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 September 30, 1998
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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
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3875 Hopyard Road, Suite 375, Pleasanton, CA 94588
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(Address of principal executive offices and zip code)
(925) 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 September 30, 1998, there were 16,813,998 shares of the registrant's
common stock outstanding.
1
YES! ENTERTAINMENT CORPORATION
INDEX
PAGE
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of
September 30, 1998 and December 31, 1997 3
Consolidated Statements of Operations
for the three months and nine months ended
September 30, 1998 and September 30, 1997 4
Consolidated Statements of Cash Flows
for the nine months ended September 30, 1998
and September 30, 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 1. Legal Proceedings 22
Item 2. Changes in Securities and Use of Proceeds 22
Item 3. Defaults Upon Senior Securities 23
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 24
Item 6. Exhibits and Reports on Form 8-K 24
SIGNATURES 25
2
ITEM 1. FINANCIAL STATEMENTS
YES! ENTERTAINMENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31,
1998 1997
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(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 169 $ 624
Accounts receivable, net of allowance for doubtful accounts
of 263,101 on September 30, 1998 and $137,000 on
December 31, 1997 $ 5,834 $ 8,659
Inventories $ 8,986 $ 13,513
Prepaid royalties $ 801 $ 955
Prepaid expenses $ 1,187 $ 1,254
Other current assets $ 2,106 $ 1,989
----------- -----------
Total current assets $ 19,083 $ 26,994
Property and equipment, net $ 4,343 $ 5,345
Intangibles and deposits, net $ 165 $ 156
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Total assets $ 23,591 $ 32,495
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Loans payable $ 9,054 $ 10,709
Accounts payable $ 8,874 $ 11,716
Accrued royalties $ 1,630 $ 2,406
Accrued liabilities $ 663 $ 2,178
Deferred royalty income $ 300 $ ---
Dividends payable $ 114 $ 123
Capital lease obligations $ 1 $ 5
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Total current liabilities $ 20,636 $ 27,137
Convertible debentures $ 1,787 $ 1,741
Stockholders' equity :
Series B convertible preferred stock, $0.001 par value:
Authorized shares 540,000
Issued and outstanding shares of 10,241 on
September 30, 1998 and 387,770 on December 31, 1997
(aggregate liquidation preference of $256,025) $ 228 $ 8,500
Series C convertible preferred stock,
$0.001 par value:
Authorized shares 540,000
Issued and outstanding shares of 353,132 on
September 30, 1998
none issued at December 31, 1997
(aggregate liquidation preference of $8,828,300) $ 7,861 $ ---
Common stock,$.001 par value:
Authorized shares 48,000,000
Issued and outstanding shares - 16,813,998
on September 30, 1998 $ 17 $ 16
and 15,537,159 on December 31, 1997
Additional paid-in capital $ 92,278 $ 90,434
Deferred compensation $ (479) $ (606)
Accumulated deficit $ (98,737) $ (94,727)
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Total stockholders' equity $ 1,168 $ 3,617
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Total liabilities and stockholders' equity $ 23,591 $ 32,495
=========== ===========
See accompanying notes.
3
YES! ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
1998 1997 1998 1997
----------- ----------- ----------- -----------
Net sales $ 7,883 $ 17,759 $ 25,587 $ 39,417
Cost of sales $ 5,485 $ 12,238 $ 15,835 $ 25,178
----------- ----------- ----------- -----------
Gross profit $ 2,398 $ 5,521 $ 9,752 $ 14,239
----------- ----------- ----------- -----------
Operating expenses:
Marketing, advertising and promotion $ 791 $ 657 $ 2,761 $ 2,096
Selling, distribution and administrative $ 4,448 $ 7,595 $ 15,019 $ 19,896
----------- ----------- ----------- -----------
Total operating expenses $ 5,239 $ 8,252 $ 17,780 $ 21,992
----------- ----------- ----------- -----------
Operating (loss) $ (2,841) $ (2,731) $ (8,028) $ (7,753)
Interest income $ 1 $ 42 $ 4 $ 67
Interest expense $ (270) $ (487) $ (918) $ (1,589)
Other income (expense), net $ 120 $ (47) $ 62 $ (113)
Gain on sale of assets $ 16 --- $ 6,019 ---
----------- ----------- ----------- -----------
Income (loss) before provision for income taxes $ (2,974) $ (3,223) $ (2,861) $ (9,388)
Provision for income taxes (income tax benefit) --- $ 616 --- ---
----------- ----------- ----------- -----------
Net income (loss) $ (2,974) $ (3,839) $ (2,861) $ (9,388)
Non-cash dividends and discount on preferred stock $ (178) $ (623) $ (1,148) $ (3,223)
----------- ----------- ----------- -----------
Net income (loss) applicable to common stockholders $ (3,152) $ (4,462) $ (4,009) $ (12,611)
=========== =========== =========== ===========
Basic earnings (loss) per share applicable to common
stockholders $ (0.19) $ (0.31) $ (0.24) $ (0.88)
=========== =========== =========== ===========
Shares used in computing basic earnings (loss) per share 16,726 14,589 16,412 14,290
=========== =========== =========== ===========
See accompanying notes.
4
YES! ENTERTAINMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30,
1998 1997
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OPERATING ACTIVITIES
Net income (loss) $ (2,861) $ (9,388)
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Gain on sale of Product Lines $ (6,019) --
Depreciation and amortization $ 2,277 $ 2,259
Advertising expenses funded by inventory $ 67 $ 118
Debt discount and warrant amortization $ 201 $ 585
Accrued interest converted to convertible debt $ 72 $ 108
Employer contribution to 401(k) plan funded with common stock $ 67 $ 124
Reduction in vendor indebtedness funded with common stock -- $ 1,554
Deferred compensation $ 127 --
Changes in operating assets and liabilities:
Accounts receivable $ 2,825 $ 3,584
Inventories $ 1,791 $ 1,955
Prepaid royalties, expenses and other current assets $ (224) $ (317)
Accounts payable $ (3,381) $ (5,625)
Accrued royalties and liabilities $ (2,461) $ 881
Income taxes payable -- $ (182)
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Net cash (used in) provided by operating activities $ (7,519) $ (4,344)
INVESTING ACTIVITIES
Proceeds from Sale of product lines $ 10,223 --
Acquisition of property and equipment $ (1,490) $ (3,416)
(Increase) decrease in intangibles and deposits and equipment $ (8) $ 41
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Net cash (used in) provided by investing activities $ 8,725 $ (3,375)
FINANCING ACTIVITIES
Proceeds from issuance of convertible debentures -- $ 1,385
Principal payments on loans payable $ (1,656) $ (1,254)
Principal payments on capital lease obligations $ (5) $ (12)
Proceeds from issuance of redeemable convertible preferred
stock, net of issuance costs -- $ 7,875
Proceeds from issuance of common stock, net of issuance costs -- $ 28
---------- ----------
Net cash (used in) provided by financing activities $ (1,661) $ 8,022
---------- ----------
Net increase (decrease) in cash and cash equivalents $ (455) $ 303
Cash and cash equivalents at beginning of period $ 624 $ 1,572
---------- ----------
Cash and cash equivalents at end of period $ 169 $ 1,875
========== ==========
See accompanying notes.
5
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, and as
amended on April 30, 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)
SEPTEMBER 30, DECEMBER 31,
1998 1997
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Raw Materials $ 962 $ 496
Work-in-process $ 72 $ 600
Finished goods $ 7,952 $ 12,417
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$ 8,986 $ 13,513
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6
3. SHAREHOLDER LAWSUITS
As of September 18, 1998, the Company was a defendant in several class
action lawsuits, as follows:
THE STATE SECURITIES CLASS ACTIONS
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Two class actions were 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
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April 15, 1997; and Miller v. YES! Entertainment Corporation et al., filed
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on July 3, 1997. In Miller, Gary L. Nemetz, a director of the Company was
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also named as a defendant.
The Wang lawsuit was purportedly brought on behalf of purchasers of the
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Company's common stock between October 23, 1996 and December 12, 1996,
inclusive. It challenged 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 alleged that these statements violated
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Corporations Code sections 25400 and 25500, which provide 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 and Professions Code
section 17200; and constituted common law fraud pursuant to California
Civil Code sections 1709-1711.
The Miller lawsuit was based on the same facts as the Wang lawsuit, but
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alleged a longer class period of March 29, 1996 to December 12, 1996, and
challenged certain additional statements made by defendants. The Miller
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first amended complaint state only one count for violation of Sections
25400 and 25500 of the California Corporations Code.
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: Harow v. YES! Entertainment Corporation et al., filed on
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April 17, 1997; Takats v. YES! Entertainment Corporation et al., filed on
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June 11, 1997 and Siegel v. YES! Entertainment Corporation et al., filed on
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June 27, 1997. On August 6, 1997, these federal actions were consolidated
for pretrial 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 Honorable
7
Charles Breyer of the Northern District of California. The Federal class
actions were based upon claims under the federal securities laws which
impose liability on persons who make false or misleading statements in
connection with the purchase or sale of securities.
The Company maintained that the allegations contained in each of the class
actions lawsuits are without merit. Nonetheless, the Company concluded
that further conduct of the class action lawsuits would be protracted and
expensive, and that it would be desirable and beneficial to the Company to
settle the lawsuits. Accordingly, on July 8, 1998, the company entered
into an agreement that settled all the class action securities lawsuits.
The settlement called for payment to the plaintiff class of $2.5 million,
which was funded under the Company's insurance policies. On September 18,
1998, the Court entered a Final Judgment and Order of Dismissal which
approved the settlement of all the class action securities lawsuits and
dismissed with prejudiced the Federal class actions.
The Miller lawsuit was dismissed with prejudiced on October 14, 1998. The
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Wang lawsuit has not yet been dismissed.
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THE MACHINA LITIGATION
----------------------
On December 19, 1997 the Company filed a demand for arbitration seeking
declaratory judgment concerning the interpretation of several license
agreements with respondent Machina, Inc. ("Machina"), as well as rescission
of certain other contracts. On January 8, 1998, Machina filed an answer
generally denying the Company's claims and counterclaiming for payment of
royalties. On January 17, 1998, the Company filed a response generally
denying the allegations set forth in Machina's counterclaim and raising
certain affirmative defenses in response thereto. The arbitration is
calendared for November 9-11, 1998.
On January 27, 1998, plaintiff Machina, Inc. ("Machina") filed a verified
complaint seeking a temporary restraining order, preliminary injunction,
and permanent injunction specifically prohibiting the Company from showing
certain products at the New York Toy Fair and generally barring the Company
from continuing to market, manufacture and sell certain products pursuant
to license agreements purportedly terminated by Machina. The Company
successfully opposed Machina's ex parte application for temporary
restraining order (denied January 27, 1998) and subsequent application for
preliminary injunction (denied February 5, 1998). On March 26, 1998, the
parties entered into a stipulation staying the
8
matter pending the arbitration. The matter remains on stay, with a status
conference calendared for January 15, 1999.
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 included approximately $10.2 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.
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 third quarter of 1998 and 1997, total comprehensive income
(loss) amounted to $ (2,974) and $ (3,839)
6. CHANGES TO THE MEMBERSHIP OF THE BOARD OF DIRECTORS
In August of 1998, David Costine resigned from the Board of Directors. Mark
Shepherd was appointed to the Board of Directors, and to the position of
Chief Executive Officer replacing Donald Kingsborough. Donald Kingsborough
resigned as Chairman of the Board but remains a director and non-officer
employee of the Company. Gary Nemetz was appointed Chairman of the Board.
In September of 1998, Stuart J. Chasanoff and Barrett N. Wissman of HW
Partners, L.P. were appointed to the Board as representatives of the
Preferred Shareholders.
9
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."
RESULTS OF OPERATIONS
- ---------------------
Three months ended Nine months ended
September 30 September 30
------------------------------------------------------------
1998 1997 1998 1997
Net Sales 7,883 17,759 25,587 39,417
Cost of sales 5,485 12,238 15,835 25,178
Gross profit 2,398 5,521 9,752 14,239
Gross profit % 30% 31% 38% 36%
Operating Expenses 5,239 8,252 17,780 21,992
Operating Expense % 66% 46% 69% 56%
Operating (loss) (2,841) (2,731) (8,028) (7,753)
Gain on Sale of Assets 16 ___ 6,019 ___
Interest and other expense, net (149) (492) (852) (1,635)
Income (loss) before provision (2,974) (3,223) (2,861) (9,388)
for income taxes
Provision for income taxes ___ 616 ___ ___
Net income (loss) (2,974) (3,839) (2,861) (9,388)
Non-cash dividends and discount (178) (623) (1,148) (3,223)
on preferred stock
Net income (loss) applicable to (3,152) (4,462) (4,009) (12,611)
common stockholders
10
NET SALES
The Company's net sales for the third quarter of 1998 decreased $9.9 million, a
decline of approximately 55.6%, to $7.9 million from $17.8 million in third
quarter 1997. International sales in the third quarter of 1998 represented
approximately 31.8% or $2.5 million of net sales as compared to 21.2% or $3.8
million in the third quarter of 1997. For the first nine months of 1998 net
sales declined by $13.8 million or 35.0% to $25.6 million as compared to $39.4
million in the first nine months of 1997. International sales represented 34.4%
or $8.8 million for the for the nine month period ending September 30, 1998 as
compared to 29.5% or $11.6 million for the comparable period in 1997.
The decrease in both domestic and international sales was due primarily to
reduced volume in YES! Gear and Power Penz product lines. Domestic volume was
further reduced by the sale of the food line in March 1998 (see Note 4 to the
financial statements) which accounted for $3.8 million in sales for third
quarter 1997 and $8.4 million in sales for the nine month period ending
September 30, 1997. As a result of the sale of the Food lines, to the extent
the loss of net sales of these lines are not replaced by increased net sales of
current or future products, the Company's net sales and operating results will
continue to be materially and adversely affected.
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. Furthermore, the industry has been impacted by
declining overall sales to Toys "R" Us due to changes in Toys "R" Us' inventory
policy
11
and store closings which could have a continuing adverse effect on the
Company's revenue.
COST OF SALES
Cost of sales were approximately 70% and 69% of net sales in the third quarters
of 1998 and 1997, respectively. The increase in cost of sales as a percentage
of net sales in the third quarter of 1998 as compared to the third quarter of
1997 was primarily the result of an increase in close-out sales and greater mix
of international sales which tend to have lower margins. For the nine month
period ending September 30, 1998 cost of sales as a percentage of total sales
was approximately 62% as compared to approximately 64% in the comparable period
of 1997. In absolute dollars, cost of sales decreased by approximately $6.8
million for the third quarter of 1998 to $5.5 million, compared to $12.2 million
in the third quarter of 1997. For the nine month period ended September 30, 1998
cost of sales decreased by approximately $9.3 million to $15.8 million as
compared to approximately $25.2 million in the comparable period in 1997. Cost
of sales in the 1998 periods in absolute dollars decreased as a result of
reduced net sales.
OPERATING EXPENSES
(in thousands) Three months ended Nine months ended
September 30 September 30
----------------------- -------------------------
1998 1997 1998 1997
---- ---- ---- ----
Marketing, advertising & promotion $ 791 $ 657 $ 2,761 $ 2,096
Selling, distribution & administrative $ 4,448 $ 7,595 $ 15,019 $ 19,896
----------------------- -------------------------
Total operating expenses $ 5,239 $ 8,252 $ 17,780 $ 21,992
Marketing, Advertising and Promotion. Marketing, advertising and promotion
expenses increased by approximately $134,000 for the third quarter of 1998 from
the third quarter of 1997. As a percentage of net sales, marketing, advertising
and promotion expenses were 10% in the third quarter of 1998 as compared to 3.7%
in the third quarter of 1997. For the nine month period ending September 30,
1998 marketing, advertising, and promotion expenses increased by $665,000 and
were 10.8% of net sales as compared to 5.3% of net sales for the comparable
period in 1997. The increase for third quarter expenditures was due to the
write-off of television production costs and the year to date increases are
related to this write-off and the promotion of W3 Speedloader and Air Vectors.
The Company expects advertising expense in the last quarter of 1998 to
significantly exceed advertising expense in the first three quarters of the year
to support anticipated seasonal increases in sales. However, depending on
Company liquidity and sales in to retail distribution channels, the Company may
choose not to run significant levels of media advertising, which may have an
adverse effect on revenue.
12
Selling, Distribution and Administrative. Selling, distribution and
administrative expenses decreased by $3.2 million, to $4.5 million in the third
quarter of 1998 as compared to $7.6 million in the third quarter of 1997. For
the nine month period ended September 30, 1998 selling, distribution, and
administrative expenses were reduced by $4.9 million to $15.0 million as
compared to $19.9 million in the prior year period. Net reductions in this
expense category were the result of cost control measures implemented by the
Company. In October, the Company underwent further headcount reductions.
INTEREST EXPENSE
The following table shows interest expense and interest income for the
applicable periods:
(in thousands) Three months ended Nine months ended
September 30 September 30
-------------------------------------------------
1998 1997 1998 1997
---- ---- ---- ----
Interest income $ 1 $ 42 $ 4 $ 67
Interest expense $ (270) $ (487) $ (918) $ (1,589)
The decrease in interest expense in the quarter ended September 30, 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
debentures and preferred stock financing and the restructuring thereof described
in detail in the Company's annual report on form 10-K for year ended December
31, 1997. The non-cash interest expense recorded in the quarter ended September
30, 1998 was $56,000. Non-cash interest expense for the nine months ended
September 30,1998 was $302,000. The decrease in interest income is the result of
lower cash balances maintained by the Company during the quarter and nine months
ended September 30, 1998 as compared to 1997.
PROVISION FOR INCOME TAXES (INCOME TAX BENEFIT)
No income tax provision has been computed for the three and nine months ended
September 30, 1998 as the Company did not have net income during such periods.
The Company does not expect to earn a profit during 1998.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998, the Company had cash and cash equivalents of
approximately $169,000, a $455,000 decrease from approximately $624,000 at
December 31, 1997. The decrease in cash and cash equivalents was due to the $1.7
million used in financing activities and $7.5 million used in operating
activities offset primarily by $8.7 million provided by investing activities.
13
The cash used by operating activities was due primarily to the Company's net
income which includes a $6.0 million gain from the sale of two product lines, a
decrease in accounts receivable of $2.8 million, a decrease in inventories of
$1.8 million offset by a decrease in accounts payable of approximately $3.4
million. The $8.7 million provided by investing activities related primarily to
proceeds from the sale of two product lines.
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's common stock, 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.
Pursuant to a Credit Agreement, dated as of September 2, 1998, Infinity
Investors Limited extended a $3,050,000 loan to the Company, due June 30, 1999,
at an interest rate of 12% per annum.
To meet seasonal working capital requirements during 1998, the Company has
borrowed 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,
14
1997, the Company was required to maintain a monthly quick ratio 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
decreased to 0.4:1 as of June 30, 1998 and shall increase to 0.5:1 thereafter.
The Company was not in compliance with this covenant requirement at September
30, 1998, however a waiver is anticipated. 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 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 not in compliance with this covenant requirement at
September 30, 1998, however a waiver is anticipated. 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 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 not in compliance with this covenant
requirement at September 30, 1998, however a waiver is anticipated. 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 September 30, 1998, the Company had borrowings of $6.1
million under the ARM Agreement. The $30 million under the ARM Agreement is
subject to a borrowing base which limits the ability to utilize the full amount
of the line.
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
15
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, the Company's planned
growth and the current financial condition of the Company, 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, under
the ARM Agreement or otherwise, 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 business and 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 third quarter of 1998, the Company incurred an operating loss of $2.8
million and an operating loss through the nine months ended September 30, 1998
of $8.0 million with a resulting accumulated deficit of $98.7 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 in 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%
16
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 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. In March 1998, the Company sold
its Food line, which accounted for a significant portion of its gross margin in
Fiscal 1997. See Note 4 of Notes to Consolidated Financial Statements. 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.
17
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
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 of Toys "R" Us' recent
inventory control policy changes and store closings, a continuing adverse effect
on the Company's revenue could occur. Orders in the toy industry are generally
cancelable at any time without penalty, therefore, 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.
18
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 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 relies 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
19
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 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 Vice President of Development, 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, or BNY Financial
Corporation
20
does not provide additional financing, and the Company is unable to obtain
financing from other sources, 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
Mark Shepherd, the Company's Chief Executive Officer and Chief 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.
Delisting on the Nasdaq Stock Exchange The Company has received notification
from The Nasdaq Stock Market of its intent to delist the Company's common stock
from the Nasdaq National Market. Nasdaq cited the Company's failure to meet the
minimum bid price maintenance and the minimum market value public float
requirements for a continued listing of YES!'s common stock on the Nasdaq
National Market. YES! has requested and been granted an oral hearing on November
13, 1998 to appeal Nasdaq's determination, and the Company's shares will
continue to be listed on the Nasdaq National Market while the appeal is being
heard. The Company, while appealing the delisting, does not expect to prevail.
In addition, as of September 30, 1998, the Company no longer met the Nasdaq net
tangible assets maintenance requirement.
Impact of Year 2000. The Company is 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 has contracted with a vendor to
perform all Year 2000 system upgrades necessary. Several other vendors are
prepared to perform Year 2000 systems upgrades should the initial vendor be
unable to fulfill all requirements. The Company expects to complete the updating
of its current systems before 2000. Estimated cost to address Year 2000 issues
is approximately $95,000. 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. The Company has completed its initial evaluation and
believes no material adverse effect on the financial condition of the Company
will result.
21
PART II. OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS
See Note 3 to the Consolidated Financial Statements on pages 7-9
hereof.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On September 2, 1998, pursuant to a Securities Exchange Agreement
(the "Exchange Agreement") entered into among the Company and
Infinity Investors Limited, Glacier Capital Limited and Infinity
Emerging Opportunities Limited (collectively, the "Investors"), the
Company exchanged with the Investors an aggregate of (i) 348,670
shares of the Company's Series B Convertible Preferred Stock
("Series B Stock") for the like number of shares of the Company's
Series C Convertible Preferred Stock ("Series C Convertible Stock"),
and (ii) $1,835,921 principal amount of 5% Convertible Debentures
("Old Debentures") for the like principal amount of 5% Convertible
Debentures ("New Debentures"). These securities were exchanged and
sold without registration in reliance on Section 4(2) under the
Securities Act of 1933, as amended, as the Investors are "accredited
investors" within the meaning of the Securities Act.
The Exchange Agreement provides that the Investors will not convert
the Series C Convertible Preferred Stock or New Debentures, or sell
any shares of Series C Convertible Preferred Stock, Common Stock or
New Debentures (subject to certain limited exceptions), in each case
until the earlier of February 21, 1999 or the occurrence of an Event
of Default (as defined in the Exchange Agreement). The Series C
Convertible Preferred Stock and New Debentures are substantially
similar to the Series B Stock and Old Debentures, except that
certain conversion and sale restrictions applicable to the Series B
Stock and Old Debentures do not apply to the Series C Convertible
Preferred Stock and the New Debentures, and the holders of the
Series C Convertible Preferred Stock are entitled to elect two
directors to the Company Board of Directors. The Exchange Agreement
also requires the Registrant to call a meeting of the stockholders
of the Registrant to (i) approve the issuance of all of the shares
of Common Stock upon conversion of the Series C Convertible
Preferred Stock and New Debentures (conversion is currently limited
due to certain Nasdaq
22
requirements which will no longer apply if such stockholder approval
is obtained or the Company's Common Stock is delisted from the
Nasdaq National Market), and (ii) to increase the number of shares
of Common Stock authorized for issuance. Failure of the Company to
obtain such stockholder approval will constitute an Event of
Default. The Company is not seeking the stockholder approval
described in (i) above and is seeking a waiver of such stockholder
approval as the Company anticipates that the Company's Common Stock
will be delisted from the Nasdaq National Market. The Company is
seeking stockholder approval of the increase in the authorized
number of shares of Common Stock described in (ii) above. If the
Company's Common Stock is delisted from the Nasdaq National Market,
the Investors are entitled to require that the Company redeem the
Series C Convertible Preferred Stock and New Debentures.
At the option of the holder, (i) the Series C Convertible Preferred
Stock is convertible into Common Stock at a conversion rate per
share equal to $25.00 divided by 81.25% of the lowest trading price
of the Common Stock over the last 30 trading days prior to
conversion (subject to certain antidilution adjustments), and (ii)
the New Debentures are convertible into Common Stock at a conversion
rate of the dollar amount being converted divided by 81.25% of the
of the lowest trading price of the Common Stock over the last 30
trading days prior to conversion (subject to certain antidilution
adjustments), in each case subject to the limitations set forth
above.
The issuance of the Series C Convertible Preferred Stock and New
Debentures was reported on a Current Report on Form 8-K filed with
the SEC on September 16, 1998, and the Exchange Agreement,
Certificate of Designation of the Series C Convertible Preferred
Stock and form of New Debenture were filed as exhibits to such
report. Reference is made to such report and exhibits for a
description of the full terms of the Series C Convertible Preferred
Stock and New Debentures.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
The Company is not in compliance with certain covenants under the
ARM Agreement with the Bank of New York. See "Part I - Item 2. -
Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources."
23
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
In September 1998, Stuart J. Chasanoff and Barrett N. Wissman of HW
Partners, L.P. were appointed to the Board of Directors
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) EXHIBITS
4.1* Form of 5% Convertible Debenture due April 30, 2002.
4.2* Amended Certificate of Designation of Series C Preferred
Shares.
10.1* Securities Exchange Agreement dated September 2, 1998.
10.2 Credit Agreement, dated as of September 2, 1998, between the
Company and Infinity Investors Limited.
10.3 Security Agreement, dated as of September 2, 1998, between
the Company and Infinity Investors Limited.
27.1 Financial Data Schedule for the quarter ended September 30,
1998
(*) Previously filed on Current Report on Form 8-K filed
September 16, 1998.
b) REPORTS ON FORM 8-K
A Current Report on form 8-K was filed on September 16, 1998.
24
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 November 13, 1998 /s/ Mark Shepherd
----------------- -----------------
Mark Shepherd
Chief Executive Officer and
Chief Financial Officer
(Principal Executive Officer and
Principal Financial and Chief Accounting
Officer)
25