<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] Quarterly Report pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934.
For the quarterly period ended March 31, 1998
OR
[ ] Transition Report pursuant to Section 13 of 15 (d) of the
Securities Exchange Act of 1934.
For the transition period from _______ to _______.
Commission File Number 0-25916
YES! ENTERTAINMENT CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 94-3165290
- ------------------------------- -------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3875 Hopyard Road, Suite 375, Pleasanton, CA 94588
--------------------------------------------------
(Address of principal executive offices and zip code)
(510) 847-9444
(Registrant's telephone number, including area code)
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 proceeding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X NO
--- ---
As of March 31, 1998, there were 16,440,733 shares of the registrant's common
stock outstanding.
This quarterly report on Form 10-Q contains 23 pages of which this is page
number 1.
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YES! ENTERTAINMENT CORPORATION
INDEX
Page
----
Part I. Financial Information
Item 1. Consolidated Financial Statements
Consolidated Statements of Operations -
Three months ended March 31, 1998
and March 31, 1997............................ 3
Consolidated Balance Sheets -
March 31, 1998 and December 31, 1997.......... 4
Consolidated Statements of Cash Flows -
Three months ended March 31, 1998
and March 31, 1997............................ 5
Notes to Consolidated Financial Statements...... 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations... 10
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K................ 22
SIGNATURE PAGE.................................................. 23
2
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Item 1. CONSOLIDATED FINANCIAL STATEMENTS
YES! ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31
---------------------------------
1998 1997
------------ ------------
<S> <C> <C>
Net sales $11,869 $ 9,042
Cost of sales 7,201 5,325
------- -------
Gross profit 4,668 3,717
------- -------
Operating expenses:
Marketing, advertising and promotion 924 880
Selling, distribution and administrative 5,597 6,118
------- -------
Total operating expenses 6,521 6,998
------- -------
Operating (loss) (1,853) (3,281)
Interest income 3 13
Interest expense (403) (657)
Other expense, net (36) (52)
Gain on sale of assets 5,913 ---
------- -------
Income (loss) before provision for income taxes 3,624 (3,977)
Provision for income taxes -- (795)
------- -------
Net income (loss) $ 3,624 $(3,182)
Non-cash dividends and discount on preferred stock (623) (1,550)
------- -------
Net income ( loss) applicable to common stockholders $ 3,001 $(4,732)
======= =======
Basic earnings (loss) per share applicable to common stockholders $ 0.19 $ (0.34)
======= =======
Shares used in computing basic earnings (loss) per share 16,043 14,044
======= ========
Diluted earnings (loss) per share applicable to common stockholders $ 0.19 $ --
======= ========
Shares used in computing diluted earnings (loss) per share 16,116 0
======= ========
</TABLE>
See accompanying notes.
3
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YES! ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1998 1997
UNAUDITED AUDITED
-------------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 781 $ 624
Accounts receivable, net of allowance for doubtful accounts of $236
on March 31, 1998 and $137 on December 31, 1997 3,682 8,659
Inventories 9,837 13,513
Prepaid royalties 600 955
Prepaid expenses 1,275 1,254
Other current assets 2,496 1,989
-------- --------
Total current assets 18,671 26,994
Property and equipment, net 4,957 5,345
Intangibles and deposits, net 172 156
-------- --------
Total assets $ 23,800 $ 32,495
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Loans payable $ 1,560 $ 10,709
Accounts payable 8,981 11,716
Accrued royalties 2,132 2,406
Accrued liabilities 1,501 2,178
Deferred royalty income 300 --
Dividends payable 113 123
Capital lease obligations 4 5
-------- --------
Total current liabilities 14,591 27,137
Convertible debentures 1,786 1,741
Stockholders' equity :
Series B convertible preferred stock, $0.001 par value:
Authorized shares 2,000,000
Issued and outstanding shares of 359,244 on March 31, 1998 and 387,770
on December 31,1997 (aggregate liquidation preference of $8,981,100) 7,859 8,500
Common stock,$.001 par value:
Authorized shares 48,000,000 at March 31, 1998
Issued and outstanding shares - 16,440,733 on March 31,1998 and
15,537,159 on December 31,1997 17 16
Additional paid-in capital 91,854 90,434
Deferred compensation (564) (606)
Accumulated deficit (91,743) (94,727)
-------- --------
Total stockholders' equity 7,423 3,617
-------- --------
Total liabilities and stockholders' equity $ 23,800 $ 32,495
======== ========
</TABLE>
See accompanying notes
4
<PAGE>
YES! ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31
--------------------------------------
1998 1997
---------------- ---------------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ 3,624 $ (3,182)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Gain on sale of product lines (5,913) --
Depreciation and amortization 519 719
Advertising expenses funded by inventory (21) 78
Debt discount and warrant amortization 113 270
Accrued interest converted to convertible debt 24 67
Employer contribution to 401(k) plan funded with common stock 39 58
Deferred compensation 42
Changes in operating assets and liabilities:
Accounts receivable 4,977 13,173
Inventories 1,214 28
Prepaid royalties, expenses and other current assets (413) (1,297)
Accounts payable (3,273) (8,571)
Accrued royalties and liabilities (1,121) (458)
Income taxes payable __ (182)
Other long-term liabilities __ 3
------- --------
Net cash (used in) provided by operating activities (189) 706
INVESTING ACTIVITIES
Proceeds from sale of product lines 9,859 --
Acquisition of property and equipment (346) (801)
(Increase) decrease in intangibles and deposits (16) 41
------- --------
Net cash (used in) provided by investing activities 9,497 (760)
FINANCING ACTIVITIES
Proceeds from issuance of convertible debentures -- 1,500
Principal payments on loans payable (9,149) (10,460)
Principal payments on capital lease obligations (2) (4)
Proceeds from issuance of redeemable convertible preferred
stock, net of issuance costs -- 8,014
------- --------
Net cash (used in) provided by financing activities (9,151) (950)
------- --------
Net increase (decrease) in cash and cash equivalents 157 (1,004)
Cash and cash equivalents at beginning of period 624 1,572
------- --------
Cash and cash equivalents at end of period $ 781 $ 567
======= ========
</TABLE>
See accompanying notes.
5
<PAGE>
YES! ENTERTAINMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. QUARTERLY CONSOLIDATED FINANCIAL STATEMENTS
Interim Financial Statements
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instructions to Form 10-Q but do not
include all of the information and footnotes required by generally accepted
accounting principles for complete consolidated financial statements and
should, therefore, be read in conjunction with the Company's audited
consolidated financial statements and notes thereto for the fiscal year
ended December 31, 1997 included in the Annual Report on Form 10-K filed
with the Securities and Exchange Commission on April 15, 1998. In the
opinion of management, all adjustments (which consist only of normal
recurring accruals) have been made to present fairly the consolidated
operating results for the unaudited periods. The interim operating results
are not necessarily indicative of the results for fiscal 1998.
Basis of Presentation
The accompanying condensed consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements
and accompanying notes. Actual results could differ from those estimates.
2. INVENTORY (IN THOUSANDS)
March 31, December 31,
1998 1997
-------- ------------
Raw Materials $ 415 $ 496
Work-in-process 74 600
Finished goods 9,348 12,417
------ -------
$9,837 $13,513
====== =======
6
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3. SHAREHOLDER LAWSUITS
The Company is defending several shareholder lawsuits, as follows:
The State Securities Class Actions
- ----------------------------------
Two class actions have been filed against the Company, Donald D. Kingsborough,
Sol Kershner and Bruce D. Bower in the California Superior court of the County
of Alameda: Wang v. YES! Entertainment Corporation et al., filed on April 15,
--------------------------------------------
1997; and Miller v. YES! Entertainment Corporation et al., filed on July 3,
-----------------------------------------------
1997. In Miller , Gary L. Nemetz, a former director of the Company, is also
------
named as a defendant.
The Wang lawsuit is purportedly brought on behalf of purchasers of the Company's
----
common stock between October 23, 1996 and December 12, 1996, inclusive. It
challenges certain statements made by defendants regarding the Company's V-Link
product, as well as its impact on the Company's sales and profitability. The
Wang lawsuit alleges that these statements violated Corporations Code Section
25400 and 25500, which provides a remedy to California residents against persons
who make false or misleading statements while engaged in "market activity";
constituted "unfair competition" in violation of California Business &
Professions Code Section 17200; and constituted common law fraud pursuant to
California Civil Code Section 1709-1711.
The Miller lawsuit is based on the same facts as the Wang lawsuit, alleges a
------ ----
longer class period of March 29, 1996 to December 12, 1996, and challenges
certain additional statements made by defendants. The Miller first amended
------
complaint states only one count, which is for violation of (S)(S)25400 and 25500
of the California Corporations Code.
In July 1997, a demurrer filed by defendants in the Wang action was sustained
with leave to amend. Plaintiffs filed an amended complaint on September 29,
1997. On January 8, 1998, the court sustained without leave to amend defendant's
demurrer to the causes of action for violations of Sections 25400 and 25500 of
the California Corporations Code, and Section 17200 of the Business and
Professions Code in the amended complaint. On January 19, 1998, the plaintiff
filed a second amended complaint alleging only one count for violation of
California Civil Code Section, 1709, 1711 and 1717. Defendants filed a demurrer
to the second amended complaint which was sustained with ten days leave to amend
on March 31, 1998. Plaintiff has not yet filed their amended complaint.
7
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On January 7, 1998, the defendants' demurrer to the first amended complaint of
the Miller action was sustained with leave to amend. On January 19, 1998,
plaintiff filed a second amended complaint. Defendants filed a demurrer to the
second amended complaint which is scheduled to be heard in May 1998. In
addition, the plaintiffs have served on the Company two separate requests for
production of documents and have noticed the deposition of Donald D.
Kingsborough with a request for the production of documents. A date for the
deposition and production of documents has not yet been agreed upon.
The Federal Securities Class Actions
- ------------------------------------
Three class actions were filed against the Company and Messrs. Kingsborough
and Kershner in the United States District Court for the Northern District of
California: Harrow v. YES! Entertainment Corporation et al., filed on April 17,
-----------------------------------------------
1997; Takats v. YES! Entertainment Corporation et al., filed on June 11, 1997;
-----------------------------------------------
and Siegel v. YES! Entertainment Corporation et al., filed on June 27, 1997. On
-----------------------------------------------
August 6, 1997, the three Federal actions were consolidated for pre-trial
proceedings and captioned In re YES! Entertainment Corp. Securities Litigation,
Civil Action No. C-97-1388 MHP. On December 4, 1997, the action was referred to
the Northern District of California. On August 18, 1997, all defendants filed a
motion to dismiss the consolidated action. In response, on November 8, 1997,
plaintiffs filed a first amended consolidated complaint for violation of the
Securities Exchange Act of 1934. Defendants filed a motion to dismiss the
consolidated complaint on January 5, 1998. The hearing date for the motion is
set for May 22, 1998. The Federal class actions are based upon claims under the
federal securities laws, which impose liability on persons who make false or
misleading statements in connection with the sale or purchase of securities.
The State and Federal securities class action lawsuits have been tendered to the
applicable directors and officers insurance carriers who have responded with a
reservation of rights pending a final determination of coverage. Directors and
officers insurance coverage totals $5 million. The primary insurance policy is
subject to certain deductible and retention provisions.
The Company believes that it has meritorious defenses to these lawsuits and
intends to vigorously defend them. However, no assurance can be given as to the
outcome of the lawsuits. The Company believes it will incur substantial time and
expense to defend these lawsuits, and an adverse result in any of the lawsuits
would have a material effect on the Company's operating results and financial
condition. The State and Federal actions seek compensatory and punitive damages,
interest, attorneys' fees and other costs, as well as equitable relief to
preserve defendants' assets. The inability of the Company to prevail in the
8
<PAGE>
lawsuits could have a material adverse effect on the Company's business,
financial condition, and results of operations.
The Company is involved from time to time in other litigation matters
incidental to its business.
4. SALE OF PRODUCT LINES
In March 1998, the Company entered into a definitive agreement with Wham-O, Inc.
to purchase the assets of YES!'s Food and Girls Activity product lines. The
total purchase price includes approximately $9.8 million in cash for the
purchase of the lines and related inventories, a $2.5 million contingency
payment to be earned based upon certain performance criteria for the Food line
in the first year, and royalties of up to $5.5 million over a seven year period.
The company reported a gain of $5.9 million for the period ending March 31, 1998
related to this transaction.
Sales from these product lines were $15.7 million, $5.1 million and $0 for 1997,
1996 and 1995. Gross margin from these product lines were $9.5 million, $2.8
million and $0 for 1997, 1996 and 1995.
5. FASB STATEMENT NO. 130, REPORTING COMPREHENSIVE INCOME
As of January 1, 1998 the Company adopted Statement 130, Reporting Comprehensive
Income. Statement 130 establishes new rules for the reporting and display of
comprehensive income and its components; however, the adoption of the Statement
had no impact on the Company's net income or shareholders' equity.
During the first quarter of 1998 and 1997, total comprehensive income (loss)
amounted to 3,624 and (3,182).
9
<PAGE>
YES! ENTERTAINMENT CORPORATION -- PART I, ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results of
Operations includes certain forward looking statements about the Company that
are based on current expectations. Actual results may differ materially as a
result of any one or more of the risks identified in this section, as well as in
the section captioned "Business Risk Factors."
<TABLE>
<CAPTION>
Results of Operations
- ------------------------------------
(Dollars in thousands) Three months ended
March 31,
--------------------
1998 1997
------- -------
<S> <C> <C>
Net sales $11,869 $ 9,042
Cost of sales 7,201 5,325
------- -------
Gross profit 4,668 3,717
Gross profit % 39% 41%
Operating expenses 6,521 6,998
Operating expense % 55% 77%
Operating (loss) (1,853) (3,281)
Gain of Sale of Assets 5,913 --
Interest and other expense, net (436) (696)
------- -------
Income (loss) before provision for 3,624 (3,977)
income taxes
Provision for income taxes -- (795)
------- -------
Net income (loss) $ 3,624 $(3,182)
======= =======
Non-cash dividends and discount
on preferred stock (623) (1,550)
------- -------
Net income (loss) applicable to
common stockholders $ 3,001 $(4,732)
======= =======
</TABLE>
10
<PAGE>
NET SALES:
The Company's net sales for the first quarter of 1998 increased $2.8 million or
approximately 32% to $11.9 million from $9.0 million in the first quarter of
1997. Net sales in the first quarter of 1998 were comprised of approximately
$2.4 million in sales of lower margin close-out goods pertaining to V-Link and
Radical Air Weapons ("R.A.W.") product lines. International sales in the first
quarter of 1998 represented approximately 35% of total sales as compared to 30%
in the first quarter of 1997. In absolute dollars, international sales were up
approximately $1.4 million.
The increase in net sales in the first quarter of 1998 was due primarily to an
increase in lower margin close-out sales related primarily to V-Link and R.A.W.
product lines. Net sales in the quarter reflected lower sales of older products
as compared to the prior year period offset by sales of products which were
introduced subsequent to the first quarter of 1997, such as Air Vectors and W-3
Wild Water Weapons. The company expects that net sales in the second quarter of
1998 will be lower than in the first quarter of 1998 and that the subsequent
loss will also be greater.
The Company recognizes revenue upon shipment of product and computes net sales
by concurrently deducting a provision for sales returns and allowances,
including allowances for defective returns, price protection, mark downs and
other returns. Sales allowances may vary as a percentage of gross sales due to
changes in the Company's product mix, defective product allowances or other
sales allowances.
Sales of toys traditionally have been highly seasonal, with a majority of retail
sales occurring during the December holiday season. The Company expects that
its operating results will vary significantly from quarter to quarter, because
the majority of the Company's products are shipped in the quarters ending
September 30 and December 31.
The Company is dependent on a relatively small number of customers, in
particular Toys "R" Us, Inc. and Wal-Mart Stores, Inc., for a significant
percentage of its sales. Significant reductions in sales to any one or more of
the Company's largest customers would have a material adverse effect on the
Company's operating results. Because orders in the toy industry are generally
cancelable at any time without penalty, there can be no assurance that present
or future customers will not terminate their purchase agreements with the
Company or significantly change, reduce or delay the amount of products ordered
from the Company. Any such termination of a customer relationship or change,
reduction or delay in orders would have a material adverse effect on the
Company's operating results.
11
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COST OF SALES:
Cost of sales were approximately 61% and 59% of net sales in the first quarters
of 1998 and 1997, respectively. The increase in cost of sales as a percentage
of net sales in the first quarter as compared to the first quarter of 1997 was
primarily the result of an increased percentage of lower margin close-out sales
related to the Company's V-Link and R.A.W. product lines. The percentage
increase is also a result of the higher percentage of international sales in the
first quarter of 1998 as compared to the first quarter of 1997. International
sales have a higher cost of sales in general as compared to domestic sales.
In absolute dollars, cost of sales increased by $1.9 million or approximately
35% to $7.2 million in the first quarter of 1998 from $5.3 million in the first
quarter of 1997. This is due primarily to the higher sales volume with a much
higher percentage of low margin close-out sales.
<TABLE>
<CAPTION>
OPERATING EXPENSES:
(in thousands) Three months ended
March 31,
------------------
1998 1997
------- -------
<S> <C> <C>
Marketing, advertising & promotion $ 924 $ 880
Selling, distribution & administrative 5,597 6,118
------ ------
Total operating expenses $6,521 $6,998
====== ======
</TABLE>
Marketing, Advertising and Promotion. Marketing, advertising and promotion
expenses increased by approximately $44,000. As a percentage of net sales,
marketing, advertising and promotion expenses were 7.8% in the first quarter of
1998 as compared to 9.7% in the first quarter of 1997.
Selling, Distribution and Administrative. Selling, distribution and
administrative expenses decreased by $521,000, or approximately 8.5%, to $5.6
million in the first quarter of 1998 as compared to $6.2 million in the first
quarter of 1997. Selling , distribution, and administrative expenses as a
percentage of net sales were reduced to 47% in the first quarter of 1998 as
compared to 68% in the first quarter of 1997. Net reductions in this expense
category were the result of cost control measures implemented by the Company in
the quarter ended March 31, 1998.
12
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INTEREST EXPENSE:
The following table shows interest expense and interest income for the
applicable periods:
<TABLE>
<CAPTION>
(in thousands) Three months ended
March 31,
------------------
1998 1997
-------- -------
<S> <C> <C>
Interest income $ 3 $ 13
Interest expense (403) (657)
</TABLE>
The decrease in interest expense in the quarter ended March 31, 1998 as compared
to the comparable period in 1997 is the result of lower bank borrowings and non-
cash interest expense recorded in connection with the convertible debenture and
preferred stock financing, and the restructuring thereof, described in detail in
the Company's Annual Report on Form 10-K for the year ended December 31, 1997.
The non-cash interest expense recorded in the quarter ended March 31, 1998 was
$148,000. The decrease in interest income is the result of the lower cash
balances maintained by the Company during the quarter ended March 31, 1998 as
compared to the comparable period in 1997.
PROVISION FOR INCOME TAXES (INCOME TAX BENEFIT):
No income tax provision has been computed for the three months ended March 31,
1998 as the Company has sufficient net operating loss carryforwards to offset
the first quarter net income. The Company does not expect to earn a profit
during 1998.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 1998, the Company had cash and cash equivalents of approximately
$781,000, a $157,000 increase from approximately $624,000 at December 31, 1997.
The increase in cash and cash equivalents was due to $9.5 million provided by
investing activities, primarily offset by $9.2 million used in financing
activities and $189,000 used in operating activities.
The cash used by operating activities was due primarily to the Company's net
income which includes a $5.9 million gain from the sale of two product lines, a
decrease in accounts receivable of $5.0 million, a decrease in inventories of
$1.2 million partially offset by a decrease in accounts payable of approximately
$3.3 million.
13
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The $9.5 million provided by investing activities related primarily to proceeds
from the sale of two product lines which were used primarily to pay down the
Company's line of credit.
In March 1998, the Company sold its Licensed Food line, including its Mrs.
Fields Baking Factory and Baskin-Robbins Ice Cream Maker products, and its girls
activity business unit, including its Dance Studio and Cheer Leader products, to
Wham-O, Inc. The total purchase price included $9.8 million in cash for purchase
of the lines and related inventory, a contingency payment of up to $2.5 million
to be earned based upon certain performance criteria for the food line in the
first year, royalties of up to $5.5 million over a seven year period and an
allocation of $50,000 of such purchase price to Donald Kingsborough as
compensation for his agreement to a noncompete provision in the asset purchase
agreement.
Since its inception, the Company's internally generated cash flow has not been
sufficient to finance trade receivables, inventory, capital equipment
requirements and new product development, or to support operations. The Company
has met its capital requirements to date primarily through the initial public
offering of the Company, which generated net proceeds to the Company of
approximately $10.9 million, the exercise of IPO Warrants which generated
approximately $19.7 million, the private sales of approximately $50.0 million of
equity securities, borrowings of $2.0 million of long-term convertible
subordinated notes (now repaid), borrowings under short term loans from certain
stockholders, borrowings under bank loans guaranteed by certain shareholders,
borrowings under a factoring agreement with a group of banks, borrowings under a
Loan and Security Agreement with Congress Financial Corporation Western (now
repaid), and borrowings under an Accounts Receivable Management and Security
Agreement entered into with BNY Financial Corporation in July 1995, as amended
(the "ARM Agreement"). In addition, in the first quarter of 1997, the Company
raised net proceeds of approximately $9.3 million from the sale of convertible
debentures, preferred stock and warrants and, in the third quarter of 1997,
satisfied trade debt of $3.1 million by issuing common stock to several of its
vendors.
To meet seasonal working capital requirements during 1998, the Company
anticipates borrowing substantial amounts under the ARM Agreement. The terms of
the ARM Agreement, as amended, provide that BNY Financial Corporation may
advance YES! up to $30 million on the basis of the Company's accounts
receivable, inventory and product being imported on a letter of credit basis.
Loans to the Company are fully secured by all of the Company's assets, including
intellectual property, and BNY acquired ownership of all of the Company's trade
receivables. The Company is required to remain in compliance with certain
financial and other covenants under the ARM Agreement. As of December 31, 1997,
the Company was required to maintain a monthly quick ratio
14
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of 1:1 under the ARM Agreement. The ratio at December 31, 1997 was 0.5:1 and the
Company obtained a waiver for the month of December 1997 with regard to the
quick ratio requirement. Since the month ended December 31, 1997, BNY Financial
Corporation and the Company have amended the ARM Agreement to require that a
monthly quick ratio of 0.5:1 be maintained for the quarter ending March 31,
1998, which ratio shall decrease to 0.4:1 as of June 30, 1998 and increase to
0.5:1 thereafter. The company was in compliance with this covenant requirement
at March 31, 1998. As of December 31, 1997, the ARM Agreement required that a
ratio of earnings calculated before interest, taxes, depreciation and
amortization to total interest expense of 5:1 on a retrospective rolling four
quarter basis be maintained. The Company recorded a loss before interest, taxes,
depreciation and amortization for the four quarters ended December 31, 1997. The
Company has obtained a waiver from BNY with regard to this covenant for the
fourth quarter of 1997. Since the month ended December 31, 1997, BNY Financial
Corporation and the Company have amended the ARM Agreement to require that a
ratio of earnings calculated before interest, taxes, depreciation and
amortization to total interest expense of 5:1 on a prospective rolling four
quarter basis be maintained for the year beginning January 1, 1998 and reverts
back to a retrospective rolling four quarter basis effective January 1, 1999.
The company was in compliance with this covenant requirement at March 31, 1998.
A tangible net worth of $32 million at December 31, 1997 was required under the
ARM Agreement. As of December 31, 1997 the Company had a tangible net worth of
$3.5 million. The Company has obtained a waiver with respect to this requirement
from BNY Financial Corporation for the fourth quarter of 1997. Since the month
ended December 31, 1997, BNY Financial Corporation and the Company have amended
the ARM Agreement to require a tangible net worth of $6.9 million at March 31,
1998, $3.8 million at June 30, 1998, $4.3 million at September 30, 1998 and $3.0
million at December 31, 1998. The company was in compliance with this covenant
requirement at March 31, 1998. The ARM Agreement also restricts the ability of
the Company to obtain working capital in the form of indebtedness, other than
indebtedness incurred in the ordinary course of the Company's business or to
grant security interests in the assets of the Company. As of March 31, 1998, the
Company had borrowings of $1.6 million under the ARM Agreement.
The Company's working capital needs will depend upon numerous factors, including
the extent and timing of acceptance of the Company's products in the market, the
Company's operating results, the cost of increasing the Company's sales and
marketing activities and the status of competitive products, none of which can
be predicted with certainty. The Company has experienced severe working capital
shortfalls in the past, which have restricted the Company's ability to conduct
its business as anticipated. As a result of seasonality in the toy industry, the
timing of new product introductions and the Company's planned
15
<PAGE>
growth, there can be no assurance that the Company will not require additional
funding. There can be no assurance that any additional financing will be
available to the Company on acceptable terms, if at all, when required by the
Company. The inability to obtain such financing would have a material adverse
effect on the Company's operating results.
BUSINESS RISK FACTORS
History of Losses; Accumulated Deficit. The Company incurred operating losses of
$38.2 and $12.6 million for the years ended December 31, 1997 and 1996,
respectively. In 1997, the Company had a net cash outflow of $1.4 million. In
the first quarter of 1998, the Company incurred an operating loss of $1.9
million with a resulting accumulated deficit of $91.7 million. As a result of
these losses, the Company has incurred indebtedness to finance its operations.
See "Dependence on Restricted Facility." In the event the Company continues to
incur operating losses and is unable to obtain additional financing on favorable
terms, or at all, in the future, its operating results and financial condition
would be materially adversely affected.
Dependence on 1998 Products. In 1998, the Company has introduced and expects to
commence sales of a number of new product lines in new product categories, such
as the W-3 Wild Water Weapons, Air Vectors SFX, Yak Live, Fistful of Aliens and
Teddy Ruxpin. In addition, the Company also expects to expand its existing
product lines in 1998, particularly its YES! Gear line of products.
Manufacturing of certain of these items in commercial quantities has not
commenced or is just commencing. The Company expects that completing the
development and the manufacture of its 1998 product lines will place great
demands on management and other Company resources. If the Company is not able to
complete the development, tooling, manufacture and successful marketing of its
1998 product lines, the Company's operating results and financial condition
would be materially adversely affected.
Dependence on Yak Bak and Power Penz. The majority of the Company's current
product lines are sold under the YES! Gear brand and consist of Yak Bak and
Power Penz products. The Company had a significant decline in the sales of its
Yak Bak products in 1997 as compared to 1996 and, while Power Penz revenues were
stable, gross margins on its Power Penz sales declined due to a shift from
domestic to international sales. These product lines accounted for 51% and 72%
of net sales in 1997 and 1996 respectively. The Power Penz brand accounted for
26% and 22% of net sales in 1997 and 1996 respectively. The Company expects
these brands to continue to account for a substantial percentage of the
Company's business, but there can be no assurance that they will be able to
sustain sales at the 1997 level, or at a level necessary to maintain its overall
sales
16
<PAGE>
and revenues. In addition, a number of toy manufacturers have attempted to
duplicate the Company's success in these areas and there can be no assurance
that the sale of these competitive products will not impact the sale of the Yak
Bak or Power Penz product lines.
Just in Time Inventory; Compressed Sales Cycles. Most of the Company's most
significant customers have adopted inventory management systems to track sales
of particular products and rely on reorders being filled rapidly by suppliers,
rather than maintaining large on-hand inventories to meet consumer demand. While
these systems reduce a retailer's investment in inventory, they increase
pressure on suppliers like the Company to fill orders promptly and shift a
significant portion of inventory risk to the supplier. The limited inventory
carried by the Company's customers may also reduce or delay consumer sell-
through which in turn could impair the Company's ability to obtain reorders of
its product in quantities necessary to permit the Company to achieve planned
sales and income growth. In addition, the Company may be required to incur
substantial additional expense to fill late reorders in order to ensure the
product is available at retail prior to Christmas; these may include drop-
shipment expense and higher advertising allowances which would otherwise be
borne by the Company's customers. In the event that anticipated reorders do not
materialize, the Company may incur increased inventory carrying costs.
Changes in 1998 Product Line. The Company constantly evaluates the toy markets
and its development and manufacturing schedules. As the year progresses, the
Company may elect to reduce the number of products it currently plans on
shipping in 1998 for a variety of reasons, which include but are not limited to
more accurate evaluation of demand, supply and manufacturing difficulties, or
competitive considerations. Similarly, the Company may add products to its 1998
line either by accelerating development schedules or strategic acquisitions of
current product lines. Reducing or adding products from and to the Company's
line may have an impact on the Company's financial performance depending on,
among other things, the price points, advertising and promotional support for
and development, tooling and manufacturing costs of such products, relative to
products they replace or are replaced by, as the case may be, if applicable.
Sales Concentration Risk. The Company's ten largest customers accounted for 73%,
85% and 87% of sales for the years ending December 31, 1997, 1996 and 1995,
respectively. For the year ended December 31, 1997, the Company's two largest
customers, TRU and Wal-Mart, accounted for 21% and 13% of net sales,
respectively. For the year ended December 31, 1996, the same two customers
accounted for approximately 21% and 20% of net sales, respectively, and for the
year ended December 31, 1995, TRU and Wal-Mart each accounted for 27% of net
sales. While the Company intends to expand distribution to new accounts, the
17
<PAGE>
Company expects to continue to depend on a relatively small number of customers
for a significant percentage of its sales. Significant reductions in sales to
any one or more of the Company's largest customers would have a material adverse
effect on the Company's operating results. Because orders in the toy industry
are generally cancelable at any time without penalty, there can be no assurance
that present or future customers will not terminate their purchase arrangements
with the Company or significantly change, reduce or delay the amount of products
ordered from the Company. Any such termination of a significant customer
relationship or change, reduction or delay in significant orders could have a
material adverse effect on the Company's operating results.
Price Protection; Stock Balancing; Reliance of Timely Payment. In connection
with the introduction of new products, many companies in the toy industry
discount prices of existing products, provide for certain advertising allowances
and credits or give other sales incentives to their customers, particularly
their most significant customers. In addition, in order to address working
capital requirements, sales of inventory, changes in marketing trends and other
issues, many companies in the toy industry allow retailers to return slow-moving
products for credit, or if the manufacturer lowers the prices of its products,
to provide price adjustments for inventories on hand at the time the price
change occurs. The Company has made such accommodations in the past, and expects
to make accommodations such as stock balancing, returns, other allowances or
price protection adjustments in the future. Any such accommodations by the
Company in the future could have a material adverse effect on the Company's
operating results. In addition, in the past certain of the Company's retail
customers have delayed payment beyond the date such payment is due. Delays in
payments from retail customers in the future could materially impact the
Company's anticipated cash flow to the detriment of the Company's business.
Delays or reductions in payment have, in the past, increased the Company's
reliance on other sources of capital, including bank lines of credit, which has
increased the Company's interest expense and, in the case of payment reductions,
reduced profitability, or increased loss, by an amount equivalent to such
reductions. Delays or reductions in payment in the future would have the same or
similar effect.
Seasonality. Sales of toys traditionally have been highly seasonal, with a
majority of retail sales occurring during the December holiday season.
Accordingly, the Company expects that its operating results will vary
significantly from quarter to quarter, particularly in the third and fourth
quarters, when the majority of products are shipped, and the first quarter, when
a disproportionate amount of receivables are collected and trade credits are
negotiated. In addition, although indications of interest are provided by
retailers early in the year for product shipments for the December holiday
season, committed orders are not placed
18
<PAGE>
until later in the year and, even when placed, such orders generally are
cancelable at any time without penalty. Accordingly, the Company generally must
enter into tooling, manufacturing media and advertising commitments prior to
having firm orders. As a result, there can be no assurance that the Company can
maintain sufficient flexibility with respect to its working capital needs or its
ability to manufacture products and obtain supplies of raw materials, tools and
components to be able to minimize the adverse effects of an unanticipated
shortfall or increase in demand. Failure to accurately predict and respond to
consumer demand may cause the Company to produce excess inventory which could
materially adversely affect the Company's operating results and financial
condition. Conversely, if a product achieves greater success than anticipated,
the Company may not have sufficient inventory to meet retail demand, which could
adversely impact the Company's relations with its customers.
Short Product Cycles. Consumer preferences in the toy industry are continuously
changing and are difficult to predict. Few products achieve market acceptance,
and even when they do achieve commercial success, products typically have short
life cycles. There can be no assurance that (i) new products introduced by the
Company will achieve any significant degree of market acceptance, (ii)
acceptance, if achieved, will be sustained for any significant amount of time,
or (iii) such products' life cycles will be sufficient to permit the Company to
recover development, manufacturing, marketing and other costs associated
therewith. In addition, sales of the Company's existing product lines are
expected to decline over time, and may decline faster than expected unless
existing products are enhanced or new product lines are introduced. Failure of
new product lines to achieve or sustain market acceptance would have a material
adverse effect on the Company's operating results and financial condition. Any
or all products within the YES! Gear and Power Penz categories, which categories
account for a majority of the Company's overall product sales, will experience
relatively short life cycles.
International Business Risk. The Company will rely in 1998 principally on
foreign distributors to market and sell the Company's products outside the
United States. Although the Company's international sales personnel work closely
with its foreign distributors, the Company cannot directly control such
entities' sales and marketing activities and, accordingly, cannot directly
manage the Company's product sales in foreign markets. The percentage of total
sales constituting foreign sales for 1995, 1996 and 1997 are 7%, 21% and 32%,
respectively. In addition, the Company's international sales may be disrupted by
currency fluctuations or other events beyond the Company's control, including
political or regulatory changes. To date, substantially all of the Company's
international sales have been denominated in US dollars and therefore the
19
<PAGE>
Company has not to date experienced any adverse impact from currency
fluctuations. To the extent future sales are not denominated in US dollars,
currency exchange fluctuations in the countries where the Company does business
could materially adversely affect the Company's business, financial condition
and results of operations.
Dependence on Manufacturing Facilities Based in People's Republic of China. The
Company contracts for the manufacture of substantially all of its products with
entities based in Hong Kong whose manufacturing facilities are located in the
People's Republic of China. In June 1997, Hong Kong became a sovereign territory
of the People's Republic of China. While the People's Republic of China has
provided assurances that Hong Kong will be allowed to maintain critical economic
and tax policies, there can be no assurance that political or social tensions
will not develop in Hong Kong that would disrupt this process. In addition,
tensions between the Peoples Republic of China and the Republic of China
(Taiwan), and the United States' involvement therein, could result either in a
disruption in manufacturing in the China mainland or in the imposition of
tariffs or duties on Chinese manufactured goods. Either event would have an
adverse impact on the Company's ability to obtain its products or on the cost of
these products, respectively, such that its operating results and financial
condition would be materially adversely affected.
Dependence on Restrictive Facility. The Company is dependent on the ARM
Agreement with BNY Financial Corporation to meet its financial needs during
1998, due in large part to the seasonality of the Company's business whereby the
Company is required to finance the manufacture of a substantial portion of its
products in the summer and autumn but does not collect on the sale of these
products until the fourth quarter of that year and the first quarter of the
following year. Under the terms of the ARM Agreement, BNY Financial Corporation
has taken a first priority security interest in substantially all of the
Company's assets, including its intellectual property. The ARM Agreement also
contains a number of restrictive covenants and events of default, including a
provision specifying that it shall be an event of default if Donald
Kingsborough, the Company's Chief Executive Officer, is not active in the
management of the Company and is not replaced within ninety (90) days with a
suitable individual of comparable experience and capability. In the event the
Company falls out of compliance with the ARM Agreement, and BNY Financial
Corporation does not provide financing, the Company would not be able to finance
its operations as contemplated, and its operating results and financial
condition would be materially adversely affected.
Dependence on Key Personnel. The Company's future success will depend to a
significant extent on the efforts of the key management personnel, including
20
<PAGE>
Donald D. Kingsborough, the Company's Chairman and Chief Executive Officer, Mark
Shepherd, the Company's Chief Operating and Financial Officer and other key
employees. The loss of one or more of these employees could have a material
adverse effect on the Company's business. In addition, the Company believes that
its future success will depend in large part on its ability to attract and
retain highly qualified management, operations and sales personnel. There can be
no assurance that the Company will be able to attract and retain the employees
it needs to in order to ensure its success.
Impact of Year 2000. The Company in the process of evaluating and updating its
internal management information systems so that they will have the capability to
manage and manipulate data involving the transition of dates from 1999 to 2000
without functional or data abnormality and without inaccurate results relating
to such dates. The Company expects to complete the updating of its current
systems before 2000. Any new systems implemented by the Company would be Year
2000 compliant. Other participants in the Company's industry may also experience
functional or data abnormality. Any failures on the part of the Company or the
Company's manufacturers, lending institutions and key customers to ensure their
respective software complies with Year 2000 requirements, could have a material
adverse effect on the financial condition and results of operation of the
Company.
21
<PAGE>
PART II. OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS
See Note 3 to the Consolidated Financial Statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
10.1/(1)/ Third Amendment to Accounts Receivable Management and
Security Agreement by and between Registrant and BNY
Financial Corporation.
27.1 Financial Data Schedule for the quarter ended
March 31, 1998.
b) Reports on Form 8-K
No current reports pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 were filed by the Company
during the quarter ended March 31, 1998.
(1) Previously filed as Exhibit 10.28 to the Registrant's Annual Report on Form
10-K.
22
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
YES! Entertainment Corporation
------------------------------
Registrant
Date May 15, 1998 /s/ Donald D. Kingsborough
------------ --------------------------
Donald D. Kingsborough
Chief Executive Officer
(Principal Executive Officer)
Date May 15, 1998 /s/ Mark Shepherd
------------ -----------------
Mark Shepherd
Chief Financial Officer
(Principal Financial and
Accounting Officer)
23
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