ITEM 1. BUSINESS - ------- --------
GENERAL - -------
The Right Start, Inc. ("Right Start" or "the Company") is a leading merchant offering unique, high-quality products for infants and young children. The Company markets its products through 24 retail stores, primarily located in major regional malls across the nation, and The Right Start Catalog. The Company is a market leader offering approximately 500 items targeting children up to age four in such product categories as Baby on the Go, Nursery, Bath Time, Kitchen and Health and Safety. The products offered are primarily the same for both catalog and retail, with a number of items available as either "retail- only" or "catalog-only."
HISTORY - -------
The Company was formed in 1985 to capitalize upon growing trends towards the use of mail order catalogs and the demand for high quality infants' and children's goods. Until formation of the Company, new parents' alternatives were low-service mass merchant stores or sparsely-stocked, high-priced infant and children specialty stores. To counter this, The Right Start carefully screened infant and toddler products in order to identify those considered to be the most unique, safest, most durable, best designed and best valued items.
The Right Start then grew its operations beyond The Right Start Catalog and into retail sales through The Right Start stores. Based on the strong results of the retail stores coupled with the extensive challenges facing the catalog industry, the Company's strategy evolved to include a reduction in The Right Start Catalog circulation and plans for a major retail expansion.
Management has always made customer service the Company's highest priority. By offering sales associates with extensive product knowledge, carefully selected and tested products, fast shipment that is generally less than 48 hours from receipt of catalog orders, and a 24 hour a day/365 day a year ordering capability, The Right Start is able to differentiate itself from many other infant and children merchants.
RETAIL OPERATIONS AND EXPANSION - -------------------------------
The Company operates 24 retail stores. Twenty-two of these stores are mall stores located in major regional malls throughout the United States; two are non-mall locations in California. The Company has plans for continued expansion of its retail operations with
18 stores planned for fiscal 1997.
New stores will be located primarily in high-traffic major regional malls across the United States. Potential sites are evaluated based on mall strength, relative strength of certain comparable specialty store operators in the same mall, the extent of Right Start Catalog customer/brand development, available census, demographic and psychographic data, as well as lease economics. In many areas, store sites which otherwise meet the Company's criteria may be difficult to lease on acceptable terms.
The Company's ability to open and operate new stores profitably is dependent on the identification and availability of suitable locations, the negotiation of acceptable lease terms, the Company's financial resources, the successful hiring and training of store managers and the Company's ability to control the operational aspects of growth. There can be no assurance that the Company will be able to open and operate new stores on a timely and profitable basis or that same store sales will increase in the future.
THE RIGHT START CATALOG - -----------------------
The Right Start Catalog offers high quality infants' and children's products through mail order catalogs targeted primarily to middle and upper income new parents and the grandparents of their children. Several attractive glossy issues are mailed each year, targeting the Company's principal customers, educated, first-time parents from 23-40 years old, with average annual household income in excess of $60,000. The Right Start Catalog has minimized the marketing of children's clothing, furniture and bedding items, all of which require different merchandising distribution and marketing strategies.
MERCHANDISING - --------------
The Right Start's basic business strategy/concept is to provide exemplary service to customers as a means of building strong loyalty,
to offer unique, hard-to-find items, and to increase market share and customer awareness through new store openings and continuous new product introductions.
To accomplish its strategy, the Company offers a selection of brand name and private label infant, toddler and preschool products through strategically selected store locations and highly targeted catalog mailings. Items are selected based on their quality, durability, uniqueness, historic product demand, seasonality, appeal to target markets and value. The addition of new products is key to keeping the stores and catalogs fresh and interesting to the customer base.
ADVERTISING AND MARKETING - -------------------------
The Right Start Catalog serves as the primary marketing tool for The Right Start stores. Catalogs are distributed in existing and future retail store markets through both direct mail and focused distribution to target groups (e.g. day care centers, hospitals, doctor's offices and other children's stores). In addition, the stores' point of sale system also provides a strong marketing database. Customers' names and addresses are captured and are then used for promotional mailings and other follow up.
The Company reaches its catalog customers through extensive mailings of The Right Start Catalog to qualified segments of the Company's own customer list and selected rented lists. In order to achieve this efficiently the customer list is segmented by frequency, recency and size of purchase. Over the past two years, the Company has experienced a decline in the Right Start Catalog response rate. While the Company has made extensive circulation cuts to exclude less profitable mailing lists, there can be no assurance that profitability of the overall catalog business will increase or that the Company will not continue to experience a declining response rate.
PURCHASING - ----------
The Right Start purchases products from over 200 vendors. No single vendor represents more than 3% of overall sales. The Company directly imports approximately 5% of the products offered and this source is expected to grow over time as the Company expands its private label and import programs. Imported items have historically had higher gross profit margins and tend to be more unique.
SEASONALITY - -----------
The Company's business is not significantly impacted by seasonal fluctuations, as compared to many other retail and catalog operations. The Right Start customer often is the end user of the product so purchases are spread throughout the year, rather than being concentrated between October and December, as are traditional gift purchases.
EMPLOYEES - ---------
As of August 20, 1996 the Company employed 397 employees, approximately 41 percent of whom were part-time. During the retail holiday season, additional temporary employees are hired. The Company has no collective bargaining agreements nor any unions and considers its employee relations to be good.
COMPETITION - -----------
The specialty catalog and retail infants' and children's markets are highly competitive. The Company's specialty mail order catalogs, retail stores and products compete with other retail stores, including specialty stores, mass merchants, discount chains, and department stores, and with a growing number of other mail order catalogs. Some of the Company's competitors have substantially greater financial, distribution and marketing resources than the Company. The substantial sales growth in the mail order catalog industry has encouraged the entry of many new competitors and continues to foster an increase in competition from established companies. The catalog and retail businesses could become even more competitive in the future.
The primary competition for The Right Start stores comes from "big box" concept children's stores which are becoming more and more prevalent. This type of operation offers customers an extensive variety of products (including apparel, furniture, bedding, etc.) for children and is typically located in up to 50,000 square feet, generally in lower real estate cost locations. In addition, certain stores face competition from local specialty baby stores.
There are a variety of general and specialty catalogs selling infants' and children's items in competition with The Right Start Catalog. The Company considers its primary catalog competition, however, to be "One Step Ahead," "Kids Club" by Perfectly Safe, and "Sensational Beginnings." These catalogs emerged several years after The Right Start Catalog and directly compete by offering a very similar product line at comparable price points to the same target market.
The Company's ability to continue to introduce innovative products to customers, to locate its stores in strategic, high-traffic locations, and to provide distinctive customer service is key to its ability to maintain or grow its market share.
TRADEMARKS - ----------
The Company has registered and continues to register, when deemed appropriate, certain U.S. trademarks and trade names, including "The Right Start" and "The Right Start Catalog". The Company considers these to be readily identifiable with, and valuable to, its business.
RECENT DEVELOPMENTS - -------------------
In July 1996, the Company sold its phone center operations to a telemarketing services provider for approximately $500,000, $250,000 of which was in cash and the remainder of which was in a two-year note secured by the assets in the phone center. There was no gain or loss on the sale. In conjunction with the sale, the Company entered into a telemarketing services agreement for RSC.
In April 1996, the Company completed a rights offering which generated approximately $4.9 million of net proceeds to the Company. Pursuant to the rights offering, approximately 1.5 million shares of common stock were issued. The offering was fully subscribed.
In February 1996, Lenny Targon, one of the co-founders of The Right Start, resigned from his position as Chief Executive Officer and Director. Jerry Welch, Chairman of the Board, assumed the title of Chief Executive Officer.
In August 1995, an investor group led by Kayne, Anderson Investment Management, Inc. acquired 3,937,000 shares of the Company's common stock, representing approximately 62% of the then outstanding shares, from American Recreation Centers, Inc. Richard A. Kayne, Jerry R. Welch and Howard M. Zelikow of Kayne, Anderson and Robert R. Hollman, Fred Kayne and Andrew D. Feshbach were appointed to The Right Start's Board of Directors. Robert Crist, Robert Feuchter and Stanley Schneider resigned from the board, concurrent with the close of the transaction.
ITEM 2.

ITEM 2. PROPERTIES - ------- ----------
The Right Start leases all of its locations under operating leases. Lease terms at the Company's retail locations range from six to ten years, with provisions for early termination in most locations if certain sales levels are not achieved and, at certain locations, the Company has options to extend the term. In most cases, rent provisions include a fixed minimum rent plus a contingent percentage rent based on net sales of the store in excess of a certain threshold.
The Right Start currently leases approximately 39,000 square feet of mixed use space in Westlake Village, California. The Company's
corporate office and first retail store reside in this space. The building is leased and the agreement includes options to extend through 2001.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS - ------- -----------------
The Company is not party to any legal actions.
ITEM 4.

ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- ----------------------------------------------------
Not applicable.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDERS' - ------- --------------------------------------------------------------- MATTERS -------
The Company's common stock is traded on the Nasdaq National Market System under the symbol RTST. The Company's stock is beneficially held by 1,535 shareholders.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - (Dollars in thousands except share data) - ------- -----------------------
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------- --------------------------------------------------------------- RESULTS OF OPERATIONS ---------------------
FISCAL 1996 COMPARED WITH FISCAL 1995 - -------------------------------------
Revenues for fiscal 1996 were $41.8 million compared to $45.7 million in 1995. Catalog net sales declined $13.5 million or 37% reflecting the December 1994 sale of Children's Wear Digest (CWD) and reduced response rates and circulation on The Right Start Catalog (RSC). CWD was a wholly owned subsidiary of the Company selling children's apparel by catalog. For fiscal 1997, the Company has further reduced the circulation of RSC and reduced the number of editions from five to three.
Retail net sales increased over 100% from $7.8 million to $17.1 million. The increase results from the additional eleven stores opened in fiscal 1996 and the impact of a full year's sales for the eight stores opened in fiscal 1995. All but the Company's two oldest stores are located in major upscale regional malls across the United States.
Cost of goods sold decreased 8.7% or $2.0 million to $21.6 million in fiscal 1996. The decrease is primarily due to the decrease in net sales. Additionally, the Company's cost of goods sold was negatively impacted in fiscal 1996 by inventory write-downs and adjustments totalling approximately $.5 million.
Operating expenses decreased $1.1 million or 5% from $19.9 million in fiscal 1995 to $18.8 million in fiscal 1996. The decrease represents a $3.4 million decrease in catalog production costs offset by retail and other operating expense increases. The decrease in catalog production costs results from the decrease in RSC circulation. Retail operating expenses increased due to the additional payroll and occupancy costs associated with the new store openings.
General and administrative expense increased to $4.8 million in fiscal 1996 from $3.0 million in fiscal 1995. This increase includes approximately $1.1 million in one-time charges related to employee severance and termination expenses, hiring and relocation expenses for new key management personnel and consulting fees related to the restructuring of the catalog operations. The remaining increase reflects the investment in the Company's infrastructure to position it to manage the accelerated store opening plans.
Pre-opening cost amortization increased $304,000 in fiscal 1996 as compared to fiscal 1995. The Company amortizes its store opening costs over the first twelve months of each store's operations. The fiscal 1996 increase reflects the impact of both fiscal 1995 and 1996 store openings.
Depreciation and amortization increased $193,000 in fiscal 1996 as more assets were employed in the retail operations due to new store openings.
The Company recognized $927,000 of income tax benefit for the year ended June 1, 1996, net of a valuation allowance provided against the deferred tax asset in the fourth quarter of the fiscal year. In evaluating the deferred tax asset, management considered
the Company's projections and available tax planning strategies.
FISCAL 1995 COMPARED WITH FISCAL 1994 - -------------------------------------
Revenues for fiscal 1995 were $45.7 million, a decrease of $4.8 million or 9.5% from fiscal 1994. Catalog net sales declined $9.2 million or 20.1% as a result of both the December 1994 sale of CWD and the decline in response rates and circulation for RSC. Based on the decline in RSC response rates experienced during the first half of the year, circulation cuts of up to 40% were taken for the spring and summer catalogs.
Retail net sales increased over 100% to $7.8 million from $3.2 million in fiscal 1994. The increase resulted from the fall 1994 openings of eight mall stores, two of which were relocations from leased departments in Rich's department stores, and 32% same-store-sales increases (28% as adjusted for the additional week in fiscal 1995) for the remaining three stores experienced during the second half of fiscal 1995.
Cost of goods sold decreased $2.4 million or 9.0% from fiscal 1994. The decline is in line with the decrease in sales with a slight degradation in gross margin due to the sale of CWD, typically a higher margin business than RSC and retail.
Operating expense decreased $.6 million to $19.9 million from fiscal 1994 to fiscal 1995. The decrease was primarily the result of decreased costs associated with the CWD and improved catalog delivery rates, offset by additional retail selling expenses for the new stores opened in fiscal 1995.
General and administrative expenses increased $.3 million or 13.2% to $3.0 million in fiscal 1995 compared to $2.7 million in fiscal 1994. This is primarily a result of increased costs incurred in support of the expanding retail operations and the systems development and support related thereto. These increases were offset by decreases resulting from the sale of CWD.
The loss on the sale of CWD of $1.7 million reflects the one-time charge associated with the writedown of goodwill related to the sale of CWD in December 1994.
LIQUIDITY AND CAPITAL RESOURCES - -------------------------------
During fiscal 1996, the Company's primary sources of liquidity were from borrowings under its credit facility and the issuance of common stock through a rights offering. These sources financed the Company's operating losses and capital expenditures. Capital expenditures of approximately $4.2 million were incurred in opening
eleven new retail stores and installing the information systems necessary to support the existing and planned retail growth.
The Company's existing credit facility provides for borrowings of up to $5 million, subject to a defined borrowing base. This agreement expires in June 1998. Outstanding borrowings are secured by all of the assets of the Company. At June 1, 1996, there were no borrowings outstanding on the line and approximately $2.8 million was available.
The Company opened eight new stores in fiscal 1995, 11 new stores in fiscal 1996, and currently expects to open up to 18 additional new stores in fiscal 1997. The Company expects to expend approximately $400,000 for each new store it opens. The Company expects to fund store openings contemplated by its current plan from borrowings under its credit facility and cash flow from operations. The Company anticipates that it will be profitable in the future, however, there can be no assurance that the Company's expansion strategy will be successful or that the Company will not continue to incur operating losses. Losses could negatively affect working capital, the extension of credit by the Company's suppliers and the Company's ability to implement its expansion strategy.
IMPACT OF INFLATION - -------------------
The impact of inflation on results of operations has not been significant
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- -------------------------------------------
The consolidated financial statements and supplementary data are as set forth in Item 14(a).
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------- --------------------------------------------------------------- FINANCIAL DISCLOSURE --------------------
Not applicable.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- --------------------------------------------------
The information contained in the Company's 1996 Proxy Statement under the captions "Principal Shareholders and Management" and "Election of Directors" is incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION - -------- ----------------------
The information contained in the Company's 1996 Proxy Statement under the caption "Executive Compensation and Other Information" is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- --------------------------------------------------------------
The information contained in the Company's 1996 Proxy Statement under the caption "Principal Stockholders and Management" is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ----------------------------------------------
The information contained in the Company's 1996 Proxy Statement under the caption "Certain Relationships and Related Transactions" is incorporated herein by reference.
This Annual Report on Form 10-K contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Discussions containing such forward-looking statements may be found in the material set forth under Item 1. Business--Retail Operations and Expansion, --Seasonality, - --Competition, and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources, as well as within this Annual Report generally (including any document incorporated by reference herein). Also, documents subsequently filed by the Company with the Securities and Exchange Commission will contain forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors identified herein or in other public filings by the Company, including but not limited to, the Company's Registration Statement on Form S-3 (File No. 333-08175).
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
(a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT.
All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.
(3) LISTING OF EXHIBITS
The following exhibits are filed as part of, or incorporated by reference into, this annual report:
INDEX TO EXHIBITS
EXHIBIT NUMBER - ------
3.1 Amended and Restated Articles of Incorporation of the Company, dated August 12, 1991*
3.1.1 Amendment to Articles of Incorporation, dated August 20, 1991*
3.1.2 Form of Amendment to Articles of Incorporation, dated August 24, 1991*
3.2 Bylaws of the Company, as amended*
3.3 Specimen Certificate of the Common Stock (without par value)*
4.1 Warrant Certificate for Representative's Warrants*
10.1 Lease between the Company and Westlake Industrial Complex, a California Limited Partnership, dated August 9, 1988, as amended February 6, 1991*
10.2 Employment Agreement between the Company and Stanley Fridstein, dated May 30, 1991, as amended*
10.3 1991 Key Employee Stock Option Plan*
10.4 Stock Option Grant to Stanley Fridstein, dated March 15, 1991, as amended (see Exhibit 10.2)*
10.5 Stock Option Grant to Lenny Targon, dated March 15, 1991, as amended*
- ----------------- * Previously filed.
10.6 Form of Indemnification Agreement between Registrant and its directors and executive officers*
10.7 Westlake Industrial Complex Lease Agreement for 31333 Agoura Road, Westlake Village, CA*
10.8 Software License Agreement between the Registrant and Marriner Systems, Inc., dated April 27, 1994*
10.9 1995 Non-employee Directors Option Plan
10.10 Registration Rights Agreement between Registrant and Kayne Anderson Non-Traditional Investments LP, ARBCO Associates LP, Offense Group Associates LP, Opportunity Associates LP, Fred Kayne, Albert O. Nicholas and Primerica Life Insurance Company
10.11 Termination and Release Agreement by and between The Right Start, Inc. and Lenny M. Targon dated February 28, 1996
10.12 Loan Agreement dated June 12, 1995 by and between Wells Fargo Bank, National Association and The Right Start, Inc.
10.13 Asset Purchase Agreement dated as of July 29, 1996 by and between Blasiar, Inc. (DBA Alert Communications Company) and The Right Start, Inc.
23.1 Consent of Independent Accountants
27.1 Financial Data Schedule
- ----------------- * Previously filed.
(b) REPORTS ON FORM 8-K
Form 8-K dated March 27, 1996: The Right Start, Inc. issued a press release reporting third quarter results.
(c) Not applicable
(d) Not applicable
SIGNATURES
Pursuant to the requirement of Sections 13 and 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.
THE RIGHT START, INC. (Registrant)
Dated: August 28, 1996 /s/ JERRY R. WELCH -------------------------------------- Jerry R. Welch Chairman of the Board and Chief Executive Officer
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ JERRY R. WELCH August 28, 1996 - --------------------------------------- Jerry R. Welch, Chairman of the Board and Chief Executive Officer
/s/ STANLEY M. FRIDSTEIN August 28, 1996 - --------------------------------------- Stanley M. Fridstein, President and Director
/s/ RICHARD A. KAYNE August 28, 1996 - --------------------------------------- Richard A. Kayne, Director
/s/ ANDREW D. FESHBACH August 28, 1996 - --------------------------------------- Andrew D. Feshbach, Director
/s/ ROBERT R. HOLLMAN August 28, 1996 - --------------------------------------- Robert R. Hollman, Director
/s/ FRED KAYNE August 28, 1996 - --------------------------------------- Fred Kayne, Director
/s/ HOWARD M. ZELIKOW August 28, 1996 - --------------------------------------- Howard M. Zelikow, Director
/s/ GINA M. SHAUER August 28, 1996 - --------------------------------------- Gina M. Shauer, Chief Financial Officer (Principal Financial and Accounting Officer)
REPORT OF INDEPENDENT ACCOUNTANTS ---------------------------------
To the Board of Directors and Shareholders of The Right Start, Inc.
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 12 present fairly, in all material respects, the financial position of The Right Start, Inc. and its subsidiary at June 1, 1996 and May 31, 1995, and the results of their operations and their cash flows for each of the three fiscal years in the period ended June 1, 1996, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP Woodland Hills, California July 3, 1996
THE RIGHT START, INC.
CONSOLIDATED BALANCE SHEET --------------------------
See accompanying notes to consolidated financial statements.
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF OPERATIONS ------------------------------------
See accompanying notes to consolidated financial statements.
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY --------------------
See accompanying notes to consolidated financial statements.
THE RIGHT START, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS ------------------------------------
See accompanying notes to consolidated financial statements.
THE RIGHT START, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------
NOTE 1 - THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES: - ------------------------------------------------------------
The Company - -----------
The Right Start, Inc. (the Company) is a specialty merchant of infants' and children's products throughout the United States. In 1991, the Company completed the sale of 2,300,000 shares of its common stock in an initial public offering. Prior to that, it was a wholly owned subsidiary of American Recreation Centers, Inc. (ARC). ARC maintained majority ownership of the Company through July 1995. In August 1995, an investment group led by Kayne, Anderson Investment Management, Inc. (KAIM) acquired the 3,937,000 shares of common stock owned by ARC.
The Company's financial statements also include the accounts of its wholly owned subsidiary, Children's Wear Digest (CWD) through the date the Company sold CWD (see Note 6). All material intercompany balances and transactions have been eliminated.
Fiscal Year - -----------
The Company has a fiscal year consisting of fifty-two or fifty-three weeks ending on the last Saturday (formerly Wednesday) in May. The fiscal year ended May 31, 1995 is a fifty-three week period. The other fiscal years presented consist of fifty-two week periods.
Revenue Recognition - -------------------
Retail sales are recorded at time of sale or when goods are delivered. Catalog sales are recorded at the time of shipment. The Company provides for estimated returns at the time of the sale.
Cash and Equivalents - --------------------
Cash and equivalents include demand deposits and marketable securities with original maturities of three months or less. These investments are subject to minimal credit and market risk. The carrying amount of cash and equivalents approximates fair value.
NOTE 1: (Continued) - ------
Merchandise Inventories - -----------------------
Merchandise inventories consist of products purchased for resale and are stated at the lower of cost or market value. Cost is determined on a first-in, first- out basis.
Catalog Production Expenses - ---------------------------
Prepaid catalog expenses consist of the costs to produce, print and distribute catalogs. These costs are amortized over the expected sales life of each catalog, which is three months. The Company adopted Statement of Position Number 93-7 (SOP 93-7), "Reporting on Advertising Costs", in the fourth quarter of fiscal year 1995. The adoption of SOP 93-7 did not result in a material impact on the Company's consolidated financial position or results of operations.
Catalog production expenses of $6,061,000, $9,457,000 and $10,068,000 were recorded in fiscal 1996, 1995 and 1994, respectively.
Property, Plant and Equipment - -----------------------------
Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation is provided using the straight line method based upon the estimated useful lives of the assets, generally three to ten years. Amortization of leasehold improvements is based upon the term of the lease or the estimated useful life of the leasehold improvements, whichever is shorter.
Store Opening Costs - -------------------
Costs incurred in opening stores are deferred and included in other current assets and are amortized over 12 months commencing with the store opening. Unamortized store opening costs were $531,000 and $277,000 at June 1, 1996 and May 31, 1995, respectively.
Deferred Rent - -------------
The Company recognizes rent expense on a straight-line basis over the life of the underlying lease. The benefit from tenant allowances and landlord concessions are recorded as deferred rent and recognized over the lease term.
Income Taxes - ------------
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standard No. 109 (FAS 109), "Accounting for Income Taxes." FAS 109 requires an asset and liability approach under which deferred tax liabilities and assets are recognized for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities.
During the periods that the Company was majority owned by ARC, the Company provided for income taxes as a separate taxpayer. State income taxes were settled pursuant to an informal tax sharing agreement and the Company filed a separate federal income tax return.
NOTE 1: (Continued) - ------
Other Revenues - --------------
Other revenues include rentals of customer mailing lists and revenues from order fulfillment services.
Per Share Data - --------------
Earnings per share has been computed in accordance with the treasury stock method based upon the weighted average number of common shares and dilutive common stock equivalents outstanding. Common stock equivalents comprise options outstanding to key executives, employees and directors (see Note 5).
Reclassifications - -----------------
Certain reclassifications have been made to conform prior year amounts to current year presentation.
Use of Estimates - ----------------
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
NOTE 2 - PROPERTY, PLANT AND EQUIPMENT, NET: - -------------------------------------------
Depreciation and amortization expense for property, plant and equipment amounted to $935,000, $645,000 and $484,000, for fiscal years 1996, 1995 and 1994, respectively.
NOTE 3 - CREDIT AGREEMENTS: - --------------------------
In June 1995, the Company entered into a revolving credit agreement with a bank which expires in June 1998. The credit agreement provides for borrowings up to $5,000,000, including letters of credit, the availability of which is subject to a borrowing base, as defined in the agreement. Interest accrues at the bank's prime lending rate plus 1%.
The agreement requires that the Company must comply with certain financial and other covenants, and borrowings are secured by all of the assets of the Company. The Company is required by the agreement to pay annual fees of $25,000 in addition to an unused line fee. The unused line fee is equal to .5% per annum of the amount by which $3,500,000 exceeds the outstanding balance on the line.
NOTE 4 - INCOME TAXES: - ---------------------
The (benefit) provision for income taxes is comprised of the following:
The Company's effective income tax rate differed from the federal statutory rate as follows:
NOTE 4: (Continued) - ------
Deferred tax liabilities/(assets) are comprised of the following:
The Company's deferred tax asset is net of a valuation allowance of $940,000. In evaluating the deferred tax asset, management considered the Company's projections and available tax planning strategies.
The Company has federal and state net operating loss carryforwards at June 1, 1996 of $5,850,000 and $3,612,000, respectively. These carryforwards will expire in fiscal years ending 2002 to 2011, and were not significantly impacted by the August 1995 change in ownership.
NOTE 5 - CAPITAL STOCK: - ----------------------
In April 1996, the Company issued 1,578,806 shares of common stock pursuant to a rights offering. Net proceeds to the Company were $4,906,000.
In connection with its initial public offering, the Company granted the representative of the underwriters 200,000 warrants to purchase the Company's common stock at an exercise price of $7.19. The warrants provide for registration rights and anti-dilution protection and expire in October 1996.
NOTE 6 - CHILDREN'S WEAR DIGEST: - -------------------------------
Pursuant to an asset purchase agreement dated December 30, 1994 (the Agreement) and a letter of intent agreement entered in November 1994, the Company and its wholly owned subsidiary, Children's Wear Digest, Inc. (CWD), sold substantially all of the assets of CWD to Small People, Inc. (SPI). A significant owner of SPI was the president of CWD until his resignation effective December 30, 1994 and was also the owner of CWD at the time of its purchase by the Company. Under the terms of the Agreement, CWD sold certain assets, consisting primarily of inventory, fixed assets and intangible assets, in exchange for cash of approximately $2,437,000. The transaction resulted in a loss of $1,744,000.
In connection with the Agreement, the parties also entered into a separate Telemarketing Agreement, a Confidentiality and Noncompetition Agreement, and termination agreements related to certain employment and management contracts between CWD and its former owners which were entered when the Company purchased CWD in September 1992. The acquisition was accounted for as a purchase and the resultant goodwill was amortized over its estimated useful life.
NOTE 7 - WEEBOK CATALOG: - -----------------------
In September 1992, the Company secured the exclusive mail order rights to the Weebok line of children's clothing. Based on the results, management elected to discontinue mailing the Weebok catalog in November 1993. As a consequence, the Company recorded a charge of $470,000 comprised of prepaid catalog expenses and inventory.
NOTE 8 - EMPLOYEE BENEFITS AND STOCK OPTIONS: - --------------------------------------------
On March 15, 1991, two key executives were granted options to acquire up to 900,000 shares of the Company's common stock under a non-qualified stock option plan. The options were granted at fair market value of $3.33 per share. These options expire June 1, 2001. In August 1995, the terms of the options were amended. The number of shares subject to such options was reduced to 776,000 with an exercise price of $3.00 per share. At June 1, 1996, 731,000 shares are outstanding under this plan.
One of the executives covered by this plan was the Company's chief executive officer who resigned in March 1996. In connection with his resignation, he is entitled to salary and benefits through May 1997 and the cash surrender value of a life insurance policy.
The Company adopted the 1991 Employee Stock Option Plan, covering an aggregate of 300,000 shares of the Company's common stock, in October 1991. Options granted vest either 20% or 33% (depending on the terms of the individual grant) each year commencing on grant date and expire 10 years thereafter. In August 1995, those holding options under the 1991 Employee Stock Option Plan were given the right to cancel their options (the "existing options") and have an equal number of options (the "new options") reissued to them at the fair market value of $3.00 per share. The vesting period on the existing options is 20% each year and the new options vest 33% each year, both from date of grant. Options for 254,000 shares were outstanding as of June 1, 1996, 5,200 of which were exercisable. Authorization for the amount by which the outstanding options exceed the amount allowed in the plan is subject to ratification by the Company's shareholders.
NOTE 8: (Continued) - ------
On January 13, 1992, the Company adopted the 1992 Stock Option Plan for Non- Employee Directors covering an aggregate of 50,000 shares. This plan provides that all non-employee directors will automatically receive options to purchase 5,000 shares exercisable at the fair market value at the date of the grant. The Company granted options to purchase 10,000 shares at $4.25 on April 22, 1992 and 5,000 shares at $3.25 on September 14, 1992. These options vest 20% at the grant date and an additional 20% each year thereafter. Upon resignation of non- employee directors from the Company's Board of Directors, all unvested options expire. Of the 15,000 options granted under this plan, 8,000 were exercised in January 1996 and the remaining options expired.
In October 1995, the Company adopted the 1995 Non-Employee Directors Option Plan. This Plan provides for the annual issuance, to each non-employee director, of options to purchase 3,000 shares of common stock. In addition, each director is entitled to make an election to receive, in lieu of directors' fees, additional options to purchase common stock. The amount of additional options is determined based on an independent valuation such that the value of the options issued is equivalent to the fees that the director would be otherwise entitled to receive. Options issued under this plan vest on the anniversary date of their grant and upon termination of Board membership. 61,902 options were issued under this plan, none of which were exercisable at June 1, 1996.
Prior to fiscal 1993, the employees of the Company participated in the ARC Employee Stock Ownership Plan (ARC ESOP) and the ARC Employee Stock Purchase Plan (ARC ESPP). In fiscal 1993, the Company adopted a separate employee stock ownership plan (Company ESOP) and employee stock purchase plan (Company ESPP) for the benefit of its employees. The employee balances in the ARC ESOP were transferred to the Company ESOP. The employee balances in the ARC ESPP remain in that plan.
The Company matches employees' contributions to the Company ESPP at a rate of 50%. The Company's contributions amounted to $28,000, $58,000 and $56,000 in fiscal 1996, 1995 and 1994, respectively.
The Company ESOP is funded exclusively by discretionary contributions determined by the Board of Directors. The Board of Directors authorized contributions of $70,000 in fiscal 1996 and $50,000 for both fiscal 1995 and 1994.
The following table summarizes option activity through June 1, 1996:
NOTE 9 - RELATED PARTY TRANSACTIONS: - -----------------------------------
KAIM receives a quarterly fee for providing certain management and advisory services to the Company. Management fees of $75,000 were paid to KAIM in fiscal 1996.
ARC incurred certain expenses on behalf of the Company and charged the Company for such expenses. These expenses include amounts allocated on an actual basis for income taxes, insurance premiums, telephone charges and professional fees. Corporate office overhead charges of $27,000 for each of fiscal 1995 and 1994 were allocated on the basis of estimated corporate staff effort on behalf of the Company.
The Company provided telemarketing services through July 1996, to K.A. Industries, a related party to KAIM. Revenues generated from this service amount to $365,000 for fiscal 1996. Management believes that the terms of this agreement are no less favorable than those that would have been negotiated with an unrelated third party.
NOTE 10 - OPERATING LEASES: - --------------------------
The Company leases real property and equipment under non-cancelable agreements expiring from 1997 through 2007. Certain retail store lease agreements provide for contingent rental payments if the store's net sales exceed stated levels ("percentage rents"). A majority of the leases contain escalation clauses which provide for increases in base rental for increases in future operating cost and renewal options at fair market rental rates. The Company's minimum rental commitments are as follows:
Net rental expense under operating leases was $1,959,000, $1,166,000 and $667,000 for fiscal 1996, 1995 and 1994, respectively. Percentage rents incurred in fiscal 1996 amounted to $82,000.
NOTE 11 - COMMITMENTS AND CONTINGENCIES: - ---------------------------------------
The Company is not party to any legal actions.
NOTE 12 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: - ----------------------------------------------------------
Changes in assets and liabilities, net of the effects of the acquisition and subsequent disposition of CWD, which increased (decreased) cash and equivalents are as follows:
Cash paid for income taxes was $552,000 for fiscal year 1994. Non-cash investing activity consists of $57,000 accrued in conjunction with the CWD acquisition in fiscal 1994 (see Note 6).
NOTE 13 - FOURTH QUARTER ADJUSTMENTS - ------------------------------------
The Company recorded approximately $500,000 in inventory write-downs and adjustments during the fourth quarter of fiscal 1996.
NOTE 14 - NEW ACCOUNTING PRONOUNCEMENTS - ---------------------------------------
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 will become effective for the Company in fiscal 1997. The adoption of SFAS 123 is not expected to have a material effect on the Company's consolidated financial position or results of operations.
Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", will become effective for the Company in fiscal 1997. This Statement requires that long-lived assets and certain identifiable intangibles to be held and used by the Company be reviewed for impairment whenever there is an indication that the carrying amount of the asset may not be recoverable. Measurement of an impairment loss should be based on the fair value of the asset. This Statement also requires that any such assets that are to be disposed of be reported at the lower of carrying amount or fair value less cost to sell. Adoption of the Statement is not expected to have a material impact on the Company's financial position and results of operations.
THE RIGHT START, INC.
SCHEDULE II - VALUATION RESERVES --------------------------------


ITEM 1 -- BUSINESS
GENERAL
The Metzler Group, Inc. is a leading nationwide provider of consulting services to electric utilities and other energy-related businesses. The Company offers a wide range of consulting services related to information technology, process/operations management, business strategy development, and marketing and sales designed to assist its clients in succeeding in a business environment of changing regulation, increasing competition and evolving technology. The Company has competed successfully in this environment, having achieved revenue growth of 29% from 1994 to 1995 and over 60% in 1996.
The electric utility industry is one of the largest industries in the United States. According to the Edison Electric Institute, in 1995 the total assets of investor-owned utilities (which account for the vast majority of the industry's generating capacity and revenues) exceeded $575 billion and electric utility industry revenues from sales to end users totaled approximately $207 billion.
The demand for consulting services in the U.S. electric utility industry is driven in significant part by the revolutionary change facing the industry as it begins to convert from a regulated monopoly structure to an increasingly competitive environment. Historically, due to the significant fixed costs inherent in generating and transmitting electricity, electric utilities were viewed as natural local monopolies, operating as an integrated entity to generate, transmit and distribute retail electricity within designated geographic service areas without competition from other suppliers.
However, as a result of recent market, regulatory and legislative factors, competition in the electric utility industry is being encouraged at both the state and federal regulatory levels, but the transformation to a competitive market for electricity is proceeding unevenly. Although deregulation of the transportation and telecommunications industries was accomplished relatively rapidly, deregulation of the electric utility industry has been more difficult due to the complex and overlapping web of over 200 federal and state regulatory bodies and the presence of a large number of separate, regulated companies. Accordingly, implementation will likely unfold on a state-by-state basis into the next century and may well face challenges from utilities and state and local governments.
The changing competitive environment in the electric utility industry has forced utility companies to confront an evolving range of strategic options and challenges. In order to deal with these challenges and address these opportunities, electric utilities are formulating and implementing new strategies and tactics, including redesigning business processes, re-engineering work forces, acquiring more effective information technology and adopting or restructuring customer service and marketing programs. Utilities are increasingly turning to experienced outside consulting firms to assist in or lead this process because: (i) the pace of change is eclipsing utilities' internal resources; (ii) many utilities lack the depth and breadth of experience to identify, evaluate and implement the full range of possible options and solutions; (iii) outside specialists often enable electric utilities to develop better solutions in shorter time frames; (iv) purchasing consulting expertise converts fixed labor costs to variable costs and can be more cost-effective; and (v) consultants can often formulate more objective advice, free of internal cultural or political forces.
Metzler believes that several competitive factors distinguish it from other participants in the consulting market including: (i) established electric utility expertise developed over more than thirteen years of providing consulting services to the electric utility industry; (ii) deep-rooted client relationships supporting multiple engagements; (iii) proprietary knowledge base that the Company has developed internally and continuously refines for incorporation into analysis for new engagements; (iv) wide range of industry-specific services that enables the Company to be a single-source provider of consulting services to utilities while maintaining advanced skill sets in each area; and (v) strategic planning methodology using a high-level modeling tool developed by Metzler to support the comprehensive strategic planning process of utilities.
Metzler's growth strategy includes the following elements: (i) further penetrating its existing client base; (ii) seeking new clients and expanding its geographic presence; (iii) continuing to recruit highly skilled
professionals with skill sets and client relationships complementary to the Company's existing professional base; (iv) pursuing strategic acquisitions that provide the Company with an expeditious and cost-effective method of increasing its number of consultants, broadening its client base, expanding its skill sets or expanding its presence in a geographic region; and (v) expanding its service offerings to include other service areas that the Company believes will be in demand as the industry continues its move toward a more competitive environment.
SERVICES
The Company offers its consulting services in four principal areas: information technology, process/operations management, strategy, and marketing and sales. In order to understand the basic characteristics of a client, organizational unit or project, the Company generally performs more than 75% of the engagement at the client's site. This on-site presence helps avoid the development of conclusions drawn from limited exposure to company personnel, processes and facilities and enables Metzler consultants to be available to service further or expanded client needs as they may evolve. Although extensive time is spent on site, all Metzler consultants have portable computers running common software for word processing and tabular and graphic presentations, thereby allowing the project team to remain relatively independent of and non-intrusive into the client's daily business operations.
The table below provides examples of the Company's service offerings in each of these areas.
MARKETING AND SALES
The Company markets its services directly to senior executives of utilities from its headquarters near Chicago, Illinois. The Company employs a variety of business development and marketing techniques to communicate directly with current and prospective clients, including on-site presentations to senior utility executives, industry seminars featuring presentations by Metzler personnel and authoring of articles and other publications regarding the utility industry and the Company's methodologies.
A significant portion of new business arises from prior client engagements. Clients frequently expand the scope of engagements during delivery to include follow-on complementary activities. Also, the Company's on-site presence affords it the opportunity to become aware of, and to help define, additional project opportunities as they are identified by the client. The strong client relationships arising out of many engagements often facilitate the Company's ability to market additional capabilities to its clients in the future. In addition, the Metzler senior management teamis actively engaged in meeting with utilities that have not yet engaged the Company and newly appointed senior managers in utilities where the Company has worked in the past to make them aware of the Company's capabilities.
CLIENTS AND REPRESENTATIVE SERVICES
The Company has performed consulting assignments for more than 120 utility industry clients, principally investor-owned electric utilities. The Company's clients also include gas and water companies and other ownership structures such as holding companies, electric cooperatives, public power agencies and state regulatory commissions. The Company also serves independent power producers, co-generators and power marketers and suppliers to the utility industry.
Because of the nature and scope of many of the Company's projects, the Company derives a significant portion of its revenues from a relatively limited number of clients that operate exclusively in the electric utility
industry. For example, during 1996, revenues from the Company's ten most significant clients accounted for approximately 80.1% of its revenues. In 1996, a group of affiliated clients and the Company's then largest single client accounted for approximately 20.5% and 15.5% of the Company's revenues, respectively. The Company's largest clients typically engage the Company on consulting projects that span from twelve to eighteen months and thereafter the Company may not be rehired for a significant project for varying periods of time. This typical engagement cycle causes the Company's ten most significant clients, absent project carryovers, to change from year to year. For these reasons, the Company believes that it is not materially dependent on any particular client.
HUMAN RESOURCES
As of March 14, 1997, the Company's personnel consisted of 67 employees. The Company's success depends in large part on attracting, retaining and motivating talented, creative and experienced professionals at all levels. In connection with its hiring efforts, the Company employs a full-time human resources director, retains executive search firms and relies on personal and business contacts to recruit professionals with significant utility industry or consulting experience. The Company's hiring focus is not on finding a large number of employees, but rather on identifying candidates who are well suited by background and temperament to serve the Company's utility client base. The Company's consultants are drawn from utility and related industries such as engineering, construction and telecommunications, and from accounting and other consulting organizations. The Company's fifteen senior most managers each average a total of fifteen years of utility industry and consulting experience. The Company has experienced consultant attrition of approximately 15% over each of the last two years, predominately at the associate level.
The Company has developed mentoring programs to assist in training its employees, and intends to further enhance its focus on employee training in the future. The Company also develops its consultants through a training program, as well as review of precedent from prior Company engagements.
The Company promotes loyalty and continuity of its consultants by offering packages of base and incentive compensation and benefits that it believes are significantly more attractive than those offered by the consulting industry in general. In addition, to attract and retain consultants, the Company has established several employee benefit plans.
In addition to the employees discussed above, Metzler supplements its consultants on certain engagements with independent contractors, many of whom are former employees of the Company. The Company is responsible for selecting these individuals and integrating their work product into a total solution for the Company's utility client. The Company believes that its practice of retaining independent contractors on a per-engagement basis provides it with greater flexibility in adjusting professional personnel levels in response to changes in demand for its services.
COMPETITION
The market for consulting services to electric utilities is intensely competitive, highly fragmented and subject to rapid change. The market includes a large number of participants from a variety of market segments, including general management consulting firms, the consulting practices of "Big Six" accounting firms, and local or regional firms specializing in utility services. Many information technology consulting firms also maintain significant practice groups devoted to the utility industry. Many of these companies are national and international in scope and have greater financial, technical and marketing resources than the Company. The Company believes that its experience, reputation, industry focus and broad range of services will enable it to compete effectively in its marketplace.
ITEM 2

ITEM 2 -- PROPERTIES
Metzler currently operates from 10,000 square feet of leased office space located in Deerfield, Illinois. The Company believes that additional space will be required as its business expands geographically and that it will be able to obtain suitable space as needed.
ITEM 3

ITEM 3 -- LEGAL PROCEEDINGS
The Company is not a party to any litigation and is not aware of any pending or threatened litigation that would have a material adverse effect on the Company or its business.
ITEM 4

ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of 1996 and prior to the effective date of its initial public offering, the Company submitted the approval of a Long Term Incentive Plan (the "Plan") and the granting of options pursuant to the Plan to its stockholders in anticipation of the offering. On October 2, 1996, holders of 100% of the issued and outstanding shares of Common Stock of the Company approved the Plan and the options granted thereunder by unanimous written consent.
PART II
ITEM 5

ITEM 5 -- MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "METZ". The following table shows the range of reported high and low bid quotations for the Company's Common Stock, for the fiscal periods indicated, as reported on the Nasdaq National Market.
The Company had 10 holders of record of its Common Stock at March 14, 1997 and approximately 1,400 beneficial owners. The Company has never paid a cash dividend on its Common Stock and does not expect to pay a cash dividend on its Common Stock in the foreseeable future.
ITEM 6

ITEM 6 -- SELECTED FINANCIAL DATA
The selected financial data set forth below should be read in conjunction with the Company's Financial Statements and related Notes thereto and with "Item 7.

ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Statements included in Management's Discussion and Analysis of Financial Condition and Results of Operations which are not historical in nature, are intended to be, and are hereby identified as, "forward looking statements" for purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended by Public Law 104-67. Forward-looking statements may be identified by words including "anticipate," "believe," "intends," "estimates," "expect" and similar expressions. The Company cautions readers that forward-looking statements, including without limitation, those relating to the Company's future business prospects, revenues, working capital, liquidity, and income, are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated in the forward looking statements, due to several important factors herein identified, among others, and other risks and factors identified from time to time in the Company's reports filed with the SEC.
OVERVIEW
The Metzler Group, Inc. is a leading nationwide provider of consulting services to electric utilities and other energy-related businesses. The Company offers a wide range of consulting services related to information technology, process/operations management, strategy, and marketing and sales designed to assist its clients in succeeding in a business environment of changing regulation, increasing competition and evolving technology.
The Company derives substantially all of its revenues from fees for professional services, which are billed at standard daily rates or provided on a fixed-bid basis. Over the last three years, the substantial majority of the Company's revenues has been generated under standard daily rates billed on a time and expenses basis. Clients are typically invoiced on a monthly basis with revenue recognized as the services are provided. Fixed-bid revenue is recognized by the percentage of completion method based on the ratio of costs incurred to total estimated project costs. Although fixed-bid projects subject the Company to the risk of cost overruns, the Company has not incurred a loss on a fixed-bid contract during the last three years.
The Company's most significant expenses are project personnel costs, which consist of consultant salaries and benefits, and travel-related direct project expenses. Project personnel are typically full-time professionals employed by the Company, although the Company supplements its project professional personnel through the use of independent contractors. The Company retains contractors for specific client engagements on a task-specific, per diem basis during the period their expertise or skills are required. The Company believes that retaining contractors on a per-engagement basis provides it with greater flexibility in adjusting professional personnel levels in response to changes in demand for its services.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, selected statements of operations data as a percentage of revenues:
1996 COMPARED TO 1995
Revenues. Revenues increased 64% to $22.1 million in 1996 from $13.5 million in 1995. This increase was caused by increased demand for management consulting services in the electric utility industry and a change in the Company's management compensation structure that places more emphasis on the generation of new client engagements. These factors generated increases in both the number of client projects and the average size of client projects.
Gross Profit. Gross profit consists of revenues less cost of services, which includes consultant salaries, benefits and travel-related direct project expenses. Gross profit increased 56% to $11.0 million in 1996 from $7.0 million in 1995. Gross profit as a percentage of revenues was 50% in 1996 compared to 52% in 1995. The year over year decrease in the gross profit percentage was due to lower utilization rates for full time professional personnel and a higher proportion of subcontracted labor in 1996. Utilization rates in 1995 exceeded the Company's expected standard levels and were reduced to levels that the Company considers to be sustainable.
Selling, General and Administrative Expenses. Selling, general and administrative expenses include salaries and benefits of management and support personnel, facilities costs, training, direct selling, outside professional fees and all other corporate costs. Selling, general and administrative expenses decreased 51% to $3.7 million in 1996 from $7.6 million in the prior year. As a percentage of revenues, selling, general and administrative expenses decreased to 17% in 1996 from 57% in 1995. The decrease is attributable primarily to the change in the taxable status of the Company from a C-corporation to an S-corporation commencing January 1, 1996, with the Company's profits being distributed to its principal executives. In conjunction with the change in taxable status, the Company eliminated all other incentive compensation programs for these key executives. Effective July 1, 1996, in contemplation of the termination of the Company's S-corporation status in connection with the closing of the Company's initial public offering of common stock, the Company adopted a new executive compensation plan. The pro forma adjustments for 1996 and 1995 reflect the impact of this compensation plan. The pro forma adjustment for 1996 includes an increase in officer compensation of $1.0 million while the pro forma adjustment for 1995 incorporates a decrease in officer compensation of $2.8 million. After giving effect to these pro forma adjustments, selling, general and administrative expenses would represent $4.8 million, or 22% of revenues, in 1996 and $4.9 million, or 36% of revenues, in 1995. Although selling, general and administrative expenses generally increase as the Company's revenues increase, the Company believes it can continue to leverage its existing overhead structure to lower selling, general and administrative expenses as a percentage of revenue in the future.
Operating Income (Loss). Operating income for 1996 was $7.2 million, as opposed to an operating loss for 1995 of $0.6 million. The improvement is attributable to the increased revenues and the decrease in selling, general and administrative expenses resulting from the change in compensation for the Company's key executives, as described above.
Income Taxes. Effective January 1, 1996, the stockholders of the Company elected to be taxed under Subchapter S of the Internal Revenue Code. As an S-corporation, the net income of the Company from January 1, 1996 was taxable for federal (and some state) income tax purposes directly to the Company's stockholders. The Company's S-corporation status was terminated October 4, 1996 upon the completion of the Company's initial public offering of its common stock. Accordingly, the consolidated statement of operations for 1996 does not include a provision for federal or certain state income taxes for the period January 1, 1996 through October 3, 1996.
1995 COMPARED TO 1994
Revenues. Revenues increased 29% to $13.5 million in 1995 from $10.4 million in 1994. The increase in revenues was attributable to a 10% increase in the Company's standard daily rates, an increase in the number of client projects and an increase in the average size of client projects. The rate increase was applicable to new client engagements that commenced after the third quarter of 1994, but the full effect was not evident until 1995 because of the high level of work in process for the fourth quarter of 1994.
Gross Profit. Gross profit increased 36% to $7.0 million in 1995 from $5.2 million in 1994. Gross profit as a percentage of revenues increased to 52% in 1995 from 49% in 1994. This increase is attributable to higher utilization rates for professional personnel, higher standard daily rates and reduced reliance on independent subcontractors in 1995.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased 44% to $7.7 million in 1995 from $5.3 million in 1994. This increase is attributable to higher 1995 compensation for the Company's principal executive officers. The Company's 1995 executive incentive plan provided for compensation payments that were largely commensurate with increased gross profits generated from incremental revenues. Selling, general and administrative expenses, as a percentage of revenues, increased to 57% in 1995 from 51% in 1994. Excluding the incentive compensation expense for key executives, the remaining selling, general and administrative expenses were 11% and 13% of revenues in 1995 and 1994, respectively.
Operating Income (Loss). The operating loss increased to $0.6 million in 1995 from $0.2 million in 1994. The higher operating loss in 1995 was driven by increased compensation for the Company's principal executive officers, mitigated to some degree by improved gross margins.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of liquidity has been cash flow from operations, periodically supplemented by borrowings under a bank line of credit and by loans from stockholders. Cash flow from operations amounted to $5,140,000, $112,000 and $254,000 for 1996, 1995 and 1994, respectively. The increase in cash flows from operations for 1996 is largely commensurate with the increase in revenues and the decrease in selling, general and administrative expenses for the period, as described above. Operating cash flows for 1995 and 1994 reflect the operating income and net income levels during those years and the effects of changes in two key elements of working capital: accounts receivable and accrued compensation and related costs. Accounts receivable decreased in 1994 as improvements in year-end collections reduced the days revenue outstanding at year end. At year end 1995, accounts receivable increased as a result of higher revenues and billings, partially offset by improvements in collections which further reduced the days revenue outstanding. The Company has a substantial level of accrued compensation at each year end because salaries are paid monthly, in arrears, and because annual incentives and bonuses earned and accrued during the calendar year are typically paid in the first quarter of the subsequent year. Incentives and bonuses are based on individual as well as overall business performance and represent a significant proportion of total compensation for both project personnel and executive management. In 1994, accrued compensation decreased with the reduction in
full time equivalent consultants. Accrued compensation for 1995 increased in line with the growth in professional personnel and higher utilization rates.
Investing activities have not required significant cash flows historically.
Cash flow provided by financing activities was $27.6 million for 1996. On October 4, 1996 the Company completed an initial offering of 2,585,000 shares of its common stock which resulted in proceeds of approximately $37 million after deducting underwriting discounts and commissions and other offering expenses. Concurrent with this offering and pursuant to an agreement negotiated in July 1996, the Company redeemed 1,714,285 shares of common stock held by its founding shareholder in exchange for a promissory note in the amount of $7,975,000. The promissory note was repaid within 30 days after the effective date of the offering. In January 1996, the Company issued notes payable to two shareholders in the aggregate amount of $1.0 million. The notes, each with a principal amount of $0.5 million, bear interest at a rate of 10%. The proceeds from these notes were used to repay $406,000 in debt outstanding under a line of credit and to provide working capital for operations during the interim periods prior to the stock offering. During the period from January 1, 1996 to October 4, 1996 the Company was taxed as an S-corporation. As an S-corporation, all the Company's net income from that period will be distributed to its key executives and included in their personal taxable income. During 1996, the Company distributed $2.2 million of S-corporation earnings. Undistributed S-corporation earnings amount to $3.5 million as of December 31, 1996.
The Company believes the net proceeds from the initial offering of its common stock, together with funds generated by operations, will provide adequate cash to fund its anticipated cash needs, which may include future acquisitions of complementary businesses, at least through the next eighteen months. Thereafter, the Company anticipates that its cash requirements related to future operations and potential acquisitions will be funded with cash generated from operations and short-term borrowings. The Company currently has no agreements, understandings or commitments regarding future acquisitions. Pending such uses, the net proceeds are invested in short-term, interest-bearing investment grade securities. The Company currently anticipates that it will retain all of its earnings for development of the Company's business and does not anticipate paying any cash dividends in the foreseeable future.
ITEM 8

ITEM 8 -- CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
The Consolidated Financial Statements of the Company are annexed to the report as pages through. An index to such materials appears on page.
ITEM 9

ITEM 9 -- CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCUSSIONS
Not applicable
PART III
The information required by this Part III will be provided in the definitive proxy statement for the Company's 1997 Annual Meeting of Stockholders (involving the election of directors), which definitive proxy statement (the 'Proxy Statement") will be filed pursuant to Regulation 14A no later than 120 days following the Company's fiscal year ended December 31, 1996, and is incorporated herein by this reference to the extent provided below.
ITEM 10

ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information in response to this item is incorporated by reference herein from the section of the Proxy Statement captioned "Board of Directors -- Director Compensation," "Management Compensation" and "Compliance with Section 16(a) of the Exchange Act."
ITEM 11

ITEM 11 -- EXECUTIVE COMPENSATION
Information in response to this item is incorporated by reference herein from the section of the Proxy Statement captioned "Board of Directors" -- Director Compensation" and "Management Compensation."
ITEM 12

ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to this item is incorporated by reference herein from the section of the Proxy Statement captioned "Stock Ownership of Directors, Executive Officers and Principal Holders."
ITEM 13

ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this item is incorporated by reference herein from the section of the Proxy Statement captioned "Certain Relationships and Related Transactions."
PART IV
ITEM 14

ITEM 14 -- EXHIBITS, FINANCIAL STATEMENTS AND REPORTS ON FORM 8-K
The consolidated financial statements filed as part of this report are listing in the accompanying Index to Consolidated Financial Statements. The exhibits filed as part of this report are listed in the accompanying Exhibit Index. No reports of Form 8-K were filed by the Company during the last quarter of the period covered by this report. All financial statement schedules have been omitted because the information is not required.
THE METZLER GROUP, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
The Stockholders and Board of Directors The Metzler Group, Inc.
We have audited the accompanying consolidated balance sheets of The Metzler Group, Inc. and subsidiary as of December 31, 1996 and 1995 and related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Metzler Group, Inc. and subsidiary as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996 in conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP
Chicago, Illinois February 6, 1997
THE METZLER GROUP, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying Notes to Consolidated Financial Statements.
THE METZLER GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying Notes to Consolidated Financial Statements.
THE METZLER GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
See accompanying Notes to Consolidated Financial Statements.
THE METZLER GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying Notes to Consolidated Financial Statements.
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
The Metzler Group, Inc. (the "Company") is a leading provider of consulting services to electric utilities and other energy-related businesses.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. Intercompany accounts and transactions have been eliminated.
Cash and Cash Equivalents
Cash equivalents are comprised of highly liquid instruments with original maturities of 90 days or less.
Property and Equipment
Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight-line method based on the estimated useful lives, ranging from three to five years, of the various classes of property and equipment. Depreciation related to capital lease obligations is amortized over the shorter of their useful lives or the term of the related leases by use of the straight-line method.
Fair Value of Financial Instruments
The carrying amount of the Company's financial instruments approximates fair value because of the short maturity of those instruments.
Revenue Recognition
The Company recognizes revenues as the related services are performed.
Stock Based Compensation
The Company utilizes the intrinsic value-based method of accounting for its stock-based compensation arrangements.
Income Taxes
Income taxes, including pro forma calculations, are accounted for in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement 109). Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Prior to January 1, 1996, the Company had operated as a C-corporation. Effective January 1, 1996, the stockholders of the Company elected to be taxed under Subchapter S of the Internal Revenue Code. Federal income taxes are the responsibility of the Company's stockholders as are certain state income taxes. As of the effective date of the election, the Company is responsible for Federal built-in-gain taxes to the extent applicable. Accordingly, the consolidated statement of operations for the year ended December 31, 1996 provides for such taxes. The S-corporation election terminated in connection with the consummation of the initial public offering of the Company's common stock on October 4, 1996.
Pro Forma Net Income Per Share
Pro forma net income per common and common equivalent share is computed based on the weighted average of 10,046,218 common and common equivalent shares outstanding during the year ended December 31, 1996 and 9,781,051 common and common equivalent shares outstanding during the year ended December 31, 1995.
Net income per share is computed using the weighted average number of shares of common stock and dilutive common equivalent shares resulting from the grant of 363,666 common stock options during the period from June 30, 1996 to September 30, 1996 (using the treasury stock method). Pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 83, common and common equivalent shares issued by the Company during the twelve-month period prior to the initial public offering have been included in the calculation of common and common equivalent shares using the treasury stock method and the initial public offering price per share as if they were outstanding for all periods presented.
The pro forma adjustments during the years 1996 and 1995 reflect the impact of a compensation plan effective July 1, 1996. The pro forma adjustments for 1996 include an increase to officer compensation expense of $1,019,460. The pro forma adjustments for 1995 include a decrease to officer compensation expense of $2,775,293.
The pro forma adjustments for 1996 include federal and additional state income tax expense of $1,799,403 that would have been required had the Company not made the S-corporation election effective January 1, 1996. The pro forma adjustments for 1995 include additional federal and state income tax expense of $1,110,117, that would have been required had the Company's compensation expense decreased in 1995 to the level commensurate with the compensation plan adopted effective July 1, 1996, as noted above.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
3. INITIAL PUBLIC OFFERING
On October 4, 1996 the Company completed an initial public offering of its common stock in which 2,300,000 shares were sold by the Company, along with an additional over-allotment of 285,000 shares, resulting in net proceeds of approximately $37 million, net of issuance costs of approximately $4 million.
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Concurrent with the completion of the initial public offering and in accordance with an agreement entered into during July 1996 between the Company and its founding shareholder, the Company redeemed 1,714,285 shares of the shareholder's common stock and issued to the shareholder a promissory note for $7,975,000. See Note 10 of the Notes to Consolidated Financial Statements regarding repayment of the promissory note.
4. NOTE PAYABLE
The Company had a line of credit with a bank which provided for maximum borrowings limited to 65% of eligible accounts receivable. The line of credit, which expired on December 31, 1996, had maximum borrowing of $1,200,000 and bore interest at the bank's prime rate (8.25% at December 31, 1996) plus 1/2%. There were no outstanding borrowings under the line of credit were at December 31, 1996. At December 31, 1995 the line of credit had maximum borrowing of $800,000 and bore interest at the bank's prime rate (8.5% at December 31, 1995) plus 1%. Outstanding borrowings under the line of credit were $405,740 at December 31, 1995.
5. REVENUES AND ACCOUNTS RECEIVABLE FROM SIGNIFICANT CUSTOMERS
The Company's customers are located throughout the United States and Canada. In 1996, 1995, and 1994 the Company's five largest clients accounted for approximately, 58%, 55% and 58% of the Company's total revenues, respectively. The balance due from the largest single customer represented 17% and 15% of the Company's accounts receivable at December 31, 1996 and 1995, respectively.
6. LEASE COMMITMENTS
The Company leases its office facilities and certain equipment under operating and capital lease arrangements which expire at various dates through January 31, 2002.
Operating Leases
The Company leases office facilities under a noncancelable operating lease which includes scheduled base rent increases over the term of the lease and provides for monthly payments of real estate taxes, insurance and other operating expenses applicable to the property. The total amount of the base rent payments is being charged to expense as incurred. In addition, the Company leases equipment under a noncancelable operating lease.
Future minimum annual lease payments, for the years subsequent to 1996 and in the aggregate, are as follows:
Rent expense for operating leases entered into by the Company and charged to operations amounted to $186,000 for the year 1996, and $156,000 for each of the years 1995 and 1994.
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Capital Lease
The Company leases equipment which is classified within the Company's consolidated financial statements as a capital lease. Included in the property, plant and equipment in the accompanying consolidated balance sheets is the following asset held under capital lease:
The future minimum annual lease payments under the noncancelable capital lease are as follows:
7. INCOME TAX EXPENSE (BENEFIT)
Income tax expense (benefit) consists of the following:
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Income tax expense (benefit) differs from the amounts estimated by applying the statutory income tax rates to income (loss) before income tax expense (benefit) as follows:
Deferred income taxes result from temporary differences between years in the recognition of certain expense items for income tax and financial reporting purposes. The source and income tax effect of these differences are as follows:
8. LONG-TERM INCENTIVE PLAN
On June 30, 1996, the Company adopted a Long-Term Incentive Plan which provides for common stock, common stock-based, and other performance incentives to employees, consultants, directors, advisors, and independent contractors of the Company. The maximum number of shares of common stock which may be issued and sold under the plan is 1,300,000 shares. As of December 31, 1996, the Company has granted 458,166 options at a weighted average exercise price of $15.53 per share which was equal to the estimated fair market value of common stock at the dates of grant. As of December 31, 1996 no options were exercisable. In general, the options are exercisable in three or four annual installments commencing on the second anniversary of the date of grant.
The Company applies APB Opinion 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for its plan. Accordingly, no compensation cost has been recognized. Had compensation cost for the plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method of FASB Statement 123, Accounting for Stock-Based Compensation, (FASB 123), the Company's compensation expense for the year ended December 31, 1996 would have been increased by $102,000, net of related income taxes. As a result,the Company's proforma net earnings, available to common stockholders and earnings
THE METZLER GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
per common and common equivalent shares would have been reduced to the pro forma amounts indicated below:
For purposes of calculating compensation cost under FASB 123, the fair value of each option grant is estimated as of the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used in the model for grants made in 1996:
Additional information on the shares subject to options is as follows:
The following table summarizes information about stock options outstanding at December 31, 1996:
9. EMPLOYEE BENEFIT PLANS
The Company has a Profit Sharing and Savings Plan and Trust ("Savings Plan"). The Savings Plan covers employees upon the completion of one year of service. Participants may contribute up to 15% of their eligible compensation. The Company, at its discretion, matches participant contributions as defined within the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Savings Plan. In addition, the Company, at its discretion, makes profit sharing contributions. Company contributions to the Savings Plan which were charged to operations were the following:
10. RELATED-PARTY TRANSACTIONS
During January 1996, the Company entered into note payable agreements with two officers. The notes, each with a principal amount of $500,000, bear interest at a rate of 10%. The notes matured on December 31, 1996 and were repaid on January 2, 1997.
In May 1996, the Company made an advance of $725,000 to an officer as part of an employment agreement and entered into a note receivable agreement with the officer. The note receivable bore interest at a rate of 6%. The note, plus accrued interest, was repaid on November 8, 1996.
During July 1996, the Company entered into an agreement with its founding shareholder, who, at that time, was the beneficial owner of 15% of the Company's common stock, to redeem 1,714,285 shares of the shareholder's common stock in exchange for a promissory note in the amount of $7,975,000. The redemption value per share was negotiated by the Company's other executive officers, who collectively owned the remaining 85% of the Company's common stock at the time of the agreement. The Company redeemed the stock on October 4, 1996 in accordance with the agreement and repaid the note promissory within 30 days of the redemption.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Dated: March 31, 1997
THE METZLER GROUP, INC.
By: /s/ ROBERT P. MAHER
------------------------------------ Robert P. Maher Chairman, President and Chief Executive Officer
By: /s/ JAMES F. HILLMAN
------------------------------------ James F. Hillman Chief Financial Officer
By: /s/ GERALD R. LANZ
------------------------------------ Gerald R. Lanz Chief Operating Officer
By: /s/ PETER B. POND
------------------------------------ Peter B. Pond Director
By: /s/ JAMES T. RUPRECHT
------------------------------------ James T. Ruprecht Director
By: /s/ MITCHELL H. SARANOW
------------------------------------ Mitchell H. Saranow Director
EXHIBIT INDEX
- ------------------------- (1) Incorporated by reference from the Registrant's Form S-1 Registration Statement No. 333-9019 as filed with the SEC on July 26, 1996.
(2) Incorporated by reference from the Registrant's Amendment No. 1 to Form S-1 Registration Statement No. 333-9019 as filed with the SEC on September 4, 1996.
(3) Incorporated by reference from the Registrant's Amendment No. 2 to Form S-1 Registration Statement No. 333-9019 as filed with the SEC on September 20, 1996.