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 May 31, 1997 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 (201) 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 JUNE 27, 1997 Common stock, par value $.01 4,514,400 Page 1 of 10 RAG SHOPS, INC. AND SUBSIDIARIES INDEX Page PART 1 - FINANCIAL INFORMATION Item 1. Financial Statements Condensed consolidated balance sheets - May 31, 1997 (unaudited), June 1, 1996 (unaudited) and August 31, 1996 3 Condensed consolidated statements of income - three and nine months ended May 31, 1997 (unaudited) and June 1, 1996 (unaudited) 4 Condensed consolidated statements of cash flows - nine months ended May 31, 1997 (unaudited) and June 1, 1996 (unaudited) 5 Notes to condensed consolidated financial statements 6 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 7-9 PART II - OTHER INFORMATION Items 1. - 5. 10 Item 6. Exhibits and Reports on Form 8-K 10 SIGNATURES 10 Page 2 of 10 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (All amounts in thousands) May 31, June 1, August 31, 1997 1996 1996 (Unaudited) (Unaudited) (Note A) ASSETS Current assets: Cash $ 2,372 $ 785 $ 821 Merchandise inventories 21,827 21,040 26,280 Prepaid expenses 655 832 345 Other current assets 411 376 474 Deferred taxes 728 674 728 Total current assets 25,993 23,707 28,648 Property and equipment, net 4,483 4,448 4,462 Other assets 272 513 445 $30,748 $28,668 $33,555 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Note payable-bank $ - $ - $ 1,130 Accounts payable-trade 4,481 3,402 7,604 Accrued expenses and other current liabilities 1,331 1,451 1,565 Accrued salaries and wages 939 556 583 Income taxes payable 632 245 150 Current portion of long-term debt 670 619 632 Total current liabilities 8,053 6,273 11,664 Deferred taxes 68 133 68 Long-term debt 728 1,391 1,230 Stockholders' equity: Common stock 45 45 45 Additional paid-in capital 6,039 6,039 6,039 Retained earnings 15,815 14,787 14,509 Total stockholders' equity 21,899 20,871 20,593 $30,748 $28,668 $33,555 Note A: Derived from the August 31, 1996 audited balance sheet. See notes to the condensed consolidated financial statements. Page 3 of 10 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (All amounts in thousands, except share data) Three Months Ended Nine Months Ended May 31, June 1, May 31, June 1, 1997 1996 1997 1996 Net sales $ 19,629 $ 18,506 $ 69,517 $ 67,351 Cost of merchandise sold and occupancy costs 12,509 11,750 43,888 43,005 Gross profit 7,120 6,756 25,629 24,346 Store expenses 4,577 3,991 16,186 15,658 General and administrative expenses 2,260 2,141 7,224 7,272 Total operating expenses 6,837 6,132 23,410 22,930 Income from operations 283 624 2,219 1,416 Interest expense-net 6 30 64 120 Income before provision for income taxes 277 594 2,155 1,296 Provision for income taxes 110 228 849 497 Net income $ 167 $ 366 $ 1,306 $ 799 PER SHARE DATA: Net income per share $ .04 $ .08 $ .29 $ .18 Dividends per share $ - $ - $ - $ - Weighted average shares outstanding 4,557,905 4,514,400 4,532,901 4,515,895 See notes to the condensed consolidated financial statements. Page 4 of 10 RAG SHOPS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (All amounts in thousands) Nine Months Ended May 31, June 1, 1997 1996 Cash flows from operating activities: Net income $ 1,306 $ 799 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,096 929 Loss on disposition of property and equipment 45 14 Changes in assets and liabilities: (Increase) decrease in: Merchandise inventories 4,453 6,519 Prepaid expenses (310) (291) Other current assets 63 (284) Other assets 160 (209) Increase (decrease) in: Accounts payable-trade (3,123) (4,046) Accrued expenses and other current liabilities (234) (330) Accrued salaries and wages 356 (96) Income taxes payable 482 245 Net cash provided by operating activities 4,294 3,250 Cash flows from investing activities: Payments for purchases of property and equipment (1,150) (645) Proceeds from sale of property and equipment 1 4 Net cash used in investing activities (1,149) (641) Cash flows from financing activities: Proceeds from issuance of note payable-bank 7,075 25,880 Repayments of note payable-bank (8,205) (30,615) Long-term borrowings - 2,000 Repayments of long-term debt (464) - Net cash used in financing activities (1,594) (2,735) Net increase (decrease) in cash 1,551 (126) Cash, beginning of period 821 911 Cash, end of period $ 2,372 $ 785 Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 122 $ 147 Income taxes $ 518 $ 198 Supplemental schedule of non-cash investing and financing activities: Purchase of property and equipment in exchange for debt $ - $ 10 See notes to the condensed consolidated financial statements. Page 5 of 10 RAG SHOPS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE AND NINE MONTHS ENDED MAY 31, 1997 AND JUNE 1, 1996 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 nine months ended May 31, 1997 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 con- densed 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 1996. Page 6 of 10 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 Nine Months Ended May 31, June 1, May 31, June 1, 1997 1996 1997 1996 Net sales 100.0% 100.0% 100.0% 100.0% Cost of merchandise sold and occupancy costs 63.7 63.5 63.1 63.9 Gross profit 36.3 36.5 36.9 36.1 Store expenses 23.3 21.5 23.3 23.2 General and administrative expenses 11.5 11.6 10.4 10.8 Income from operations 1.5 3.4 3.2 2.1 Net income 0.9% 2.0% 1.9% 1.2% The Company's net sales increased by $1,123,000 and $2,166,000 for the three and nine months ended May 31, 1997 representing an increase of 6.1% and 3.2%, respectively, over the comparable prior periods. These increases were primarily due to increases in comparable store sales of $1,123,400 or 6.4% and $2,729,600 or 4.2% in addition to new store sales of $855,300 and $2,280,000 for the three and nine month periods, respectively, over the comparable prior periods. Management believes that the marketing plan launched in September 1996 and the mild weather conditions in the northeast region during the fiscal second quarter compared to the comparable prior periods contributed significantly to the positive comparable store sales results. Gross profit percentage remained relatively constant and increased by 0.8% for the three and nine months ended May 31, 1997, respectively, from the comparable prior periods. For the nine months ended May 31, 1997, the increase was primarily due to (i) a decrease in markdowns as a percent of sales of 0.4% primarily due to improved control of promotions during the Christmas selling season and (ii) a 0.4% decrease in the Company's shrinkage estimate based on the results of the fiscal 1996 annual physical inventory and continuation of loss prevention efforts. Store expenses increased by $586,000 and as a percentage of net sales increased by 1.8% for the three months ended May 31, 1997 from the comparable prior period. The increases were due primarily to increases in payroll and payroll related expenses and secondarily to planned increases in advertising. Store expenses increased by $528,000 and as a percentage of net sales remained relatively constant for the nine months ended May 31, 1997 in comparison to the corresponding prior period. The dollar increase was primarily due to an increase in (i) payroll and payroll related expenses, and Page 7 of 10 RAG SHOPS, INC. AND SUBSIDIARIES (ii) depreciation expense due to the installation of point-of-sale equipment net of a decrease in advertising costs as a result of an increase in vendor contributions. As a percentage of net sales, the Company was able to leverage these costs against the increase in sales as previously discussed. General and administrative expenses increased by $119,000 and as a percentage of net sales decreased by 0.1% for the three months ended May 31, 1997 from the comparable prior period. The increase in general and administrative expenses was primarily due to an increase in payroll and payroll related expenses. General and administrative expenses remained relatively constant and as a percentage of net sales decreased by 0.4% for the nine months ended May 31, 1997 from the comparable prior period. The decrease in general and administrative expenses as a percentage of net sales for the three and nine month periods ending May 31, 1997 was primarily due to the Company leveraging these relatively fixed costs against the increase in net sales as previously discussed. Interest expense-net decreased for the three and nine months ended May 31, 1997 from the comparable prior periods as a result of cash provided by operating activities. This decrease was net of additional interest on the Company's term loan to finance its point-of-sale cash register software, data collection and computer systems. See "Liquidity and Capital Resources". The effective tax rate for the three and nine months ended May 31, 1997 was estimated at 39.4% as compared to 38.3% for the comparable prior periods. This increase is attributed to a higher effective state and local income tax rate. Net income decreased by $199,000 for the three months ended May 31, 1997 as compared to the comparable prior period due to the increase in operating expenses which was partially offset by increases in comparable store sales and the related increase in gross profit. Net income increased by $507,000 for the nine months ended May 31, 1997 primarily due to increases in comparable store sales and the related increase in gross profit partially offset by increases in store 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 nine months ended May 31, 1997 and the comparable prior period, Page 8 of 10 RAG SHOPS, INC. AND SUBSIDIARIES 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 $956,000 for the nine months ended May 31, 1997 as compared to the August 31, 1996 amount as a result of the Company retaining its net income for this period. The Company maintains a $10 million credit facility with a bank which is renewable on or before each December 31. The credit facility consists of a discretionary $8,000,000 unsecured line of credit for direct borrowings and the issuance and refinance of letters of credit and a $2,000,000 three (3) year term loan maturing May 1, 1999. Borrowings under the line of credit bear interest at the bank's prime rate (8.50% at May 31, 1997) and under the term loan are fixed at eight percent (8%). The credit facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants. 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 $1,460,000 and $4,935,000 for the nine months ended May 31, 1997 and June 1, 1996, respectively. The Company intends to maintain the availability of a line of credit for working capital requirements and in order to be able to take advantage of future opportunities and to continue to utilize the term loan to finance its new point-of-sale cash register software, data collection and computer systems ("point-of-sale systems"). The Company fully expects to complete installation of its point-of-sale systems in all stores by the end of July 1997. In addition, we are continuing with the development of our automated store ordering systems and anticipate commencing installation in January 1998. Net cash provided by operating activities for the nine months ended May 31, 1997 and June 1, 1996 amounted to $4,294,000 and $3,250,000, respectively, and $1,150,000 and $645,000, respectively, was used for purchases of property and equipment. As of May 31, 1997 the Company has opened four new stores, closed four stores and was operating sixty-seven stores. Subsequent to May 31, 1997 the Company closed one store. 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. Forward-Looking Statements Certain statements contained in this report that are not historical facts are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statement. These risks and uncertainties include, but are not limited to, changes in customer demand, changes in trends in the fabric and craft industry, changes in competitive pricing for products, the impact of competitor store openings and closings, the availability of merchandise, general economic conditions and other risk factors. Page 9 of 10 RAG SHOPS, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Items 1.- 5. Not applicable 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: July 3, 1997 /s/ Stanley Berenzweig Stanley Berenzweig Chairman Of The Board and Principal Executive Officer Date: July 3, 1997 /s/ Steven B. Barnett Steven B. Barnett Principal Financial Officer and Principal Accounting Officer Page 10 of 10