FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (MARK ONE) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For Quarter Ended February 26, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ... to ... Commission File No. 0-19194 RAG SHOPS, INC. (Exact name of registrant as specified in its charter) DELAWARE 51-0333503 (State or other jurisdiction of (I.R.S. Employer Identification incorporation or organization) Number) 111 WAGARAW ROAD HAWTHORNE, NEW JERSEY 07506 (Address of principal executive (Zip Code) offices) Registrant's telephone number, including area code (973) 423-1303 Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. CLASS OUTSTANDING AT MARCH 24, 2000 Common stock, par value $.01 4,810,883 Page 1 of 12 RAG SHOPS, INC. AND SUBSIDIARIES INDEX Page PART 1 - FINANCIAL INFORMATION Item 1. Financial Statements Condensed consolidated balance sheets - February 26, 2000 (unaudited), February 27, 1999 (unaudited) and August 28, 1999 3 Condensed consolidated statements of income - three and six months ended February 26, 2000 (unaudited) and February 27, 1999 (unaudited) 4 Condensed consolidated statements of cash flows - six months ended February 26, 2000 (unaudited) and February 27, 1999 (unaudited) 5 Notes to condensed consolidated financial statements 6-7 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 8-11 PART II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders 12 Item 6. Exhibits and Reports on Form 8-K 12 SIGNATURES 12 Page 2 of 12 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (All amounts in thousands) February 26,February 27,August 28, 2000 1999 1999 ---- ---- ---- (Unaudited) (Unaudited) (Note A) ASSETS Current assets: Cash $ 4,803 $ 2,989 $ 934 Merchandise inventories 23,198 24,063 30,563 Prepaid expenses 312 376 536 Other current assets 146 252 225 Deferred taxes 805 707 805 ------- ------- ------- Total current assets 29,264 28,387 33,063 Property and equipment, net 3,862 4,692 4,490 Other assets 270 283 316 ------- ------- ------- $33,396 $33,362 $37,869 ====== ====== ====== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Note payable-bank $ - $ - $ 6,570 Accounts payable-trade 5,484 6,635 5,928 Accrued expenses and other current liabilities 2,447 2,189 2,505 Accrued salaries and wages 709 667 605 Income taxes payable 844 669 157 Current portion of long-term debt - 197 - ------ ------ ------ Total current liabilities 9,484 10,357 15,765 Stockholders' equity: Common Stock 48 45 48 Additional paid-in capital 6,268 6,039 6,268 Unamortized restricted stock awards (96) - (207) Retained earnings 17,756 16,921 16,059 Treasury stock, at cost (64) - (64) ------ ------ ------ Total stockholders' equity 23,912 23,005 22,104 ------ ------ ------ $33,396 $33,362 $37,869 ====== ====== ====== Note A: Derived from the August 28, 1999 audited balance sheet. See notes to the condensed consolidated financial statements. Page 3 of 12 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (All amounts in thousands, except share data) Three Months Ended Six Months Ended February 26,February 27,February 26,February 27, 2000 1999 2000 1999 ---- ---- ---- ---- Net sales $26,492 $25,061 $54,678 $51,756 Cost of merchandise sold and occupancy costs 16,914 15,909 34,381 32,587 ------ ------ ------ ------ Gross profit 9,578 9,152 20,297 19,169 ------ ------ ------ ------ Store expenses 6,115 6,008 12,254 11,760 General and administrative expenses 2,649 2,741 5,515 5,324 ------ ------ ------ ------ Total operating expenses 8,764 8,749 17,769 17,084 ------ ------ ------ ------ Income from operations 814 403 2,528 2,085 Interest income (expense), net 36 15 (72) (13) ------ ------ ------ ------ Income before income taxes and cumulative effect of change in accounting 850 418 2,456 2,072 Provision for income taxes 332 164 958 809 ------ ------ ------ ------ Income before cumulative effect of change in accounting 518 254 1,498 1,263 Cumulative effect of change in accounting for merchandise inventories, net of income taxes - - 198 - ------ ------ ------ ------ Net income $ 518 $ 254 $ 1,696 $ 1,263 ====== ====== ====== ====== EARNINGS PER COMMON SHARE : Basic and diluted Income before cumulative effect of change in accounting $ .11 $ .05 $ .31 $ .27 Cumulative effect of change in accounting - - .04 - ------ ------ ------ ------ Net income $ .11 $ .05 $ .35 $ .27 ====== ====== ====== ====== See notes to the condensed consolidated financial statements. Page 4 of 12 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (All amounts in thousands) Six Months Ended February 26, 2000 February 27, 1999 Cash flows from operating activities: Net income $ 1,696 $ 1,263 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 675 685 Loss on disposition of property and equipment 14 20 Amortization of restricted stock awards 112 - Cumulative effect of accounting change (325) - Changes in assets and liabilities: (Increase) decrease in: Merchandise inventories 7,690 2,396 Prepaid expenses 225 156 Other current assets 79 (175) Other assets 45 37 Increase (decrease) in: Accounts payable-trade (445) 80 Accrued expenses and other current liabilities (29) 224 Accrued salaries and wages 104 49 Income taxes payable 687 425 ------ ------ Net cash provided by operating activities 10,528 5,160 ------ ------ Cash flows from investing activities: Payments for purchases of property and equipment (89) (1,070) ------ ------ Net cash used in investing activities (89) (1,070) ------ ------ Cash flows from financing activities: Proceeds from issuance of note payable-bank 5,805 6,595 Repayments of note payable-bank (12,375) (8,230) Repayments of long-term debt - (362) ------ ------ Net cash used in financing activities (6,570) (1,997) ------ ------ Net increase in cash 3,869 2,093 Cash, beginning of period 934 896 ------ ------ Cash, end of period $ 4,803 $ 2,989 ====== ====== Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 197 $ 47 ====== ====== Income taxes $ 353 $ 258 ====== ====== See notes to the condensed consolidated financial statements. Page 5 of 12 RAG SHOPS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE AND SIX MONTHS ENDED FEBRUARY 26, 2000 AND FEBRUARY 27, 1999 NOTE 1 - BASIS OF PRESENTATION The accompanying financial statements are unaudited, but in the opinion of management reflect all adjustments, which include normal recurring accruals necessary for a fair presentation of the consolidated financial statements for the interim period. Since the Company's business is seasonal, the operating results for the three and six months ended February 26, 2000 are not necessarily indicative of results for the fiscal year. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these condensed consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission in November 1999. Certain reclassifications have been made to prior year amounts in order to conform with the presentation for the current year. NOTE 2 - EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share: Three Months Ended Six Months Ended February 26,February 27, February 26,February 27, 2000 1999 2000 1999 ---- ---- ---- ---- Numerator: Income before cumulative effect of change in accounting $ 518,000 $ 254,000 $1,498,000 $1,263,000 Cumulative effect of change in accounting - - 198,000 - ----------- ----------- ----------- ----------- Net income $ 518,000 $ 254,000 $1,696,000 $1,263,000 ========== ======== ========= ========= Denominator: Denominator for basic earnings per share-weighted average shares 4,810,883 4,740,063 4,810,883 4,740,063 Effect of dilutive securities: Employee stock options - 18,272 20 18,731 --------- --------- --------- ---------- Denominator for diluted earnings per share-adjusted weighted average shares and assumed conversions 4,810,883 4,758,335 4,810,903 4,758,794 ========= ========= ========= ========= Page 6 of 12 RAG SHOPS, INC. AND SUBSIDIARIES Three Months Ended Six Months Ended February 26,February 27, February 26,February 27, 2000 1999 2000 1999 ---- ---- ---- ---- Basic earnings per share: Income before cumulative effect of change in accounting $ .11 $ .05 $ .31 $ .27 Cumulative effect of change in accounting - - .04 - --------- ------------ ------------- ----------- Net income $ .11 $ .05 $ .35 $ .27 =========== ============ ============ ============ Diluted earnings per share: Income before cumulative effect of change in accounting $ .11 $ .05 $ .31 $ .27 Cumulative effect of change in accounting - - .04 - ---------- ------------ ------------ ------------ Net income $ .11 $ .05 $ .35 $ .27 =========== ============ ============ ============ Earnings per share calculations for the three and six months ended February 27, 1999 have been adjusted to give retroactive effect to the 5% stock dividend on the Company's common stock declared by the Company on June 28, 1999 which was paid on August 10, 1999 to stockholders of record on July 14, 1999. NOTE 3 - CHANGE IN ACCOUNTING PRINCIPLE Effective August 29, 1999, the Company changed its method of calculating ending merchandise inventories under the retail inventory method. Prior to August 29, 1999, the Company utilized an average cost-to-retail ratio to value ending inventory. In fiscal year 2000, the Company began utilizing a method that weights the cost-to-retail ratio using multiple inventory categories. Management believes that this change in accounting improves the measurement of the Company's profitability based upon a changing product mix. The cumulative effect of this accounting change was to increase the Company's first quarter fiscal 2000 profit, net of income taxes, by approximately $198,000. NOTE 4 - ADOPTION OF ACCOUNTING STANDARDS In April 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Position No. 98-5 "Reporting on the Costs of Start-Up Activities" ("SOP"). This SOP requires the costs associated with start-up activities, such as opening a new store, be expensed as incurred. Effective August 29, 1999 the Company adopted this SOP. The adoption of this SOP did not have any effect on the Company's results of operations. Page 7 of 12 RAG SHOPS, INC. AND SUBSIDIARIES Item 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Results of Operations The following table sets forth as a percentage of net sales, certain items appearing in the condensed consolidated statements of income for the indicated periods. Three Months Ended Six Months Ended February 26,February 27,February 26, February 27, 2000 1999 2000 1999 ---- ---- ---- ---- Net sales 100.0% 100.0% 100.0% 100.0% Cost of merchandise sold and occupancy costs 63.8 63.5 62.9 63.0 ----- ----- ----- ----- Gross profit 36.2 36.5 37.1 37.0 Store expenses 23.1 24.0 22.4 22.7 General and administrative expenses 10.0 10.9 10.1 10.3 ----- ----- ----- ----- Income from operations 3.1 1.6 4.6 4.0 Income before cumulative effect of change in accounting 2.0 1.0 2.7 2.4 Cumulative effect of change in accounting - - .4 - Net income 2.0% 1.0% 3.1% 2.4% ==== ===== ==== ===== The Company's net sales increased by $1,431,000 and $2,922,000 for the three and six months ended February 26, 2000 representing an increase of 5.7% and 5.6%, respectively, over the comparable prior periods due to new store sales of $1,324,000 and $3,611,000, respectively, in addition to increases in comparable store sales of $732,000 or 3.1% and $657,000 or 1.3%, respectively, over the comparable prior periods, and closed store sales of $625,000 and $1,346,000 for the three and six month periods, respectively. The increase in comparable store sales was primarily attributable to strong December sales. Gross profit as a percentage of net sales decreased by .3% for the three months ended February 26, 2000, from the comparable prior period primarily due to an increase in occupancy costs, principally attributable to the five new stores opened in the prior fiscal year, and promotional markdowns. These amounts were partially offset by an improvement in the initial markup of inventory purchases due to an increase in the mix of direct imports, which are more profitable than domestic purchases. Gross profit as a percentage of net sales increased by .1% for the six months ended February 26, 2000 from the comparable prior period due to an increase in the initial markup, offset by an increase in occupancy costs, as mentioned above. Store expenses increased by $107,000 and $494,000 for the three and six months ended February 26, 2000, respectively, from the comparable prior period, due to an increase in payroll and payroll related expenses that were principally attributable to new stores opened net of closed stores in the prior fiscal year. As a percentage of net sales, store expenses decreased by .9% and .3% for the three and six months ended February 26, 2000, respectively, over the comparable prior period as these expenses were leveraged against the increase in net sales. General and administrative expenses decreased by $92,000 and .9% as a percentage of net sales for the three months ended February 26, 2000, over the comparable prior period principally due to Page 8 of 12 RAG SHOPS, INC. AND SUBSIDIARIES the reduction of costs in our distribution center operation. General and administrative expense increased $191,000 for the six months ended February 26,2000 primarily due to an increase in professional fees. As a percentage of net sales, general and administrative expenses decreased .2% from the comparable prior period as the Company was able to leverage these expenses against the increase in net sales. Interest income, net increased by $21,000 for the three months ended February 26, 2000 from the comparable prior period due to an increase in cash provided by operating activities. Interest expense, net increased by $59,000 for the six months ended February 26, 2000 from the comparable prior period as a result of higher borrowings on the Company's line of credit in the first fiscal quarter, partially offset by the increase in interest income as previously mentioned. See "Liquidity and Capital Resources". Net income increased by $264,000 for the three months ended February 26, 2000 as compared to the comparable prior period due to an increase in comparable stores sales and a decrease in general and administrative expenses, that was partially offset by an increase in store expenses. Net income increased $433,000 for the six months ended February 26, 2000 compared to the prior period as a result of increases in comparable stores sales, gross profit and the cumulative effect of change in accounting for merchandise inventories, that was partially offset by an increase in operating expenses. Seasonality The Company's business is seasonal, which the Company believes is typical of the retail fabric and craft industry. The Company's highest sales and earnings levels historically occur between September and December. The Company has historically operated at a loss during the fourth quarter of its fiscal year, the June through August summer period. Year to year comparisons of quarterly results and comparable store sales can be affected by a variety of factors, including the timing and duration of holiday selling seasons and the timing of new store openings and promotional markdowns. Liquidity and Capital Resources The Company's primary needs for liquidity are to maintain inventory for the Company's existing stores and to fund the costs of opening new stores, including capital improvements, initial inventory and pre-opening expenses. During the six months ended February 26, 2000 and the comparable prior period, the Company relied on internally generated funds, short-term borrowings and credit made available by suppliers to finance inventories and new store openings. The Company's working capital has increased $2,482,000 for the six months ended February 26, 2000 as compared to the August 28, 1999 amount primarily as a result of the Company retaining its net income for this period and the reduction in merchandise inventories net of the bank line of credit repayment. The Company maintains a $10 million credit facility with a bank. The credit facility is renewable annually on or before each December 31 and consists of a discretionary unsecured line of credit for direct borrowings and the issuance and refinance of letters of credit. Borrowings under the line of credit bear interest at the bank's prime rate (8.75% at February 26, 2000). The credit facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants. The Company has satisfied its line of credit clean-up provision for year 2000 during the three months ended February 26, 2000. Historically, the amount borrowed has varied based on the Company's seasonal requirements, generally reaching a maximum amount outstanding during the fourth quarter of each fiscal year. The maximum amount borrowed under the line was $7,490,000 and $2,330,000 for the six months ended February 26, 2000 and Page 9 of 12 RAG SHOPS, INC. AND SUBSIDIARIES February 27, 1999, respectively. The Company intends to maintain the availability of a line of credit for seasonal working capital requirements and in order to be able to take advantage of future opportunities. Net cash provided by operating activities for the six months ended February 26, 2000 and February 27, 1999 amounted to $10,528,000 and $5,160,000, respectively, and $89,000 and $1,070,000, respectively, was used for purchases of property and equipment. During the six months ended February 26, 2000 the Company did not open any new stores, closed two existing stores and was operating sixty-seven stores at the end of the period. During the remainder of the fiscal year ending September 2, 2000 the Company anticipates no new store openings, closing two additional stores and resume opening new stores in the ensuing fiscal year. Costs associated with the opening of new stores, including capital expenditures, inventory and pre-opening expenses, have approximated $350,000 per store. These costs will be financed primarily from cash provided by operating activities, credit made available by suppliers to finance inventories and, if necessary, from the Company's bank line of credit. However, the Company will redeploy assets of stores being closed to the new stores as opportunities evolve in order to curtail the costs of opening new stores. Year 2000 Readiness Disclosure To conduct its business efficiently, the Company relies on several critical information technology ("IT") systems for functions including point-of-sale operations, inventory control, financial and accounting management, communications, purchasing, records retention, and general administrative procedures. Beginning in 1997, the Company began an internal review of its IT systems to ensure their viability in light of the highly-publicized "Year 2000" problem. The Company has also begun to assess other, non-IT systems (such as security and electrical) to identify potential Year 2000 issues that may arise from embedded chip technology. Because the Company's use of internal systems that include such technology is limited, management does not expect its non-IT systems to pose a material Year 2000 issue. Concurrently, management has been undertaking a general reevaluation of the Company's IT systems in its effort to enhance efficiency and increase profitability in a highly competitive marketplace. In several cases, this modernization program has allowed management to address Year 2000 compliance issues by entirely replacing certain obsolete technology with new systems that are Year 2000-compliant. Among the systems whose modernization is completed or underway are those controlling inventory, purchasing, point-of-sale data and central administration. As part of this review, management has also communicated with its most important suppliers and other vendors to ensure their Year 2000 compliance. The Company is cooperating with these vendors to upgrade certain software and maintain Year 2000 compliance both internally and externally. Management believes that its efforts has allowed the Company to be fully Year 2000-compliant, including allowances for integrated testing. Management has allowed for further time in the event certain system elements need additional upgrading. However, management believes that this possibility is unlikely as much of the necessary work has already been completed and tested. The Company completed and implemented its contingency plan in early December of the current fiscal year in the event there were to be an interruption of key internal or external services. In particular the Company's plan establishes alternatives in the event of any disturbance in external telecommunications, electric power, financial or transportation networks. As of the date of this filing, the Company has not experienced any disturbances or interruption in its ability to transact business with its suppliers or customers as a result of the Year 2000 transition. Page 10 of 12 RAG SHOPS, INC. AND SUBSIDIARIES Since most of the Company's Year 2000 compliance expenses have arisen in the context of a general IT modernization, these remediation costs did not rise to a material level. Forward-Looking Statements This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by safe harbors created hereby. Such forward-looking statements include those regarding the Company's future results in light of current management activities, and involve known and unknown risks, including competition within the craft retail industry, weather-related changes in the selling cycle, and other uncertainties (including those risk factors referenced in Company's filings with the Securities and Exchange Commission). Page 11 of 12 RAG SHOPS, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders The Annual Meeting of Shareholders of the Company was held on January 27, 2000. Mr. Steven Barnett was elected a Class III Director by a vote of 4,575,134 shares in favor and 48,823 shares withheld, Mr. Evan Berenzweig was elected a Class III Director by a vote of 4,575,333 shares in favor and 48,624 shares withheld and Mr. Alan Mintz was also elected a Class III Director by a vote of 4,575,396 shares in favor and 48,561 shares withheld. The firm of Deloitte & Touche, LLP was ratified as auditors for the Company's fiscal year ending September 2, 2000 by a vote of 4,603,930 in favor, 16,103 against and 3,924 abstaining. No other matters were considered by the Shareholders at said Annual Meeting. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits - None (b) No reports on Form 8-K have been filed during the quarter for which this report is filed. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. RAG SHOPS, INC. Date: March 30, 2000 /s/ Stanley Berenzweig Stanley Berenzweig Chairman Of The Board and Principal Executive Officer Date: March 30, 2000 /s/ Steven B. Barnett Steven B. Barnett Principal Financial Officer and Principal Accounting Officer Page 12 of 12