-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OlrkACrxAsEHzHcCn3kMvz2+DwjhckfzidOjfd+ImhtFmGoVqMmAe2Z4vB8d/5Zg 3jMUG71mFokRZ8vVwzkoiQ== 0000874385-98-000005.txt : 19981130 0000874385-98-000005.hdr.sgml : 19981130 ACCESSION NUMBER: 0000874385-98-000005 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980829 FILED AS OF DATE: 19981127 FILER: COMPANY DATA: COMPANY CONFORMED NAME: RAG SHOPS INC CENTRAL INDEX KEY: 0000874385 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-HOBBY, TOY & GAME SHOPS [5945] IRS NUMBER: 510333503 STATE OF INCORPORATION: DE FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-19194 FILM NUMBER: 98760280 BUSINESS ADDRESS: STREET 1: 111 WAGARAW RD CITY: HAWTHORNE STATE: NJ ZIP: 07506 BUSINESS PHONE: 9734231303 MAIL ADDRESS: STREET 1: 111 WAGARAW RD CITY: HAWTHORNE STATE: NJ ZIP: 07506 10-K 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended August 29, 1998 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 Number: 0-19194 RAG SHOPS, INC. (Exact name of registrant as specified in its charter) DELAWARE 51-0333503 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification 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 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes x No As of October 30, 1998, there were outstanding 4,514,400 shares of Common Stock. Based on the price at which such stock was sold on that date, the approximate aggregate market value of such shares held by non-affiliates was $5,173,500. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's 1998 Definitive Proxy Statement, which statement will be filed not later than 120 days after the end of the fiscal year covered by this Report, are incorporated by reference in Part III hereof. Certain exhibits are incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto, as listed in response to Item 14(a)(3). [The remainder of this page is intentionally blank.] PART I ITEM 1. BUSINESS. General Rag Shops, Inc., a Delaware corporation formed in April 1991, is the successor by merger to a New Jersey corporation having the same name which was incorporated in September 1984, as a holding company for numerous subsidiaries that have operated retail stores since 1963. As of August 29, 1998, Rag Shops, Inc. operates 66 specialty retail stores which sell competitively priced craft and fabric merchandise. The Company caters to value conscious consumers who create decorative accessories and sew. The Company believes that its wide selection of currently popular merchandise, value-pricing policy and commitments to both customer service and advertising are principal factors contributing to its profitability. The Company's stores are destination-oriented and also attract shoppers from other stores located in the same shopping center. As of August 29, 1998, the Company operated 33 retail stores in New Jersey, 19 in Florida, seven in Pennsylvania, six in New York and one in Connecticut. The Company anticipates opening five to seven stores and closing one store during the remainder of its fiscal year ending August 28, 1999. The Company's expansion strategy is to grow by expanding within areas from which it presently attracts customers and into contiguous market areas, enabling the Company to capitalize on pre-existing advertising and name recognition. The following table sets forth information with respect to store openings and closings since fiscal 1994: Fiscal Years 1998 1997 1996 1995 1994 Stores open at beginning of period 66 67 69 68 61 Stores opened during period 2 4 1 2 8 Stores closed during period 2 5 3 1 1 Stores open at end of period 66 66 67 69 68 Products The Company's stores offer a diverse and extensive assortment of value-priced crafts, fabrics and related items to creative craft and sewing consumers. For fiscal years 1996, 1997 and 1998, sales of crafts accounted for approximately 65.3%, 67.3% and 68.2% respectively, of the Company's net sales, and sales of fabrics accounted for the remainder. Each of the Company's stores offers craft, fabric and related products. Craft items include silk flowers, wicker, picture frames, wood products, stitchery, yarn, wearable art, art supplies and craft supplies. Fabric items available at the Company's stores include apparel and home decorative fabrics, trimmings, patterns and sewing notions. As of August 29, 1998, fifty-nine stores offer custom picture framing. The Company also sells a wide variety of seasonal merchandise with special emphasis on the Easter, Back-to- School, Halloween and Christmas seasons. Through their purchase of craft, fabric and other items, used either individually or in combination, the Company's customers can hand make a wide variety of finished products for personal use, gifts, home beautification and seasonal decoration. For example, fabrics can be made into career, leisure, children's, bridal and special occasion fashions, draperies and upholstery for home decoration and hand made quilts and, from the Company's selection of craft items, customers can create needle point and stitchery, personalized hand painted apparel, floral arrangements and dolls. Merchandising and Advertising The Company's marketing and merchandising strategy emphasizes the sale of multiple products to be used by the customer to create a single project. To assist customers in making their own selections and to encourage their purchase of several products, the Company's stores display finished models that incorporate a variety of merchandise in close proximity to where the components are sold. The models are created by employees at the stores conforming to Company guidelines. Craft or sewing classes are offered every week at a select number of each of the Company's stores to further promote both specific products and store business. During each class, participants complete a project using materials purchased from the store at which the class is offered. Merchandise instructional demonstrations are held periodically at charitable organizations, conventions and schools as an effective method of attracting customers and generating the purchase of fabrics, crafts and related merchandise necessary for the customer to create the featured apparel. Merchandise at the Company's stores is displayed on conveniently arranged fabric tables and fixtures to facilitate customer access. The general layout of merchandise, adjusted seasonally and as otherwise necessary to adapt to marketing conditions, is planned by the Company's management to give prominence to the types of merchandise currently in demand. Approximately five percent of the Company's sales is expended for a 52 week per year advertising program. In September 1996 the Company commenced utilizing free standing newspaper inserts, alternating with newspaper print advertisements. These newspaper inserts are also displayed at the front of each store and describe a calendar of promotions emphasizing special sale items, seasonal products and other currently popular merchandise. Previously the Company utilized direct mail, newspaper print, weekly in-store promotions and television in the New Jersey metropolitan area and in Florida. The free standing newspaper inserts are received by approximately 3 million people as compared to the direct mail previously utilized that was received by approximately 1 million people. For the Back-to-School season and holiday seasons of Easter, Halloween and Christmas, the Company utilizes a fully developed merchandising program including special inventory, layout, instructional ideas and promotions with highly focused displays. During these peak seasons approximately 25% of store selling space is devoted to seasonal merchandise. 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 generally operated at a loss during its fourth fiscal quarter, the June through August summer period. The Company's results of operations depend significantly upon the sales generated from September through December and any material decrease in sales for such period could have a material adverse effect upon the Company's profitability. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Seasonality." Store Operations The Company's store operations are divided into six geographic districts, each managed by a district manager. Stores typically are staffed with a manager, an assistant manager, one department head each for fabrics and crafts, sales personnel, cashiers and stock clerks. District managers supervise store management, monitor the Company's stores to ensure compliance with procedures, policies and budgets, determine whether adequate levels of merchandise are available at the stores and reallocate merchandise among stores as dictated by selling trends at individual stores. Store managers are responsible for operation of individual stores, including recruiting and hiring store personnel. Store managers place orders to replenish inventory from the Company's 85,000 square foot distribution center in Paterson, New Jersey, and may also directly order certain core merchandise designated by management from the Company's suppliers. Orders for merchandise stocked in the distribution center are placed by the store manager on a regular basis through a computer in the store. Deliveries from the distribution center are made by Company-owned vehicles or by independent trucking companies. Stores are generally open from 10:00 A.M. to 9:00 P.M. Monday through Saturday and 11:00 A.M. to 6:00 P.M. on Sunday, with extended hours during the Christmas season. All stores are operating with point-of-sale cash register systems. Approximately 68% of receipts at the Company's stores are for cash or check, with the balance paid for with MasterCard, Visa, Discover or American Express. The average sale is approximately $12.30. Expansion Strategy While management does not believe there are significant geographic constraints on the locations of future stores, the Company's strategy is to grow by expanding within areas from which it presently attracts customers and into contiguous market areas, enabling the Company to capitalize on pre-existing advertising and name recognition. When deciding whether to open a new store, the principal factors the Company typically evaluates are the amount of consumer traffic generated by the market area, the demographic composition of the customer base in the market area, store position in the shopping center, rent structure, available media, advertising expense, and other costs associated with opening the store. Historically, stores tend to become profitable after six to twenty-four months. Sources of Supply The Company purchases its merchandise from more than 300 suppliers. The Company's merchandise is primarily purchased from domestic suppliers (including distributors that import goods from the Far East) and the balance is acquired directly from manufacturers in the Far East, including Hong Kong, Taiwan, Korea, China and the Philippines. All of the merchandise purchased directly from foreign manufacturers, consisting primarily of silk flowers, seasonal merchandise and staple craft products, is sold under the Company's private label. As is customary in the industry, the Company does not have any long-term or exclusive contracts with any suppliers. The Company believes that alternate sources of merchandise are readily available at comparable prices. Consistent with industry practice, merchandise from manufacturers in the Far East is ordered four to six months in advance to assure delivery prior to the selling season for the merchandise. Letters of credit are issued to foreign manufacturers with specific terms regarding the merchandise ordered, inspection prior to shipment and time and place of delivery. The Company assumes the risk of loss on a F.O.B. basis when goods are delivered to a shipper and is insured against casualty losses arising during shipping. Competition The retail craft and fabric industry is highly competitive. The Company competes with other national, regional and independent specialty craft and/or fabric retailers and mass merchandisers, some of which have greater financial and other resources than the Company. The Company believes it competes on the basis of merchandise selection, customer service, price and advertising. Competitors include A.C. Moore Arts & Crafts, Inc., Jo-Ann Stores, Inc., and Michaels Stores, Inc. Employees As of August 29, 1998, the Company has approximately 1,150 employees, consisting of approximately 310 full time and 840 part time employees. Full time personnel consist of approximately 200 salaried and 110 hourly employees. All part time personnel are hourly employees. During seasonal peak periods, the Company hires temporary personnel. Approximately 38 employees in the Company's distribution center are covered by a collective bargaining agreement with Local 161 of the Union Of Needletrades, Industrial And Textile Employees, AFL-CIO. This agreement expires in March 1999. The Company considers its relationships with its employees to be good. Trademarks The Company's trademark "THE RAG SHOP" was registered in the United States Patent Office on September 9, 1969 and thereafter renewed. This registration is renewable indefinitely so long as the mark is used by the Company. ITEM 2. PROPERTIES. The Company's office facilities and its Hawthorne, New Jersey store occupy approximately 15,900 and 17,600 square feet, respectively, in the same strip shopping center in Hawthorne, New Jersey. The store and offices are leased from Momar Realty L.L.C., the two members of which are Stanley Berenzweig, Chairman of the Board and Doris Berenzweig, Secretary. The Company's distribution center and all of its other stores are leased from non-affiliates of the Company. The Company's 85,000 square foot distribution center is located in Paterson, New Jersey. The Company believes that its distribution center is adequate for its needs through the expiration of the current term of the lease in July 2000. The Company has one option to renew the lease for a period of two years. The Company also leases approximately 50,000 square feet of warehouse space to accommodate seasonal merchandise. The Company's stores, all of which are located in leased facilities, range in size from approximately 6,200 square feet to 17,600 square feet. The average size of the Company's stores is approximately 9,700 square feet with approximately 90% of the area of each store representing selling space. The Company seeks to open new stores in the range of approximately 12,000 to 15,000 square feet. However, the Company often maintains options to expand store size and will exercise those options or otherwise enlarge particular stores as circumstances warrant. The following table sets forth the number of store leases due to expire, including options to renew, during the year indicated. LEASE EXPIRATIONS Year Number Year Number 2000 1 2013 5 2001 2 2014 3 2003 2 2015 1 2004 2 2016 3 2005 2 2017 10 2006 2 2018 6 2008 3 2019 6 2009 1 2020 2 2010 2 2021 2 2011 4 2023 2 2012 2 2026 1 2027 2 Sixty-three of the above stores are located in strip shopping centers, and the remaining three are free-standing buildings. The stores generally are located in close proximity to population centers and other retail operations and are usually on a major highway or thoroughfare, making them easily accessible by automobile. All of the stores provide free parking. The leases for the Company's stores are generally for a term of five years, usually with four options to renew for five years each. Under most leases, the Company is required to pay, in addition to fixed minimum rental payments, additional rent based on charges for real estate taxes, common area maintenance fees, utility charges and insurance premiums. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in various legal proceedings incidental to the conduct of its business. The Company currently is not engaged in any legal proceedings that is expected to have a material adverse effect on the Company's results of operations or financial position. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Company did not submit any matters to vote of its stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended August 29, 1998. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is traded on the NASDAQ National Market System ("NASDAQ/NMS") under the symbol "RAGS." The following table sets forth, for the periods indicated, the range of high and low sale prices of the Common Stock as reported by NASDAQ from September 1, 1996, through August 29, 1998. These prices reflect interdealer prices and do not include retail mark- ups, mark-downs or commissions, and do not necessarily represent actual transactions. High Low Fiscal Quarter Ended November 29, 1997 $ 3.50 $2.125 February 28, 1998 3.438 2.625 May 30, 1998 3.688 2.813 August 29, 1998 3.75 2.50 Fiscal Quarter Ended November 30, 1996 $ 2.50 $1.938 March 1, 1997 4.313 2.00 May 31, 1997 3.75 2.688 August 30, 1997 3.688 2.50 On October 30, 1998, the closing price of the Common Stock was $2.50. The approximate number of stockholders of record of the Common Stock at October 30, 1998 was 287. The number of beneficial owners whose shares are held by banks, brokers and other nominees exceeds 800. The Company has not paid any dividends. The Company presently intends to retain all earnings for the operation and expansion of its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. Any future determination as to the payment of dividends on the Common Stock will depend upon future earnings, results of operations, capital requirements, the financial condition of the Company and any other factors the Board of Directors of the Company may consider. In addition, pursuant to the Company's bank line of credit, the Company is prohibited from declaring dividends in any year in excess of its earnings for such year or which would otherwise result in a violation of the Company's covenant to maintain a tangible net worth (as defined in the line of credit commitment letter) of $9,000,000. ITEM 6. SELECTED FINANCIAL DATA. Fiscal Year Ended(1) August 29, August 30, August 31, September 2, September 3, 1998 1997 1996 1995 1994 (in thousands, except Common Stock Data and Statistics) OPERATIONS Net sales $ 90,566 $ 86,528 $ 83,767 $ 86,089 $ 89,529 Gross profit 32,772 31,044 30,440 31,592 33,886 Store expenses and general and administrative expenses 31,167 30,578 29,500 30,566 32,504 Interest expense, net 61 115 161 134 266 Income before income taxes 1,544 351 779 893 1,117 Income before cumulative effect of change in accounting principle 942 207 520 542 692 Net income $ 942 $ 207 $ 520 $ 542 $ 767 COMMON STOCK DATA (2) Net income per share before cumulative effect of change in accounting principle Basic $ .21 $ .05 $ .12 $ .12 $ .15 Diluted .21 .05 .12 .12 .15 Net income per share Basic .21 .05 .12 .12 .17 Diluted .21 .05 .12 .12 .17 Book value per share $ 4.82 $ 4.61 $ 4.56 $ 4.45 $ 4.33 Weighted average shares and equivalents outstanding Basic 4,514,400 4,514,400 4,514,400 4,514,400 4,514,400 Diluted 4,555,787 4,533,830 4,514,412 4,524,026 4,514,400 FINANCIAL POSITION Working capital $ 17,095 $ 16,256 $ 16,985 $ 15,161 $ 13,851 Total assets 33,318 32,264 33,555 34,821 36,079 Short-term debt 2,194 3,119 1,762 4,735 6,555 Long-term debt - 554 1,231 - - Stockholders' equity $ 21,742 $ 20,800 $ 20,593 $ 20,073 $ 19,531 Fiscal Year Ended(1) August 29, August 30, August 31, September 2, September 3 1998 1997 1996 1995 1994 (in thousands, except Common Stock Data and Statistics) STATISTICS Net sales increase (decrease) 4.7% 3.3% (2.7%) (3.8%) 6.4% Comparable store net sales increases (decreases) (4) 3.2% 3.8% (4.9%) (7.3%) (4.1%) Return on net sales, after income taxes 1.0% .2% .6% .6% .9% Return on average stockholders' equity 4.4% 1.0% 2.6% 2.7% 4.0% Average net sales per gross square foot (3) $ 143 $ 139 $ 135 $ 141 $ 154 Average net sales per store (000's)(3) $ 1,374 $ 1,296 $ 1,214 $ 1,265 $ 1,362 Stores open at end of period 66 66 67 69 68 (1) Fiscal year ended September 3, 1994 was a 53 week fiscal year, all other years are 52 week fiscal years. (2) Per share data and the number of shares have been restated as required by Statement of Financial Accounting Standards No. 128 "Earnings Per Share". (3) For purposes of calculating these amounts, the number of stores and the amount of gross square footage have been adjusted to reflect the number of months during the period that new stores were open. These amounts have not been adjusted to reflect the seasonal nature of the Company's net sales or the resulting impact of opening stores in different periods during the year. See "Management's Discussion and Analysis of Financial Information and Results of Operations--Seasonality." (4) Comparable store sales increases for a fiscal year include stores commencing with their thirteenth consecutive entire fiscal month. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Results of Operations The following table sets forth as a percentage of net sales, certain items appearing in the Company's Consolidated Income Statements for the indicated years. Year Ended 1998 1997 1996 Net sales 100.0% 100.0% 100.0% Cost of merchandise sold and occupancy costs 63.8 64.1 63.7 Gross profit 36.2 35.9 36.3 Store expenses 23.4 23.9 23.8 General and administrative expenses 11.0 11.5 11.4 Income from operations 1.8 0.5 1.1 Net income 1.0% .2% .6% The Company's net sales increased in 1998 by $4,038,000 or 4.7% due to increases in comparable store sales of $2,647,000 or 3.2% in addition to new store sales of $3,891,000 net of the impact of closed store sales. Management believes the increases in comparable store sales in 1998 were primarily due to improved buying and timely inventory replenishment based on information from the Company's point-of-sale cash register software, data collection and computer systems ("point-of-sale systems") installed in the prior year and from the continuation of its marketing plan that commenced in the prior year. The Company's net sales increased in 1997 by $2,761,000 or 3.3% due to increases in comparable store sales of $3,038,000 or 3.8% in addition to new store sales of $3,417,000 net of the impact of closed store sales. 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 increased by .3% in 1998 as compared to 1997 primarily as a result of a decrease in markdowns, which was partially attributable to the improved buying and timely inventory replenishment mentioned above. Gross profit percentage decreased by .4% in 1997 as compared to 1996 as a result of an increase in the annual shrinkage of inventory of .7% partially offset by a decrease in markdowns of .4% due to improved control of promotions during the Christmas selling season. Store expenses increased by $507,000 or 2.5% in 1998 as compared to 1997. The dollar increase was primarily the result of an increase in (i) the cost of operating the point-of-sale systems for an entire fiscal year, (ii) credit card processing costs principally due to accepting a new credit card at the beginning of this fiscal year and (iii) payroll and payroll related expenses. As a percentage of net sales, store expenses decreased by .5% in 1998 as compared to 1997 principally due to the Company leveraging these expenses against the increase in net sales. Store expenses increased by $754,000 or 3.8% in 1997 as compared to 1996. The dollar increase was primarily due to an increase in (i) payroll and payroll related expenses, (ii) depreciation expense as a result of the installation of the point-of-sale systems and (iii) advertising in connection with the new marketing plan. As a percentage of net sales, store expenses in 1997 remained relatively constant compared to 1996. General and administrative expenses increased marginally in 1998 as compared to 1997. As a percentage of net sales, general and administrative expenses decreased by .5% as the Company was able to leverage these costs against the increase in net sales. General and administrative expenses increased by $324,000 or 3.4% in 1997 as compared to 1996. The increase was primarily due to an increase in payroll and payroll related expenses. As a percentage of net sales, general and administrative expenses in 1997 remained relatively constant compared to 1996. Interest expense, net decreased in 1998 as compared to 1997 as a result of the reduction in the Company's term loan. Interest expense, net decreased in 1997 as compared to 1996 as a result of lower borrowings on the Company's line of credit. This decrease was net of additional interest on the Company's term loan to finance its point-of-sale systems. See "Liquidity and Capital Resources." The effective tax rate for 1998 was 39.0% as compared to 41.0% in 1997. The decrease is primarily attributed to a tax settlement in 1997. The effective tax rate for 1997 was 41.0% as compared to 33.2% in 1996. The increase is primarily due to a $15,000 tax settlement paid in 1997 for the tax years 1993 through 1995 based upon the results of an Internal Revenue Service audit. Net income increased by $734,000 for 1998 as compared to 1997 due to the increase in sales and the related increase in gross profit which was partially offset by the increase in operating expenses. Net income decreased by $313,000 for 1997 as compared to 1996 due to the increase in operating expenses which was partially offset by the increase in sales and the related increase in gross profit. 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. This period includes the Back-to-School, Halloween and Christmas seasons. The Company has generally operated at a loss during its fourth quarter, the June through August summer period. See "Business- - -Seasonality." 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. In 1998 and 1997, the Company relied on short-term borrowings, internally generated funds and credit made available by suppliers to finance inventories and new store openings. The Company's working capital has increased $838,000 in 1998 as compared to 1997 primarily as a result of the increase in its merchandise inventories and reduction in note payable-bank which was partially offset by an increase in accounts payable-trade. 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 $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 August 29, 1998) and under the term loan are fixed at seven and one- half percent (7.5%) effective March 1, 1998, formerly at eight percent (8%) since inception. The credit facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants which require a minimum defined working capital and tangible net worth, a maximum ratio of debt to tangible net worth and set limits on the payment of dividends. As of August 29, 1998, the Company was in compliance with such 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 $2,785,000, $2,755,000 and $4,935,000 in 1998, 1997 and 1996, respectively. As of August 29, 1998 and August 30, 1997, $1,635,000 and $2,435,000, respectively, was outstanding under the line of credit for direct borrowings and $548,000 and $1,227,000, respectively, was outstanding under the term loan with $548,000 maturing in 1999. The Company intends to maintain the availability of the 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 systems. The Company completed installation of its point- of-sale systems in all stores as of July 1997. In addition, the Company is in the test phase of its automated store ordering and receiving systems and anticipates having all stores fully operational by March 1999. The Company purchases merchandise directly from manufacturers in the Far East. Generally, these purchases are supported by letters of credit payable in United States dollars. The results of operations of the Company have not been significantly affected by foreign currency fluctuation. At August 29, 1998, the Company had outstanding letters of credit in the approximate amount of $138,400. During 1998, 1997 and 1996, the Company had net cash provided by operating activities of $2,443,000, $1,135,000 and $2,659,000, respectively, and used $835,000, $1,877,000 and $1,001,000, respectively, for purchases of property and equipment. Cash provided by operating activities increased in 1998 primarily as a result of increases in net income and accounts payable partially offset by an increase in merchandise inventories. The Company expects to open five to seven stores and close one existing store during 1999. Costs associated with 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 stores. Year 2000 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 current efforts will allow the Company to be fully Year 2000-compliant by June of 1999, 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. Because the Company has focused its attention primarily on updating its systems, it has not yet developed a contingency plan in the event of any interruption of key internal or external services. Management currently expects to complete such a plan by the middle of calendar year 1999, subject to further review and refinement thereafter to reflect changing circumstances. In particular, the Company's plan will seek to establish alternatives in the event of any disturbance in external telecommunications, electric power, financial or transportation networks. Although at this time the Company cannot estimate the impact of an interruption in any of these services, it is possible that a sustained disruption would materially affect the Company's operations and financial results. Since most of the Company's Year 2000 compliance expenses have arisen in the context of a general IT modernization, management does not believe that these remediation costs will rise to a material level. 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, lease negotiations and other risk factors. New Accounting Standards In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130) and No. 131 "Disclosure about Segments of an Enterprise and Related Information" (SFAS No. 131). SFAS No. 130 establishes standards for reporting the display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Both SFAS No. 130 and SFAS No. 131 are effective for fiscal periods beginning after December 15, 1997. The Company has not yet determined the impact, if any, of adopting these standards. In April 1998, the FASB issued Statement of Position (SOP) No. 98-5 "Reporting on the Costs of Start-Up Activities". This SOP requires the costs associated with start-up activities, such as opening a new store, be expensed as incurred. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. While a final determination has not been made, it is anticipated that such adoption will not have a material effect on the Company's results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Market risk is the potential change in a financial instrument's value caused by fluctuations in interest or currency exchange rates, or in equity and commodity prices. The Company's activities expose it to certain risks that Management evaluates carefully to minimize earnings volatility. At August 29, 1998, the Company was not a party to any derivative arrangement and the Company does not engage in trading, market-making or other speculative activities in the derivatives markets. The Company's foreign currency exposure is not material and the Company does not engage in regular hedging activities to minimize the impact of foreign currency fluctuations. As discussed in Notes 3 and 4 of the Notes to Consolidated Financial Statements, loans outstanding under the Company's unsecured line of credit bear interest at the bank's prime rate (8.5% at August 29, 1998), and the Company's term loan is payable at a fixed rate of 7.5% effective March 1, 1998, reduced from 8% previously. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Item 14(a)1 in Part IV. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required for this item is incorporated by reference to the Company's 1998 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 29, 1998. ITEM 11. EXECUTIVE COMPENSATION. The information required for this item is incorporated by reference to the Company's 1998 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 29, 1998. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required for this item is incorporated by reference to the Company's 1998 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 29, 1998. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required for this item is incorporated by reference to the Company's 1998 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 29, 1998. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report. 1.Financial Statements Page Independent Auditors' Report F-1 Consolidated Balance Sheets as of August 29, 1998 and August 30, 1997 F-2 Consolidated Statements of Income for the years ended August 29, 1998, August 30, 1997 and August 31, 1996 F-3 Consolidated Statements of Stockholders' Equity for the years ended August 29, 1998, August 30, 1997 and August 31, 1996 F-4 Consolidated Statements of Cash Flows for the years ended August 29, 1998, August 30, 1997 and August 31, 1996 F-5 Notes to Consolidated Financial Statements F-7 2.Financial Statement Schedules None 3.Exhibits 3.1*Certificate of Incorporation of the Company 3.2*By-Laws of the Company 10.1*Promissory Note (Revolving) with Valley National Bank 10.2*1991 Stock Option Plan 10.3*Lease between Momar Realty Co. and the Company, dated as of March 1, 1991 21.1List of subsidiaries of the Company 23.1Consent of Deloitte & Touche LLP 24.1Power of Attorney to sign Form 10-K (set forth on page 20) 27Financial Data Schedule (Filed electronically with SEC only) ________________________________ *Incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto. (b) The Company did not file a Current Report on Form 8-K during the last quarter of the period covered by this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Hawthorne, New Jersey, on November 24, 1998. RAG SHOPS, INC. By: /s/ Stanley Berenzweig STANLEY BERENZWEIG, Chairman POWER OF ATTORNEY Each of the undersigned hereby appoints Stanley Berenzweig and Steven Barnett as his or her attorneys-in-fact to sign his or her name, in any and all capacities, to any amendments to this Form 10-K and any other documents filed in connection therewith to be filed with the Securities and Exchange Commission. Each of such attorneys has the power to act with or without the others. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title(s) Date /s/ Michael Aaronson Director November 24, 1998 Michael Aaronson /s/ Steven Barnett Principal Financial November 24, 1998 Steven Barnett Officer, Principal Accounting Officer and Director /s/ Evan Berenzweig Director November 24, 1998 Evan Berenzweig /s/ Stanley Berenzweig Principal Executive November 24, 1998 Stanley Berenzweig Officer and Director /s/ Fred J. Damiano Director November 24, 1998 Fred J. Damiano /s/ Judith Lombardo Director November 24, 1998 Judith Lombardo /s/ Alan C. Mintz Director November 24, 1998 Alan C. Mintz RAG SHOPS, INC. Index to Consolidated Financial Statements INDEX TO EXHIBITS Exhibit Sequentially Number Description of Exhibits Numbered Pages 3.1 Certificate of Incorporation of the Company * 3.2 By-Laws of the Company * 10.1 Promissory Note (Revolving) with Valley National Bank * 10.2 1991 Stock Option Plan * 10.3 Lease between Momar Realty Co. and the Company, dated as of March 1, 1991 * 21.1 List of subsidiaries of the Company 23.1 Consent of Deloitte & Touche LLP 24.1 Power of Attorney to sign Form 10-K (set forth on page 20) 27 Financial Data Schedule (Filed electronically with SEC only) ________________________________ * Incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders Rag Shops, Inc. Hawthorne, New Jersey We have audited the accompanying consolidated balance sheets of Rag Shops, Inc. and its subsidiaries as of August 29, 1998 and August 30, 1997, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended August 29, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Rag Shops, Inc. and subsidiaries as of August 29, 1998 and August 30, 1997, and the results of their operations and their cash flows for each of the three years in the period ended August 29, 1998, in conformity with generally accepted accounting principles. Deloitte & Touche LLP Parsippany, New Jersey November 11, 1998 F-1 RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS August 29, August 30, ASSETS 1998 1997 CURRENT ASSETS: Cash $ 896,123 $ 763,668 Merchandise inventories 26,458,628 25,123,037 Prepaid expenses 531,535 298,823 Other current assets 77,475 242,297 Deferred taxes 707,346 697,146 Total current assets 28,671,107 27,124,971 PROPERTY AND EQUIPMENT, NET 4,327,559 4,885,520 OTHER ASSETS 319,690 253,198 $33,318,356 $32,263,689 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Note payable - bank $ 1,635,000 $ 2,435,000 Accounts payable - trade 6,555,499 5,080,546 Accrued expenses and other current liabilities 1,965,345 1,857,216 Accrued salaries and wages 618,112 812,028 Income taxes payable 243,821 - Current portion of long-term debt 558,802 683,980 Total current liabilities 11,576,579 10,868,770 DEFERRED TAXES - 40,361 LONG-TERM DEBT - 554,298 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value 2,000,000 shares authorized; no shares issued or outstanding - - Common stock, $.01 par value, 13,000,000 shares authorized; 4,514,400 shares issued and outstanding at August 29, 1998 and August 30, 1997 45,144 45,144 Additional paid-in capital 6,039,162 6,039,162 Retained earnings 15,657,471 14,715,954 Total stockholders' equity 21,741,777 20,800,260 $33,318,356 $32,263,689 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Year Ended August 29, August 30, August 31, 1998 1997 1996 NET SALES $90,565,996 $86,527,566 $83,766,651 COST OF MERCHANDISE SOLD AND OCCUPANCY COSTS 57,793,619 55,483,180 53,326,702 Gross profit 32,772,377 31,044,386 30,439,949 OPERATING EXPENSES: Store expenses 21,199,678 20,692,692 19,938,761 General and administrative expenses 9,967,252 9,885,242 9,561,294 Total operating expenses 31,166,930 30,577,934 29,500,055 INCOME FROM OPERATIONS 1,605,447 466,452 939,894 INTEREST EXPENSE, Net 61,430 115,129 160,887 INCOME BEFORE PROVISION FOR INCOME TAXES 1,544,017 351,323 779,007 PROVISION FOR INCOME TAXES 602,500 143,900 258,700 NET INCOME $ 941,517 $ 207,423 $ 520,307 EARNINGS PER COMMON SHARE: Basic and diluted $.21 $.05 $.12 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Additional Common Stock Paid-In Retained Shares Dollars Capital Earnings Total BALANCE, SEPTEMBER 2, 1995 4,514,400 $45,144 $6,039,162 $13,988,224 $20,072,530 Net income - - - 520,307 520,307 BALANCE, AUGUST 31, 1996 4,514,400 45,144 6,039,162 14,508,531 20,592,837 Net income - - - 207,423 207,423 BALANCE, AUGUST 30, 1997 4,514,400 45,144 6,039,162 14,715,954 20,800,260 Net income - - - 941,517 941,517 BALANCE, AUGUST 29, 1998 4,514,400 $45,144 $6,039,162 $15,657,471 $21,741,777 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended August 29, August 30, August 31, 1998 1997 1996 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 941,517 $ 207,423 $ 520,307 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,366,589 1,406,285 1,273,770 Deferred taxes (73,200) 8,000 (132,900) Loss on disposition of property and equipment 24,764 59,738 15,613 Changes in assets and liabilities: (Increase) decrease in: Merchandise inventories (1,335,591) 1,157,405 1,278,377 Prepaid expenses (232,712) 46,626 195,438 Other current assets 164,822 231,682 (381,948) Other assets (45,924) 169,668 (129,917) Increase (decrease) in: Accounts payable - trade 1,474,953 (2,523,537) 156,121 Accrued expenses and other current liabilities 108,129 142,870 (66,206) Accrued salaries and wages (193,916) 228,943 (69,211) Income taxes payable 243,821 - - Net cash provided by operating activities 2,443,252 1,135,103 2,659,444 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of property and equipment 3,350 4,331 3,895 Payments for purchases of property and equipment (834,671) (1,877,180) (1,000,511) Net cash used in investing activities (831,321) (1,872,849) (996,616) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of note payable - bank 12,810,000 14,520,000 34,415,000 Repayments of note payable - bank (13,610,000) (13,215,000) (38,020,000) Long-term borrowings - - 2,000,000 Repayments of long-term debt (679,476) (624,571) (148,080) Net cash (used in) provided by financing activities (1,479,476) 680,429 (1,753,080) NET INCREASE (DECREASE) IN CASH 132,455 (57,317) (90,252) CASH, BEGINNING OF YEAR 763,668 820,985 911,237 CASH, END OF YEAR $ 896,123 $ 763,668 $ 820,985 (continued) RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 120,725 $ 165,922 $ 232,667 Income taxes $ 464,206 $ 532,087 $ 200,013 SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Purchase of property and equipment in exchange for debt $ - $ - $ 10,929 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary Of Significant Accounting Policies Organization and Nature of Business Rag Shops, Inc. (the "Company"), a Delaware corporation formed in April 1991, is the successor by merger to a New Jersey Corporation having the same name which was incorporated in 1984. The Company operates a chain of retail fabric and craft stores through its subsidiaries predominantly located in New Jersey, New York, Pennsylvania and Florida. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All significant intercompany transactions and balances have been eliminated. Merchandise Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market as determined by the retail inventory method, and consist primarily of fabrics and crafts. Property and Equipment Property and equipment are stated at cost. Depreciation is computed over the estimated useful lives of the assets using straight-line and accelerated methods. Leasehold improvements are amortized by the straight-line method over an estimated useful life or the term of the related lease, whichever is shorter. Effective September 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" (SFAS No. 121). This Statement establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles and goodwill related to those assets to be held and used, and for long-lived assets and certain identifiable intangibles to be held and used by an entity to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The provisions of SFAS No. 121 did not have any impact on the Company's financial position or results of operations. Pre-opening and Closing Store Expenses All pre-opening costs incurred in connection with the opening of new retail stores are charged to expense on or before the stores opening. Costs associated with closing stores, when material, are charged to expense at the time the decision to close a store is determined. Amortization Lease acquisition costs are being amortized on the straight-line method over the remaining lives of the leases. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130) and No. 131 "Disclosure about Segments of an Enterprise and Related Information" (SFAS No. 131). SFAS No. 130 establishes standards for reporting the display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Both SFAS No. 130 and SFAS No. 131 are effective for fiscal periods beginning after December 15, 1997. The Company has not yet determined the impact, if any, of adopting these standards. In April 1998, the FASB issued Statement of Position (SOP) No. 98-5 "Reporting on the Costs of Start-Up Activities". This SOP requires the costs associated with start-up activities, such as opening a new store, be expensed as incurred. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. While a final determination has not been made, it is anticipated that such adoption will not have a material effect on the Company's results of operations. Use Of Estimates The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the Company's financial statements and accompanying notes to financial statements. Actual results could differ from those estimates. Fair Value Of Financial Instruments Management of the Company believes that the fair value of financial instruments approximates their cost as of August 29, 1998 and August 30, 1997. In management's opinion, the fair value of its fixed-rate term loan approximates book value based on borrowing rates currently available to the Company and amounts outstanding under its line of credit approximate fair value due to their variable rate. Fiscal Year The Company's fiscal year end is the Saturday closest to August 31. The financial statements for the fiscal years ended August 31, 1996, August 30, 1997 and August 29, 1998 were each comprised of 52 weeks. Note 2. Property And Equipment Property and equipment consists of the following: Useful August 29, August 30, Lives 1998 1997 Furniture and fixtures 5-10 years $7,506,894 $7,127,202 Leasehold improvements 10 years 2,831,728 2,579,142 Transportation equipmen 3-7 years 481,568 461,324 Data processing equipment 5 years 3,383,206 3,295,785 14,203,396 13,463,453 Less accumulated depreciation and amortization 9,875,837 8,577,933 $ 4,327,559 $4,885,520 Note 3. Note Payable - Bank The Company maintains a $10,000,000 credit facility with a bank. The credit facility is renewable annually on or before each December 31 and 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 year term loan (see Note 4). The facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants which require a minimum defined working capital and tangible net worth, a maximum ratio of debt to tangible net worth and set limits on the payment of dividends. As of August 29, 1998, the Company was in compliance with such covenants. Borrowings under the line of credit bear interest payable quarterly at the bank's prime rate (8.50% at August 29, 1998). The borrowings outstanding under the line of credit as of August 29, 1998 and August 30, 1997 were $1,635,000 and $2,435,000, respectively, and the unused line of credit for direct borrowings and the issuance of letters of credit at August 29, 1998 was $6,226,600. Note 4. Long-Term Debt Long-term debt outstanding consists of the following: August 29, August 30, 1998 1997 Term loan $ 547,873 $1,227,349 Other 10,929 10,929 558,802 1,238,278 Less current portion 558,802 683,980 $ - $ 554,298 During the year ended August 31, 1996, the Company borrowed $2,000,000 ("term loan") under the terms of its credit facility with a bank to finance its new point-of-sale cash register software, data collection and computer systems. Interest on the term loan is payable monthly at a fixed interest rate of 7.5% effective March 1, 1998, formerly at 8%. The term loan matures May 1, 1999, has monthly payments of $62,803 and is collateralized by equipment having a net book value of $1,278,496 as of August 29, 1998. Note 5. Commitments And Contingencies The Company leases its facilities in accordance with operating leases, having initial terms of more than one year, which expire in various years through 2012. Substantially all of the leases contain renewal options. In addition, certain leases require that the Company pay its pro rata share of utilities, taxes, insurance and maintenance. Rent expense for 1998, 1997 and 1996 amounted to $6,633,633, $6,140,557 and $5,863,758, respectively, and includes contingent rentals (computed on a percentage of sales, as defined in the leases) of $17,287, $28,168 and $42,565, respectively. The Company leases certain premises from an entity controlled by the majority stockholders of the Company. For the years ended 1998, 1997 and 1996, rental payments under this agreement amounted to $209,313, $307,695 and $288,897, respectively. Future minimum annual rental commitments under noncancellable operating leases are as follows: Fiscal Year Ended 1999 $6,511,367 2000 5,929,787 2001 4,810,688 2002 3,692,244 2003 2,698,217 Thereafter 4,400,161 $28,042,464 In addition, at August 29, 1998 the Company has outstanding letters of credit for the purchase of merchandise inventories of approximately $138,400. The Company is involved in various legal proceedings incidental to the conduct of its business. The Company currently is not engaged in any legal proceedings that is expected to have a material adverse effect on the Company's results of operations or financial position. Note 6. Earnings Per Share In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share ("Statement 128"). Statement 128 replaced the previously reported primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants, and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been restated to conform to the Statement 128 requirements. Year Ended August 29, August 30, August 31, 1998 1997 1996 Numerator: Net income for basic and diluted earnings per share $ 941,517 $ 207,423 $ 520,307 Denominator: Denominator for basic earnings per share-weighted average shares 4,514,400 4,514,400 4,514,400 Effect of dilutive securities: Employee stock options 41,387 19,430 12 Denominator for diluted earnings per share-adjusted weighted average shares and assumed conversions 4,555,787 4,533,830 4,514,412 Basic earnings per share $ .21 $ .05 $ .12 Diluted earnings per share $ .21 $ .05 $ .12 Note 7. Stock Options And Warrants In April 1991, the Company adopted the 1991 Stock Option Plan (the "Plan") covering employees and nonemployee directors. The plan permits options to purchase a total of 450,000 shares of common stock, of which 435,600 shares have been reserved by the Company as of August 29, 1998. Such options may be incentive stock options ("ISO") or nonqualified options. The term of an option will not exceed ten years and an option is exercisable as determined by the Option Committee of the Board of Directors. The exercise price of the shares covered by an ISO may not be less than the fair market value of the shares at the time of grant. The exercise price of the shares covered by a nonqualified option is determined by the Option Committee. The options granted are generally exercisable 20% per year. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS No. 123). Accordingly, no compensation cost has been recognized for the stock options awarded. Had compensation cost for the Company's stock option plan been recorded based on the fair value at the grant date for awards in 1998 and the effect of grants in 1997, consistent with the provisions of SFAS No. 123, the Company's net income and income per share would have been reduced to the pro forma amounts indicated below: Year Ended August 29, August 30, 1998 1997 Net income-as reported $941,517 $207,423 Net income-pro forma $935,066 $201,139 Net income per share-as reported, basic and diluted $ .21 $ .05 Net income per share-pro forma, basic and diluted $ .21 $ .04 The weighted-average fair value per share of options granted during the year is $2.01. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used for grants in 1998 and 1997: dividends yield of 0%, expected volatility of 50%, risk-free interest rate of 5.0% and 4.5%, respectively and expected lives of 7.5 years. Information with respect to options granted under the Plan is as follows: Number of Exercise Price Weighted-Average Shares Per Share Exercise Price Outstanding, September 2, 1995 224,150 $2.375-$12.375 $5.601 Granted 12,000 $2.125 $2.125 Canceled (21,400) $3.188-$12.375 $6.107 Outstanding, August 31, 1996 214,750 $2.125-$12.375 $5.356 Granted 115,000 $2.34-$3.00 $2.362 Canceled (23,700) $2.125-$12.375 $7.228 Outstanding, August 30, 1997 306,050 $2.125-$12.375 $4.086 Granted 2,000 $3.375 $3.375 Canceled (8,000) $2.125-$6.25 $3.672 Outstanding, August 29, 1998 300,050 $2.125-$12.375 $4.093 Exercisable, August 31, 1996 136,200 $6.00-$12.375 $6.726 Exercisable, August 30, 1997 145,050 $2.375-$12.375 $5.980 Exercisable, August 29, 1998 156,050 $2.125-$12.375 $5.658 The weighted-average remaining contractual life of stock options outstanding at August 29, 1998 is 5.8 years. Note 8. Income Taxes Income tax expense consists of the following: Year Ended August 29, August 30, August 31, 1998 1997 1996 Federal: Current $ 570,200 $ 135,900 $ 362,800 Deferred (73,200) 8,000 (115,800) State: Current 105,500 - 28,800 Deferred - - (17,100) $ 602,500 $ 143,900 $ 258,700 The deferred income tax arises from the following temporary differences: Year Ended August 29, August 30, August 31, 1998 1997 1996 Uniform inventory capitalization $10,200 $(30,600) $ 53,800 Depreciation 59,600 27,700 64,600 Straight-line of leases 3,400 (5,100) 14,500 $73,200 $ (8,000) $132,900 The effective tax rate differs from the Federal statutory rate as follows: Year Ended August 29, August 30, August 31, 1998 1997 1996 Statutory tax rate 34.0% 34.0% 34.0% State and local income taxes, net of federal income tax benefit 4.5 - 1.0 Other .5 7.0 (1.8) Effective tax rate 39.0% 41.0% 33.2% Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company's state deferred tax asset has been reduced by a valuation allowance based on current evidence indicating that it is not more likely than not that the future benefits of these temporary differences will be realized. The tax effect of significant items comprising the Company's deferred tax assets and liabilities are as follows: Year Ended August 29, August 30, 1998 1997 Current deferred tax asset: Uniform inventory capitalization $707,346 $697,146 Non-current deferred tax assets: Straight-line of leases 115,073 111,673 Difference between book and tax depreciation methods 19,239 - Net operating losses for State purposes 441,100 404,522 Valuation allowance (366,400) (329,822) 916,358 883,519 Non-current deferred tax liability: Difference between book and tax depreciation methods - 40,361 Net deferred tax asset $916,358 $843,158 Note 9. Employee Benefit Plan Effective January 1, 1996, the Company adopted a voluntary 401(k) savings plan. All non-union employees of the Company are eligible to participate on or after reaching age 21 and completing one year of eligibility service. The Company did not make any discretionary contributions to the 401(k) plan for the years ended August 29, 1998, August 30, 1997 and August 31, 1996. Note 10. Quarterly Results (Unaudited) The following is a summary of selected quarterly financial data (thousands of dollars, except per share amounts): Fiscal Quarter Ended Nov. 29, Feb. 28, May 30, Aug. 29, Fiscal 1998 1997 1998 1998 1998 Net sales $26,277 $24,998 $20,699 $18,592 Gross profit 9,741 9,047 7,490 6,494 Net income (loss) 982 431 224 (696) Earnings (loss) per common share (a): Basic .22 .10 .05 (.15) Diluted .22 .09 .05 (.15) Fiscal Quarter Ended Nov. 30, Mar. 1, May 31, Aug. 30, Fiscal 1997 1996 1997 1997 1997 Net sales $26,181 $23,707 $19,629 $17,011 Gross profit 9,791 8,718 7,120 5,415 Net income (loss) 921 218 167 (1,099)(b) Earnings (loss) per common share (a): Basic .20 .05 .04 (.24)(b) Diluted .20 .05 .04 (.24)(b) (a) Earnings (loss) per common share calculations for each quarter are restated to reflect accounting changes required under Statement of Accounting Standards No. 128, Earnings per Share. See Note 6. (b) Included in the fiscal quarter ended August 30, 1997 was a charge of $220,000 or $.05 per share, basic and diluted, based on the Company's annual shrinkage results compared to those estimates. The sum of the four quarters may not equal the full year computation due to rounding. * * * * * * EXHIBIT 21.1 RAG SHOPS, INC. LIST OF SUBSIDIARY COMPANIES Name State Incorporated RSL, Inc. Delaware Mobile Fabrics, Inc. New Jersey The Rag Shop/Glen Burnie, Inc. Maryland The Rag Shop, Inc. New York Rag Shop/Wayne, Inc. New Jersey Rag Shop/Parsippany, Inc. New Jersey Rag Shop/Edison, Inc. New Jersey The Rag Shop/West Orange, Inc. New Jersey The Rag Shop/Middletown, Inc. New Jersey The Rag Shop/Toms River, Inc. New Jersey The Rag Shop/Hamilton Square, Inc. New Jersey The Rag Shop/Hazlet, Inc. New Jersey The Rag Shop/Howell, Inc. New Jersey The Rag Shop/Ocean, Inc. New Jersey The Rag Shop/Sayreville, Inc. New Jersey The Rag Shop/Bricktown, Inc. New Jersey The Rag Shop/Totowa, Inc. New Jersey The Rag Shop/North Lauderdale, Inc. Florida The Rag Shop/West Palm Beach, Inc. Florida The Rag Shop/Palm Beach Gardens, Inc. Florida The Rag Shop/Lancaster, Inc. Pennsylvania The Rag Shop/Sunrise, Inc. Florida The Rag Shop/Lantana, Inc. Florida The Rag Shop/York, Inc. Pennsylvania The Rag Shop/Selinsgrove, Inc. Pennsylvania The Rag Shop/Pembroke Pines, Inc. Florida The Rag Shop/Jacksonville, Inc. Florida The Rag Shop/Olean, Inc. New York The Rag Shop/Boca Raton, Inc. Florida The Rag Shop/Port Richey, Inc. Florida The Rag Shop/Deptford, Inc. New Jersey The Rag Shop/Deerfield, Inc. Florida The Rag Shop/Jacksonville-San Jose, Inc. Florida The Rag Shop/Rostraver, Inc. Pennsylvania The Rag Shop/Evesham, Inc. New Jersey The Rag Shop/Allentown, Inc. Pennsylvania The Rag Shop/Jensen Beach, Inc. Florida The Rag Shop/Jacksonville-Orange Park, Inc. Florida The Rag Shop/Jacksonville-Regional, Inc. Florida The Rag Shop/Boro Park, Inc. New York The Rag Shop/Secaucus, Inc. New Jersey The Rag Shop/North Bergen, Inc. New Jersey The Rag Shop/Coral Springs, Inc. Florida The Rag Shop/Turnersville, Inc. New Jersey The Rag Shop/Hialeah, Inc. Florida The Rag Shop/Hollywood, Inc. Florida The Rag Shop/Binghamton, Inc. New York (continued) (continued) RAG SHOPS, INC. LIST OF SUBSIDIARY COMPANIES Name State Incorporated The Rag Shop/Lacey, Inc. New Jersey The Rag Shop/West Boca Raton, Inc. Florida The Rag Shop/Ocala, Inc. Florida The Rag Shop/Fishkill, Inc. New York The Rag Shop/Hampden, Inc. Pennsylvania The Rag Shop/East Norriton, Inc. Pennsylvania The Rag Shop/Wall Township, Inc. New Jersey The Rag Shop/Northern Lights, Inc. New York The Rag Shop/Linden, Inc. New Jersey The Rag Shop/Burlington, Inc. New Jersey The Rag Shop/Kingstown, Inc. Rhode Island The Rag Shop/Norwalk, Inc. Connecticut The Rag Shop/East Hollywood, Inc. Florida The Rag Shop/Edgewater, Inc. New Jersey The Rag Shop/Danbury, Inc. Connecticut The Rag Shop/Voorhees, Inc. New Jersey Each of the above does business under the name "The Rag Shop." EXHIBIT 23.1 RAG SHOPS, INC. INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in the Registration Statement of Rag Shops, Inc. on Form S-8 of our report dated November 11, 1998, appearing in this Annual Report on Form 10-K of Rag Shops, Inc. for the year ended August 29, 1998. Deloitte & Touche LLP Parsippany, New Jersey November 24, 1998 EX-27 2
5 YEAR AUG-29-1998 AUG-31-1997 AUG-29-1998 896,123 0 0 0 26,458,628 28,671,107 14,203,396 9,875,837 33,318,356 11,576,579 0 0 0 45,144 21,696,633 33,318,356 90,565,996 90,565,996 57,793,619 88,960,549 0 0 61,430 1,544,017 602,500 941,517 0 0 0 941,517 0.21 0.21
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