00 p.m., Sunday to Thursday, and
10:00 a.m. to 9:00 p.m. on Friday and Saturday. The Company generates most of
its revenue on Friday through Sunday.
Intellectual Property
The names "Discovery Zone" and "DZ" and the Company's logo are
registered trademarks and service marks in the United States for a variety of
goods and services offered at the FunCenters. The Company has registered and/or
is in the process of registering its names and/or logo in the following foreign
countries: Australia, Belgium, Brazil, Canada, France, Germany, Hong Kong,
Israel, Italy, Japan, Mexico, South Korea, Spain and the United Kingdom. The
Company considers these intellectual property rights material to its business
and actively defends and enforces them.
9
<PAGE>
Insurance
The Company maintains customary insurance coverages, including primary
commercial liability insurance with limits of $1 million per occurrence and $2
million in the aggregate. The Company also maintains umbrella and excess
policies aggregating $100 million per occurrence and in the aggregate, which
policies are available after the Company has paid or become legally obligated to
pay $100,000 or $250,000 per claim, depending upon the policy year. When the
Company's aggregate indemnity and expense amounts in any policy year exceed an
aggregate of $2.5 million, the Company's trailing self-insured retention is
reduced to $10,000 or $25,000 per occurrence, depending upon the policy year.
The Company believes that it carries adequate insurance coverage for its
business activities. However, the Company can give no assurance that such
coverage will prove to be adequate or will continue to be available to the
Company. In addition, if such coverage proves to be inadequate, such event may
have a material adverse effect on the financial condition or results of
operations of the Company. Claims paid to date have been within amounts accrued
by the Company using historical data based on prior experience.
Regulation
The Company is subject to various federal, state and local laws and
regulations affecting operations, including those relating to the use of video
and arcade games, the preparation and sale of food and beverages and those
relating to building and zoning requirements. The Company is also subject to
laws governing its relationship with employees, including minimum wage
requirements, overtime, working and safety conditions and citizenship
requirements. Difficulties or failures in obtaining required licenses or other
regulatory approvals could delay or prevent the opening of a new FunCenter, and
the suspension of, or inability to renew, a license or permit could interrupt
operations at an existing FunCenter.
Employees
At March 30, 1999, the Company had approximately 4,700 full and
part-time employees, including those employed at its corporate headquarters,
regional offices and FunCenters. A typical FunCenter has a staff of between 20
and 40 employees, including managers, counter attendants, coaches and party
hosts, most of whom are part-time. The Company's employees are not represented
by any labor union or covered by a collective bargaining agreement. The Company
believes its relationship with its employees to be good.
10
<PAGE>
ITEM 2. PROPERTIES
As of March 30, 1999, the Company operated 195 FunCenters in 38 states,
Canada and Puerto Rico. The Company also operates two Block Party stores, one of
which was closed on March 30, 1999. See, "FunCenter Closure Plan." Pursuant to
the Company's plan of reorganization, the Company terminated the franchise
agreements related to seven franchised FunCenters. These stores continue to
operate using the Company's trademarks pending completion of alternative
operating arrangements with the franchisees. Approximately 80% of the Company's
FunCenters are located adjacent to, or are part of, major shopping centers or
strip shopping centers. The following chart shows the Company's FunCenters by
location:
Number of Number of
Location Fun Centers Location Fun Centers
- - -------- ------------ -------- -----------
Alabama 4 New Jersey 8
Arizona 1 New Mexico 1
California 19 New York 16
Colorado 4 North Carolina 2
Connecticut 2 Ohio 10
Delaware 1 Oklahoma 3
Florida 10 Oregon 2
Georgia 6 Pennsylvania 9
Hawaii 1 Rhode Island 1
Idaho 1 South Carolina 2
Illinois 5 Tennessee 4
Indiana 8 Texas 19
Iowa 1 Utah 1
Kansas 2 Virginia 8
Kentucky 2 Washington 2
Louisiana 3 Wisconsin 4
Maryland 6 _____
Massachusetts 7 Total United States 188
Michigan 5 Canada 5
Minnesota 2 Puerto Rico 2
Missouri 5 _____
Nevada 1 Total 195
The Block Party Stores are located in
Indiana and New Mexico
The Company owns fifteen of the sites on which the FunCenters operate.
Fourteen of these owned sites are subject to mortgages and security interests
held by McDonald's to secure the McDonald's Rent Deferral Secured Notes, the
McDonald's Note and the Company's future payment obligations under 21 subleases
with McDonald's. During the Company's Chapter 11 reorganization, it delivered
these notes, mortgages and security interests to McDonald's in settlement of
damages suffered by McDonald's as a result of the rejection of certain leases
and the restructuring of a security interest granted to McDonald's in connection
with a prior acquisition. The indebtedness evidenced by the McDonald's Note and
the McDonald's Rent Deferral Secured Notes is referred to as the "McDonald's
Indebtedness." The Company leases all of the remaining FunCenter sites. (See
FunCenter Closure Plan.) The Company believes
11
<PAGE>
that, in most cases, it could find alternative space at competitive market rates
if it were unable to renew the lease for a FunCenter site; however, it would
likely incur significant relocation expenses and capital expenditures as a
result.
The Company holds three parcels of undeveloped land which it intends to
sell. Each of these parcels secures the McDonald's Indebtedness. The proceeds of
sales of collateral securing the McDonald's Indebtedness, if any, will be
applied first to a reduction of principal on the McDonald's Note and then to
principal of the McDonald's Rent Deferral Secured Notes. Future principal
payments on the McDonald's Note will be reduced to the extent of the reduction
of the outstanding principal balance.
During the first quarter of 1999, the Company entered into a contract
for the sale of property in Littleton, Colorado. The Littleton property consists
of two parcels. One parcel is improved with a FunCenter and the other parcel is
unimproved land. This contract provides for the sale of such property for $4.2
million. This $4.2 million will reduce the outstanding principal balance of the
McDonald's Note to approximately $800,000, and reduce the annual debt service on
the McDonald's Note to approximately $130,000 per year. The Littleton sale is
scheduled to close in June 1999. The Company can give no assurance that this
sale will ultimately occur or what the actual price and terms of the sale will
be if it does occur.
The Company leases approximately 10,000 square feet of office space in
the Plantation, Florida area for its finance, purchasing, management information
systems and other administrative functions. The Company also subleases
approximately 6,500 square feet of office space for its executive offices in
Elmsford, New York.
FunCenter Closure Plan
In order to conserve cash available for operations and to continue as a
going concern, the Company developed a plan in March 1999 calling for the
closure of approximately 25% of its FunCenters beginning in April 1999,
including some FunCenters that were renovated in connection with the Turnaround
Plan, and one Block Party facility which closed on March 30, 1999. The Company
did not pay rent in March 1999 on many of the leases for these FunCenters. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital and Resources."
ITEM 3. LEGAL PROCEEDINGS
On March 25, 1996, Discovery Zone, Inc. and all of its domestic
subsidiaries filed voluntary petitions for relief under Chapter 11 with the U.S.
Bankruptcy Court for the District of Delaware.
In November 1996, the Company filed its plan of reorganization with the
bankruptcy court and a related disclosure statement. The bankruptcy court
confirmed the plan of reorganization on July 18, 1997. On July 29, 1997, the
plan of reorganization became effective and the Company emerged from Chapter 11.
Substantially all of the claims against the Company relating to pre-petition
causes of action were discharged on July 29, 1997.
The Company has been sued by DuPont Corporation for $1.3 million.
DuPont alleges that the Company failed to pay for certain renovations to its
FunCenters. The Company has countersued, alleging that it incurred significant
damages as a result of delays for which DuPont was responsible in the
installation of flooring at FunCenters under renovation. The Company has fully
accrued the amount claimed by DuPont as a liability in its financial statements.
The Company is involved in other litigation from time to time in the
ordinary course of its business. In the opinion of the Company, any liability
that may be incurred upon the resolution of certain claims and lawsuits in which
the Company is involved at this time will not, in the aggregate, exceed the
limits of the Company's
12
<PAGE>
insurance policies or otherwise have a material adverse effect upon the
financial condition or results of operations of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its annual meeting of stockholders on December 23,
1998. The following individuals were nominated and elected to serve as
directors: Chet Obieleski, Martin S. Davis, Greg S. Feldman, Jason B. Fortin,
David L. Kass, Scott Johnson, L.G. Schafran, Christopher R. Smith, David Eaton
and Mary McGrath. In accordance with the Company's plan of reorganization, a
committee of pre-petition unsecured creditors of the Company appointed Paul D.
Kurnit to act as their representative on the Company's board of directors. Mr.
Kurnit continued to serve as a director of the Company until he resigned on
February 12, 1999. As of March 30, 1999, no successor has been appointed to fill
the vacancy created by Mr. Kurnit's resignation.
The stockholders of the Company voted on the following matters:
1. Election of Directors. The voting result for each nominee is as
follows:
Name No. of Votes For No. of Votes Withheld
- - ---- ---------------- ---------------------
Chet Obieleski 429,461,316 *
Martin S. Davis 429,461,316 *
Greg S. Feldman 429,461,316 *
Jason B. Fortin 429,461,316 *
David J. Kass 429,461,316 *
Scott Johnson 429,461,316 *
L.G. Schafran 429,461,316 *
Christopher R. Smith 429,461,316 *
David Eaton 429,461,316 *
Mary McGrath 429,461,316 *
2. The Company's 1998 Stock Incentive Plan was approved by a count of:
votes for: 429,461,316
votes against: *
votes abstaining: 0
broker non-votes. 0
- - -----------------
* Less than .01% of shares entitled to vote.
13
<PAGE>
3. The reappointment of Ernst & Young LLP as the Company's independent
accountants was approved by a count of:
votes for: 429,461,316
votes against: *
votes abstaining: 0
broker non-votes: 0
- - -----------------
* Less than .01% of shares entitled to vote.
For further information regarding the foregoing matters submitted to
stockholder approval, see the Company's Proxy Statement on Schedule 14A filed
with the Securities and Exchange Commission on December 14, 1998.
14
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS
At March 30, 1999, there were approximately 1,000 record holders of the
Company's common stock. As of March 30, 1999, there was no established public
trading market for the common stock. The Company did not pay any dividends on
its common stock in 1998 and does not expect to pay any dividends on the common
stock in the future. The Company's ability to pay dividends is limited under the
indentures for the 1997 Notes and the 1998 Notes and its Revolving Credit
Facility.
15
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
The following selected historical financial data of the Company as of
and for each of the years in the three-year period ended December 31, 1996, for
the seven-month period ended July 31, 1997 and as of and for the five-month
period ended December 31, 1997 have been derived from the historical audited
consolidated financial statements of the Company. Historical data are not
necessarily indicative of future results. The financial data presented below
with respect to periods prior to the Company's emergence from Chapter 11 on July
29, 1997 are not comparable to that for periods after such date because of the
application of Fresh Start Accounting with respect to periods after such date.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Fresh Start Reporting." The data set forth below should be read in
conjunction with the discussion under "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the consolidated financial
statements of the Company and the related notes thereto included elsewhere in
this report.
<TABLE>
<CAPTION>
Predecessor Company Successor Company
------------------------------------------------- --------------------------
Seven Months Five Months
Year Ended December 31, Ended Ended Year Ended
----------------------------------- July 31, December 31, December 31,
1994 1995 1996 1997 1997 1998
--------- --------- --------- --------- --------- -----------
(Amounts in thousands except per share and location data)
Statement of Operations Data:
<S> <C> <C> <C> <C> <C> <C>
Total revenue ..................... $ 180,573 $ 259,490 $ 181,725 $ 82,704 $ 49,107 $ 125,870
Cost of goods sold ................ 36,858 50,227 34,276 14,136 7,311 20,310
Store operating expenses(1)(2) .... 97,631 185,587 140,486 60,192 44,189 102,772
Selling, general and administrative
expenses(2) .................... 36,451 58,201 40,779 10,402 10,866 28,043
Loss on Impairment of Assets....... -- -- -- -- -- 41,900
Depreciation and amortization ..... 16,183 31,972 21,876 11,920 9,314 22,431
Restructuring and other charges ... 14,024 372,160 -- -- -- --
--------- --------- --------- --------- --------- -------
Operating loss .................... (20,574) (438,657) (55,692) (13,946) (22,573) (89,586)
Interest income (expense), net .... (5,137) (12,226) (6,277) (3,163) (5,066) (15,596)
Other income (expense), net ....... 2,331 476 (580) 73 (327) 1,250
Minority interest ................. 256 5,162 -- -- -- --
Reorganization items .............. -- -- (21,285) 11,583 -- --
--------- --------- --------- --------- --------- -------
Loss before income tax,
extraordinary item and
cumulative effect of change in
accounting method ............. (23,124) (445,245) (83,834) (5,453) (27,966) (103,932)
Income tax provision (benefit) .... (4,000) 4,000 -- -- -- --
Extraordinary item - gain on
discharge of debt ................. -- -- -- 332,165 -- --
Cumulative effect of change
in accounting method .......... 5,773 -- -- -- -- --
Accrued Dividends on 14.5% Cumulative
Preferred Stock ............... -- -- -- -- -- (711)
Accretion of Convertible and
Cumulative Preferred Stock to
redemption value .............. -- -- -- -- (97) (303)
--------- --------- --------- --------- --------- ---------
Net income (loss) applicable to $ (24,897) $(449,245) $ (83,834) $ 326,712 $ (28,063) $(104,946)
common shareholders ........... ========= ========= ========= ========= ========= =========
Per common share -- basic and
diluted(3):
Loss before extraordinary
item and cumulative effect of
change in method of accounting $ (0.45) $ (8.30) $ (1.45) $ (0.09) $ (7.02) $ (.52)
Extraordinary Gain ................ -- -- -- 5.75 -- --
Cumulative effect of change in
accounting method ............. (0.13) -- -- -- -- --
--------- --------- --------- --------- --------- ---------
Net loss .......................... $ (0.58) $ (8.30) $ (1.45) $ 5.66 $ (7.02) $ (.52)
========= ========= ========= ========= ========= =========
Weighted average number of
common shares outstanding ..... 42,696 54,139 57,691 57,705 4,000 200,230
Other Data:
Cash used in operations ........... $ (4,481) $ (59,103) $ (39,888) $ (10,959) $ (22,457) $ (25,895)
Cash provided by (used in)
investing activities .......... (121,972) (64,562) 3,805 (468) (10,642) (14,293)
Cash provided by (used in)
financing activities .......... 16,162 121,729 33,460 51,493 (1,686) 32,936
--------- --------- --------- --------- --------- ---------
Net cash flows .................... $(110,291) $ (1,936) $ (2,623) $ 40,066 $ (34,785) $ (7,252)
EBITDA(5) ......................... $ (4,391) $(406,685) $ (55,101) $ (15,272) $ (13,259) $ (67,155)
Capital expenditures .............. $ 119,134 $ 51,732 $ 2,672 $ 567 $ 10,642 $ 14,293
Store Data:
Company-owned stores at
period-end(4) ................. 318 321 212 210 207 199
Franchised stores at
period-end(6) ..................... 29 15 7 -- -- --
--------- --------- --------- --------- --------- --------
Total stores at period-end ........ 347 336 219 210 207 199
Operating Ratio:
Ratio of earnings to fixed
charges(7) .................... -- -- -- -- -- --
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
Predecessor Company Successor Company
-------------------------------------- ---------------------------
As of December 31 As of As of
-------------------------------------- December 31, December 31,
1994 1995 1996(8) 1997 1998(9)
--------- ---------- --------- ---------- -----------
(Amounts in thousands, except per share and location data)
<S> <C> <C> <C> <C> <C>
Balance Sheet Data:
Cash and cash equivalents
(unrestriced) ................... $ 7,885 $ 5,949 $ 3,326 $ 8,607 $ 1,355
Restricted cash and investments .... -- -- -- 19,017 10,385
Total assets ....................... 474,686 171,571 125,786 176,591 108,344
Total long-term debt, including
current portion ................. 139,796 240,663 350,072 88,193 105,841
Convertible Preferred Stock ........ -- -- -- 13,897 13,176
Cumulative Preferred Stock ......... -- -- -- -- 10,917
Total stockholders' equity (deficit) 238,963 (180,173) (263,572) 42,255 (62,541)
</TABLE>
- - ----------
(1) Excludes depreciation and amortization and certain unallocated expenses.
(2) Net of $22.2 million, $13.6 million, $0.2 million, $0.0 million, $0.3
million, and $.5 million of capitalized costs related to the Company's
expansion for the years ended December 31, 1994, 1995, 1996, the seven
months ended July 31, 1997, the five months ended December 31, 1997 and
the year ended December 31, 1998, respectively.
(3) Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per
Share, was adopted by the Company in 1997. All periods presented have been
restated to conform to the provisions of SFAS No. 128.
(4) Includes the Block Party Stores.
(5) EBITDA represents net earnings (losses) before interest, income taxes,
depreciation and amortization, other income and expense, including
minority interest and the portion of capitalized lease expense
attributable to interest, change in accounting method, extraordinary item
and unallocated reorganization value. EBITDA is presented here to provide
additional information about the Company's operations. EBITDA is not a
measure of financial performance under generally accepted accounting
principles, or GAAP, and should not be considered as an alternative to (i)
net income (loss) as a measure of performance (or any other measure of
performance under GAAP) or (ii) cash flows from operating, investing or
financing activities as an indicator of cash flows or as a measure of
liquidity.
(6) The Company rejected or terminated its arrangements with all franchises on
or prior to the Effective Date.
(7) For purposes of this item, "fixed charges" represent interest, the
interest element of rental expense, capitalized interest and amortization
of debt issuance costs, and "earnings" represent income (loss) before
income taxes, extraordinary items, cumulative effect of change in
accounting method and fixed charges. Earnings were insufficient to cover
fixed charges by $23.1 million, $445.4 million, $83.8 million, $5.5
million, $28.0 million and $103.9 million in each of the years ended
December 31, 1994, 1995 and 1996, the seven months ended July 31, 1997,
the five months ended December 31, 1997 and the year ended December 31,
1998, respectively.
(8) Includes certain claims and other liabilities totaling $344.1 million as
of December 31, 1996, which were restricted or extinguished in connection
with the plan of reorganization.
(9) Based upon an independent appraisal of the fair market value of the equity
interests in the Company, which concluded that the 1998 Note Warrants and
the Series A and B Preferred Unit Warrants have no or a nominal value, the
Company has allocated $100,000 of the gross proceeds of the offering of
the 1998 Note Units to the 1998 Note Warrants and has allocated 100% of
the gross proceeds of the offering of the Series A and Series B Preferred
Stock Units to the Cumulative Preferred Stock. The Company cannot give any
assurance that such allocations will be indicative of the prices at which
such securities may actually trade.
17
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Overview
The Company owns and operates pay-for-play children's entertainment
centers in North America, with a national network of 195 FunCenters in 38
states, Puerto Rico and Canada targeted at children ages two to 12 and two Block
Party Stores which target adult customers. See, "Business -- Properties --
FunCenter Closure Plan."
The Company generates revenue primarily from the operation of the
FunCenters. FunCenter revenues are derived from admission charges, food and
beverage sales, redemption game and other concession revenue, and birthday party
fees. The Company's revenues are subject to significant quarterly variations
based upon several factors, including seasonal changes in weather, holidays and
the school calendar. The Company experienced negative comparable store sales
while operating in Chapter 11 and this trend has continued through March 1999.
See "Recent Developments."
Since emerging from bankruptcy in July 1997, 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 weekdays and other off-peak times. The Turnaround Plan consists of a
number of cost-cutting and revenue enhancing initiatives, including an extensive
FunCenter renovation program designed 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 1998, the
Company had renovated approximately 80% of the FunCenters. The renovations
enable FunCenters to offer new products that have been developed by the Company
in conjunction with the Company's entertainment and promotional partners. The
Company also has converted approximately 90% of its FunCenters to offer Pizza
Hut products. Per customer spending on food increased 35% from the second
quarter of 1997 through the fourth quarter of 1998. While the Company has made
progress in many areas of its operations since emerging from bankruptcy, its
turnaround is taking longer to accomplish and is proving to be more costly than
the Company anticipated. As a result, the Company has yet to generate positive
cash flow from operations and requires additional capital to complete the
turnaround and continue as a going concern. In addition, the Company can give no
assurance that its Turnaround Plan, as currently constituted, will reverse the
declines in revenues and negative operating results that the Company is
continuing to experience.
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. These savings
have been largely offset by increases in rent and other occupancy costs.
The Company's selling, general and administrative expenses include
salaries, corporate and regional management expenses and other administrative,
promotional and advertising expenses.
Comparable store revenues during the fourth quarter of 1998 were down
3.8%, as compared to a decline of 10.3% during the fourth quarter of 1997. For
the twelve months ended December 31, 1998, comparable store revenues declined
2.4%, compared to a 15.6% decline in comparable store revenues for the twelve
months ended December 31, 1997. This decline in comparable store revenues for
1998 consisted of a 1.7% increase in general admission revenues, offset
primarily by decreases in birthday party and game revenues. In 1998, 79 stores
(40.1% of total stores) had increased comparable store revenues as compared to 8
stores (4.1% of total stores) in 1997, and 108 stores (54.8% of total stores)
had increased general admission revenue as compared to 17 stores (8.6% of total
stores) in 1997.
18
<PAGE>
In spite of some limited improvements relative to comparable periods of
the prior year, the Company's revenues in 1998 were less than expected due to
(i) construction delays in completing its FunCenter renovation program and
related business disruptions, (ii) delays in launching certain marketing and
promotional programs, (iii) unseasonably warm and sunny weather in many parts of
the United States, which diminished demand for a variety of indoor entertainment
activities and (iv) price increases. See "Business -- Recent Developments." The
Company is reporting negative EBITDA for 1998 and expects to report negative
EBITDA for the first quarter of 1999. Consequently, the Company sought, and has
obtained, a waiver of two financial covenant defaults related to the month ended
January 1997 under its Revolving Credit Facility.
Currently, the Company does not have, and is not generating from
operations, sufficient cash to meet its obligations as they become due. Due to a
lack of funds, in the fourth quarter of 1998 the Company suspended its
renovation program and stopped making any further renovations to its FunCenters.
Additionally, the Company did not pay rent on certain of its properties in March
1999. As an interim measure, in order to reduce operating costs and conserve
cash, the Company plans to close approximately 25% of its underperforming
FunCenters, including some FunCenters that were renovated in connection with the
Turnaround Plan, by the end of the second quarter of 1999.
Historically, the cash necessary to fund the Company's working capital,
operating losses and capital expenditures has been provided by debt or equity
financing. However, the Company does not have any further borrowing availability
under its Revolving Credit Facility and is severely restricted in its ability to
obtain additional debt or equity financing. On February 8, 1999, the Company
engaged the investment banking firm of Ladenburg, Thalmann & Co. to assist it in
raising additional capital and exploring other strategic alternatives, including
possible investments by one or more strategic partners or other investors. If
the Company is unable to obtain additional debt or equity financing or arrange a
sale of the Company or substantially all of its assets in the near future, it
will have to seek bankruptcy protection. See "Business -- Recent Developments"
and "--Liquidity and Capital Resources."
In addition, in their report on the Company's consolidated financial
statements set forth in this annual report, Ernst & Young LLP stated that the
Company's continued operating losses and its need for additional capital to
continue funding operations and meet its obligations as they become due raises
substantial doubt about the Company's ability to continue as a going concern.
Results of Operations
Upon emerging from bankruptcy, the Company adopted Fresh Start
Accounting. See "-- Fresh Start Reporting." Thus the Company's balance sheets
and statements of income and cash flows after July 29, 1997, reflect a new
reporting Company (the "Successor Company") and are not comparable to periods
prior to the July 29, 1997, which reflect the Company prior to and during its
Chapter 11 reorganization (the "Predecessor Company").
The twelve months ended December 31, 1997 include the results of the
Predecessor Company for the seven months ended July 31, 1997 and the Successor
Company for the five months ended December 31, 1997. The principal differences
between these periods relate to reporting changes regarding the Company's
capital structure and indebtedness and the revaluation of the Company's
long-term assets, which primarily affect depreciation and amortization expense
and interest expense in the Company's results of operations.
Comparison of Years Ended December 31, 1998 and 1997
Revenue. The Company had revenue of $125.9 million in 1998, a decrease
of 4.5% from revenue of $131.8 million in 1997. This decrease in revenue in 1998
consisted of a 2.4% decrease in comparable store sales during 1998 (as compared
to a 15% decline in 1997). The decrease in revenue in 1998 was due to a
reduction in the number of operating FunCenters, from 205 in 1997 to 197 in 1998
as a result of store closings, and a 14.5% decline in comparable store
attendance from 1997, offset in part by increases in general admission prices in
renovated Fun Centers and improvements in in-store spending for food and games.
The decrease in revenue in 1998 was also offset in part by $1.7 million in
additional sponsorship revenue.
Cost of Goods Sold. Cost of goods sold, which consists primarily of the
cost of food, redemption merchandise and other product sales, was $20.3 million
for 1998 and $21.4 million for 1997. As a percentage of revenue, cost of goods
sold declined from 16.3% in 1997 to 16.1% in 1998. This reduction was
attributable primarily to simplified product offerings, improved cost management
and lower costs associated with the 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, decreased from
$104.4 million ($104.2 million before GAAP Rent Adjustments (defined below)) in
1997 to $102.8 million ($101.2 million before GAAP Rent Adjustments) in 1998. As
a percentage of total revenue, store operating expenses increased from 79.2% in
1997 to 81.6% in 1998. This increase was attributable to lower comparable
revenues and 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 1998, store operating expenses included certain nonrecurring
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
19
<PAGE>
advertising expenses, increased from $21.3 million in 1997 to $28.0 million in
1998. This increase was attributable primarily to an increase in sales and
marketing programs associated with the Company's revitalization plan and to
increases in general and administrative costs in 1998 compared to 1997.
Depreciation and Amortization Expense. Depreciation and amortization
expenses increased from $21.2 million in 1997 to $22.4 million in 1998. During
the 1998 period this expense reflected depreciation and amortization expense
related to an increase in the carrying value of the Company's trademarks,
property and equipment as a result of its adoption of Fresh Start Accounting for
the Successor Company.
Other Charges; Loss on Impairment of Assets. The Company recorded a
$41.9 million loss on impairment of assets consisting of a $35.5 million
reduction in the carrying value of certain property and equipment and a $6.4
million reduction in the carrying value of certain trademark assets pursuant to
SFAS No. 121 "Accounting for the Impairment of Long Lived Assets to be Disposed
of" primarily related to the Company's FunCenter Closure Plan.
Interest Expense. Interest expense increased from $9.3 million in 1997
to $16.6 million in 1998. This increase was due to the issuance of the 1998
Notes in July 1998 and due to the fact that 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.
Interest Income. Interest income decreased from $1.1 million in 1997 to
$1.0 million in 1998. The decrease was due to lower balances in restricted cash
and investments accounts (the interest escrow accounts established in connection
with the Company's note offerings) in 1998 versus 1997.
Other, net. The Company recorded $2.8 million of other income from a
revision in the estimate of accrued Prepetition Tax Claims due to settlements
during the claim resolution process. This was offset by $1.0 million of other
expense from the accrual of future rent expense from unused equipment leases
incurred in conjunction with the Company's renovation program and $.7 million of
net losses from the disposal of certain assets.
Reorganization Items. Reorganization items of $11.6 million (increase
to income) were incurred by the Company during 1997 in connection with its
reorganization under Chapter 11. Included in reorganization items for 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, offset by losses on assets associated with the closing
of FunCenters, the write-off of deferred financing costs on certain pre-petition
indebtedness, $6.2 million incurred for professional fees and other expenses
associated with the Company's plan of reorganization.
EBITDA. The Company reported negative EBITDA for 1998 of $23.7 million,
before reorganization and non-cash GAAP rent adjustments which were affected by
Fresh Start Accounting ("GAAP Rent Adjustments"), and $25.3 million after such
adjustments, compared to negative EBITDA of $15.1 million before such
adjustments, and $15.3 million after such adjustments, for 1997. This decline
was attributable primarily to lower revenues during 1998 as compared to 1997 and
increased expenditures for sales and marketing programs.
Comparison of Years Ended December 31, 1997 and 1996
The twelve months ended December 31, 1997 include the results of the
Predecessor Company for the seven months ended July 31, 1997 and the results of
the Successor Company for the five months ended December 31, 1997. The principal
differences between the periods relating to the Predecessor Company, on the one
hand, and periods relating to the Successor Company, on the other hand, relate
to reporting changes regarding the Company's capital structure and indebtedness
and the revaluation of the Company's long-term assets, which primarily affect
depreciation and amortization expense and interest expense in the Company's
results of operations.
Revenue. The Company had revenue of $131.8 million in 1997, a decrease
of 28% from $181.7 million in 1996. This decrease resulted primarily from a
decrease in the number of FunCenters in operation and a reduction in average
sales per FunCenter. In connection with the Company's reorganization, the
Company has closed or sold 130 underperforming stores. See "Business -- Cost
Reduction Program." The decrease in same store average sales per FunCenter of
approximately 15% was due primarily to disruptions in the business associated
with the Company's bankruptcy and a lack of new attractions at the FunCenters.
During the fourth quarter of 1997, revenues were also negatively impacted as the
Company temporarily closed stores and discounted admission prices as part of its
renovation program.
20
<PAGE>
Cost of Goods Sold. Cost of goods sold was $21.4 million in 1997 and
$34.3 million in 1996. As a percentage of revenue, cost of goods sold declined
from 18.9% in 1996 to 16.3% in 1997. This percentage reduction was primarily
attributable to simplified product offerings, better cost management and,
beginning in the fourth quarter of 1997, lower costs associated with conversion
to a new food and supply vendor. The decline in actual dollars also was due, in
part, to a lower number of FunCenters operating in 1997.
Store Operating Expense. Store operating expenses were $104.4 million
in 1997, compared with $140.5 million in 1996. As a percentage of total
revenues, store operating expenses increased from 77% in 1996 to 79% in 1997.
The increase as a percentage of revenue was attributable to the decline in
revenues during 1997. The $36.1 million reduction in store operating expenses
is primarily attributable to the implementation of labor planning, lower rent
from renegotiated leases, reductions in central reservation expenses and other
cost savings generated through the Company's cost reduction program and store
closings. During the five months ended December 31, 1997, store operating
expenses included certain non-recurring costs resulting from training and
start-up expenses for new product offerings and renovation program disruptions
to FunCenter operations.
Selling, General and Administrative Expense. Selling, general and
administrative expenses were $21.3 million in 1997, a decrease of 47.8% from
$40.8 million in 1996. As a percentage of revenue, selling, general and
administrative expenses declined from 22% in 1996 to 16% in 1997 despite a 28%
reduction in revenue. This decrease reflected a reduction in corporate staff and
related expenses, and marketing expenses as part of the Company's cost reduction
program, combined with a general reduction in spending due to the lower number
of FunCenters in operation during 1997.
Depreciation and Amortization Expense. Depreciation and amortization
expense was $21.2 million in 1997, a decrease of 3% from $21.9 million in 1996.
The decline resulted primarily from the reduction in the number of FunCenters in
operation, offset by an increase during the five months ended December 31, 1997
attributable to an increase in the carrying value of the Company's plant and
equipment as a result of adopting Fresh Start Accounting for the Successor
Company.
Interest Expense. Interest expense was $6.1 million during the five
months ended December 31, 1997 for the Successor Company and $3.2 and $6.3
million, respectively, for the Predecessor Company during the seven months ended
July 31, 1997 and the year ended December 31, 1996. Reported interest for the
Predecessor Company did not include interest on the pre-petition indebtedness,
which was suspended during the Company's reorganization under Chapter 11. Had
these interest costs been accrued, reported interest expenses would have been
$12.4 and $18.2 million, respectively, for the seven months ended July 31, 1997
and the year ended December 31, 1996.
Interest Income. The Company reported interest income of $1.1 million
during 1997 and $0 in 1996. The increase was due to investment earnings from the
escrowed interest account for the 1997 Notes and short-term investments of the
proceeds of the offering of the 1997 Units and Convertible Preferred Stock in
the exit financing.
Reorganization Costs. Reorganization costs of $11.6 million (increase
to income) and $21.3 million (decrease to income) were incurred by the Company
during its reorganization under Chapter 11 for the years ended December 31, 1997
and 1996, respectively, including $6.2 million and $7.1 million incurred for
professional fees in the 1997 and 1996 periods, respectively. Included in
reorganization items for the year ended 1997 was an increase in net income of
$24,829,000 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 Consolidated 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 Plan of Reorganization.
21
<PAGE>
Liquidity and Capital Resources
The Company does not require significant working capital for inventory
because it uses trade credit to purchase food products and other supplies. The
Company does require cash to fund operating losses and debt service and to
finance capital expenditures to maintain and upgrade its existing stores.
Historically, the Company has met these liquidity requirements primarily through
external financing, including the issuance of debt and equity securities and
borrowings under its credit facilities, as well as through cash generated by
operating activities.
In connection with its 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
and the McDonald's Indebtedness.
Post-Bankruptcy Financings. In July 1997, the Company received net
proceeds of $93.8 million from the offerings of the 1997 Units and the
Convertible Preferred Stock. See "Business -- Financing Arrangements." Of this
amount, the Company used (i) $45.5 million to repay borrowings, claims and
expenses incurred under Chapter 11, (ii) $21.6 million to purchase U.S. Treasury
Securities which were placed in escrow and pledged as security for scheduled
interest payments on the 1997 Notes through August 1, 1999 and (iii) $26.7
million to finance capital expenditures, working capital and other general
corporate purposes.
In March 1998, the Company entered into a $10.0 million Revolving
Credit Facility with Foothill Capital Corporation. The Revolving Credit Facility
bears interest at prime plus 1%, plus certain fees, and initially allowed 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. The indentures for the 1997 Notes and 1998 Notes permit
the Company to incur up to $5.0 million of additional indebtedness under an
eligible credit facility (as defined therein), which could include a $5.0
million increase in the Revolving Credit Facility up to a maximum principal
amount of $15.0 million. On December 18, 1998, the Company obtained a $2.5
million increase in the Revolving Credit Facility through March 15, 1999, at
which time the line was scheduled to be reduced to $12 million in accordance
with its terms.
In July 1998, the Company received net proceeds of approximately $27
million from the 1998 Unit Offerings. See "Business -- Financing Arrangements."
The Company used these net proceeds (i) to repay outstanding borrowings under
the Revolving Credit Facility, (ii) 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 1998 Notes through August 1, 1999 and (iii) for working
capital, capital expenditures and other general corporate purposes, including
the payment of expenses previously incurred in connection with the Company's
renovation program. In addition, shares of Convertible Preferred Stock with an
aggregate stated value of $1.0 million were tendered to the Company as part of
the consideration paid for the Series A Preferred Stock Units, which shares were
then canceled by the Company.
Liquidity. In 1998 and 1997, the Company used cash in operations of
$25.0 million and $27.8 million, respectively, before reorganization items. The
decrease in cash used in operations during 1998 was attributable primarily to
decreases in prepaid expenses and other assets, such as prepaid insurance and
post-petition vendor deposits.
In connection with its renovation program, the Company had incurred or
committed approximately $28 million in capital expenditures for renovations
through December 31, 1998, of which approximately $1.5 million remains unpaid.
These renovations were more costly and took longer to complete than the Company
originally anticipated. Continuing negative operating cash flow in 1998 resulted
in less capital being available for the Company's renovation program. Due to
this lack of funds, the Company stopped making any further renovations to its
FunCenters in the fourth quarter of 1998. This, in turn, has slowed the
implementation of the Company's Turnaround Plan.
22
<PAGE>
Because the Company's operations have not generated positive cash flow
and its renovation program has cost more than expected, the Company requires
additional capital to fund debt service, operating losses and capital
expenditure requirements. However, as discussed below, the Company is severely
restricted in its ability to obtain additional debt or equity financing and
cannot provide any assurance that such additional financing will be obtained.
At December 31, 1998, the Company had an unrestricted cash balance of
approximately $1.4 million. At March 30, 1999, the Company had an overdraft in
unrestricted cash of approximately $(1.0) million. As of December 31, 1998, the
Company had $10.4 million in cash and investments in escrowed interest accounts
for the 1997 Notes and the 1998 Notes. This balance is dedicated to making
scheduled payments of interest on the 1997 and 1998 Notes through August 1,
1999. Thereafter, the Company will have to pay interest on the 1997 and 1998
Notes using cash available from operations, unless it can obtain additional
sources of capital to finance these obligations.
As of December 31, 1998, the Company had $9.4 million of borrowings
outstanding under the Revolving Credit Facility and had an ability to borrow an
additional $3.1 million, subject to a reserve of $150,000 for an outstanding
letter of credit. On March 30, 1999, the Company had $9.93 million of borrowings
outstanding under the Revolving Credit Facility which, together with the
required reserve of $150,000 for an outstanding letter of credit, leaves the
Company with minimal additional borrowing capacity under the Revolving Credit
Facility. The Company is unable to incur significant additional indebtedness
without obtaining the consent of Foothill Capital, as lender under the Revolving
Credit Facility, and holders of the 1997 Notes and 1998 Notes. The Company
cannot give any assurance that it will be able to obtain additional debt
financing. Additionally, even if the Company were able to find a source of
additional debt financing, the Company cannot give any assurance that it would
be able to obtain the required consent from Foothill Capital or holders of the
1997 and 1998 Notes in a timely manner, or at all, in order to incur such
additional indebtedness.
The Company is also limited in its ability to raise additional equity.
The Company has only a limited amount of authorized and unissued shares of
capital stock. If an investor were to propose making a substantial equity
investment in the Company, the Company would need to increase the amount of its
authorized share capital. In connection with the 1998 Unit Offerings, certain
investors in such financing required the Company to amend its Certificate of
Incorporation to provide that, unless representatives of the holders of the 1998
Notes then constitute a majority of the Company's board of directors, the
Company's Certificate of Incorporation cannot be amended without the unanimous
consent of all of the Company's stockholders. Given the large number of
stockholders, this provision effectively bars the Company from increasing its
authorized share capital without first reconstituting its board of directors so
that designated representatives of the holders of the 1998 Notes comprise a
majority of directors. As a result, the Company is significantly restricted in
its ability to obtain additional equity capital.
Due to the deterioration of its financial position, the Company
breached two financial covenants under the Revolving Credit Facility as of
January 31, 1999. On March 31, 1999, the Company again will state in its report
for February 1999 that it is in technical default under the Revolving Credit
Facility with respect to minimum required EBITDA at the store and overall
Company levels for February 1999. Foothill Capital has agreed to waive these
defaults for January and February 1999. On April 30, 1999, the Company expects
that it will state in its report for March 1999 that it will be in technical
default under the Revolving Credit Facility with respect to minimum required
EBITDA at the store and overall Company levels for March 1999. The Revolving
Credit Facility permits a 30-day grace period with respect to such defaults
which will end on May 30, 1999. Under the terms of the Revolving Credit
Facility, the Company may develop and present to Foothill Capital an action plan
to address these defaults which Foothill will consider in deciding whether to
grant another waiver. Unless these defaults are cured or waived, this breach
will constitute an event of default under the Revolving Credit Facility which,
in turn, will trigger an event of default under the indentures governing the
1997 and 1998 Notes and the McDonald's Notes. If such events of default were to
occur, Foothill Capital and the holders of the 1997 and 1998 Notes and the
McDonald's Notes can accelerate such debt. If such acceleration occurs, all
amounts owed under the Revolving Credit Facility, the 1997 Notes and the 1998
Notes and the McDonald's Notes would be declared immediately due and payable and
reclassified as such on the Company's financial statements. In such event, the
Company would not have enough cash to pay such debt and would be forced to seek
bankruptcy protection.
23
<PAGE>
The Company does not have, and is not generating from operations,
sufficient cash to meet all of its obligations as they become due, including
required payments under agreements material to current FunCenter operations. The
Company did not pay rent on certain of its properties in March 1999. As
discussed above, the Company is significantly restricted in its ability, and
likely will not be able, to obtain any additional debt or equity financing. As
an interim measure, in order to reduce operating costs and conserve cash, the
Company plans to close approximately 25% of its FunCenters (primarily
under-performing FunCenters), including some FunCenters that were renovated in
connection with the Turnaround Plan, by the end of the second quarter of 1999.
Additionally, the Company is considering selling certain noncore assets to
provide additional capital for operations. The Company can give no assurance
that it will be able to sell any such assets or obtain additional financing or
other capital in sufficient time to permit the Company to pay its obligations as
they become due. Any failure to pay such obligations as they become due may lead
to, among other things, third parties exercising their contractual and other
legal rights and remedies against the Company and its properties and assets.
Accordingly, in the absence of an immediate sale of all or a substantial portion
of the Company or additional financing (which, in either case, would require
consents or waivers from the Company's lenders), the Company will have no choice
but to seek bankruptcy protection.
In addition, in their report on the Company's consolidated financial
statements set forth in this annual report, Ernst & Young LLP stated that the
Company's continued operating losses and its need for additional capital to
continue funding operations and meet its obligations as they become due raises
substantial doubt about the Company's ability to continue as a going concern.
Potential Sale of the Company. On February 8, 1999, the Company engaged
the investment banking firm of Ladenburg, Thalmann & Co. to assist it in raising
additional capital and exploring other strategic alternatives, including
possible investments by one or more strategic partners or other investors. This
engagement may result in the sale of the Company through a merger, joint
venture, business combination, sale of assets or other similar transaction.
Ladenburg has contacted numerous parties, some of which have expressed interest
in reviewing due diligence materials regarding the Company. Three of these
parties have begun preliminary due diligence reviews. The Company cannot provide
any assurance:
o that any party will offer to purchase the Company or its
assets, or to invest significant capital in the business,
o that required waivers or consents from the Company's lenders
(including Foothill Capital and holders of the 1997 Notes and
the 1998 Notes) can be obtained,
o that any such transaction could be completed without the
Company first seeking bankruptcy protection.
Even if the Company does locate a buyer, given its highly leveraged
capital structure and the restrictions contained in various agreements governing
its debt and equity securities, it is likely that such a buyer would require
that all or substantially all of the Company's existing debt be converted into
equity or otherwise subordinated. Unless the Company's existing lenders agree to
such a conversion, the Company would have no choice but to seek to reorganize
under Chapter 11 of the U.S. Bankruptcy Code in order to complete such a
transaction.
The Company was required by investors in its 1998 Unit Offerings (a) to
enter into a Stockholders' Agreement among the Company, certain of its
stockholders and the Trustee for the 1998 Notes and (b) to amend its Certificate
of Incorporation. Both the Stockholders' Agreement and the amendment to the
Certificate of Incorporation provide that the Company will not, and will not
permit any subsidiary, to
o file for bankruptcy,
o appoint a custodian for all of the Company's assets,
o consent to, or assist in, the institution of a bankruptcy or
insolvency proceeding against the Company, or
o make any general assignment for the benefit of creditors,
unless any of such action has been approved by a unanimous vote of the Company's
board of directors. If this provision is enforceable, the Company would not be
able to seek bankruptcy protection until its board of directors unanimously
approves such action. If the Company fails to pay its obligations as they become
due, the Company's creditors may exercise their contractual and other legal
rights and remedies against the Company. If this occurs and the provisions
described above are determined to be enforceable, delay by the Company's board
of directors in timely
24
<PAGE>
seeking bankruptcy protection could have a material adverse effect on the
Company's financial condition and results of operations.
Seasonality
The Company's FunCenters experience seasonal fluctuations in their
revenues. Higher revenues occur in the first quarter of the year due to the fact
that many FunCenters are located in cold weather regions where children are less
likely to play outside during this time of year. In 1998, the FunCenters
generated 31.7% of their revenue in the first quarter versus 23.7%, 22.8% and
21.8% in the second, third and fourth quarters, respectively. These fluctuations
in revenues are primarily related to the school year and the weather.
Income Taxes
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS No.
109"), issued in February 1992. Deferred income tax assets and liabilities are
determined based on differences between financial reporting and tax bases of
assets and liabilities and are measured using the enacted tax rates and laws in
effect when the differences are expected to reverse. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized as income in the
period that includes the enactment date. A valuation allowance must be
established for deferred tax assets if it is "more likely than not" that all or
a portion of the deferred tax assets will not be realized. At December 31, 1998,
the Company's deferred tax valuation allowance was equal to its net deferred tax
assets because, in management's judgment, it is "more likely than not" that all
of the net deferred tax assets will not be realized.
As a result of its reorganization under Chapter 11, the Company
realized discharge of indebtedness income of $332,165,000. Although this income
is not taxable to the Company for federal or state purposes due to the Company's
insolvency, the Company's net operating loss carryforwards ("NOLs") are reduced
by a corresponding amount. In addition, as a result of the reorganization, the
Company is treated as having experience an "ownership change" under Internal
Revenue Code Section 382. Accordingly, the Company's ability to offset income in
each post-reorganization taxable year by its then remaining NOLs and certain
built-in losses (including depreciation and amortization deductions of any
portion of the Company's basis in assets with built-in-losses) is limited to an
amount not to exceed the aggregate value of the Company's common stock
immediately before the change in control (taking into account the increase in
value resulting from the cancellation of creditors' claims under the Plan of
Reorganization) multiplied by the long-term tax-exempt rate published monthly by
the Internal Revenue Service. At December 31, 1998, the Company's NOLs were
approximately $137 million and the use of approximately $256 million of those
NOLs was limited to approximately $4.0 million per year.
Fresh Start Reporting
The effects of the Company's reorganization under Chapter 11 have been
accounted for in the Company's financial statements using the principles
required by the American Institute of Certified Public Accountants' Statement of
Position 90-7, "Financial Reporting by Entities in Reorganization Under the
Bankruptcy Code" ("Fresh Start Accounting"). Pursuant to such principles, the
Company's assets and liabilities have been restated at "reorganization value,"
which is defined as the value of the entity before considering liabilities on a
going-concern basis following the reorganization and approximates the amount a
willing buyer would pay for the assets of the Company immediately after the
reorganization. The reorganization value for the Company has been determined by
reference to liabilities remaining after the bankruptcy plus the estimated value
of total stockholders' equity of the outstanding shares of the Company's common
stock. The reorganization value of the Company has been allocated to the assets
of the Company in conformity with the procedures specified by Accounting
Principles Board Opinion No. 16, Business Combinations, for transactions
reported on the basis of the purchase method of accounting.
25
<PAGE>
Accounting Pronouncements
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," which is effective for fiscal years beginning after December 15, 1997.
This statement established standards for the reporting and display of
comprehensive income and its components in a full set of general purpose
financial statements. This statement would require that the Company classify
items of other comprehensive income by their nature in a financial statement and
display the accumulated balance of other comprehensive income separately from
retained earnings and additional paid-in capital in the equity section of the
balance sheet. The Company adopted SFAS No. 130 in 1998 which had no material
impact to the Company's financial statement presentation.
Also in June 1997, the FASB issued SFAS No. 131, "Disclosure about
Segments of an Enterprise and Related Information," which is effective for
fiscal years beginning after December 15, 1997. This statement had no impact on
the Company's Financial Statements for 1998, because the Company reviews the
operations of each FunCenter and does not segment its FunCenters into geographic
or product line segments for purposes of management review.
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 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 also has 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.
26
<PAGE>
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 only if it does not complete the upgrades of hardware and
software currently underway before September 30, 1999.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company has determined that the Company's interest rate risk and
foreign currency risk are immaterial to its financial statements.
RISK FACTORS AFFECTING FUTURE OPERATING PERFORMANCE
The Company Does Not Have Sufficient Cash to Meet All of Its
Obligations and Is Significantly Restricted in Its Ability to Obtain Additional
Financing
The Company does not have, and is not generating from its operations,
sufficient cash to meet its obligations as they become due. Historically, the
cash necessary to fund the Company's working capital, operating losses and
capital expenditures has been provided by debt or equity financing. As of March
30, 1999, the Company had an overdraft of $(1.0) million in unrestricted cash
and $1.9 million of borrowing availability under its Revolving Credit Facility,
leaving the Company with minimal additional borrowing capacity. In addition, the
Company is unable to incur significant additional indebtedness without obtaining
the consent of Foothill Capital, as lender under the Revolving Credit Facility,
and holders of the 1997 Notes and 1998 Notes. The Company cannot give any
assurance that it will be able to obtain additional debt financing.
Additionally, even if the Company were able to find a source of additional debt
financing, the Company cannot give any assurance that it would be able to obtain
the required consent from Foothill Capital or holders of the 1997 and 1998 Notes
in a timely manner, or at all, in order to incur such additional indebtedness.
The Company is also limited in its ability to raise additional equity.
The Company has only a limited amount of authorized and unissued shares of
capital stock. If an investor were to propose making a substantial equity
investment in the Company, the Company would need to increase the amount of its
authorized share capital. In connection with the 1998 Unit Offerings, certain
investors in such financing required the Company to amend its Certificate of
Incorporation to provide that, unless representatives of holders of the 1998
Notes then constitute a majority of the Company's board of directors, the
Company's Certificate of Incorporation cannot be amended without the unanimous
consent of all of the Company's stockholders. Given the large number of
stockholders, this provision effectively bars the Company from increasing its
authorized share capital without first reconstituting its board of directors so
that designated representatives of the holders of the 1998 Notes comprise a
majority of directors. As a result, the Company is significantly restricted in
its ability to obtain additional equity capital.
The Company cannot provide any assurance that it will be able to obtain
additional debt or equity financing or consummate a sale of the Company or
substantially all of its assets as described under "Management's Discussion &
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources." Unless in the near future, the Company obtains additional
debt or equity financing or is able to consummate a sale of the Company or
substantially all of its assets, the Company will not be able to pay its
obligations as they become due. This may lead to, among other things, third
parties exercising their contractual and other legal rights and remedies against
the Company and its properties and assets. Such actions would have a material
adverse effect on the ability of the Company to conduct its operations and, in
the absence of additonal financing or a sale of the Company or its assets, the
Company would have no choice but to seek bankruptcy protection See "Management's
Discussion & Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
27
<PAGE>
Potential Acceleration of Outstanding Debt
Due to the deterioration of its financial position, the Company
breached two financial covenants under the Revolving Credit Facility as of
January 31, 1999. On March 31, 1999, the Company again will state in its report
for February 1999 that it is in technical default under the Revolving Credit
Facility with respect to minimum required EBITDA at the store and overall
Company levels for February 1999. Foothill Capital has agreed to waive these
defaults for January and February 1999. On April 30, 1999, the Company expects
that it will state in its report for March 1999 that it will be in technical
default under the Revolving Credit Facility with respect to minimum required
EBITDA at the store and overall Company levels for March 1999. The Revolving
Credit Facility permits a 30-day grace period with respect to such defaults
which will end on May 30, 1999. Under the terms of the Revolving Credit
Facility, the Company may develop and present to Foothill Capital an action plan
to address these defaults which Foothill will consider in deciding whether to
grant another waiver. Unless these defaults are cured or waived, this breach
will constitute an event of default under the Revolving Credit Facility which,
in turn, will trigger an event of default under the indentures governing the
1997 and 1998 Notes and the McDonald's Notes. If such events of default were to
occur, Foothill Capital and the holders of the 1997 and 1998 Notes and the
McDonald's Notes can accelerate such debt. If such acceleration occurs, all
amounts owed under the Revolving Credit Facility, the 1997 Notes and the 1998
Notes and the McDonald's Notes would be declared immediately due and payable and
reclassified as such on the Company's financial statements. In such event, the
Company would not have enough cash to pay such debt and would be forced to seek
bankruptcy protection.
Potential Delay in Seeking Bankruptcy Protection
The Company was required by certain investors in its 1998 Unit
Offerings (a) to enter into a Stockholders' Agreement among the Company, certain
of its stockholders and the Trustees for the 1998 Notes and (b) to amend its
Certificate of Incorporation. Both the Stockholders' Agreement and the amendment
to the Certificate of Incorporation provide that the Company will not, and will
not permit any subsidiary, to
o file for bankruptcy,
o appoint a custodian for all of the Company's assets,
o consent to, or assist in, the institution of a bankruptcy or
insolvency proceeding against the Company, or
o make any general assignment for the benefit of creditors,
unless any of such action has been approved by a unanimous vote of the Company's
board of directors. If this provision is enforceable, the Company would not be
able to seek bankruptcy protection until its board of directors unanimously
approves such action. If the Company fails to pay its obligations as they become
due, the Company's creditors may exercise their contractual and other legal
rights and remedies against the Company. If this occurs and the provisions
described above are determined to be enforceable, delay by the Company's board
of directors in timely seeking bankruptcy protection could have a material
adverse effect on the Company's financial condition and results of operations.
Substantial Leverage and Ability to Service Debt
The Company is highly leveraged. As of March 30, 1999, the Company had
an aggregate of $117.0 million of outstanding debt.
The Company's ability to make scheduled payments of principal and
interest or to refinance its obligations with respect to its debt will depend on
its financial and operating performance, which, in turn, will be subject to
prevailing economic conditions and to certain financial, business and other
factors beyond the Company's control. The Company had negative EBITDA before
extraordinary items and unallocated reorganization value of $33.8 million in
1996, $15.3 million in 1997 and $67.2 million in 1998. After August 1, 1999,
interest on the 1997 Notes and the 1998 Notes no longer will be funded from
payments out of escrow accounts. [See me] The Company cannot give any assurance
that, based on current levels of cash flow from operations, the Company will
have sufficient cash available to pay such interest and other obligations as
they become due. If the Company's cash flow and capital resources are
insufficient to fund its debt service obligations, the Company will be forced to
sell assets, obtain
28
<PAGE>
additional capital, restructure its debt or file for bankruptcy protection. The
Company cannot give any assurance that it will achieve or sustain profitability,
generate positive cash flow or have sufficient capital resources to meet its
debt service obligations, capital expenditure requirements or working capital
requirements. An inability to do so would have a material adverse effect on the
financial condition and results of operations of the Company. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources."
The Company's high degree of leverage could adversely affect the
Company in a number of ways. For example:
o the Company's ability to obtain necessary financing for
working capital, capital expenditures, debt service
requirements or other purposes is limited;
o the Company's level of debt could limit its flexibility in
planning for, or reacting to, changes in its business;
o the Company is more highly leveraged than most of its
competitors, which places it at a competitive disadvantage;
o the Company's degree of indebtedness makes it more vulnerable
to a downturn in its business or the economy generally;
o the terms of the Company's existing and future debt restrict,
and may restrict, the payment of dividends by the Company; and
o a substantial portion of the Company's cash flow from
operations must be dedicated to the payment of principal and
interest on its debt and will not be available for other
purposes.
History of Net Losses
The Company has experienced substantial net losses. Since emerging from
bankruptcy under Chapter 11, the Company incurred a net loss before
extraordinary items of approximately $28.0 million for the five month period
ended December 31, 1997 and $104 million for the year ended December 31, 1998.
The Company expects to incur net losses for the year 1999. As of December 31,
1998, the Company had an accumulated deficit of approximately $132 million. The
Company cannot give any assurance that net losses will cease to occur in future
periods.
Successful Execution of Turnaround Plan
The Company is implementing its business strategy called the Turnaround
Plan. The Turnaround Plan 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. While the Company has completed planned renovations
at 60% of the FunCenters, it has experienced significant delays and cost
overruns in completing the renovation program as originally contemplated. Due to
lack of funds, the Company has stopped making any further renovations to its
FunCenters. The Company cannot give any assurance that the renovation program
will be completed. Full implementation of the Company's business strategy will
require additional capital through either debt or equity financing. See "-- The
Company Does Not Have Sufficient Cash to Meet All of Its Obligations and Is
Significantly Restricted in Its Ability to Obtain Financing."
Full implementation of the Company's business strategy also will
require the successful repositioning of the Company's brand image with its
target customers, which will depend, in part, upon successful marketing and
promotional campaigns, as well as customer acceptance of product changes. Due to
delays and cost overruns in its
29
<PAGE>
renovation program, the Company has selectively deferred some of its marketing
and promotional campaign, which has affected the Company's ability to attract
additional customers. Additionally, as a result of its strategy of developing
promotional events with partners, the Company depends on the success of the
product offerings of its promotional partners to attract customers and increase
visit frequency, which success is largely beyond the Company's control and
subject to unpredictable shifts in consumer tastes. Finally, successful
implementation of the Turnaround Plan will depend upon the Company's ability to
attract and retain qualified FunCenter managers capable of implementing its
revised operating strategy.
The Company experienced negative comparable store sales while operating
in Chapter 11. Since emerging from Chapter 11, the Company has not been
successful increasing attendance and reversing this trend due to a number of
factors including:
o construction delays in its FunCenter renovation program
adversely affected results, particularly during the first
quarter of 1998;
o with respect to renovated FunCenters, construction delays,
combined with poor execution of new product offerings
disrupted store operations, and price increases discouraged
repeat visits;
o financial constraints caused the Company to delay and scale
back certain marketing and promotional programs;
o poor price-to-value relationships in the pricing of the
Company's general admission, birthday party and group sales;
and
o unseasonably warm and dry weather in many parts of the United
States diminished demand for a variety of indoor entertainment
activities.
Accordingly, the Company will require additional capital to continue its
operations. As an interim measure, in order to reduce operating costs and
conserve cash, in March 1999 the Company established a plan to close
approximately 25% of its underperforming FunCenters, by the end of the second
quarter of 1999 including some FunCenters that were renovated in connection with
the Turnaround Plan. Without additional financing, the Company will be required
to seek bankruptcy protection. Even if the Turnaround Plan is fully implemented,
the Company may not be able to reverse comparable store sales and/or earnings
trends. The Company cannot provide any assurance that it will be able to
successfully implement the Turnaround Plan and any failure to do so would
materially adversely effect the Company.
Non-comparability of Financial Information
Information reflecting the results of operations and financial
condition of the Company since it emerged from Chapter 11 on July 29, 1997 is
not comparable to prior periods due to:
o store closings undertaken during the Company's reorganization;
o the replacement of the management team and the restructuring
of the Company's store operations and general and
administrative activities;
o the costs and expenses relating to the Company's bankruptcy
case and the impact of the restructuring or extinguishment of
certain interests and liabilities; and
o the application of Fresh Start Accounting, pursuant to which
the Company's assets have been stated at "reorganization
value," which is defined as the value of the entity (before
considering liabilities) on a going-concern basis following
the reorganization. This valuation approximates the amount a
willing buyer would pay for the assets of the Company
immediately after the reorganization.
30
<PAGE>
Accordingly, there is only limited financial and operating history of the
Company for a potential investor to evaluate. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
Dependence on Key Personnel
The Company's success is dependent upon its senior managers, including:
Chet Obieleski, who is the President, the Chief Executive Officer and the Chief
Operating Officer; Robert G. Rooney, who is the Senior Vice President and the
Chief Financial and Administrative Officer; Sharon L. Rothstein, who is the
Senior Vice President of Marketing and Entertainment; and Jeffrey Sasson, who is
the Senior Vice President of Retail and Corporate Services. The loss of the
services of any such individuals could have a material adverse effect upon the
Company.
Control by Principal Stockholders
The Company's executive officers and directors (and their respective
affiliates) (collectively, the "Principal Stockholders") beneficially own 99.6%
of the common stock. See "Principal Stockholders." The Principal Stockholders,
if voting together, have sufficient voting power to elect a majority of the
Company's directors, exercise control over the business, policies and affairs of
the Company and, in general, determine the outcome of any corporate transaction
or other matters submitted to the stockholders for approval (other than with
respect to a decision to file a petition on behalf of the Company under Chapter
11), such as any proposed amendment to the certificate of incorporation of the
Company, the authorization of additional shares of capital stock, and any
merger, consolidation, sale of all or substantially all of the assets of the
Company, and could prevent or cause a Change of Control of the Company, all of
which may adversely affect the Company.
In addition, in connection with the 1998 Units Offerings, certain
investors in such financing required a Stockholders' Agreement to be entered
into among the Company, the trustee for the 1998 Notes and certain principal
stockholders which own a majority of the Company's outstanding voting capital
stock. The Stockholders' Agreement provides, among other things, that upon the
occurrence of certain events, including an event of default under the indenture
for the 1998 Notes or the filing of an involuntary bankruptcy petition by the
Company's creditors, at the request of the holders of the 1998 Notes, the
Company and such principal stockholders agreed to take appropriate action in
order to reconstitute the Company's board of directors so that individuals
designated by the holders of the 1998 Notes would constitute a majority of the
board of directors. Under a related pledge agreement, the principal stockholders
also pledged their shares of capital stock in favor of the trustee for the 1998
Notes in support of their obligations under the Stockholders' Agreement.
Seasonality
The Company's FunCenters typically experience seasonal fluctuations in
their revenues. Higher revenues generally occur 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 less likely to play outside during this time
of year. In 1998, the Company's FunCenters generated approximately 32% of their
revenue in the first quarter versus 24%, 23% and 21% in the second, third and
fourth quarters, respectively. These fluctuations in revenues are primarily
influenced by the school year and the weather.
Industry Conditions/Competition
The Company competes against a wide variety of concepts vying for
family leisure time and entertainment spending. These competing concepts
encompass a broad spectrum of entertainment opportunities, including family
entertainment centers, theme parks, movie theaters and other in-home and
out-of-home entertainment activities. In particular, the Company competes in the
pay-for-play children's entertainment center industry by targeting its
activities and programming to children ages two to twelve. This industry is
affected by general and local economic conditions, demographic trends and
consumer tastes over which the Company has no control. Consumer tastes, in
particular, are subject to rapid changes which could result in the Company's
activities falling out of favor with its target customers, requiring it to
invest in new equipment for FunCenters. The Company's future revenues will
depend to a significant extent upon its ability to respond to changes in
consumer tastes. The performance of individual FunCenters may be affected by a
variety of factors such as the location of competing facilities, increased labor
and employee benefit costs and the availability of experienced management and
hourly employees.
Competitive market conditions, including the emergence of significant
new competitors, could materially adversely affect the Company's ability to
improve its results of operations. Such new competitors, which may include The
Walt Disney Company (which has a family entertainment concept in two locations
and has announced plans to open additional store locations), and certain
existing competitors have or may have longer operating histories, substantially
greater name recognition and more extensive financial, technical, marketing,
sales and distribution resources. The Company can give no assurance it will be
able to compete successfully against existing and future
31
<PAGE>
competitors or that competitive pressures faced by the Company will not
materially adversely affect its business, operating results and financial
condition.
Limitation on Use of Net Operating Losses and Built-in Losses
The Company was required to reduce its Net Operating Loss carryforwards
("NOLs") as a result of the cancellation of indebtedness pursuant to the
confirmation of the Company's plan of reorganization.
At December 31, 1998, the Company's NOLs were approximately $256
million (after taking into account the reduction due to the cancellation of
indebtedness). As a result of its reorganization under Chapter 11, the Company
is treated as having experienced an ownership change under Internal Revenue Code
Section 382. Thus, the Company's ability to offset income in each
post-reorganization taxable year by its remaining NOLs and built-in losses
(including depreciation and amortization deductions of any portion of the
Company's basis in assets with built-in losses) is limited to an amount not to
exceed the aggregate value of the Company's common stock immediately before such
change in control (taking into account in such calculation, however, any
increase in value resulting from any surrender or cancellation of creditors'
claims in connection with the Plan) multiplied by the long-term tax-exempt rate
published monthly by the Internal Revenue Service. Based on this calculation,
the Company's use of approximately $137 million of these NOLs is limited to
approximately $4.0 million per year as of January 1, 1999, and may be limited
further in the event of subsequent ownership changes under Code Section 382.
32
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
Report of Independent Certified Public Accountants 34
Consolidated Statements of Operations for the year ended December 31,
1998, the five month period ended December 31, 1997, the seven
month period ended July 31, 1997, and the year ended
December 31, 1996 35
Consolidated Balance Sheets as of December 31, 1998 and 1997 37
Consolidated Statements of Cash Flows for the year ended December 31,
1998, the five month period ended December 31, 1997, the seven
month period ended July 31, 1997, and the year
ended December 31, 1996 39
Consolidated Statements of Redeemable Preferred Stock, Common Stock and
Other Equity (Deficit) for the year ended
December 31, 1998, the five month period
ended December 31, 1997, the seven month period
ended July 31, 1997, and the year ended December 31, 1996 41
Notes to Consolidated Financial Statements 42
33
<PAGE>
Report of Independent Certified Public Accountants
Board of Directors and Stockholders
Discovery Zone, Inc.
We have audited the accompanying consolidated balance sheets of Discovery Zone,
Inc. and subsidiaries as of December 31, 1998 and 1997 (Successor Company) and
the related consolidated statements of operations, redeemable preferred stock,
common stock and other equity (deficit), and cash flows for the year ended
December 31, 1998 and five-month period ended December 31, 1997 (Successor
Company), and the seven-month period ended July 31, 1997 and year ended December
31, 1996 (Predecessor Company). Our audits also included the financial statement
schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Discovery Zone,
Inc. and subsidiaries at December 31, 1998 and 1997 (Successor Company) and the
consolidated results of their operations and their cash flows for the year ended
December 31, 1998 and five-month period ended December 31, 1997 (Successor
Company), and the seven-month period ended July 31, 1997, and year ended
December 31, 1996 (Predecessor Company), in conformity with generally accepted
accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly in all material respects the information set forth
therein.
The accompanying consolidated financial statements have been prepared assuming
that Discovery Zone, Inc. will continue as a going concern. As more fully
described in Note 13, the Successor Company has experienced continued operating
losses and management has determined that it will require additional capital to
continue funding operations and meet its obligations as they come due. These
conditions raise substantial doubt about the Successor Company's ability to
continue as a going concern. Management's plans in regard to these matters are
also described in Note 13. The consolidated financial statements do not include
any adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the outcome of this uncertainty.
/s/ ERNST & YOUNG LLP
West Palm Beach, Florida
March 30, 1999
34
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
<TABLE>
<CAPTION>
Successor Company Predecessor Company
---------------------------- ---------------------------
Five Months
Year Ended Ended Seven Months Year Ended
December 31, December 31, Ended December 31,
1998 1997 July 31, 1997 1996
------------- ------------ ------------- -------------
<S> <C> <C> <C> <C>
REVENUE $ 125,870 $ 49,107 $ 82,704 $ 181,725
COST OF GOODS SOLD 20,310 7,311 14,136 34,276
STORE OPERATING EXPENSE 102,772 44,189 60,192 140,486
SELLING, GENERAL AND
ADMINISTRATIVE EXPENSE 28,043 10,866 10,402 40,779
LOSS ON IMPAIRMENT OF ASSETS 41,900 -- -- --
DEPRECIATION AND
AMORTIZATION 22,431 9,314 11,920 21,876
--------- --------- --------- ---------
OPERATING LOSS (89,586) (22,573) (13,946) (55,692)
OTHER INCOME (EXPENSE):
Interest expense (Note 1) (16,647) (6,076) (3,249) (6,277)
Interest income 1,051 1,010 86 --
Other, net 1,250 (327) 73 (580)
--------- --------- --------- ---------
Total other expense, net (14,346) (5,393) (3,090) (6,857)
--------- --------- --------- ---------
LOSS BEFORE REORGANIZATION
ITEMS, INCOME TAX PROVISION,
AND EXTRAORDINARY ITEM (103,932) (27,966) (17,036) (62,549)
REORGANIZATION ITEMS:
Professional fees -- -- (6,164) (7,076)
Loss on asset disposals -- -- -- (8,867)
Unallocated reorganization value -- -- 24,829 --
Other, net -- -- (7,082) (5,342)
--------- --------- --------- ---------
Total reorganization items -- -- 11,583 (21,285)
--------- --------- --------- ---------
LOSS BEFORE EXTRAORDINARY ITEM (103,932) (27,966) (5,453) (83,834)
EXTRAORDINARY ITEM-GAIN ON
DISCHARGE OF DEBT -- -- 332,165 --
--------- --------- --------- ---------
NET INCOME (LOSS) (103,932) (27,966) 326,712 (83,834)
</TABLE>
Continued Next Page
35
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (Continued)
(In thousands, except per share data)
<TABLE>
<CAPTION>
Successor Company Predecessor Company
---------------------------- ---------------------------
Five Months
Year Ended Ended Seven Months Year Ended
December 31, December 31, Ended December 31,
1998 1997 July 31, 1997 1996
------------- ------------ ------------- -------------
<S> <C> <C> <C> <C>
ACCRETION OF REDEEMABLE PREFERRED
STOCK TO REDEMPTION VALUE (303) (97) -- --
ACCRUED DIVIDENDS ON 14.5% CUMULATIVE
PREFERRED STOCK (711) -- -- --
--------- --------- --------- ---------
NET INCOME (LOSS) APPLICABLE TO
COMMON SHAREHOLDERS $(104,946) $ (28,063) $ 326,712 $ (83,834)
Per common share-- basic and diluted:
Loss before extraordinary item $ (0.52) $ (7.02) $ (0.09) $ (1.45)
Extraordinary item-gain on discharge
of debt -- -- 5.75 --
--------- --------- --------- ---------
Net income (loss) $ (0.52) $ (7.02) $ 5.66 $ (1.45)
========= ========= ========= =========
Weighted average number of common
shares outstanding 200,230 4,000 57,705 57,691
========= ========= ========= =========
</TABLE>
The accompanying notes are an integral part of these statements
36
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
Successor Company
-------------------------------------
ASSETS December 31, 1998 December 31, 1997
------------------ -----------------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 1,355 $ 8,607
Restricted cash and investments 10,385 13,036
Receivables, net 842 750
Inventories 2,111 1,739
Prepaid expenses 869 2,289
Current deposits 1387 2,804
--------- ---------
TOTAL CURRENT ASSETS 16,949 29,225
RESTRICTED CASH AND INVESTMENTS -- 5,981
PROPERTY AND EQUIPMENT, net (Note 4) 69,379 112,452
LAND HELD FOR SALE 3,475 3,635
TRADEMARKS, net (Note 4) 11,094 18,900
OTHER ASSETS, net 7,447 6,398
========= =========
TOTAL ASSETS $ 108,344 $ 176,591
========= =========
LIABILITIES AND EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 10,516 $ 13,657
Accrued liabilities 10,602 11,116
Notes payable and short-term borrowings 1,945 304
Senior secured revolving credit facility 9,353 --
Current portion of long-term debt 1,102 1,102
--------- ---------
TOTAL CURRENT LIABILITIES 33,518 26,179
LONG-TERM DEBT 104,739 87,091
OTHER LONG-TERM LIABILITIES 8,535 7,169
</TABLE>
Continued Next Page
37
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED BALANCE SHEETS (Continued)
(In thousands, except share data)
<TABLE>
<CAPTION>
Successor Company
-------------------------------------
December 31, 1998 December 31, 1997
------------------ -----------------
<S> <C> <C>
LIABILITIES AND EQUITY (DEFICIT)
SERIES A CONVERTIBLE PREFERRED STOCK - 1,000 shares authorized, 933 and
1,000 shares issued and outstanding and redemption value of $14,000 and
$15,000 in 1998 and 1997, respectively
13,176 13,897
14.5% CUMULATIVE PREFERRED STOCK - Series A Senior Cumulative
Preferred - 80,000 shares authorized, issued and outstanding, and
Series B Senior Cumulative Preferred - 340,000 shares authorized,
337,101 shares issued and outstanding, liquidation value of $10,400
10,917 --
COMMITMENTS AND CONTINGENCIES
COMMON STOCK AND OTHER EQUITY (DEFICIT):
Common stock - $.00017 par value, 2,400,000,000 shares authorized,
430,333,492 shares issued and outstanding in 1998, and Common
Stock - $.01 Par Value, 10,000,000 shares authorized,
4,000,000 shares issued and outstanding in 1997 73 40
Additional paid-in capital 69,188 70,063
Cumulative translation adjustment 96 118
Accumulated deficit (131,898) (27,966)
--------- ---------
TOTAL COMMON STOCK AND OTHER EQUITY (DEFICIT) (62,541) 42,255
--------- ---------
TOTAL LIABILITIES AND EQUITY (DEFICIT) $ 108,344 $ 176,591
========= =========
</TABLE>
The accompanying notes are an integral part of these statements
38
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>
Successor Company Predecessor Company
------------------------------ -------------------------------
Year Five Months Seven Months
Ended Ended Ended Year Ended
December 31, December 31, July 31, December 31,
1998 1997 1997 1996
------------- ------------- -------------- ------------
<S> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(103,932) $ (27,966) $ 326,712 $ (83,834)
Adjustments to reconcile net income (loss) to net cash
used in operating activities before reorganization
items:
Reorganization items -- -- (11,583) 21,285
Plan administrative payments (151) (5,391) (1,109) --
Extraordinary item-gain on discharge of debt -- -- (332,165) --
Depreciation and amortization 22,431 9,314 11,920 21,876
Amortization of debt discount and other noncash
interest charges 2,450 398 -- 1,383
Provision for bad debts -- -- -- 1,093
Loss on impairment of assets 41,900 -- -- --
Loss on asset disposals 801 -- -- 1,010
Changes in operating assets and liabilities:
Restricted cash 11,447 2,591 -- --
Receivables (92) (42) 630 (831)
Inventories (372) (425) 724 1,998
Prepaid expenses and other assets 2,897 (1,825) (484) (3,757)
Accounts payable (1,392) 4,779 814 8,792
Accrued liabilities (1,095) (1,779) (3,182) (5,193)
Other 133 375 (108) --
--------- --------- --------- ---------
Net cash used in operating activities before
reorganization items (24,975) (19,971) (7,831) (36,178)
Reorganization items: -- -- 11,583 (21,285)
Adjustments to reconcile reorganization items to
cash provided by (used in) reorganization items:
Unallocated reorganization value -- -- (24,829) --
Loss on asset disposals -- -- -- 8,867
Write-off of deferred debt items -- -- -- 4,340
Accrued reorganization expenses (920) (2,486) 10,118 2,615
Proceeds from sale of property and equipment -- -- -- 1,753
--------- --------- --------- ---------
Net cash provided by (used in) reorganization items (920) (2,486) (3,128) 3,710
--------- --------- --------- ---------
Net cash used in operating activities after
reorganization items (25,895) (22,457) (10,959) (39,888)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (14,293) (10,642) (567) (2,672)
Proceeds from sale of property and equipment -- -- 99 6,477
--------- --------- --------- ---------
Net cash provided by (used in) investing activities (14,293) (10,642) (468) 3,805
</TABLE>
39
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(In thousands)
<TABLE>
<CAPTION>
Successor Company Predecessor Company
------------------------------ -------------------------------
Year Five Months Seven Months
Ended Ended Ended Year Ended
December 31, December 31, July 31, December 31,
1998 1997 1997 1996
------------- ------------- -------------- ------------
<S> <C> <C> <C> <C>
CASHFLOWS FROM FINANCING
ACTIVITIES:
Proceeds from 14.5% Cumulative Preferred Stock $ 9,500 $ -- $ -- $ --
Proceeds from Senior Collateralized Notes with
Warrants 20,000 -- -- --
Net proceeds from Senior Secured Revolving Credit
Facility 9,353 -- -- --
Net proceeds from debtor-in-possession credit -- -- -- 22,448
facilities
Net repayment of debtor-in-possession credit
facilities -- -- (22,448) --
Proceeds from Senior Secured Notes
with Warrants -- -- 85,000 --
Proceeds from Redeemable Convertible
Preferred Stock -- -- 15,000 --
Payment of financing costs (2,535) (1,800) (4,569) --
Escrow of restricted cash (2,815) -- (21,608) --
Increase in McDonald's Rent Deferral Note 398 -- -- --
Payment of McDonald's Secured Rejection Note (735) -- -- --
Payment of prepetition tax claims (230) -- -- --
Proceeds from short-term borrowings -- 276 276 7,500
Repayment of short-term borrowings -- (162) (158) (7,500)
Advances from Birch Holdings LLC -- -- 2,500 --
Repayment of advances from Birch
Holdings LLC -- -- (2,500) --
Advances from affiliate, net -- -- -- 10,730
Proceeds from the exercise of options
and warrants -- -- -- 282
--------- --------- --------- ---------
Net cash provided by (used in) financing
activities 32,936 (1,686) 51,493 33,460
--------- --------- --------- ---------
Net increase (decrease) in cash and cash
equivalents (7,252) (34,785) 40,066 (2,623)
Cash and cash equivalents, beginning of period 8,607 43,392 3,326 5,949
--------- --------- --------- ---------
Cash and cash equivalents, end of period $ 1,355 $ 8,607 $ 43,392 $ 3,326
========= ========= ========= =========
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest $ 13,066 $ 3,194 $ 3,340 $ 844
========= ========= ========= =========
Cash paid for professional fees in connection
with Chapter 11 Proceedings $ 1,367 $ 1,331 $ 3,128 $ 5,461
========= ========= ========= =========
Equipment purchased under short-term borrowings $ 1,641 $ -- $ -- $ --
========= ========= ========= =========
</TABLE>
The accompanying notes are an integral part of these statements.
40
<PAGE>
DISCOVERY ZONE, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK, COMMON STOCK
AND OTHER EQUITY (DEFICIT)
FOR THE THREE YEARS ENDED DECEMBER 31, 1998
(In thousands, except share data)
<TABLE>
<CAPTION>
14.5% Cumulative Series A Convertible Additional
Preferred Stock Preferred Stock Common Treasury Paid-In
Shares Amount Shares Amount Shares Amount Shares Amount Capital Warrants
------ ------ ------ ------ ------ ------ ------ ------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 -- -- -- -- 57,535,470 $ 575 (59,545) $(588) $ 291,546 $ 99
Stock issued on exercise
of nonqualified stock
options -- -- -- -- 170,000 2 -- -- 280 --
Cumulative translation
adjustment -- -- -- -- -- -- -- -- -- --
Net loss -- -- -- -- -- -- -- -- -- --
------ ------ ------ ------ ---------- ------- ------ ------- --------- ------
Balance at December 31, 1996 -- -- -- -- 57,705,470 577 (59,545) (588) 291,826 99
Cumulative translation
adjustment -- -- -- -- -- -- -- -- -- --
Cancellation of old
common shares and
elimination of existing
stockholders' equity upon
emergence from bankruptcy -- -- -- -- (57,705,470) (577) 59,545 588 (228,716) (99)
Issuance of Series A
Convertible Redeemable -- -- 1,000 13,800 -- -- -- -- -- --
Preferred Stock
Issuance of new common
shares -- -- -- -- 4,000,000 40 -- -- -- --
Record value of warrants
Issued in connection
with exit financing -- -- -- -- -- -- -- -- 7,050 --
Net income -- -- -- -- -- -- -- -- -- --
------ ------ ------ ------ ---------- ------- ------ ------- --------- ------
Balance at July 31, 1997 -- -- 1,000 13,800 4,000,000 40 -- -- 70,160 --
Accretion of convertible
redeemable preferred
stock to redemption value -- -- -- 97 -- -- -- -- (97) --
Cumulative translation
adjustment -- -- -- -- -- -- -- -- -- --
Net loss -- -- -- -- -- -- -- -- -- --
------ ------ ------ ------ ---------- ------- ------ ------- --------- ------
Balance at December 31, 1997 -- -- 1,000 13,897 4,000,000 40 -- -- 70,063 --
Issuance of 14.5% Cumulative
Preferred Stock 420,000 10,254 (67) (1,000) -- -- -- -- -- --
Accretion of redeemable
preferred stock to
redemption value -- 24 -- 279 -- -- -- -- (303) --
Convert part value
from $.01/share to $.00017 -- -- -- -- -- (39) -- -- 39 --
Record value of warrants
issued in connection
sith issuance of -- -- -- -- -- -- -- -- 100 --
Senior Collaterialized Notes
Stock issued on exercise of
200 Series B Warrants (2,899) (72) -- -- 426,333,492 72 -- -- -- --
Dividends on 14.5%
Cumulative Preferred Stock -- 711 -- -- -- -- -- -- (711) --
Cumulative translation
adjustment -- -- -- -- -- -- -- -- -- --
Net loss -- -- -- -- -- -- -- -- -- --
------- ------- ------ ------- ----------- ------- ------ ------- --------- ------
Balance at December 31, 1998 417,101 $10,917 933 $13,176 430,333,492 $73 -- $ -- $ 69,188 $ --
======= ======= ====== ======= =========== ======= ====== ======== ========= ======
</TABLE>
<TABLE>
<CAPTION>
Retained
Earnings Cumulative
(Accumulated Translation
Deficit) Adjustment
------------ -----------
<S> <C> <C>
Balance at December 31, 1995 $(471,714) $ (91)
Stock issued on exercise
Of nonqualified stock
Options -- --
Cumulative translation
adjustment -- 153
Net loss (83,834) --
---------- ------
Balance at December 31, 1996 (555,548) 62
Cumulative translation -- (30)
Adjustment
Cancellation of old
Common shares and
Elimination of existing
Stockholders' equity upon
Emergence from bankruptcy 228,836 (32)
Issuance of Series A
Convertible Redeemable -- --
Preferred Stock
Issuance of new common
Shares -- --
Record value of warrants
Issued in connection
With exit financing -- --
Net income 326,712 --
---------- ------
Balance at July 31, 1997 -- --
Accretion of convertible
Redeemable preferred
Stock to redemption value -- --
Cumulative translation
Adjustment -- 118
Net loss (27,966) --
---------- ------
Balance at December 31, 1997 (27,966) 118
Issuance of 14.5% Cumulative
Preferred Stock -- --
Accretion of preferred
Stock to redemption
Value -- --
Convert part value
From $.01/share to $.00017 -- --
Record value of warrants
Issued in connection
With issuance of -- --
Senior Collaterialized Notes
Stock issued on exercise of
200 Series B Warrants -- --
Dividends on 14.5%
Cumulative Preferred Stock -- --
Cumulative translation
adjustment -- (22)
Net loss (103,932) --
---------- ------
Balance at December 31, 1998 $(131,898) $(96)
========== ======
The accompanying notes to consolidated financial statements are an integral part of these statements.
</TABLE>
41
<PAGE>
DISCOVERY ZONE, INC>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(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 195 FunCenters in 38 states, Puerto Rico and Canada.
The Company also operates two entertainment centers targeting adult customers,
under the "Block Party" name. (See Note 13.) The accompanying financial
statements present the consolidated financial position of the Company and its
wholly-owned subsidiaries. All material intercompany transactions and balances
have been eliminated in consolidation.
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"). 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").
The 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. As discussed further
in Note 4, the assets and liabilities of the Company were restated as of July
31, 1997 in accordance with SOP 90-7 and therefore, the results of operations
and cash flows for periods prior July 31, 1997 (the "Predecessor Company") are
not comparable to the results of operations and cash flows of the Company
subsequent to emergence from bankruptcy (the "Successor Company").
In accordance with SOP 90-7, the Company did not accrue interest on its
prepetition interest bearing obligations after the Petition Date as it was
unlikely such interest would be paid under the Plan. The amount of such
unaccrued contractual interest during the seven-month period ended July 31, 1997
and the year ended December 31, 1996 was approximately $9,176,000 and
$11,900,000, 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.
Certain amounts in the 1996 and 1997 Consolidated Financial Statements
have been reclassified to conform with the 1998 presentation.
(2) JOINT PLAN OF REORGANIZATION AND EXIT FINANCING
Under the Bankruptcy Code, certain claims against the Company arising
prior to the Petition Date were stayed. In addition, in accordance with the
Bankruptcy Code, the members of the Group sought court approval for the
rejection of certain pre-petition executory contracts and real property leases.
Such lease rejections gave rise to pre-petition claims for damages pursuant to
the Bankruptcy Code. The Group rejected 91 real property leases during 1996 and
4 during 1997.
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 and confirmed by the Bankruptcy Court. The Plan became effective on
July 29, 1997 and the Company emerged from bankruptcy as of that date.
42
<PAGE>
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
prepetition liabilities permitted under the Plan) to equity interests in the
Company and, (iii) cancellation of all of the prepetition equity interests in
the Company, 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 received 4,000,000 shares of Common Stock and Ten Year Warrants
exercisable for 444,444 shares of Common Stock. As a result of the transactions
which occurred on the Effective Date, indebtedness of $332,165,000 was
discharged, resulting in a gain, reflected as an extraordinary item in the
accompanying consolidated statements of operations. This gain is not recognized
for tax purposes to the extent the Company was insolvent at the date of
discharge. However, the Company's net operating loss carryforwards were reduced
by the amount of the gain.
In connection with its emergence from bankruptcy, the Company raised
$100 million through the issuance of $15 million of Convertible Redeemable
Preferred Stock ("Preferred Stock") and $85 million of 13.5% Senior Secured
Notes with Warrants, resulting in approximately $93.8 million of net proceeds to
the Company after deducting related offering costs (the "Exit Financing"). The
proceeds were used to repay debtor-in-possession borrowings incurred while the
Company was under Chapter 11 protection, to pay 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 consolidated financial statements. The Senior Secured Note holders
also received warrants (the "Warrants") to purchase 805,154 shares of Common
Stock at an exercise price of $.01 per share exercisable through August 1, 2007.
A portion of the proceeds from the Senior Secured Notes was allocated to the
Warrants. (See Note 7).
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. 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.
(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS
Cash and Cash Equivalents
The Company considers all highly liquid investments with original
maturities of ninety days or less to be cash and cash equivalents. Such
investments are valued at quoted market prices.
Restricted Cash and Investments
Restricted cash and investments primarily consists of U.S. treasury
securities purchased to fund the Bond Interest Escrow Accounts (See Notes 2 and
5). The securities are stated at cost plus accrued interest which approximates
fair value. Maturity dates of the securities correspond to the periodic interest
dates funded.
Receivables
The Company believes that the carrying amount of accounts receivable at
December 31, 1998 and 1997 approximates the fair value at such date.
43
<PAGE>
Inventories
Inventories, consisting primarily of facility operating supplies, food
and apparel items, are valued at lower of cost (first in, first out) or market.
Property and Equipment
Property and equipment is stated at cost. Depreciation and amortization
expense is provided using the straight-line method over the lesser of the
estimated useful life of the related assets or the lease term, excluding renewal
options. Property and equipment at December 31, 1998 and 1997 consists of the
following (in thousands):
<TABLE>
<CAPTION>
Successor Company
--------------------------
Life in Years 1998 1997
------------- ---- ----
<S> <C> <C> <C>
Land -- $ 8,164 $ 8,164
Building and improvements 20-40 8,196 8,811
Equipment, furniture and fixtures 3-12 48,097 51,318
Leasehold improvements 1-14 67,271 34,896
Computer equipment and software 3-5 4,046 3,778
Construction in progress -- 14,203
-------- --------
130,774 121,170
Less accumulated depreciation and amortization (19,495) (8,718)
Less impairment losses (see below) (41,900) --
-------- --------
Property and equipment, net $ 69,379 $112,452
======== ========
</TABLE>
Depreciation and amortization expense related to property and equipment
was approximately $21,000,000 for the year ended December 31, 1998, $8,718,000
for the five months ended December 31, 1997, $11,920,000 for the seven months
ended July 31, 1997, and $21,876,000 for the year ended December 31, 1996.
Additions to property and equipment are capitalized and include cost to design,
acquire and install property and equipment, costs incurred in the location,
development and construction of new facilities, major improvements to existing
property and direct incremental costs incurred in the development of management
information systems.
The Company has experienced increasing operating cash flow losses
which, along with other events (see Note 13), indicated that
property and equipment related to certain FunCenters may not be recoverable.
Accordingly, management reviewed all property and equipment and trademarks (see
discussion below) for recoverablility in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long
Lived Assets to be Disposed Of," which requires that long-lived assets and
certain identifiable intangibles, to be held and used by an entity, be reviewed
for impairment whenever events or changes in circumstances indicated that the
carrrying amount of an asset may not be recoverable. Certain assets were
determined to be impaired as a result of management's review.
For each FunCenter, the Company tested for impairment by computing an
estimate of future operating cash flows (undiscounted and without interest
charges) and comparing that result to the carrying value of that FunCenter's net
property and equipment. If such sum was less than the carrying value of the
FunCenter's assets an impairment condition was considered to exist. An
impairment loss was recognized to the extent that the carrying amount of those
impaired assets exceeded the fair value of the FunCenter's assets.
The estimate of fair value was determined by either computing the
present value of a FunCenter's estimated future operating cash flows or, for
those FunCenters where continued future operation was unlikely (See Note 13), an
estimate of salvage proceeds was used as fair value. Based upon the analysis
performed, an impairment loss of $35,500,000 relative to property and equipment
was
44
<PAGE>
recognized in the fourth quarter of 1998 and recorded as loss on impairment of
assets in the accompanying consolidated statement of operations for the year
ended December 31, 1998. Management's judgment is necessary to estimate future
operating cash flows. Accordingly, actual results could vary from such
estimates.
Land Held For Sale
The classification of land held for sale at December 31, 1998 and 1997
is based upon management's decision to dispose of certain parcels of undeveloped
land. The land is stated at the lower of historical cost or fair value less
costs to sell. (See Note 9)
Trademarks
Trademarks are stated net of accumulated amortization of approximately
$2,027,000 at December 31, 1998. Trademarks are being amortized on a
straight-line basis over an estimated useful life of 15 years. Amortization
expense related to trademarks was approximately $1,431,000 and $596,000
in 1998 and for the five months ended December 31, 1997, respectively.
As discussed above, the Company conducted a review of its long-lived
assets in accordance with SFAS No. 121 during 1998. To evaluate the
realizeability of its trademarks, the Company used an esimate of its future
undiscounted cash flows over the remaining life of those trademarks in measuring
whether the costs are recoverable. As a result of that review, the Company's
trademarks were determined to be impaired. A comparison of the carrying amount
of those impaired trademarks to an estimate of fair value (determined using
discounted future cash flows) resulted in the recognition of an impairment loss
of $6,400,000 in the fourth quarter of 1998, which has been recorded as loss on
impairment of assets in the accompanying consolidated statement of operations
for the year ended December 31, 1998.
Accrued Liabilities
Accrued liabilities included in current liabilities at December 31,
1998 and 1997 consists of the following (in thousands):
Successor Company
------------------------
1998 1997
---- ----
Bankruptcy administrative claims and
reorganization costs $ 1,895 $ 4,180
Payroll and employee benefits 1,393 1,961
Interest 3,350 2,371
Other 3,964 2,604
-------- --------
Total $ 10,602 $ 11,116
======== ========
Concentrations of Credit Risk
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents
in banks and credit card receivables from credit card transaction processing
companies. The credit risk associated with cash and cash equivalents is
considered low due to the credit quality of the financial institutions.
Earnings (Loss) Per Common Share
In 1997, the Company adopted SFAS No. 128, "Earnings per Share" (EPS).
EPS amounts for all periods presented have been restated, where appropriate, to
conform to the SFAS No. 128 requirements. Earnings (loss) per common share is
calculated based on the weighted average number of common shares outstanding
during the period. Common equivalents outstanding, 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
45
<PAGE>
antidilutive for all relevant periods presented. Shares of Common Stock 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 consolidated statement of operations for
the year ended December 31, 1998 and the five-month period ended December 31,
1997.
Comprehensive Income
SFAS No. 130, "Reporting Comprehensive Income," became effective for
the Company in 1998. SFAS No. 130 establishes standards for reporting and
displaying comprehensive income. The adoption of this statement did not result
in a change in the Company's disclosures.
Segments and Foreign Operations
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information," became effective for the Company in 1998. This statement abandons
the "Industry Segment Approach" in favor of the "Management Approach" for
segment disclosure purposes. The Company conducts business in one operating
segment. The Company determined its operating segment based on the individual
operations that the chief operating decision maker reviews for purpose of
assessing performance and making operation decisions. These individual
operations have been aggregated into one segment because the Company believes
doing so helps users understand the Company's performance and assess its
prospects, the combined operations have similar economic characteristics, and
each operation has similar products, services and customers.
Revenues from the Company's U.S. and foreign operations, which comprise
FunCenters located in Puerto Rico and Canada, totaled approximately $121,502,000
and $4,368,000 for 1998, respectively; $126,880,000 and $4,931,000 for 1997
respectively; and $175,088,000 and $6,637,000 for 1996, respectively. Property
and equipment located in the U.S. and these foreign countries totaled
approximately $65,321,000 and $4,058,000 at December 31, 1998, respectively, and
$110,223,000 and $3,087,000 at December 31, 1997, respectively.
Revenues
Revenue from Company-owned facilities is recognized at the time of
sale. Sponsorship revenue is recorded when earned under sponsorship agreements.
Sponsorship revenue of approximately $2,524,000, $789,000 and $0 was recognized
in 1998, 1997 and 1996, respectively, and has been included in revenues in the
accompanying consolidated statements of operations.
Fair Value of Financial Instruments
The following methods and assumptions were used to estimate the fair
value of financial instruments included in the following categories:
Receivables consist primarily of credit card receivables which are
converted to cash within a short time after sales transactions are completed and
therefore are reported at approximate fair value.
Interest rates and terms for the Secured Rejection Note, and Secured
Rent Deferral Notes were recently negotiated (see Note 7) and are collateralized
by properties owned by the Company which have a fair value greater than these
notes. No significant events have occurred which would indicate the reported
amounts of these debt instruments would differ from fair value.
There is no established market or trading history for the Company's
Senior Secured Notes, the Senior Collateralized Notes, the Series A Convertible
Preferred Stock and the 14.5% Cumulative Preferred Stock. However, due to the
recorded Loss on Impairment of Assets and liquidity issued discussed in Note 13,
the Company believes that the fair value of these securities has been impaired.
Because of the secured position of the Senior Secured Revolving Credit
Facility, the Company does not believe this security is impaired. The carrying
amount of outstanding borrowings under the Senior Secured Revolving Credit
Facility approximates its fair value because the interest rate changes with
market interest rates.
46
<PAGE>
Preferred Stock
The Company's redeemable preferred stock issues (see Notes 2 and 5) are
carried at the net consideration to the Company at time of issuance (fair
value), increased by accrued and unpaid cumulative dividends and periodic
accretion to redemption value using the interest method. Accrued and unpaid
cumulative dividends and redemption accretion is effected by charges against
retained earnings, or, in the absence of retained earnings, paid-in capital.
Advertising Expense
The Company expenses costs of advertisements at the time the
advertisements are first shown or published. Advertising expense for the years
ended December 31, 1998, 1997 and 1996 was approximately $9,754,000, $7,676,000
and $18,095,000, respectively.
(4) FRESH START REPORTING
Upon emergence from its Chapter 11 proceedings, the Company adopted
fresh start reporting pursuant to the provisions of SOP 90-7. Although the
Emergence Date was July 29, 1997, the Company recorded the effects of fresh
start reporting as of July 31, 1997. 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 approximated 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 consolidated
statements of operations and cash flows for the Predecessor Company are not
comparable to the results of operations and cash flows of the Successor Company.
The reorganization value of the Company's common equity of
approximately $70,200,000 was determined by the Company with the assistance of
financial advisors. 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 values of public companies
deemed generally comparable to the operating business of the Company; (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 other analysis 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 as an increase in net income
in the accompanying consolidated statement of operations for the seven month
period ended July 31, 1997. During 1998, the Company completed its allocation of
this reorganization item as required under fresh start reporting, pursuant to
which approximately $19,496,000 of such amount was allocated to the Company's
trademarks and the balance to 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. The accompanying consolidated financial statements and
related footnote disclosure herein have been retroactively adjusted to reflect
the result of the final allocation.
The accumulated deficit of the Company at July 31, 1997 of
approximately $243,234,000, which included the effects of the reorganization
items and the extraordinary gain on discharge of debt, was reclassified to
additional paid-in capital.
The effects of the Plan, the Exit Financing, and fresh start reporting
on the Company's condensed consolidated balance sheet at July 31, 1997 are as
follows (in thousands):
47
<PAGE>
<TABLE>
<CAPTION>
Pre- Discharge Exit Fresh Start Reorganized
Emergence of Financing Adjustments Balance
Balance Sheet Debt (1) (2) (3) Sheet
--------------- ---------- ---------- ------------ -------------
<S> <C> <C> <C> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 2,678 $ (33,811) $ 74,525 $ -- $ 43,392
Restricted cash and investments 134 -- 10,414 -- 10,548
Receivables, net 708 -- -- -- 708
Inventories 1,314 -- -- -- 1,314
Prepaid expenses and other current assets 3,140 -- (569) 697 3,268
--------- --------- --------- ------- ---------
TOTAL CURRENT ASSETS 7,974 (33,811) 84,370 697 59,230
RESTRICTED CASH AND INVESTMENTS -- -- 11,060 -- 11,060
PROPERTY AND EQUIPMENT, net 98,929 -- -- 3,321 102,250
LAND HELD FOR SALE 3,635 -- -- -- 3,635
TRADEMARK, net -- -- -- 19,496 19,496
OTHER ASSETS, net 2,468 443 5,000 (1,592) 6,319
--------- --------- --------- ------- ---------
TOTAL ASSETS $ 113,006 $ (33,368) $ 100,430 $ 21,922 $ 201,990
========= ========= ========= ========= =========
LIABILITIES AND EQUITY (DEFICIT)
LIABILITIES NOT SUBJECT TO
COMPROMISE:
CURRENT LIABILITIES:
Accounts payable $ 7,119 $ -- $ -- $ (1,783) $ 5,336
Accrued liabilities 10,506 (925) 1,630 8,112 19,323
Debtor-in-possession credit facility 30,895 (30,895) -- -- --
--------- --------- --------- ------- ---------
TOTAL CURRENT LIABILITIES 48,520 (31,820) 1,630 6,329 24,659
LONG-TERM DEBT 4,682 5,000 77,950 -- 87,632
OTHER LONG-TERM LIABILITIES (813) -- -- 6,512 5,699
LIABILITIES SUBJECT TO COMPROMISE 344,070 (338,713) -- (5,357) --
CONVERTIBLE REDEEMABLE
PREFERRED STOCK -- -- 13,800 -- 13,800
COMMON STOCK AND OTHER EQUITY
(DEFICIT):
Common stock (Predecessor Company) 577 -- -- (577) --
Common stock (Successor Company) -- -- -- 40 40
Treasury stock (Predecessor Company) (588) -- -- 588 --
Additional paid-in capital 291,925 -- 7,050 (228,815) 70,160
Cumulative translation adjustment 32 -- -- (32) --
Accumulated deficit (575,399) 332,165 -- 243,234 --
--------- --------- --------- ------- ---------
TOTAL COMMON STOCK AND OTHER
EQUITY (DEFICIT) (283,453) 332,165 7,050 14,438 70,200
--------- --------- --------- ------- ---------
TOTAL LIABILITIES AND EQUITY
(DEFICIT) $ 113,006 $ (33,368) $ 100,430 $ 23,934 $ 201,990
========= ========= ========= ========= =========
</TABLE>
(footnotes on next page)
48
<PAGE>
(4) FRESH START REPORTING (Continued)
(1) To record the discharge or reclassification of prepetition obligations
(liabilities subject to compromise) and debtor-in-possession credit
facilities pursuant to the Plan.
(2) To record the Exit Financing and related issuance costs.
(3) To record assets and liabilities at their fair value pursuant to fresh start
reporting and eliminate the existing accumulated deficit.
(5) 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") 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 Secured
Revolving Credit 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)
were used for working capital, capital expenditures and other general corporate
purposes, including 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 two series, has 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. Aggregate cumulative dividends in arrears at December 31, 1998 totaled
approximately $711,000. The New Preferred Stock is nonvoting, although certain
changes to the Company's Certificate of Incorporation may not be made without
the approval of the holders of the New Preferred Stock. These changes include
authorization of new Senior Preferred Stock, increases in authorized shares of
the Cumulative Preferred Stock, or modifications to the rights or privileges of
the holders of the New Preferred Stock.
If the Company completes a primary offering of common stock that
results in net proceeds to the Company of at least $20.0 million, then
simultaneously with the closing of such offering, the Company may convert all or
any portion of the New Preferred Stock into shares of common stock, the value of
which shall be equal to the aggregate liquidation preference of the shares so
converted; provided that (i) the Company pays all accrued and unpaid dividends
on the New Preferred Stock to the date of conversion and (ii) a pro rata amount
of shares of any junior preferred stock shall also be converted.
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. The Series A warrants are exercisable at any time on or after date of
issuance. The Series B warrants are exercisable at any time after December 31,
1999. Unless exercised, the warrants expire August 1, 2007. 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. (See Note 8)
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. The exercise price was satisfied through the tendering of 2,899 shares of
Series B Senior Cumulative Preferred Stock by the holders. At December 31, 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.
(6) DEBTOR-IN-POSSESSION CREDIT FACILITIES
Pursuant to a final Order of the Bankruptcy Court dated May 20, 1996,
the Discovery Zone Group was authorized to enter into a Revolving Credit
Agreement dated April 30, 1996 (the "Revolving Credit Agreement") among
Discovery Zone, Inc., as borrower, the other members of the Group, as
guarantors, and Madeleine LLC ("Madeleine"), as lender. Under the Revolving
Credit Agreement, Madeleine agreed to lend Discovery Zone up to the aggregate
principal amount of $17,000,000, inclusive of a $7,000,000 subfacility for the
issuance of letters of credit. Under the Revolving Credit Agreement, Madeleine
was granted (i) superpriority administrative expense claim status over
administrative expenses of the Group, (ii) first priority liens on and security
interests in all of the Group's owned and subsequently acquired
49
<PAGE>
unencumbered assets, (iii) liens on and security interests senior to any liens
on or security interests in all owned or subsequently acquired unencumbered
assets, other than collateral securing certain permitted liens, and (iv) junior
liens on and security interests in collateral for such permitted liens. The
Revolving Credit Agreement was amended by the First Amendment, dated as of May
28, 1996, which changed certain of the financial covenants contained in the
Revolving Credit Agreement.
In August 1996, the Group requested that Madeleine make available
additional funds to insure the Group sufficient liquidity to timely satisfy
their postpetition obligations during the months of September and October 1996.
By motion dated August 16, 1996, the Discovery Zone Group requested authority
from the Bankruptcy Court to enter into a Second Amendment to the Revolving
Credit Agreement (the "Proposed Second Amendment"), which provided for, among
other things, an increase from $17,000,000 to $20,000,000 in the aggregate
principal amount of the loans available under the Revolving Credit Agreement and
an adjustment to certain of the financial covenants therein.
Both prior to and following the filing of the motion requesting
authority to enter into the Proposed Second Amendment, the Group conducted
discussions with other prospective lenders regarding the provision of additional
financing. These negotiations resulted in a commitment from Perry Partners L.P.
("Perry Partners") to provide financing on substantially the same terms as the
Revolving Credit Agreement, as amended by the Proposed Second Amendment, but up
to the aggregate principal amount of $25,000,000. Because of this opportunity to
obtain additional credit, the Group, with consent of Madeleine, withdrew the
motion requesting authority to enter into the Proposed Second Amendment.
By Order dated October 25, 1996, the Group obtained authority from the
Bankruptcy Court to enter into a Replacement Revolving Credit Agreement (the
"Replacement Credit Agreement"), among Discovery Zone, Inc., as borrower, the
other members of the Group, as guarantors, and Perry Partners, as lender. Under
the Replacement Credit Agreement, Perry Partners agreed to lend the Group up to
the aggregate principal amount of $25,000,000, inclusive of a $7,000,000
subfacility for the issuance of letters of credit. Perry Partners was granted
(i) superpriority administrative expense claim status over administrative
expenses of the Group, (ii) first priority liens on and security interests in
all of the Group's owned or subsequently acquired unencumbered assets, (iii)
liens on and security interests senior to any liens on or security interests in
all owned or subsequently acquired unencumbered assets, other than collateral
for certain permitted liens, and (iv) junior liens on and security interests in
collateral for such permitted liens.
The Replacement Credit Agreement contained covenants similar to those
contained in the Revolving Credit Agreement, as amended by the Proposed Second
Amendment, including, among other things, the maintenance of certain financial
ratios, prohibition against the incurrence of certain additional indebtedness,
and prohibition against dividends. The Group used proceeds made available under
the Replacement Credit Agreement to repay in full all outstanding obligations
under the Revolving Credit Agreement, as amended by the First Amendment, and the
Revolving Credit Agreement, as amended, was terminated. Approximately
$16,250,000 of the $25,000,000 was used to satisfy all obligations under the
Revolving Credit Agreement.
During the fourth quarter of 1996, the Group determined that it would
require an additional $5,000,000 in postpetition financing to satisfy
obligations which would become due and payable during the first quarter of 1997.
By motion dated December 27, 1996, the Group requested authority from the
Bankruptcy Court to enter into a First Amendment to the Replacement Credit
Agreement (the "First Replacement Amendment") pursuant to which the aggregate
principal amount to be advanced to the Group by Perry Partners would be
increased from $25,000,000 to $30,000,000. By interim Order dated December 31,
1996, the amount which the Group was authorized to borrow from Perry Partners
was increased from $25,000,000 to $28,500,000. By final Order dated March 4,
1997, this amount was increased to $30,000,000.
The Replacement Credit Facility required payment of certain fees as
defined in the agreement plus an amount of additional interest to be determined
such that Perry Partners earned an internal rate of return, determined on an
annualized basis, of 21% on all borrowings (which return took into account all
interest and fees). This additional interest was due and payable upon repayment
of the loan.
At July 29, 1997, the Company had outstanding borrowings under the
Replacement Credit Facility of $28,395,000. Interest on those borrowings accrued
at prime plus 3.5% (11.75% at July 29, 1997) payable monthly. At the
50
<PAGE>
Effective Date, additional fees and interest of $821,000 over interest accrued
at the stated rate were owed. Outstanding borrowings under the facility were
repaid upon the Company's emergence from bankruptcy with the proceeds of the
Exit Financing (See Note 2) and the facility was eliminated.
In June and July 1997, the Bankruptcy Court issued orders permitting
the Company to borrow $5,000,000 from Birch as permitted under the existing
Replacement Credit Facility. The facility bore interest at prime plus 3.5% and
required the payment of certain additional fees to Birch at such time as the
Company exited bankruptcy protection. The loan was unsecured; however,
borrowings under the loan agreement had superpriority administrative claim
status with respect to payment of administrative expenses under the Plan. The
Company borrowed $2,500,000 under this facility, which was repaid with interest
and fees of approximately $82,000 upon the Company's emergence from bankruptcy
with the proceeds from the Exit Financing and the facility was eliminated.
(7) LONG-TERM DEBT
Long-term debt at December 31, 1998 and 1997 consists of the following (in
thousands):
Successor Company
-------------------------
1998 1997
---- ----
Senior Collateralised Notes due 2002, net of
unamortized discount of $88(a) $ 19,912 $ --
Senior Secured Notes due 2002, net of
unamortized discount of $5,581 and $6,652 in
1998 and 1997, respectively (b) 79,419 78,348
Secured Rejection Note (c) 3,680 4,416
Secured Rent Deferral Notes (c) 830 429
Prepetition Tax Claims (d) 2,000 5,000
--------- ---------
105,841 88,193
Less current portion (1,102) (1,102)
--------- ---------
Long-term debt $ 104,739 $ 87,091
========= =========
At December 31, 1998, maturities of the Company's long-term debt are as
follows: $1,102,000 in 1999; $1,145,000 in 2000; $1,145,000 in 2001;
$100,561,000 in 2002; $1,634,000 in 2003; and $254,000 thereafter.
(a) In July 1998, the Company issued $20,000,000 of 13.5% Senior
Collateralized Notes due May 1, 2002, (the "Private Senior Collateralized
Notes") and Warrants. The Private 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 Private 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 $2,071,000, consisting of
treasury securities and accrued interest thereon, at December 31, 1998.
The Company consummated an offer to exchange $20,000,000 13.5% Senior
Collateralized Notes due 2002 , (the "Exchange Senior Collateralized
Notes") which have been registered under the Securities Act of 1933
pursuant to a Registration Statement on Form S-4, for the $20,000,000
aggregate principal amount of the outstanding Private Senior
Collateralized Notes (the Private Senior Collateralized Notes together
with the Exchange Senior Collateralized Notes, the "Senior Collateralized
Notes").
The Private Senior Collateralized Notes contain restrictions on additional
indebtedness and cross-default provisions with other obligations of the
Company. (See Notes 8 and 13)
(b) 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
51
<PAGE>
through August 1, 1999. The interest escrow account balance totaled
approximately $8,314,000, consisting of treasury securities and accrued
interest thereon, at December 31, 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. (See
Notes 8 and 13) 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 above
and in Note 5.
(c) In connection with the 1994 acquisition of Leaps & Bounds, Inc ("Leaps &
Bounds") from the McDonald's Corporation ("McDonald's"), the Company,
through a wholly owned subsidiary, received fee simple ownership of
cetain parcels of real property. Each parcel of real property was
encumbered by a mortgage or deed of trust in favor of McDonald's which
served to secure indemnity obligations owed by the Company to McDonald's.
By Order dated November 16, 1996, the Group was granted authority by the
Bankruptcy Court to enter into, and perform under, a stipulation with
McDonald's (the "McDonald's Stipulation") which provided for a global
resolution of issues relating to, among other things, the assumption and
rejection of leases of property where McDonald's is the sublessor and
Leaps & Bounds is the subleasee (the "L&B" Subleases"); rent deferrals
which McDonald's will grant to Leaps & Bounds in respect of certain
assumed L&B Subleases; the treatment of secured claims which McDonald's
holds against the Group arising from the rejection and assumption of the
L&B Subleases, and future rent deferrals to be granted in respect of
certain of the L&B Subleases.
The McDonald's Stipulation provided that Leaps & Bounds assume L&B
Subleases with respect to 21 FunCenters (the "Assumption Locations") and
reject the L&B Subleases with respect to 17 FunCenters, which the Group
also requested the Bankruptcy Court's authority to close. The Group, upon
Leaps & Bounds assuming the L&B Subleases for the Assumption Locations,
cured all unpaid rent and other charges under these subleases pursuant to
section 365(b) of the Bankruptcy Code, which cure payments totaled
approximately $528,000. McDonald's rejection claims related to the 17
closed FunCenters currently totals $4,416,000, and is evidenced by a
six-year note payable requiring annual principal payments of approximately
$735,000 (the "Secured Rejection Note"). The Secured Rejection Note bears
interest at 11% payable annually and matures in the year 2003.
McDonald's also granted the Company rent deferrals (the "Rent Deferrals")
under the L&B Subleases, which are evidenced by nine notes due upon the
expiration of each initial sublease term (the "Secured Rent Deferral
Notes"). The Rent Deferrals currently total approximately $398,000 per
year and, when combined with the initial Emergence Date principal balance
of approximately $266,000, will total approximately $2,840,000 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 December 31, 1998, which are included in Land Held for Sale
in the accompanying 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.
(d) The prepetition tax claims (the "Tax Claims") represent taxes assessed
prior to the Company filing for bankruptcy and had an estimated initial
aggregate principal amount of $5 million. During 1997 and 1998, the
Company has pursued settlement agreements and resolution of the Tax
Claims. Based upon settlements reached with taxing authorities and
estimates of amounts to be paid to settle remaining claims, the Company
reduced the remaining Tax Claim liability to $2 million at December 31,
1998, resulting in a decrease to the 199 net loss of approximately $2.8
million, which has been reflected in other income as an offset to selling,
general and administrative expense in the accompanying consolidated
statement of operations. 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.
52
<PAGE>
(8) SENIOR REVOLVING CREDIT FACILITY
On March 31, 1998, the Company enterered in to a $10 milllion Senior
Secured Revolving Credit Facility (the "Senior Facility") with Foothill Capital
Corporation as permitted under the Senior Secured Notes. The Senior Facility
bears interest at prime plus 1% (8.75% as of December 31, 1998), plus certain
fees, and allows for the Company to borrow 133% of trailing twelve-month
FunCenter contribution (as defined) 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. (See Note 13).
On December 18, 1998, the Senior Facility was amended to allow the
Company to borrow an amount equal to the sum of (i) 150% of the trailing
twelve-month FunCenter Contribution (as defined) of the top 50 perfoming
Funcenters; (ii) 120% of trailing twelve-month FunCenter Contribution (as
defined) of the second 50 top performing FunCenters; and (iii) the lesser of
$1,800,000 or 75% of the adjusted value (as defined) of certain parcels of real
estate. The maximum loan principal was also increased to $12.5 million until
March 15, 1999 and then to $12 million thereafter. In addition to previous
restrictions, the amendment also established certain minimum levels of earnings
(as defined) which the Company must achieve monthly to be in compliance with the
agreement. (See Note 13).
(9) BUSINESS SALES AND DISPOSALS
In February 1996, the Company sold all issued and outstanding stock of
two wholly-owned subsidiaries, I&S Consultants and VLT, Inc., which together
owned and operated The Enchanted Castle, a family entertainment facility located
in Lombard, Illinois for $2,800,000. In March 1996, the Company sold all issued
and outstanding stock of its Wright Entertainment Group subsidiary for
$2,000,000.
During 1996, the Company closed 101 of its indoor entertainment
facilities resulting in a loss on asset disposals of approximately $8,867,000.
Proceeds from sale of property and equipment at these locations totaled
approximately $1,753,000.
In January 1999, the Company sold a parcel of undeveloped land in
Sugarland, Texas for approximately $728,000. As the sales price approximated the
carrying value of the property, no gain or loss was recognized on the sale.
(10) RELATED PARTY TRANSACTIONS
At December 31, 1995, 49.9% of the Company's common stock was owned by
Viacom, Inc. who provided the services of its division, Blockbuster
Entertainment Group ("Blockbuster") , in connection with the overall
coordination and supervision of the business of the Company and the day-to-day
operations and business affairs of the Company under a Management Services
Agreement ("MSA"). The MSA had an initial term of five years and thereafter
could be extended automatically for one year renewal periods unless terminated
by either party on six months' prior notice. In payment for the management
services to be provided under the MSA, the Company was required to pay Viacom a
quarterly fee equal to the actual costs, fees, expenses, and reimbursements of
the services provided, and a fair and reasonable allocation of overhead expenses
incurred by Viacom in providing such services, during the preceding calendar
quarter.
At December 31, 1995, the Company had a $13,215,000 subordinated note
payable to Viacom (the "BFF Note") related to its acquisition of all the assets
of two family entertainment centers operating under the name "Block Party". The
note had a ten-year term and interest accrued at the one-month London InterBank
Offered Rate ("LIBOR") plus .75% and was payable quarterly. Additionally, on
January 12, 1996, the Company received an interim working capital loan of up to
$10,000,000. This loan was guaranteed by Viacom and matured on February 6, 1996.
On February 6, 1996, the Company did not make its scheduled repayment of the
principal or accrued interest on the loan. The outstanding
53
<PAGE>
principal on the loan was $7,500,000. On February 7, 1996, the principal amount
of $7,500,000 and accrued interest was paid to the lender by Viacom.
On the Petition Date, in addition to the principal amount of the BFF
Note, the Company owed Blockbuster/Viacom approximately $12,660,000 in
reimbursements for construction, operating and other costs incurred or paid by
Blockbuster on behalf of the Company, $7,527,000 in repayment of debt and
accrued interest thereon paid by Viacom on behalf of the Company, accrued
interest of $748,000 on the BFF Note and $1,789,000 due Blockbuster under the
MSA.
In 1996, the Company incurred $3,724,000 of other obligations to
Blockbuster under the MSA including obligations to reimburse Blockbuster for
insurance and other costs on behalf of the Company, of which $1,424,000 was
incurred and $521,000 was paid after March 25,1996.
On May 7, 1997, the Bankruptcy Court issued an order providing for the
settlement of all of Viacom's prepetition general unsecured claims against the
Group and all claims which the Group or any holders of claims against the Group
may hold against Viacom. Under the agreement and subsequent Bankruptcy Court
order, Viacom received no property for its prepetition unsecured claims under
the Plan. In exchange for this treatment, the Group agreed to (i) satisfy in
full a claim which Iwerks Studios, Inc. held against the Group, and which was
guaranteed by Blockbuster, in the amount of $61,500, (ii) assume approximately
30 leases of the Group, which were guaranteed by Viacom, and assign them to
Blockbuster and (iii) pay Viacom's postpetition administrative claims for
expenses advanced by Viacom on behalf of the Group of approximately $991,000 and
obligations incurred under the MSA, subject to any setoff paid on behalf of
Viacom. In connection with this settlement, the MSA was terminated.
The Company subleased approximately 30,000 square feet of office space
from Blockbuster at an annual cost of approximately $600,000. A division of
Blockbuster occupied approximately 7,500 square feet of this space thereby
mitigating approximately $128,000 of the Company's cost. The Company terminated
its lease with Blockbuster and vacated the office space February 1, 1998.
As required under the Plan, the Company reimbursed Birch approximately
$1,078,000 for its out-of-pocket expenses incurred in connection with sponsoring
the Plan.
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 $8,000,000 and $7,600,000 to Griffin Bacal for creative
services and as agent for the purchase of media from third parties during the
years ended December 31, 1998 and 1997 respectively.
The Company pays an outside consulting firm, Carl Marks Group, LLC for
the services of one of its consultants to act in the capacity of Chief Executive
Officer of the Company, as well as for other services, and reimbursement for
expenses. The total amount paid for the year ended December 31, 1998 was
$384,000
(11) INCOME TAXES
The federal statutory tax rate is reconciled to the Company's effective
tax rate for the noted periods as follows:
<TABLE>
<CAPTION>
Successor Company Predecessor Company
---------------------------- -------------------------
Five Months Seven Months
Year Ended Ended Ended Year Ended
December 31, December 31, July 31, December 31,
1998 1997 1997 1996
------------- ------------ ------------ ------------
<S> <C> <C> <C> <C>
Federal statutory rate (benefit) (34.0)% (34.0)% (34.0)% (34.0)%
Change in valuation allowance 34.0 % 34.0 % 34.0 % 34.0 %
----- ----- ----- -----
Effective tax rate -- -- -- --
===== ===== ===== =====
</TABLE>
54
<PAGE>
The primary components that comprise the deferred tax assets and
deferred tax liabilities at December 31, 1998 and 1997 are as follows (in
thousands):
Successor Company
---------------------------
1998 1997
------------ -----------
Net operating loss carryforwards $ 95,000 $ 66,000
Difference between book and tax bases of
acquired net assets 12,000 12,000
Noncurrent asset reevaluations 99,000 85,000
Other assets 6,000 10,000
Other liabilities (18,000) (16,000)
----------- -----------
Net deferred tax asset before valuation
allowance 194,000 157,000
Valuation allowance (194,000) (157,000)
----------- -----------
Net deferred tax asset $ -- $ --
=========== ===========
The valuation allowance totaled approximately $261,500,000 at December
31, 1996. The valuation allowance decreased approximately $104,500,000 in 1997
due to a reduction in net operating loss carryovers related to the cancellation
of indebtedness of the Company upon emergence from bankruptcy. The valuation
allowance increased by approximately $37,000,000 in 1998. The Company has net
operating loss carryforwards for federal tax purposes totaling approximately
$256,000,000 which will expire as follows: $147,000,000 in 2011, $51,000,000
in 2012 and $65,000,000 in 2018. As a result of its reorganization under Chapter
11, the Company is treated as having experienced an ownership change under
Internal Revenue Code Section 382. Under Section 382, the Company's ability to
offset income in each post-reorganization taxable year by its remaining NOLs and
built-in losses (including depreciation and amortization deductions of any
portion of the Company's basis in assets with built-in losses) is limited to an
amount not to exceed the aggregate value of the Company's common stock
immediately before such change in control (taking into account in such
calculation, however, any increase in value resulting from any surrender or
cancellation of creditors' claims in connection with the Plan) multiplied by the
long-term tax-exempt rate published monthly by the Internal Revenue Service.
Based on this calculation, the Company's use of approximately
$137,000,000 of NOLs is limited to approximately $4,000,000 per year. The
federal income tax net operating loss carryforwards described above are not
binding on the Internal Revenue Service and may be subject to adjustments which
may be substantial in magnitude. In accordance with SOP 90-7, any realization of
the benefit from tax net operating loss carryforwards subsequent to the
effective date of the Company's Plan of Reorganization will result in an
increase to equity.
(12) WARRANTS AND OPTIONS
In connection with the MSA, the Company issued 157,821 Series A
Warrants, 157,821 Series B Warrants and 157,821 Series C Warrants to Viacom. The
Series A, Series B and Series C Warrants were to vest on the first, second and
third anniversaries of the MSA Effective Date, respectively. All such vested
warrants were to become exercisable on or after December 16, 1998, although such
exercisability was to be accelerated in certain circumstances. Each warrant
entitled Viacom to purchase one share of Series A Preferred Stock of the
Company. The exercise prices for the Series A, Series B and Series C Warrants
per share of the common stock into which the Series A Preferred Stock was
convertible were $10.375, $11.931 and $14.317, respectively.
In April 1993, the Company adopted a stock option plan (the "1993
Plan"), whereby up to 6,000,000 shares of common stock were available for grant
to key employees, consultants and directors of the Company. In addition, in July
1995, the Company adopted the 1995 Long-Term Management Incentive Plan (the
"1995 Plan") pursuant to which up to 3,000,000 shares of common stock were
available for grant to certain key employees and consultants of the Company.
Options granted under the 1993 Plan and 1995 Plan were non qualified and were
granted at a price equal to the fair market value at the date of grant. No
options were granted under the 1995 Plan.
55
<PAGE>
Pursuant to the Plan, all options and warrants and the 1993 Plan and
1995 Plan were canceled as of the Effective Date.
As part of the Plan, a stock option plan (the "1997 Stock Incentive
Plan") was established. Pursuant to certain executive employment contracts,
options to purchase 536,845 shares of Common Stock were granted to senior
executives of the Company at an exercise price of $11.88 per share. One third of
the options granted were scheduled to vest on each January 1 of 1998, 1999 and
2000. In addition, such options would vest in their entirety upon the incurrence
of a "Change in Control" as defined in the Plan. A total of 715,692 shares of
Common Stock had been reserved for issuance under the 1997 Stock Incentive Plan.
In December 1998, the Company adopted a new stock incentive plan (the
"1998 Stock Incentive Plan"). Grants of options to purchase 13,494,500 shares of
Common Stock were made to executives and senior management at an excercise price
of $.00017 per share. These options may be exercised within 10 years of the date
of grant. Two thirds of these options vested on January 1, 1999, and the
remaining one-third vest on January 1, 2000. Also, under the 1998 Stock
Incentive Plan, additional options to purchase an additional 70 percent of the
original shares granted will be awarded if certain performance goals are met.
Options granted under the 1997 Stock Incentive Plan were relinquished by the
executives receiving them in order to participate in the 1998 Stock Incentive
Plan. A total of 197,000,000 shares have been reserved for issuance under the
Company's 1998 Stock Incentive Plan.
The following summarizes stock option activity for the following
periods:
<TABLE>
<CAPTION>
Successor Company Predecessor Company
--------------------------------- ---------------------------
Five Months Seven Months
Year Ended Ended Ended Year Ended
December 31, December 31, July 31, December 31,
1998 1997 1997 1996
------------- ------------ ------------ -------------
<S> <C> <C> <C> <C>
Options outstanding at beginning
of period 536,845 -- 2,754,802 2,924,802
Granted 13,494,500 536,845 -- --
Exercised -- -- -- (170,000)
Canceled (536,845) -- (2,754,802) --
------------- --------- ----------- -------------
Options outstanding at end of
period 13,494,500 536,845 -- 2,754,802
============= ========= =========== =============
Weighted average exercise price
of options at beginning of
period $ 11.88 $ -- $ -- $ 10.47
Weighted average exercise price
of options exercised $ -- $ -- $ -- $ 1.66
Range of exercise prices of
options outstanding at
end of period $ .00017 $ 11.88 $ -- $1.67 to $24.63
Weighted average exercise price
of options
Outstanding at end of period $ .00017 $ 11.88 $ -- $ 11.01
Vested options at end of period -- -- -- 2,754,802
Options available for future
grant at end of period 183,505,500 178,847 -- 129,351
</TABLE>
56
<PAGE>
(13) COMMITMENTS AND CONTINGENCIES
Future minimum lease payments, under noncancelable operating leases as
of December 31, 1998, are as follows (in thousands):
1999.......................................... $ 27,232
2000.......................................... 27,108
2001.......................................... 25,494
2002.......................................... 24,495
2003.......................................... 21,248
Thereafter.................................... 20,689
--------
$146,266
========
The Company is also obligated under a three-year operating lease
agreement to pay a per capita license fee for laser tag equipment. This
agreement requires the Company to pay 20 cents per attendee at its FunCenters
for the first 9 million attendees; 18 cents per attendee for the next 9 million
attendees; and 16 cents for each attendee thereafter. Because the agreement is
based upon attendance, the exact payment in each of the three years cannot be
determined.
Rental expense for operating leases during the years ended December 31,
1998, 1997, and 1996 amounted to approximately $36,600,000, $34,485,000, and
$41,137,000 respectively, including $1,463,000, $590,000 and $459,000 for
contingent rent in 1998, 1997 and 1996 respectively.
From time to time, the Company is a party to a number of lawsuits and
other legal matters, including claims relating to injuries which allegedly
occurred at the Company's facilities and to alleged employment discrimination. A
portion of these claims may be covered by insurance. Management has estimated
the potential liabilities resulting from such claims which arose subsequent to
the Petition Date and which are not covered by insurance to be approximately
$3,671,000 at December 31, 1998 and $3,347,000 at December 31, 1997. These
amounts were recorded in accrued liabilities and other long-term liabilities in
the Company's consolidated balance sheets based on management estimates of the
tendering of future payments. Because these amounts represent estimates, it is
reasonably possible that a change in these estimates may occur in the future.
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. 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 December 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
is disputing, of which $1.5 million is unpaid.
The Company's business strategy is taking longer to accomplish and is
proving to be more costly than originally anticipated. Currently, the Company
does not have, and is not generating from operations, sufficient cash to meet
its obligations as they become due. Due to a lack of funds, in the fourth
quarter of 1998, the Company suspended its renovation program and stopped making
any further renovations to its FunCenters. As an interim measure, in order to
reduce operating costs and conserve cash, in March 1999, the Company established
a plan to close approximately 25% of its underperforming FunCenters and one
Block Party store by the end of the second quarter of 1999. In addition to the
Loss on on Impairment on Assets recorded at December 31, 1998 (See Note 3), the
Company preliminary estimates that it will record approximately $10 million of
charges to earnings in the second quarter of 1999 for lease and involuntary
employee terminations related to the closings.
Due to the deterioration of its financial position, the Company
breached two financial covenants under the Revolving Credit Facility as of
January 31, 1999. On March 31, 1999, the Company again will state in its report
for February 1999 that it is in technical default under the Revolving Credit
Facility with respect to minimum required EBITDA at the store and overall
Company levels for February 1999. Foothill Capital has agreed to waive these
defaults for January and February 1999. On April 30, the Company expects that it
will state in its report for March 1999 that it is in technical default under
the Revolving Credit Facility with respect to minimum required EBITDA at the
store and overall Company levels for March 1999. The Revolving Credit Facility
permits a 30-day grace period with respect to such defaults which will end on
May 30, 1999. Under the terms of the Revolving Credit Facility, the Company may
develop and present to Foothill Capital an action plan to address these defaults
which Foothill will consider in deciding whether to grant another waiver. Unless
these defaults are cured or waived, this breach will constitute an event of
default under the Revolving Credit Facility which, in turn, will trigger an
event of default under the indentures governing the Senior Secured Notes and the
New Notes and the McDonald's Notes. If such events of default were to occur,
Foothill Capital and the holders of the Senior Secured Notes and the New Notes
and the McDonald's Notes can accelerate such debt. If such acceleration occurs,
all amounts owed under the Revolving Credit Facility, the Senior Secured Notes
and the New Notes and the McDonald's Notes would be declared immediately due and
payable and reclassified as such on the Company's financial statements. In such
event, the Company would not have enough cash to pay such debt and would be
forced to seek bankruptcy protection.
Historically, the cash necessary to fund the Company's working capital,
operating losses and capital expenditures has been provided by debt or equity
financing. However, the Company has limited borrowing availability under its
Senior Revolving Credit Facility and is severally restricted in its ability to
obtain additional debt or equity financing. On February 9, 1999, the Company
engaged the investment banking firm of Ladenburg, Thalmann & Co. to assist it in
raising additional capital and exploring other strategic alternatives, including
possible investments by one or more strategic partners or other investors. If
the Company is unable to obtain additional debt or equity financing or arrange a
sale of the Company or substantially all of its assets in the near future, it
will have to seek bankruptcy protection. The consolidated financial statements
do not include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from this uncertainty.
57
<PAGE>
(14) SUMMARIZED COMBINED FINANCIAL INFORMATION
The following sets forth summarized combined financial information of
Discovery Zone (Canada) Limited (formerly Discovery Zone Children's Amusement
Canada Corporation) and Discovery Zone (Puerto Rico), Inc., which are subsidiary
guarantors under the Company's Senior Secured Notes and Senior Collateralized
Notes (See Notes 2 and 5). Separate financial statements of these subsidiary
guarantors are not included as the subsidiaries guarantee the Senior Secured
Notes and Senior Collaterdized Notes on a full, unconditional, and joint and
several basis and the subsidiary guarantors are wholly-owned subsidiaries of the
Company. Non-guarantor subsidiaries under the financing are inconsequential.
Successor Company
--------------------------
December 31, December 31,
1998 1997
---- ----
Current assets............................... $ 236 $ 233
Noncurrent assets............................ 3,627 3,124
Current liabilities.......................... 262 257
Noncurrent liabilities....................... 8,806 8,158
Year ended December 31,
----------------------------------
1998 1997 1996
---- ---- ----
Net revenue......................... $4,368 $4,931 $6,637
Operating expenses.................. 4,536 5,688 7,561
Net loss............................ (169) (542) (753)
58
<PAGE>
DISCOVERY ZONE, INC.
Valuation and Qualifying Accounts
Schedule II
(In thousands)
Balance at Additions Amounts Balance at
Beginning Charged to Written End
Description Of Year Expense Off of Year
- - ----------- ----------------------------------------------
ALLOWANCE FOR DOUBTFUL ACCOUNTS
1996 $2,185 $1,093 $2,034 $ 974
1997 974 -- 974 --
1998 -- -- -- --
RESERVE FOR OBSOLESCENCE
1996 1,025 -- 1,025 --
1997 -- -- -- --
1998 -- -- -- --
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS OR ACCOUNTING AND
FINANCIAL DISCLOSURES.
None.
59
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth the names and ages, as of December 31,
1998, of the executive officers and directors of the Company and the positions
they hold:
<TABLE>
<CAPTION>
Name Age Position
- - --------------------------------------- --- -------------------------------------------
<S> <C> <C>
Chet Obieleski......................... 55 President, Chief Executive Officer, Chief
Operating Officer and Director
Sharon L. Rothstein.................... 41 Senior Vice President, Marketing and
Entertainment
Robert G. Rooney....................... 41 Senior Vice President, Chief Financial and
Administrative Officer
Jeffrey Sasson......................... 45 Senior Vice President, Retail and Corporate
Services
Terrance Shindle....................... 51 Vice President of Store Operations
Andrew M. Smith........................ 46 Vice President, Real Estate, General Counsel
and Secretary
Leighton J. Weiss...................... 47 Vice President of Finance and Controller
Martin S. Davis........................ 71 Director
David L. Eaton......................... 45 Director
Greg S. Feldman........................ 42 Director
Jason B. Fortin........................ 28 Director
Scott Johnson.......................... 26 Director
David J. Kass.......................... 39 Director
Mary McGrath........................... 40 Director
L.G. Schafran.......................... 60 Director
Christopher F. Smith .................. 34 Director
Paul D. Kurnit......................... 50 Director
</TABLE>
Background of Directors and Executive Officers
Set forth below is a brief description of the business experience of
the executive officers and directors of the Company.
Mr. Obieleski has been Chief Operating Officer of the Company since
August 1998. Upon the resignation of Scott W. Bernstein, effective November 27,
1998, Mr. Obieleski became the President, the Chief Executive Officer and a
director of the Company as of such date, having been elected as a director by
the Board of Directors on November 11, 1998 to fill the vacancy created by Mr.
Bernstein's resignation. From October 1997 until June 1998, Mr. Obieleski served
as chief operating officer and chief financial officer of AIG Designs, a major
importer of casual furniture. From 1990 until 1996, Mr. Obieleski served as
executive vice president of Britches of Georgetown, a national specialty
menswear chain. From 1987 until 1989, Mr. Obieleski served as senior vice
president - finance and operations of Stems, a department store chain in New
York and New Jersey.
Ms. Rothstein has been Senior Vice President, Marketing and
Entertainment of the Company since March 1997. From April 1996 until March 1997,
she was Vice President -- New Business at Nabisco. From 1987 until April 1996,
she held several positions at Nabisco, including Senior Director -- New
Business, Director -- Business Marketing, Product Manager -- Ritz, Product
Manager -- New Products and Product Manager -- Snack Crackers.
60
<PAGE>
Mr. Rooney has been Senior Vice President, Chief Financial and
Administrative Officer of the Company since February 1997. From March 1994 until
September 1996, Mr. Rooney served as Chief Financial Officer of Forschner
Enterprises, a venture capital group, and from September 1992 to February 1994,
Mr. Rooney served as a director and consultant on behalf of various investors
and investment funds affiliated with Forschner Enterprises. From 1989 through
1992, Mr. Rooney served as Managing Director and Chief Financial Officer of The
Signature Group, a merchant banking group specializing in troubled real estate.
From 1986 through 1989, he served as Senior Vice President, Chief Financial
Officer and Treasurer of Imagine Entertainment, Inc., a publicly held film and
television production company. Prior to joining Imagine, Mr. Rooney spent nine
years with Ernst & Young. Mr. Rooney is a certified public accountant.
Mr. Sasson joined the Company as Senior Vice President - Retail and
Corporate Services in August 1998. From December 1996 until April 1998, Mr.
Sasson served as corporate vice president of Food Services at Six Flags Theme
Parks, Inc., a Time Warner Company. From May 1990 until December 1996, Mr.
Sasson worked for Service America Corporation and Compass Groups USA, both
national contract service companies. During that time, Mr. Sasson was employed
by Canteen Corporation, a T.W. Services Company, in several capacities,
including district manager and assistant regional general manager.
Mr. Shindle joined the Company as Regional Director of West Coast
Operations in February 1998 and has been Vice President of Company Operations
since April 1998. From October 1995 to November 1997, Mr. Shindle was a Regional
Partner with BC Detroit and Boston West California, two franchisees of Boston
Chicken, Golden, Colorado. From June 1993 to August 1995, he served as executive
vice president of Midwest Operations and, from April 1985 to June 1993, served
as vice president of West Coast Operations, for Bakers Square Restaurants, a
division of Vicorp Restaurants, Denver, Colorado.
Mr. Smith joined the Company as Vice President--Real Estate and General
Counsel in October 1997 and has served as Secretary since November 1997. From
June 1996 to October 1997, Mr. Smith served as a Managing Director of Alpine
Consulting, a real estate consulting firm. From January 1995 to May 1996, he
served as the Vice President--Operations and as a director of Influence, Inc., a
medical device manufacturer. From 1986 to 1994, Mr. Smith was a real estate
partner with Weil, Gotshal & Manges LLP, an international law firm.
Mr. Weiss has been Controller of the Company since 1996 and in 1997 he
was named Vice President of Finance. He joined the Company in July 1995, serving
as Assistant Controller. Mr. Weiss held various positions as a controller or
finance manager within the music division of Blockbuster Entertainment from
January 1994 through June 1995. Prior to that, he served as Controller and
Director of Accounting for Sound Warehouse, Inc. from October 1988 to January
1994. Prior to joining Sound Warehouse, Inc., Mr. Weiss held various positions
for Arthur Andersen LLP, where he achieved the position of manager in the audit
and financial consulting division. Mr. Weiss is a certified public accountant.
Mr. Davis was elected as a director of the Company in July 1997. Mr.
Davis has been a managing partner of Wellspring Associates L.L.C. since January
1995. Prior to founding Wellspring, Mr. Davis served as Chairman and Chief
Executive Officer of Gulf + Western Industries, Inc. and its successor company,
Paramount Communications, Inc., from 1983 to 1994. Mr. Davis is a member of the
Board of Directors of Lionel L.L.C., National Amusements, Inc., the parent
company of Viacom Inc. and SLM International, Inc.
Mr. Eaton was elected as a director of the Company in August 1998, as
one of the Noteholder Representatives (as defined herein) in accordance with the
terms of the Stockholders' Agreement (as defined herein). Mr. Eaton currently is
Vice President - Member Services at Attorneys' Liability Assurance Society, Inc.
("ALAS"), a risk retention group, which he joined in 1997. At ALAS, Mr. Eaton's
responsibilities include shareholder relations, marketing, new product
development and strategic planning. From 1991 to 1997, Mr. Eaton was a partner
in the law firm of Kirkland & Ellis in Chicago, concentrating in complex finance
and reorganization matters. Prior to joining Kirkland & Ellis, Mr. Eaton was the
senior workout/bankruptcy counsel for Continental Bank N.A.
61
<PAGE>
Mr. Feldman was elected as a director of the Company in July 1997. Mr.
Feldman has been a managing partner of Wellspring since its inception in January
1995. From September 1990 until January 1995, he was a vice president in charge
of acquisitions at Exor America Inc. (formerly IFINT-USA Inc.), the U.S.
investment arm of the Agnelli Group. From September 1988 until September 1990,
Mr. Feldman was vice president and company-founder of Clegg Industries, Inc.,
an investment firm. Mr. Feldman is a member of the Board of Directors of Lionel
L.L.C. and Chartwell Re Corporation.
Mr. Fortin was elected as a director of the Company in August 1998. Mr.
Fortin is a vice president of Wellspring which he joined in March 1995. From
1992, until he joined Wellspring, Mr. Fortin was in the corporate finance
department of Donaldson, Lufkin & Jenrette Securities Corporation.
Mr. Johnson was elected as a director of the Company in September 1998.
Mr. Johnson was an associate of Wellspring, which he joined in March 1998. From
February 1997 until March 1998, Mr. Johnson was an analyst at J. W. Childs
Associates, a private equity firm. From May 1995 until February 1997, Mr.
Johnson was an analyst in the mergers and acquisitions department for Lehman
Brothers, Inc. Prior to May 1995, Mr. Johnson was a student at the University of
Texas at Austin where he received a degree in finance. In March 1999, Mr.
Johnson resigned as a director of the Company. As of March 31, 1999, no
successor has been appointed to fill his vacancy.
Mr. Kass was elected as a director of the Company in July 1998. Mr.
Kass is the chief financial officer of Wellspring, which he joined in November
1997. From July 1995 to July 1997, Mr. Kass was a vice president and chief
financial officer of CW Group, an early stage healthcare venture capital group.
While at CW Group, Mr. Kass was actively involved in the management of several
portfolio companies, including CareAdvantage, Inc., a public managed care
company, where he served as interim president from July 1996 to April 1997. For
six years prior to joining CW Group, Mr. Kass was a director and senior
executive of Genetrix, Inc., a genetic services organization.
Ms. McGrath was elected as a director of the Company in August 1998, as
one of the Noteholder Representatives in accordance with the terms of the
Stockholders' Agreement. Ms. McGrath is currently a sales manager at Random
House, Inc., which she joined in 1991. From 1987 to 1991, Ms. McGrath was a
regional sales director and a national chain sales manager at Time Warner, Inc.
From 1985 to 1987, Ms. McGrath was a promotions director at Chas. Levy Co., a
wholesale distributor of magazines and books.
Mr. Schafran was elected as a director of the Company in July 1997. Mr.
Schafran has been a managing general partner of L.G. Schafran & Associates, a
real estate and development firm, since 1984. Mr. Schafran is a member of the
Board of Directors of several companies, including Comsat Corporation, Publicker
Industries, Inc., Capsure Holdings Corporation, Sassco Corp., Leslie Fay Inc.
and Glasstech, Inc., Chairman of the Executive Group of The Dart Group
Corporation, Chairman of the Board of Directors of Delta-Omega Technologies,
Inc. and a trustee of National Income Realty Trust.
Mr. Smith was elected as a director of the Company in July 1997. Mr.
Smith joined Wafra Investment Advisory Group, Inc. ("Wafra") in 1992, where he
is a Vice President. From 1990 until 1992, Mr. Smith served as a Vice President
of Kouri Capital Group, Inc., a merchant bank providing, among other things,
privatization advisory service. Prior to joining Kouri Capital Group, Mr. Smith
served as Assistant Vice President of Direct Equity Investment at Lambert
Brussels Capital Corporation and, prior to that, as a Corporate Loan Officer at
First Union National Bank.
Mr. Kurnit was appointed as director in accordance with the terms of
the Plan as representative of the committee of pre-petition unsecured creditors
of the Company ("Creditors Committee"). Mr. Kurnit's appointment was approved by
the Bankruptcy Court at the confirmation hearing. He was appointed to serve for
a term of three years through July 2000. However, he resigned as a director of
the Company on February 12, 1999. Mr. Kurnit has been President of Griffin Bacal
Inc. since 1988. The Company has been advised by counsel to the Creditors
Committee that the Creditors Committee intends to appoint a successor director.
62
<PAGE>
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires the Company's officers and
directors, and persons who own more than ten percent of a registered class of
the Company's equity securities, to file reports of securities ownership and
changes in such ownership with the Commission. Officers, directors and greater
than 10% shareholders also are required by rules promulgated by the Commission
to furnish the Company with copies of all Section 16(a) forms they file.
The Company believes that it has secured full current compliance with
the reporting requirements of Section 16(a), except that the Company is in the
process of filing the appropriate form fours (4s) and fives (5s) with respect to
transactions involving stock options on behalf of certain executives.
ITEM 11. EXECUTIVE COMPENSATION
The following table and discussion summarize the compensation earned by
the two individuals who have served as the Company's Chief Executive Officer
during the year ended December 31, 1998, and the other four most highly
compensated executive officers of the Company who earned more than $100,000 in
salary and bonuses (collectively, the "Named Executive Officers") for services
rendered in all capacities to the Company during the three years ended December
31, 1998.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
Long-Term
Compensation
Awards
Number of
Annual Compensation Securities
----------------------------------------- Underlying All Other
Options/ Compensation
Name Position Year Salary ($) Bonus ($) SARs ($)
- - -------------------------- ------------------ --------- --------------- --------------- ----------------- --------------
<S> <C> <C> <C> <C> <C>
Chet Obieleski(1)......... President/CEO 1998 -- -- 2,364,000 --
1997 -- -- -- --
1996 -- -- -- --
Scott W. Bernstein(2)..... President/CEO 1998 440,000 -- -- 240,000(3)
1997 416,667 200,000 357,845 --
1996 30,204 -- -- --
Robert G. Rooney(2)....... SVP--CFO 1998 185,000 25,000(4) 1,970,000 1,000(5)
1997 185,000 45,000 89,500 75,000(6)
1996 8,538 -- -- --
Sharon L. Rothstein(2).... SVP--Marketing 1998 185,000 20,000(4) 1,970,000 906(5)
1997 185,000 75,000 89,500 --
1996 -- -- -- --
Andrew M. Smith........... VP--Real Estate 1998 150,000 20,000(4) 492,500 --
and General 1997 27,500 -- -- --
Counsel 1996 -- -- -- --
Leighton J. Weiss......... VP--Finance 1998 130,000 20,000(4) 492,500 1,000(5)
1997 126,969 12,000 -- 50,000(6)
1996 115,987 23,356 -- --
</TABLE>
63
<PAGE>
- - ---------------------------
(1) Mr. Obieleski became Chief Operating Officer of the Company in
September 1998, and the President and Chief Executive Officer of the
Company in November 1998, succeeding Mr. Bernstein in such capacities
upon his resignation. Mr. Obieleski is a consultant with Carl Marks
Group, LLC and is paid by them. The Company pays Carl Marks $10,625 per
week for the services of Mr. Obieleski.
(2) Mr. Bernstein, Mr. Rooney and Ms. Rothstein became executive officers
of the Company in December 1996, February 1997 and April 1997,
respectively.
(3) Represents amounts paid to Mr. Bernstein under his severance agreement
with the Company.
(4) Paid in 1999.
(5) Represents matching contributions to the Company's 401(k) plan.
(6) Represents a one-time bonus awarded by the Company in recognition of
efforts in connection with the reorganization of the Company and its
successful emergence from Chapter 11.
Option Grants in Fiscal Year 1998
<TABLE>
<CAPTION>
Potential Realizable
Value at Assumed
Annual Rates of Stock
Price Appreciation for
Individual Grants Option Term
Number of % of Total --------------------------- ----------------------
Securities Options
Underlying Granted to Exercise
Options Employees in or Base Price Expiration
Name Granted (1) Fiscal Year ($/Sh)(2) Date 5%($) 10%($)
- - ---- ----------- ----------- --------- ---- ----- ------
<S> <C> <C> <C> <C> <C> <C>
Chet Obieleski 2,364,000 17.5 .00017 12/21/08 (3) (3)
Robert G. Rooney 1,970,000 14.6 .00017 12/21/08 (3) (3)
Sharon L. Rothstein 1,970,000 14.6 .00017 12/21/08 (3) (3)
Andrew Smith 492,500 3.6 .00017 12/21/08 (3) (3)
Leighton J. Weiss 492,500 3.6 .00017 12/21/08 (3) (3)
</TABLE>
- - -----------------------
(1) These options were awarded under the 1998 Stock Incentive Plan.
Two-thirds of the options vested on January 1, 1999 and one-third will
vest on January 1, 2000. Upon a change of control, their vesting will
accelerate fully.
(2) This exercise price represents the fair market value.
(3) Less than $1,050.
Aggregated Option Fiscal Year-End Values
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised In-the-Money
Including Unexercised Options At Options At
Fiscal Year-End Fiscal Year-End
Name Exercisable/Unexercisable Exercisable/Unexercisable ($) (1)
- - ---- ------------------------- ---------------------------------
<S> <C> <C>
Chet Obieleski................. 0/2,364,000 0
Robert G. Rooney............... 0/1,970,000 0
Sharon L. Rothstein............ 0/1,970,000 0
Andrew Smith................... 0/492,000 0
Leighton J. Weiss.............. 0/492,000 0
</TABLE>
- - -----------------------
(1) The value of the options are not in-the-money.
64
<PAGE>
Committees of the Board of Directors
None.
Compensation of Directors
The Directors, other than the Directors designated by the original
purchaser of the Senior Collateralized Notes (or successor designees) to serve
on the Board ("Noteholder Representatives"), do not receive any fee for
their services. The Noteholder Representatives receive a fee of $3,000 per
quarter. Directors are reimbursed for all out-of-pocket expenses incurred in
connection with attending meetings of the Company's Board of Directors.
Employment Agreement
On July 21, 1997, the Company entered into an employment agreement with
Mr. Bernstein providing for his continued employment as Chief Executive Officer,
President and Director. The agreement with Mr. Bernstein expires on January 1,
2001. The agreement provides for an annual base salary of $440,000 per year,
with annual increases of $40,000 beginning January 1, 1998. In addition, the
agreement provides an annual bonus, equal to 2.0% of the Company's earnings
before interest, taxes, depreciation and amortization expenses. The agreement
also provides for the reimbursement of certain other business related expenses.
Mr. Bernstein resigned as the President, the Chief Executive Officer and as a
director of the Company effective November 27, 1998. As part of a severance
package, the Company agreed to pay Mr. Bernstein (i) a single payment of
$200,000, (ii) his salary through March 1999, and (iii) his benefits through
December 1999; and Mr. Bernstein has agreed to forfeit all of his vested and
unvested stock options.
On August 1, 1997, the Company entered into an employment agreement with
Ms. Rothstein providing for her employment as Senior Vice President, Marketing
and Entertainment. The agreement with Ms. Rothstein expires on December 31,
2000. The agreement provides for an annual base salary plus performance bonuses
based on the achievement of certain objectives. Ms. Rothstein's base salary for
1999 is $195,000.
On August 1, 1997, the Company entered into an employment agreement with
Mr. Rooney providing for his employment as Senior Vice President, Chief
Financial Officer and Administrative Officer. The agreement with Mr. Rooney
expires on December 31, 2000. The agreement provides for an annual base salary
plus performance bonuses based on the achievements of certain objectives. Mr.
Rooney's base salary for 1999 is $200,000.
On August 26, 1998, the Company entered into an agreement with Carl
Marks Consulting Group, LLC ("Carl Marks") in order to obtain the financial and
management consulting services of Carl Marks. The Company appointed Mr.
Obieleski, a representative of Carl Marks, as the Company's Chief Operating
Officer. Upon the resignation of Scott Bernstein, Mr. Obieleski also became the
President, the Chief Executive Officer and a director of the Company. The
Company pays Carl Marks $10,625 per week for the services of Mr. Obieleski.
Retention Program
The Company has adopted a retention program on behalf of the Named
Executive Officers as well as certain other executives of the Company. Under the
program, the Company has agreed to pay one month's salary as of May 31, 1999,
August 31, 1999 and November 30, 1999, if the executive remains employed with
the Company and devotes substantially all of his efforts with respect to the
Company during that period.
65
<PAGE>
Committee Interlocks and Insider Participation
The Company's Board of Directors does not have a compensation committee.
The Company's Board of Directors determines all executive compensation matters.
Mr. Obieleski serves as a director on the Board of Directors and as Chief
Executive Officer and President of the Company.
Stock Incentive Plan
All of the Company's option plans and equity securities in existence
prior to the Effective Date were canceled pursuant to the Plan. The Company
adopted the 1997 Stock Incentive Plan in connection with the Plan. Pursuant to
their respective employment agreements, the Company granted to Mr. Bernstein,
Ms. Rothstein and Mr. Rooney options to purchase 357,485 shares, 89,500 shares
and 89,500 shares, respectively, of the Company's Common Stock at an exercise
price of $11.88 per share. One-third of such options vested on January 1, 1998.
In November 1998, in connection with his resignation, Mr. Bernstein
forfeited and relinquished all rights and interests to options, vested and
unvested, which he had been granted under the 1997 Stock Incentive Plan.
In December 1998, the Company adopted the 1998 Stock Incentive Plan. As
a condition to receiving grants under this plan, in January 1999, grants of
options under the 1998 Stock Incentive Plan, Ms. Rothstein, Mr. Rooney and
others were required to relinquish all rights and interests to options which had
been granted under the 1997 Stock Incentive Plan.
66
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT
The following tables set forth certain information concerning the
beneficial ownership of shares of Common Stock on March 30, 1999 (the "Table
Date"), by: (i) each stockholder known by the Company to beneficially own more
than 5% of the outstanding Common Stock; (ii) each of the Named Executive
Officers; (iii) each of the Company's directors; and (iv) all directors and
executive officers of the Company as a group.
SHARES OF PERCENT
BENEFICIALLY OWNED BENEFICIALLY
BENEFICIAL OWNER COMMON STOCK (1) OWNED (1)
- - --------------------------------------------- ------------------- ------------
Birch Holdings L.L.C. (2).................... 513,615,830 99.6(3)
Martin S. Davis (2).......................... 513,615,830 99.6(3)
Greg S. Feldman (2).......................... 513,615,830 99.6(3)
Jason B. Fortin (2).......................... -- --
David J. Kass (2)............................ -- --
L.G. Schafran (2)............................ -- --
Wafra Investment Advisory Group, Inc., 171,645,581 28.6
or its designee (4).......................
Christopher R. Smith (5)..................... -- (10)
Jefferies & Company (6)...................... 85,266,699 16.5
DZ Investors L.L.C. (7)...................... 213,166,746 33.1
Robert G. Rooney (9)......................... 1,313,202 (10)
Sharon L. Rothstein (9)...................... 1,313,202 (10)
Chet Obieleski (9)........................... 3,151,685 (10)
Jeffrey Sasson (9)........................... 656,010 (10)
Terrance Shindle (9)......................... 656,010 (10)
Andrew M. Smith (9).......................... 382,300 (10)
Leighton J. Weiss (9)........................ 382,300 (10)
David L. Eaton............................... -- --
Mary McGrath................................. -- --
Directors and executive officers as
a group (2)(5)(6)(9)...................... 693,116,120 99.9
- - -----------------------
(1) Beneficial ownership is determined in accordance with the rules and
regulations of the Commission. In computing the number of shares
beneficially owned by a person and the percentage of ownership of that
person, shares of Common Stock subject to options or warrants held by
that person that are currently exercisable or exercisable within 60
days of the Table Date are deemed outstanding. Such shares, however,
are not deemed outstanding for the purpose of computing the percentage
ownership of any other person. Under a pledge agreement in connection
with the 1998 Unit Offerings, Birch pledged a substantial portion of
its shares of capital stock in favor of the trustee for the 1998 Notes
in support of its obligations under the Stockholders' Agreement. See
"Risk Factors--Control By Principal Stockholders."
(2) Birch Acquisition L.L.C., an affiliate of Wellspring ("Birch
Acquisition"), directly owns 426,333,493 shares of Common Stock. In
addition, Birch Acquisition has voting power over 85,266,699 shares
beneficially owned by Jefferies & Company, Inc. ("Jefferies") pursuant
to an irrevocable proxy granted by Jefferies to Birch Acquisition.
Finally, Birch Acquisition has beneficial ownership of 2,015,639 shares
of Common Stock directly owned by Birch Holdings L.L.C. ("Birch
Holdings"), in which Birch Acquisition has approximately 98% economic
interest and 100% voting power. Birch Acquisition is managed by Martin
S. Davis and Greg S. Feldman. In his capacity as a managing member of
Birch Acquisition, Mr. Davis exercises voting and dispositive power
over the shares of Common Stock directly held by Birch Acquisition and
Birch Holdings, and voting power over the shares of Common Stock owned
by Jefferies. Jason Fortin, David Kass and L.G. Schafran, directors of
the Company nominated by Birch Acquisition, and Mr. Feldman, disclaim
voting and
67
<PAGE>
dispositive power over the shares of Common Stock beneficially owned by
Birch Acquisition and Birch Holdings.
(3) On a fully diluted basis, assuming the exercise of all outstanding
warrants and options, Birch Acquisition, Birch Holdings and Mr. Davis
would beneficially own 29.0% of the Company's outstanding Common Stock.
(4) Wafra Acquisition Fund 6, L.P., an affiliate of Wafra, owns $14.0
million stated value of the Company's Convertible Preferred Stock
which, by its terms, is immediately convertible into 1,112,184 shares
of Common Stock before giving effect to the Offering and the offering
of Preferred Units. Wafra Acquisition Fund 6, L.P. and Wafra Fund
Management Ltd., another affiliate of Wafra, collectively own 80 Series
A Preferred Unit Warrants to purchase, in the aggregate, 170,533,397
shares of Common Stock at an exercise price of $.00017 per share.
(5) Christopher R. Smith, a director of the Company nominated by Wafra,
disclaims voting and dispositive power over the shares of Common Stock
beneficially owned by Wafra.
(6) Pursuant to a proxy granted by the Initial Purchaser to Birch Holdings,
Birch Holdings has voting power over all of the shares of Common Stock
and securities exchangeable for or convertible into Common Stock held
by Jefferies, but Birch Holdings does not have dispositive power over
such shares.
(7) DZ Investors L.L.C. owns 100 Series B Preferred Unit Warrants to
purchase, in the aggregate, 213,166,746 shares of Common Stock at an
exercise price of $.00017 per share.
(8) Until his resignation from the Board in February, 1999, Paul D. Kurnit
as the director of the Company nominated by certain classes of
pre-petition creditors of the Company pursuant to the Plan of
Reorganization, including Griffin-Bacal, Inc., a pre-petition creditor
of the Company, of which Mr. Kurnit is an officer. Mr. Kurnit,
individually, is the beneficial owner of less than 5.0% of the
outstanding Common Stock.
(9) Represents the portion of Stock Options granted pursuant to the
Company's 1998 Stock Incentive Plan, being two-thirds of the total
Stock Options granted.
(10) Less than 1%.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Paul Kurnit, an officer of Griffin Bacal, Inc., the Company's
advertising agency, served as a director of the Company until his resignation on
February 12, 1999. The Company paid $8.0 million to Griffin Bacal for media
purchases on behalf of and creative services provided to the Company in 1998.
Management believes that the terms of its agreement with Griffin Bacal are on
terms at least as favorable to the Company as the Company could have obtained
from an independent third party.
In 1998, the Company paid $.4 million for the consulting services of
Carl Marks Consulting Group, LLC including services and expense reimbursements
for Chet Obieleski, the Company's Chief Executive Officer and President.
68
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Reference is made in the information set forth in Part II, Item 8 of
this Report, which information is incorporated herein by reference.
(a)(2) Financial Statement Schedules:
Financial Statement Schedule II, Valuation and Qualifying Accounts, for
the years ended December 31, 1998, 1997 and 1996 are submitted
herewith; all other schedules have been omitted because they are not
applicable or are not required.
(a)(3) The exhibits to this Report are listed in the Exhibit Index which
appears elsewhere in this Report and is incorporated herein by
reference.
(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
Current Report on Form 8-K dated February 8, 1999: Item 5
69
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the undersigned Registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized, in Elmsford, New York on March 31, 1999.
DISCOVERY ZONE, INC.
By: /s/ Chet Obieleski
---------------------------------
Name: Chet Obieleski
Title: Chief Executive Officer,
President and Director
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Chet Obieleski and Robert G.
Rooney, and each of them, his true and lawful attorneys-in-fact and agents, with
full power of substitution and resubstitution, for him and in his name, place
and stead, in any and all capacities to sign any and all amendments to this
report, granting unto said attorneys-in-fact and agents, and each of them, full
power and authority to do and perform each and every act and thing requisite or
necessary to be done in and about the premises, as full to all intents and
purposes as he might or could do in person, hereby ratifying and confirming that
each of said attorneys-in-fact and agents and/or either of them, or his
substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this has been signed by the following persons in the capacities
indicated on March 31, 1999.
NAME TITLE
/s/ Chet Obieleski Chief Executive Officer, President and Director
- - ----------------------
Chet Obieleski
/s/ Martin S. Davis Director
- - ----------------------
Martin S. Davis
/s/ Greg S. Feldman Director
- - ----------------------
Greg S. Feldman
/s/ David J. Kaas Director
- - ----------------------
David J. Kass
/s/ Jason B. Fortin Director
- - ----------------------
Jason B. Fortin
/s/ L.G. Schafran Director
- - ----------------------
L.G. Schafran
Director
- - ----------------------
David L. Eaton
/s/ Mary McGrath Director
- - ----------------------
Mary McGrath
70
<PAGE>
/s/ Christopher R. Smith Director
- - ----------------------
Christopher R. Smith
/s/ Robert G. Rooney Senior Vice President, Chief Financial and
- - ---------------------- Administrative Officer
Robert G. Rooney
/s/ Leighton J. Weiss Vice President of Finance and Controller
- - ---------------------- (Chief Accounting Officer)
Leighton J. Weiss
71
<PAGE>
INDEX TO EXHIBITS
Exhibit
Number Description
------ -----------
+1.1 Purchase Agreement, dated July 9, 1998, between the
Registrant and Jefferies & Company, Inc. (the
"Initial Purchaser").
++2.1 The Third Amended Joint Plan of Reorganization of
the Registrant, dated March 11, 1997.
+++2.2 Agreement and Plan of Merger, dated as of July 28,
1997, between Discovery Zone Children's Amusement
Corporation and the subsidiaries of the Registrant
listed therein.
+++2.3 Agreement and Plan of Merger, dated as of July 29,
1997, between the Registrant and Discovery Zone
Children's Amusement Corporation.
++++3.1 Restated Certificate of Incorporation of the
Registrant.
++++3.2 Amended and Restated By-laws of the Registrant.
+++++4.1 First Supplemental Indenture, dated as of July 17,
1998, among the Registrant, the guarantors named
therein and State Street Bank and Trust Company.
+++++4.2 Indenture, dated as of July 17, 1998, among the
Registrant, 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.
+4.3 Form of Exchange Note (included in Exhibit 4.2).
+++++4.4 Registration Rights Agreement, dated as of July 17,
1998, between the Registrant and the Initial
Purchaser.
++++4.5 Warrant Agreement, dated as of July 17, 1998,
between the Registrant and Firstar Bank of
Minnesota, N.A., as warrant agent (the "Warrant
Agent"), relating to the Series A Note Warrants and
the Series B Note Warrants.
+++++4.6 Warrant Agreement, dated as of July 17, 1998,
between the Registrant and the Warrant Agent,
relating to the Series A Preferred Unit Warrants.
+++++4.7 Warrant Agreement, dated as of July 17, 1998,
between the Registrant and the Warrant Agent,
relating to the Series B Preferred Unit Warrants.
+++++4.8 Escrow and Security Agreement, dated as of July 17,
1998, between the Registrant, as pledgor, and
Firstar Bank of Minnesota, N.A., as trustee and
security agent.
+++++4.9 Pledge Agreement, dated as of July 17, 1998, between
the Registrant and the Firstar Bank of Minnesota,
N.A., as collateral agent (the "Collateral Agent").
i
<PAGE>
+++++4.10 Subsidiary Pledge Agreement, dated as of July 17,
1998, between the Subsidiary Guarantors and the
Collateral Agent.
++++4.11 Security Agreement, dated as of July 17, 1998,
between the Registrant and the Collateral Agent.
++++4.12 Subsidiary Security Agreement, dated as of July 17,
1998, among the Subsidiary Guarantors and the
Collateral Agent.
++++4.13 Collateral Assignment of Patents, Trademarks and
Copyrights, dated as of July 17, 1998, among the
Registrant, as assignor, the Subsidiary Guarantors,
as assignors and Firstar Bank of Minnesota, N.A., as
assignee.
+++++4.14 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.
+++++4.15 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.
++++5.1 Opinion and Consent of Shearman & Sterling regarding
validity of the Exchange Notes.
++++10.1 Purchase Agreement, dated as of July 13, 1998, among
the Registrant, Birch Holdings, Birch Acquisition,
Wafra Acquisition Fund 6, L.P. and Wafra Fund
Management Ltd., relating to the Series A Preferred
Stock Units.
++++10.2 Purchase Agreement, dated as of July 13, 1998, among
the Registrant, Birch Acquisition, DZ Investors
L.L.C. and Jefferies & Company, Inc., relating to
the Series B Preferred Stock Units.
+++10.3 Purchase Agreement, dated July 15, 1997, between the
Registrant and Jefferies & Company, Inc.
+++10.4 Indenture, dated as of July 22, 1997, among
Registrant, as issuer, Discovery Zone Limited,
Discovery Zone (Puerto Rico), Inc. and Discovery
Zone Licensing, Inc., as guarantors (the "Existing
Guarantors") and State Street Bank and Trust
Company, as trustee (the "Existing Trustee").
+++10.5 Registration Rights Agreement, dated as of July 22,
1997, between the Registrant and Jefferies &
Company, Inc.
+++10.6 Warrant Agreement, dated as of July 22, 1997,
between the Registrant and State Street Bank and
Trust Company, as warrant agent.
+++10.7 Escrow and Security Agreement, dated as of July 22,
1997, among the Registrant, as pledgor, Jefferies &
Company, Inc., and the Existing Trustee, as
collateral agent.
+++10.8 Pledge Agreement, dated as of July 22, 1997, between
the Registrant and the Existing Trustee, as
collateral agent.
+++10.9 Security Agreement, dated as of July 22, 1997,
between the Registrant and the Existing Trustee, as
collateral agent.
ii
<PAGE>
+++10.10 Subsidiary Pledge Agreement, dated as of July 22,
1997, between the Existing Guarantors and the
Existing Trustee, as collateral agent.
+++10.11 Subsidiary Security Agreement, dated as of July 22,
1997, between the Existing Guarantors and the
Existing Trustee, as collateral agent.
+++10.12 Collateral Assignment of Patents, Trademarks and
Copyrights, dated as of July 22, 1997, among the
Registrant, as assignor, the Existing Guarantors, as
assignors and the Existing Trustee, as assignee.
+++10.13 Assignment and License Agreement, dated as of July
29, 1997, among the Registrant, as assignor, the
Existing Guarantors, as assignors, and DZ Party,
Inc., as assignee.
+++10.14 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Hamilton County, Ohio.
+++10.15 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Cook County, Illinois.
+++10.16 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Cobb County, Georgia.
+++10.17 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Franklin County, Ohio.
+++10.18 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Macomb County, Michigan.
+++10.19 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Anoka County, Minnesota.
+++10.20 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Philadelphia County,
Pennsylvania.
+++10.21 The Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, between the Company, as mortgagor and
the Existing Trustee, as mortgagee, related to
property located in Marion County, Indiana.
+++10.22 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Kenneth W. Pearson, as trustee and the Existing
Trustee, as beneficiary, relating to property
located in Dallas County, Texas.
iii
<PAGE>
+++10.23 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Kenneth W. Pearson, as trustee and the Existing
Trustee, as beneficiary, relating to property,
located in Bexar County (San Antonio), Texas.
+++10.24 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Kenneth W. Pearson, as trustee and the Existing
Trustee, as beneficiary, relating to property
located in Tarrant County, Texas.
+++10.25 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Kenneth W. Pearson, as trustee and the Existing
Trustee, as beneficiary, relating to property
located in Bexar County (Leon Valley), Texas.
+++10.26 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Kenneth W. Pearson, as trustee and the Existing
Trustee, as beneficiary, relating to property
located in Fort Bend County, Texas.
+++10.27 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor,
Chicago Title Insurance Company, as trustee and the
Existing Trustee, as beneficiary, relating to
property located in Clark County, Washington.
+++10.28 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor, The
Public Trustee of Arapahoe County, Colorado, as
trustee and the Existing Trustee, as beneficiary,
relating to property located in Arapahoe County,
Colorado.
+++10.29 The Deed of Trust, Assignment of Leases and Rents,
Security Agreement and Fixture Filing, dated as of
July 29, 1997, among the Registrant, as grantor, The
Public Trustee of Douglas County, Colorado, as
trustee and the Existing Trustee, as beneficiary,
relating to property located in Douglas County,
Colorado.
+++++++10.30 Open-end Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing (Amended and
Restated), dated as of July 29, 1997, between the
Registrant, as mortgagor and McDonald's Corporation,
as mortgagee, relating to property located in
Hamilton County, Ohio.
+++++++10.31 Amended and Restated Mortgage, Assignment of Leases
and Rents, Security Agreement and Fixture Filing,
dated as of July 29, 1997, between the Registrant,
as mortgagor and McDonald's Corporation, as
mortgagee, relating to property located in Cook
County, Illinois.
+++++++10.32 Amended and Restated Deed to Secure Debt and
Security Agreement, dated as of July 29, 1997,
between the Registrant, as mortgagor and McDonald's
Corporation, as mortgagee, relating to property in
Cobb County, Georgia.
+++++++10.33 Open-end Mortgage, Assignment of Leases and Rents,
Security Agreement and Fixture Filing (Amended and
Restated), dated as of July 29, 1997, between the
Registrant, as
iv
<PAGE>
mortgagor and McDonald's Corporation, as mortgagee,
relating to property located in Franklin County,
Ohio.
+++++++10.34 Amended and Restated Mortgage, dated as of July 29,
1997, between the Registrant, as mortgagor and
McDonald's Corporation, as mortgagee, relating to
property located in Macomb County, Michigan.
+++++++10.35 Amended and Restated Mortgage, Assignment of Leases
and Rents, Security Agreement and Fixture Filing,
dated as of July 29, 1997, between the Registrant,
as mortgagor and McDonald's Corporation, as
mortgagee, relating to property located in Anoka
County, Minnesota.
+++++++10.36 Amended and Restated Open-end Mortgage, Assignment
of Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, between the
Registrant, as mortgagor and McDonald's Corporation,
as mortgagee, relating to property in Philadelphia
County, Pennsylvania.
+++++++10.37 Amended and Restated Mortgage, Assignment of Leases
and Rents, Security Agreement and Fixture Filing,
dated as of July 29, 1997, between the Registrant,
as mortgagor and McDonald's Corporation, as
mortgagee, relating to property in Marion County,
Indiana.
+++++++10.38 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor, Kenneth W. Pearson, as
trustee and McDonald's Corporation, as beneficiary,
relating to property located in Bexar County (San
Antonio), Texas.
+++++++10.39 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor, Kenneth W. Pearson, as
trustee and McDonald's Corporation, as beneficiary,
relating to property located in Tarrant County,
Texas.
+++++++10.40 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor, Kenneth W. Pearson, as
trustee and McDonald's Corporation, as beneficiary,
relating to property located in Bexar County (Leon
Valley), Texas.
+++++++10.41 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor (borrower), McDonald's
Corporation, as grantee (lender) and Chicago Title
Insurance Company, as grantee (trustee), relating to
property located in Clark County, Washington.
+++++++10.42 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor, The Public Trustee of
Arapahoe County, Colorado, as trustee and McDonald's
Corporation, as beneficiary, relating to property
located in Arapahoe County, Colorado.
+++++++10.43 Amended and Restated Deed of Trust, Assignment of
Leases and Rents, Security Agreement and Fixture
Filing, dated as of July 29, 1997, among the
Registrant, as grantor, The Public Trustee of
Douglas County, Colorado, as trustee and McDonald's
Corporation, as beneficiary, relating to property
located in Douglas County, Colorado.
v
<PAGE>
+++++++10.44 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Hamilton
County, Ohio.
+++++++10.45 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Cook
County, Illinois.
+++++++10.46 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Cobb
County, Georgia.
+++++++10.47 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Franklin
County, Ohio.
+++++++10.48 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Macomb
County, Michigan.
+++++++10.49 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Anoka
County, Minnesota.
+++++++10.50 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in
Philadelphia County, Pennsylvania.
+++++++10.51 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Marion
County, Indiana.
+++++++10.52 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Bexar
County (San Antonio), Texas.
+++++++10.53 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Tarrant
County, Texas.
+++++++10.54 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Bexar
County (Leon Valley), Texas.
+++++++10.55 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Clark
County, Washington.
+++++++10.56 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Arapahoe
County, Colorado.
vi
<PAGE>
+++++++10.57 Subordination Agreement, dated as of July 29, 1997,
among the Registrant, the Existing Trustee, for
itself and as collateral agent, and McDonald's
Corporation, related to property located in Douglas
County, Colorado.
+++++++10.58 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Independence, Missouri.
+++++++10.59 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Royal Palm, Florida.
+++++++10.60 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Cincinnati, Ohio.
+++++++10.61 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Greenfield, Wisconsin.
+++++++10.62 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Webster, Texas.
+++++++10.63 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Houston, Texas.
+++++++10.64 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Manchester, Missouri.
+++++++10.65 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Rancho Cucomonga, California.
+++++++10.66 Secured Rent Deferral Note of McDonald's
Corporation, dated as of July 29, 1997, related to
property located in Amherst, New York.
+++++++10.67 Secured Rejection Note of McDonald's Corporation,
dated as of July 29, 1997.
++++++++10.68 Loan and Security Agreement, dated as of March 31,
1998, between the Registrant and Foothill Capital
Corporation ("Foothill").
++++10.69 Amendment No. 1 to the Loan and Security Agreement,
dated as of July 17, 1998, between the Registrant
and Foothill.
++++10.70 Amendment No. 2 to the Loan and Security Agreement,
dated as of December 18, 1998 between the Registrant
and Foothill.
++++++++10.71 General Continuing Guaranty, dated as of March 31,
1998, among Discovery Zone (Canada) Limited,
Discovery Zone (Puerto Rico), Inc. and Discovery
Zone Licensing, Inc., as guarantors (the "Foothill
Guarantors"), in favor of Foothill.
++++++++10.72 Security Agreement, dated as of March 31, 1998,
between the Foothill Guarantors and Foothill.
++++++++10.73 Stock Pledge Agreement, dated as of March 31, 1998,
between the Registrant and Foothill.
vii
<PAGE>
++++++++10.74 Trademark Security Agreement, dated as of March 31,
1998, among the Registrant, Discovery Zone
Licensing, Inc. and Foothill.
++++++++10.75 Intercreditor Agreement, dated as of March 31, 1998,
between Foothill and the Existing Trustee, as
collateral agent.
+++++++10.76 Employment Agreement, dated as of August 1, 1997,
between the Registrant and Robert G. Rooney.
+++++++10.77 Employment Agreement, dated as of August 1, 1997,
between the Registrant and Sharon L. Rothstein.
++++10.78 Consulting Agreement, dated as of August 26, 1998,
between Carl Marks Consulting Group, LLC and the
Registrant.
++++++++++10.79 1998 Stock Incentive Plan.
12.1 Statements regarding computation of ratios.
+++++++++16.1 Letter re change in certifying accountant.
++++21.1 List of Subsidiaries of the Registrant.
++++++++++22.1 Definitive Proxy Statement on Schedule 14A of the
Registrant, dated December 14, 1998.
24.1 Power of Attorney (included on signature page).
27.1 Financial Data Schedule (December 31, 1998).
27.2 Financial Data Schedule (December 31, 1997).
27.3 Financial Data Schedle (July 31, 1997).
+ Previously filed.
++ Incorporated by reference from the Current Report on
Form 8-K of the Registrant, dated July 9, 1997.
+++ Incorporated by reference from the Registration
Statement on Form S-4 of the Registrant, dated
November 19, 1997.
++++ Incorporated by reference from Amendment No. 1 to
the Registration Statement on Form S-4 of the
Registrant, dated December 23, 1998.
+++++ Incorporated by reference from the Quarterly Report
on Form 10-Q of the Registrant for the quarter ended
June 30, 1998.
++++++ Incorporated by reference from Amendment No. 3 to
the Registration Statement on Form S-4 of the
Registrant, dated January 28, 1998.
+++++++ Incorporated by reference from Amendment No. 1 to
the Registration Statement on Form S-4 of the
Registrant, dated December 9, 1997.
++++++++ Incorporated by reference from the Annual Report on
Form 10-K of the Registrant for the year ended
December 31, 1997.
+++++++++ Incorporated by reference from the Current Report
on Form 8-K of the Registrant, dated June 3, 1996.
++++++++++ Incorporated by reference from the Registrant's
Definitive Proxy Statement on Schedule 14A, dated
December 11, 1998.
viii
EXHIBIT 12.1
DISCOVERY ZONE, INC.
COOMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES
(Dollars in thousands, except ratios)
Seven Five
Months Months
Ended Ended
July 31, 1997 December 31, 1997
------------- -----------------
Income (loss) before taxes
on income: (5,453) (27,966)
Adjustments:
fixed charges 3,249 6,076
---------- -------------
Earnings before taxes
fixed charges as adjusted (2,204) (21,890)
---------- -------------
Fixed charges:
Interest incurred 3,249 6,076
Portion of rent expense which
represents interest factor -- --
---------- -------------
Total fixed charges 3,249 6,076
========== =============
Ratio of earnings to fixed charges -- --
========== =============
YEAR ENDED DECEMBER 31,
------------------------------
1998 1996
------------- -------------
Income (loss) before taxes
on income: (103,932) (83,834)
Adjustments:
fixed charges 16,647 6,277
---------- -------------
Earnings before taxes
fixed charges as adjusted (87,285) (77,557)
---------- -------------
Fixed charges:
Interest incurred 16,647 6,277
Portion of rent expense which
represents interest factor -- --
---------- -------------
Total fixed charges 16,647 6,277
========== =============
Ratio of earnings to fixed charges -- --
========== =============
<TABLE> <S> <C>
<ARTICLE> 5
<CIK> 0000900392
<NAME> Discovery Zone, Inc.
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-12-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 1,355
<SECURITIES> 0
<RECEIVABLES> 842
<ALLOWANCES> 0
<INVENTORY> 2,111
<CURRENT-ASSETS> 16,949
<PP&E> 69,379
<DEPRECIATION> 0
<TOTAL-ASSETS> 108,344
<CURRENT-LIABILITIES> 33,518
<BONDS> 104,739
13,176
10,917
<COMMON> 73
<OTHER-SE> (62,614)
<TOTAL-LIABILITY-AND-EQUITY> 108,344
<SALES> 0
<TOTAL-REVENUES> 125,870
<CGS> 0
<TOTAL-COSTS> 145,513
<OTHER-EXPENSES> 41,900
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 16,647
<INCOME-PRETAX> (103,932)
<INCOME-TAX> 0
<INCOME-CONTINUING> (103,932)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (103,932)
<EPS-PRIMARY> (0.52)
<EPS-DILUTED> (0.52)
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<CIK> 0000900392
<NAME> Discovery Zone, Inc.
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 5-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> AUG-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 8,607
<SECURITIES> 0
<RECEIVABLES> 750
<ALLOWANCES> 0
<INVENTORY> 1,739
<CURRENT-ASSETS> 29,225
<PP&E> 113,310
<DEPRECIATION> 0
<TOTAL-ASSETS> 176,591
<CURRENT-LIABILITIES> 26,179
<BONDS> 87,091
13,897
0
<COMMON> 40
<OTHER-SE> 42,215
<TOTAL-LIABILITY-AND-EQUITY> 176,591
<SALES> 0
<TOTAL-REVENUES> 49,107
<CGS> 0
<TOTAL-COSTS> 60,814
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 6,076
<INCOME-PRETAX> (27,966)
<INCOME-TAX> 0
<INCOME-CONTINUING> (27,966)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (27,966)
<EPS-PRIMARY> (7.02)
<EPS-DILUTED> (7.02)
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<CIK> 0000900392
<NAME> Discovery Zone, Inc.
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 7-MOS
<FISCAL-YEAR-END> DEC-12-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> JUL-31-1997
<CASH> 43,392
<SECURITIES> 0
<RECEIVABLES> 708
<ALLOWANCES> 0
<INVENTORY> 1,314
<CURRENT-ASSETS> 59,230
<PP&E> 102,250
<DEPRECIATION> 0
<TOTAL-ASSETS> 201,990
<CURRENT-LIABILITIES> 24,659
<BONDS> 87,632
13,800
0
<COMMON> 40
<OTHER-SE> 70,160
<TOTAL-LIABILITY-AND-EQUITY> 201,990
<SALES> 0
<TOTAL-REVENUES> 82,704
<CGS> 0
<TOTAL-COSTS> 86,248
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 3,249
<INCOME-PRETAX> (17,036)
<INCOME-TAX> 0
<INCOME-CONTINUING> (17,036)
<DISCONTINUED> 0
<EXTRAORDINARY> 332,145
<CHANGES> 0
<NET-INCOME> 326,712
<EPS-PRIMARY> 5.66
<EPS-DILUTED> 5.66
</TABLE>
