10-Q 1 d10q.txt QUARTERLY REPORT ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 29, 2001 Commission File No. 333-95945 MATTRESS DISCOUNTERS CORPORATION (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 52-1710722 (I.R.S. Employer Identification No.) 9822 Fallard Court Upper Marlboro, MD 20722 (Address of principal executive offices) (301) 856-6755 Registrant's telephone number, including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. No _________ Yes X --------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding at November 13, 2001 Class -------------------------------- ----- 100 Common Stock, $.01 Par Value ================================================================================ MATTRESS DISCOUNTERS CORPORATION -------------------------------- TABLE OF CONTENTS -----------------

-2- PART I. FINANCIAL INFORMATION Item 1. Financial Statements MATTRESS DISCOUNTERS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except for share data)

See accompanying notes to consolidated financial statements. -3- MATTRESS DISCOUNTERS CORPORATION AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands)

See accompanying notes to consolidated financial statements. -4- MATTRESS DISCOUNTERS CORPORATION AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)

See accompanying notes to consolidated financial statements. -5- MATTRESS DISCOUNTERS CORPORATION AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY (in thousands)

See accompanying notes to consolidated financial statements. -6- MATTRESS DISCOUNTERS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (in thousands) 1. Organization and Basis of Financial Statement Presentation Mattress Discounters Corporation and subsidiaries are engaged in the manufacture and retail sale of mattresses and bedding products, in various markets throughout the United States. The accompanying consolidated financial statements at September 29, 2001 and December 30, 2000 include the accounts of Mattress Discounters Corporation ("Mattress Discounters"), and its wholly owned subsidiaries T.J.B., Inc. ("T.J.B."), and The Bedding Experts, Inc. ("Bedding Experts") (collectively referred to as the "Company"). All significant intercompany accounts and transactions of the Company have been eliminated. Certain amounts in the consolidated financial statements for prior periods have been reclassified to conform to the current period's presentation. The accompanying unaudited consolidated financial statements contain all adjustments which, in the opinion of management, are necessary to present fairly the financial position of the Company at September 29, 2001, and its results of operations and cash flows for the periods presented herein. Except as discussed in Notes 5, 6 and 9 below, all adjustments in the periods presented herein are normal and recurring in nature. The accompanying unaudited consolidated financial statements should be read together with the audited consolidated financial statements for the year ended December 30, 2000. The results of operations for the three and nine-month periods ended September 29, 2001 are not necessarily indicative of the results of operations for the year ending December 29, 2001. The preparation of financial statements in conformity with generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities (including contingent assets and liabilities) reported at the date of the consolidated financial statements and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates. 2. Senior Credit Facility On August 6, 1999, the Company entered into a credit agreement with a consortium of banks (the "Senior Credit Facility"), to finance a portion of the recapitalization of the Company and to provide available borrowings for use in the normal course of business. The Senior Credit Facility provides for revolving loans for up to $20.0 million, including letters of credit of up to $5.0 million. The interest rate under the Senior Credit Facility is either: (1) the base rate, which is the higher of the prime lending rate, 1% in excess of the secondary market rate for three-month depository certificates or 0.5% in excess of the Federal funds effective rate, plus a margin or (2) the Eurodollar rate plus a margin. The margins of the loans under the Senior Credit Facility will be established and then will vary according to a pricing grid based upon the achievement of performance targets. Commitment fees are payable at a rate per annum of 0.5% on the undrawn amounts of the Senior Credit Facility, but may be reduced depending upon the achievement of performance targets, as defined by the Senior Credit Facility. There were no amounts outstanding under the Senior Credit Facility as of December 30, 2000. In April 2001, the Company borrowed $18 million under the Senior Credit Facility and such amount remained outstanding at September 29, 2001, with a weighted average interest rate of 9.3%. The Senior Credit Facility is subject to mandatory prepayment in a variety of circumstances, including upon certain asset sales and financing transactions, and, also from excess cash flow (as defined in the Senior Credit Facility). T.J.B., Bedding Experts and Mattress Holding Corporation (the Company's parent) have guaranteed the Company's obligations under the Senior Credit Facility. The Senior Credit Facility is collateralized by substantially all assets of the Company (see Note 10). -7- Further, the Senior Credit Facility requires that the Company meet certain financial covenants which include a maximum total debt ratio and a minimum interest coverage ratio. In addition, the Senior Credit Facility contains restrictions, subject to certain exceptions, including, but not limited to, engaging in transactions with affiliates; prepaying subordinate debt and the senior notes; incurring indebtedness and liens; declaring dividends or redeeming or repurchasing capital stock; and making loans and investments; engaging in mergers, acquisitions, consolidations and asset sales; and making capital expenditures. The revolving loans under the Senior Credit Facility are due in August 2005. Pursuant to the terms of the Senior Credit Facility, non-compliance with one or more of the financial covenants permits the lenders to exercise certain remedies, which include the termination of the commitment and to declare the related principal balance and any accrued interest immediately due and payable. As of March 31, 2001, the Company was not in compliance with the total debt ratio and the interest coverage ratio covenants. On May 14, 2001, the Company entered into an agreement to amend the Senior Credit Facility. Such amendment increased the applicable margin, as defined, to 3.5% per annum with respect to Eurodollar loans and to 2.5% per annum with respect to Prime Rate based loans. Additionally, the May 14/th/ amendment waived the Company's non-compliance with respect to the financial covenants as of March 31, 2001. Such waiver was scheduled to expire on June 22, 2001. On June 21, 2001, an additional agreement was entered into that extended the waiver until July 9, 2001. Such waiver expired on July 9, 2001. Consequently, as of July 10, 2001, and continuing through the date of this report, the Company is not in compliance with the applicable total debt ratio and interest coverage ratio covenants contained in its existing Senior Credit Facility as of March 31, 2001, June 30, 2001 and September 29, 2001. Although the lenders are permitted to exercise the remedies discussed above, they have not done so as of the date of this report. Additionally, the Company anticipates that it will not be in compliance with the financial covenants during the remainder of 2001 without further modifications to the agreement and, accordingly, is currently in discussions with its lenders to amend the agreement. There can be no assurance that the Company will be successful in its negotiations with its lenders. Inability of the Company to reach an agreement with its lenders on an amendment or to arrange for alternative financing could have a material adverse effect on the Company. As a result of the noncompliance with the financial covenants, amounts outstanding under the Senior Credit Facility are classified as current liabilities as of September 29, 2001. In the event the Company and the bank group are able to satisfactorily amend the financial covenants under the Senior Credit Facility, the Company believes that funds generated from operations, together with borrowings under the Senior Credit Facility and arranging for alternative financing, should be sufficient to finance its current operations, debt service requirements and planned capital expenditures for at least the next twelve months. The Company anticipates that it will require additional financing in excess of the $20.0 million currently provided for by the existing Senior Credit Facility. However, no assurances can be given that the Company will be able to arrange for such additional financing. Additionally, the Company had approximately $2.3 million of outstanding letters of credit at December 30, 2000 and September 29, 2001. 3. Accounts Payable and Accrued Expenses Accounts payable and accrued expenses consisted of the following at:

-8- 4. Segment Information The Company operates in two reportable segments, as described below: (a) Retail Segment--Sale of mattresses and bedding products through 289 and 283 retail locations as of September 29, 2001 and September 30, 2000, respectively. (b) Manufacturing Segment--Manufacture and sale of mattresses, box springs and foundations to the retail segment and to external retailers at current market prices. All intersegment sales prices are market-based. The Company evaluates performance based on the operating earnings of the respective business units. Summarized unaudited financial information concerning the Company's reportable segments is shown in the following table:

(1) Segment profit (loss) represents income (loss) from operations. (2) Identifiable assets represent only inventories and net property and equipment in the retail and manufacturing segments. All other assets are included in Corporate/Other. -9- 5. Loss on Disposal of Denver Assets On June 18, 2001, the Company entered into an agreement whereby an unrelated third party (the "Buyer") purchased substantially all of the assets of our Denver, Colorado retail operations, including inventory and property and equipment. Additionally, the Buyer has subleased all properties currently leased by the Company in the Denver market. The effective date of the transaction was August 2, 2001. Total consideration received by the Company for the sale of the related assets aggregated $297 resulting in a loss on disposal of assets of $1,689. Such loss is included in the accompanying statement of operations and includes provisions for employee severance, future minimum lease commitments and costs associated with the closing of the transaction. The Company has a continuing liability under these leases in the event the Buyer defaults on its commitment under these lease assignments. Future minimum rents associated with these leases are $249 in 2001, $898 in 2002, $756 in 2003, $439 in 2004, $320 in 2005 and $178 thereafter. The Company has received $350 in escrow funds from the Buyer that can be used to offset any lease liability that may result from the Buyer's breach of contract. The Denver market consisted of 14 stores and a distribution center servicing the metro Denver area. Revenues for the Denver market included in the accompanying statements of operations for the three and nine months ended September 29, 2001 were $171 and $1,891, respectively. Revenues for the three and nine months ended September 30, 2000 were $1,318 and $3,925, respectively. The operating loss for the Denver market included in the accompanying statements of operations for the three and nine months ended September 29, 2001 were $188 and $1,163, respectively. The operating loss for the three and nine months ended September 30, 2000 were $368 and $996, respectively. 6. Reserve for Heilig-Meyers Receivable As previously disclosed, the Company has been pursuing its rights in the Heilig-Meyers bankruptcy proceeding to recover an outstanding receivable in the aggregate amount of $1,564. While the Company will continue to pursue its rights related to this claim, events occurring in the second quarter of 2001 caused management to believe that the recoverability of these amounts was uncertain. Accordingly, a charge in the amount of $1,564 was recorded during the second quarter of 2001 to establish a reserve against this outstanding receivable. 7. New Accounting Pronouncements In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), Business Combinations, which supersedes Accounting Principles Board ("APB") Opinion No. 16, Business Combinations. SFAS 141 eliminates the pooling-of-interests method of accounting for business combinations and modifies the application of the purchase accounting method. The elimination of the pooling-of-interests method is effective for transactions initiated after September 29, 2001. The remaining provisions of SFAS 141 will be effective for transactions accounted for using the purchase method that are completed after September 29, 2001. The Company does not believe this pronouncement will have a material effect on the Company's consolidated financial statements. In July 2001, the FASB also issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), Goodwill and Other Intangible Assets which supersedes APB Opinion No. 17, Intangible Assets. SFAS 142 eliminates the current requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with a defined life and addresses the impairment testing and recognition for goodwill and intangible assets. SFAS 142 will apply to goodwill and intangible assets arising from transactions completed before and after the effective date of the Statement. SFAS 142 is effective for the year commencing December 30, 2001. While we have not yet completed our assessment of the impact of this statement on our financial statements, adoption will result in a reduction in our amortization expense, but will have no impact on cash flow. -10- In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144 ("SFAS 144"), Accounting for the Impairment or Disposal of Long-Lived Assets which supersedes FASB Statement No. 121 ("SFAS 121"), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS 144 provides guidance on the accounting for the impairment or disposal of long-lived assets, and applies to all long-lived assets (including discontinue operations) and consequently amends APB 30, Reporting Results of Operations -- Reporting the Effects of Disposal of a Segment of a Business. SFAS 144 develops one accounting model (based on the model in SFAS 121) for long-lived assets that are to be disposed of by sale, as well as addresses the principal implementation issues. SFAS 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. That requirement eliminates APB 30's requirement that discontinued operations be measured at net realizable value or that entities include under "discontinued operations" in the financial statements amounts for operating losses that have not yet occurred. Additionally, SFAS 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS 144 is effective for the year commencing December 30, 2001. The Company does not believe this pronouncement will have a material effect on the Company's consolidated financial statements. 8. Inventories Inventories are summarized as follows, as of: December 30, September 29, 2000 2001 ------------ ------------ (Unaudited) Finished Goods $ 18,235 $ 17,957 Work in Process 199 166 Raw Materials 1,404 1,061 ------------ ------------ $ 19,838 $ 19,184 ============ ============ 9. Deferred Tax Asset Valuation Allowance During the quarter ended September 29, 2001, events and circumstances caused the Company to reevaluate the recoverability of its deferred tax assets. Based upon a number of factors, management believes that the available objective evidence creates sufficient uncertainty regarding the recoverability of the Company's deferred tax assets. Accordingly, a 100% valuation allowance has been established against the deferred tax assets. As a result, a non-cash charge in the aggregate amount of $99.0 million has been recorded during the three month period ended September 29, 2001, inclusive of $0.5 million related to state tax liabilities incurred by the Company. Such charge is reflected in the provision for income taxes in the accompanying statement of operations. The deferred tax assets primarily relate to net operating loss carryforwards and future goodwill amortization deductions. The future utilization of these tax assets is dependent upon the generation of future taxable income. The recording of the deferred tax asset valuation allowance for financial reporting purposes does not have any impact on the Company's right to offset future taxable income. -11- 10. Summarized Financial Information The Company's Senior Credit Facility and Senior Notes are guaranteed, fully, jointly and severally, and unconditionally by all of the Mattress Discounters' current and future, direct and indirect subsidiaries. The following is summarized condensed consolidating financial information of the Company, segregating the parent company (Mattress Discounters) and its guarantor subsidiaries. As described in Note 1--Organization and Basis of Financial Statement Presentation, each of Mattress Discounters' subsidiaries are wholly owned. Separate financial statements of the guarantor subsidiaries are not presented because management believes that separate financial statements would not be beneficial to investors. Index to Unaudited Condensed Consolidating Information ------------------------------------------------------ . Consolidating Balance Sheets at September 29, 2001 . Consolidating Statements of Operations for the three months ended September 29, 2001 . Consolidating Statements of Operations for the nine months ended September 29, 2001 . Condensed Consolidating Statements of Cash Flows for the nine months ended September 29, 2001 . Consolidating Balance Sheets at December 30, 2000 . Consolidating Statements of Operations for the three months ended September 30, 2000 . Consolidating Statements of Operations for the nine months ended September 30, 2000 . Condensed Consolidating Statements of Cash Flows for the nine months ended September 30, 2000 -12- Unaudited Consolidating Balance Sheets September 29, 2001 (in thousands)

-13- Unaudited Consolidating Statements of Operations For the three months ended September 29, 2001 (in thousands)

Unaudited Consolidating Statements of Operations For the nine months ended September 29, 2001 (in thousands)

-14- Unaudited Condensed Consolidating Statements of Cash Flows For the nine months ended September 29, 2001 (in thousands)

-15- Unaudited Consolidating Balance Sheets December 30, 2000 (in thousands)

-16- Unaudited Consolidating Statements of Operations For the three months ended September 30, 2000 (in thousands)

Unaudited Consolidating Statements of Operations For the nine months ended September 30, 2000 (in thousands)

-17- Unaudited Condensed Consolidating Statements of Cash Flows For the nine months ended September 30, 2000 (in thousands)

-18- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview (dollars in thousands) Mattress Discounters Corporation ("MDC" or the "Company") operates in two segments: mattress retailing and mattress manufacturing. As of September 29, 2001, we operated our retail business through a nationwide network of 289 stores in 14 markets. Our manufacturing segment consists of three manufacturing facilities that produce mattresses for sale in our retail stores under the Comfort Source brand and for sale to external retailers under separate brands. Results of Operations The following discussion compares our results of operations for the three months ended September 29, 2001 to the three months ended September 30, 2000. The table below sets forth our statement of operations in dollars and as a percentage of sales for the periods indicated.

Three Months Ended September 29, 2001 Compared to Three Months Ended September 30, 2000 Net sales: The Company's net sales for the three months ended September 29, 2001 decreased $4.3 million to $69.1 million from $73.4 million for the three months ended September 30, 2000. The decrease in sales is primarily due to the overall decline in mattress sales throughout the industry. The decrease represents a $3.1 million, or 4.3% decrease in our retail net sales coupled with a decrease of $1.2 million, or 87.4% in the external net sales of our manufacturing operation. Our net sales from retail operations, manufacturing sales to our retail operations, and manufacturing sales to external retailers were $68.9 million, $9.6 million, and $0.2 million, respectively, in the three months ended September 29, 2001, and $72.0 million, $11.1 million and $1.4 million, respectively, in the three months ended September 30, 2000. Overall, MDC's retail sales for the three months ended September 29, 2001 decreased $3.1 million or 4.3%. The decrease in retail sales for the three months ended September 29, 2001 is attributable to (a) a $5.7 million decrease in comparable store sales offset by (b) a $2.6 million net increase resulting from net new store openings since September 30, 2000. Comparable store sales declines were reflected throughout most of our markets. Management continues to pursue initiatives to improve the operating performance of the retail stores. Net sales generated by the Company's manufacturing operations during the three months ended September 29, 2001, decreased $2.7 million to $9.8 million from $12.5 million for the three months ended September 30, 2000. Substantially all of our manufacturing output is now consumed by our retail operations. Sales to external -19- retailers decreased to $0.2 million from $1.4 million. The decrease in external net sales of our manufacturing operations is due to lower sales to Heilig-Meyers. Heilig-Meyers is currently reorganizing under Chapter 11 of the U.S. Bankruptcy Code (see below for further discussion of this matter). Effective August 2, 2001, the Company closed its Denver, Colorado retail operations. The Denver market consisted of 14 stores and a distribution center servicing the metro Denver area. Revenues for the Denver market included in the accompanying statements of operations for the three months ended September 29, 2001 and September 30, 2000 were $171 and $1,318, respectively. The operating loss for the Denver market included in the accompanying statements of operations for the three months ended September 29, 2001 and September 30, 2000 were $188 and $368, respectively. See Loss on disposal of Denver assets for further discussion of this transaction. Gross profit: Gross profit for the three months ended September 29, 2001 decreased $3.8 million or 13.7% to $24.0 million from $27.8 million for the three months ended September 30, 2000. The decrease in gross profit percentage is primarily attributable to higher occupancy costs as a result of additional store openings and lower sales volumes in the current period coupled with a decrease in purchase discounts taken during the current period. As of September 29, 2001, 289 stores were in operation compared to 283 stores operating as of September 30, 2000. General and administrative expenses: General and administrative expenses for the three months ended September 29, 2001 increased $2.7 million or 13.5% to $22.7 million from $20.0 million for the three months ended September 30, 2000. As a percentage of net sales, general and administrative expenses were 32.9% in the three months ended September 29, 2001, compared to 27.3% in the three months ended September 30, 2000. The increase in general and administrative expenses is primarily due to increased advertising, legal and insurance costs partially offset by decreases in payroll costs. Interest expense: Interest expense for the three months ended September 29, 2001 and September 30, 2000 was $5.3 million and $5.0 million, respectively. The increase in interest expense is due to the interest on the $18.0 million incremental borrowings under the Company's Senior Credit Facility. Provision for income taxes: During the quarter ended September 29, 2001, events and circumstances caused the Company to reevaluate the recoverability of its deferred tax assets. Based upon a number of factors, management believes that the available objective evidence creates sufficient uncertainty regarding the recoverability of the Company's deferred tax assets. Accordingly, a 100% valuation allowance has been established against the deferred tax assets. As a result, a non-cash charge in the aggregate amount of $99.0 million has been recorded during the three month period ended September 29, 2001, inclusive of $0.5 million related to state tax liabilities. The effective income tax rate for the three months ended September 29, 2000 was 61.9% and differed from the federal statutory rate primarily as a result of state income taxes and the non-deductibility of goodwill amortization. Net income (loss): Primarily as a result of the reasons discussed above, net loss was $102.9 million in the three months ended September 29, 2001, as compared to net income of $1.1 million or 1.5% of net sales in the three months ended September 30, 2000. -20- The following discussion compares our results of operations for the nine months ended September 29, 2001 to the nine months ended September 30, 2000. The table below sets forth our statement of operations in dollars and as a percentage of sales for the periods indicated.

Nine Months Ended September 29, 2001 Compared to Nine Months Ended September 30, 2000 Net sales: The Company's net sales for the nine months ended September 29, 2001 decreased $21.9 million to $190.6 million from $212.5 million for the nine months ended September 30, 2000. The decrease in sales is primarily due to the overall decline in mattress sales throughout the industry. The decrease represents a $9.5 million, or 4.8 % decrease in our retail net sales coupled with a decrease of $12.4 million, 89.9% in the external net sales of our manufacturing operation. Our net sales from retail operations, manufacturing sales to our retail operations, and manufacturing sales to external retailers were $189.2 million, $28.5 million, and $1.4 million, respectively, in the nine months ended September 29, 2001, and $198.7 million, $30.6 million and $13.8 million, respectively, in the nine months ended September 30, 2000. Overall, MDC's retail sales for the nine months ended September 29, 2001 decreased $9.5 million or 4.8%. The decrease in retail sales for the nine months ended September 29, 2001 is attributable to (a) a $22.4 million decrease in comparable store sales offset by (b) a $12.9 million net increase resulting from net new store openings since September 30, 2000. Comparable store sales declines were reflected throughout most of our markets nationwide. Management continues to pursue initiatives to improve the operating performance of the retail stores. Net sales generated by the Company's manufacturing operations during the nine months ended September 29, 2001, decreased $14.6 million to $29.9 million from $44.5 million for the nine months ended September 30, 2000. Substantially all of our manufacturing output is now consumed by our retail operations. Sales to external retailers decreased to $1.4 million from $13.8 million. The decrease in external net sales of our manufacturing operations is due to lower sales to Heilig-Meyers. Heilig-Meyers is currently reorganizing under Chapter 11 of the U.S. Bankruptcy Code (see further discussion of this matter below). Effective August 2, 2001, the Company closed its Denver, Colorado retail operations. The Denver market consisted of 14 stores and a distribution center servicing the metro Denver area. Revenues for the Denver market included in the accompanying statements of operations for the nine months ended September 29, 2001 -21- and September 30, 2000 were $1,891 and $3,925, respectively. The operating loss for the Denver market included in the accompanying statements of operations for the nine months ended September 29, 2001 and September 30, 2000 were $1,163 and $996, respectively. See Loss on disposal of Denver assets for further discussion of this transaction. Gross profit: Gross profit for the nine months ended September 29, 2001 decreased $15.5 million or 20.0% to $62.0 million from $77.5 million for the nine months ended September 30, 2000. The decrease in gross profit percentage is primarily attributable to higher occupancy costs as a result of additional store openings and lower sales volumes in the current period coupled with a decrease in purchase discounts taken during the current nine-month period. General and administrative expenses: General and administrative expenses for the nine months ended September 29, 2001 increased $4.1 million or 6.8% to $64.5 million from $60.4 million for the nine months ended September 30, 2000. As a percentage of net sales, general and administrative expenses were 33.8% in the nine months ended September 29, 2001, compared to 28.4% in the nine months ended September 30, 2000. The increase in general and administrative expenses is primarily due to increased advertising and occupancy costs coupled with additional reserves recorded for bad debts and workers compensation claims, partially offset by decreases in payroll costs. Loss on disposal of Denver assets: During the period ended September 29, 2001, the Company entered into an agreement to sell substantially all of the assets of our Denver, Colorado retail operations, including inventory and property and equipment. Total consideration received by the Company for the sale of the related assets aggregated $297 resulting in a loss on sale of assets of $1,689. Such loss included provisions for employee severance, future minimum lease commitments and costs associated with the closing of the transaction. Reserve for Heilig-Meyers receivable: The Company has been pursuing its rights in the Heilig-Meyers bankruptcy proceeding to recover an outstanding receivable in the aggregate amount of $1,564. While the Company will continue to pursue its rights related to this claim, events in the second quarter of 2001 caused management to believe that the recoverability of these amounts was uncertain. Accordingly, a charge in the amount of $1,564 was recorded in the second quarter of 2001 to establish a reserve against this outstanding receivable. Interest expense: Interest expense for the nine months ended September 29, 2001 and September 30, 2000 was $15.7 million and $15.0 million, respectively. The increase in interest expense is due to the interest on the $18.0 million incremental borrowings under the Company's Senior Credit Facility. Provision for income taxes: During the quarter ended September 29, 2001, events and circumstances caused the Company to reevaluate the recoverability of its deferred tax assets. Based upon a number of factors, management believes that the available objective evidence creates sufficient uncertainty regarding the recoverability of the Company's deferred tax assets. Accordingly, a 100% valuation allowance has been established against the deferred tax assets. This $99.0 million non-cash charge is offset by the $6.4 million tax benefit recorded during the first six months of 2001 resulting in a $92.6 million provision for income taxes for the nine months ended September 29, 2001, inclusive of $0.5 million related to state tax liabilities. The effective income tax rate for the nine months ended September 30, 2000 was 62.4% and differed from the federal statutory rate primarily as a result of state income taxes and the non-deductibility of goodwill amortization. Net loss: Primarily as a result of the reasons discussed above, the net loss was $113.8 million in the nine months ended September 29, 2001, as compared to net income of $1.0 million or 0.5% of net sales in the nine months ended September 30, 2000. Liquidity and Capital Resources In connection with the leveraged recapitalization in August 1999, the Company incurred significant amounts of debt ("Senior Notes") requiring interest payments on the Senior Notes and interest and principal payments under the Senior Credit Facility. Our liquidity needs relate to working capital, debt service, capital expenditures -22- and potential acquisitions. We intend to fund our working capital, capital expenditures and debt service requirements through cash flow generated from operations and through borrowings under the Senior Credit Facility. At December 30, 2000, there were no amounts outstanding under the Senior Credit Facility. In April 2001, the Company borrowed $18 million under the Senior Credit Facility and such amount remained outstanding at September 29, 2001 with a weighted average interest rate of 9.3%. Cash and cash equivalents at December 30, 2000 and September 29, 2001 were approximately $8.2 million and $5.2 million, respectively. The Senior Credit Facility requires that the Company meet certain financial covenants which include a maximum total debt ratio and a minimum interest coverage ratio. In addition, the Senior Credit Facility contains restrictions, subject to certain exceptions, including, but not limited to, engaging in transactions with affiliates; prepaying subordinate debt and the senior notes; incurring indebtedness and liens; declaring dividends or redeeming or repurchasing capital stock; and making loans and investments; engaging in mergers, acquisitions, consolidations and asset sales; and making capital expenditures. The revolving loans under the Senior Credit Facility are due in August 2005. Pursuant to the terms of the Senior Credit Facility, non-compliance with one or more of the financial covenants permits the lenders to exercise certain remedies, which include the termination of the commitment and to declare the related principal balance and any accrued interest immediately due and payable. As of March 31, 2001, the Company was not in compliance with the total debt ratio and the interest coverage ratio covenants. On May 14, 2001, the Company entered into an agreement to amend the Senior Credit Facility. Such amendment increased the applicable margin, as defined, to 3.5% per annum with respect to Eurodollar loans and to 2.5% per annum with respect to Prime Rate based loans. Additionally, the May 14th amendment waived the Company's non-compliance with respect to the financial covenants as of March 31, 2001. Such waiver was scheduled to expire on June 22, 2001. On June 21, 2001, an additional agreement was entered into that extended the waiver until July 9, 2001. Such waiver expired on July 9, 2001. Consequently, as of July 10, 2001, and continuing through the date of this report, the Company is not in compliance with the applicable total debt ratio and interest coverage ratio covenants contained in its existing Senior Credit Facility as of March 31, 2001, June 30, 2001 and September 29, 2001. Although the lenders are permitted to exercise the remedies discussed above, they have not done so as of the date of this report. Additionally, the Company anticipates that it will not be in compliance with the financial covenants during the remainder of 2001 without further modifications to the agreement and, accordingly, is currently in discussions with its lenders to amend the agreement. There can be no assurance that the Company will be successful in its negotiations with its lenders. Inability of the Company to reach an agreement with its lenders on an amendment or to arrange for alternative financing could have a material adverse effect on the Company. As a result of the noncompliance with the financial covenants, amounts outstanding under the Senior Credit Facility are classified as current liabilities as of September 29, 2001. In the event the Company and the bank group are able to satisfactorily amend the financial covenants under the Senior Credit Facility, the Company believes that funds generated from operations, together with borrowings under the Senior Credit Facility and arranging for alternative financing, should be sufficient to finance its current operations, debt service requirements and planned capital expenditures for at least the next twelve months. The Company anticipates that it will require additional financing in excess of the $20.0 million currently provided for by the existing Senior Credit Facility. However, no assurances can be given that the Company will be able to arrange for such additional financing. At December 30, 2000 and September 29, 2001, the Company had approximately $2.3 million of outstanding letters of credit. Net cash used in operating activities for the nine months ended September 29, 2001 was $17.9 million, as compared to the $12.0 million of cash provided by operating activities for the nine months ended September 30, 2000. The primary cause of the decreased cash flow from operations in the nine-month period ended September 29, 2001 is the Company's pre-tax loss of $21.2 million in the current period. Our principal use of cash for investing activities has historically been capital expenditures for new store openings. Total capital expenditures were $3.3 million for each of the nine months ended September 29, 2001 -23- and September 30, 2000. The spending in 2001 is primarily related to new store openings as well as to the continued implementation of a new POS/Inventory system. Through September 29, 2001, the new POS/Inventory system has been successfully implemented in the Pittsburgh, Detroit, Boston, Washington, Baltimore, Richmond, San Diego, Sacramento and San Francisco markets. Net cash provided by financing activities was $17.9 million for the nine months ended September 29, 2001 as compared to $3.7 million used in financing activities in the nine months ended September 30, 2000. Cash provided by financing activities in the nine month period ended September 29, 2001 primarily related to $18.0 million in borrowings under the Company's Senior Credit Facility. Cash used in financing activities in the nine month period ended September 30, 2000 primarily related to the repurchase of stock options for $2.8 million and to costs incurred in connection with the issuance of the Senior Notes. Management Subsequent to the end of the third quarter, there have been changes to the management team of MDC. Effective November 5, 2001, Bryan Flanagan, the Company's Chief Financial Officer, has left the Company to pursue other opportunities. Rick Frier has recently joined the Company and will assume the responsibilities and position of Chief Financial Officer. Forward-Looking Statements This document includes forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Although we believe that our assumptions made in connection with the forward-looking statements are reasonable, we cannot assure you that our assumptions and expectations will prove to have been correct. These forward-looking statements are subject to various risks, uncertainties and assumptions about us, including, among other things: . anticipated growth strategies and pursuit of potential acquisition opportunities . dependence upon our senior management team . increased future competition . possibility of fluctuations in the cost of raw materials and loss of suppliers . changes in economic and market conditions . dependence on Sealy . reliance on certain trademarks and other intellectual property . ability to return our stores in certain markets to profitability . ability to refinance the Senior Credit Facility and to arrange additional financing. The Company undertakes no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this quarterly report on Form 10-Q might not occur. Item 3. Quantitative and Qualitative Disclosure About Market Risk We do not believe that we have material quantitative or qualitative market risk exposures. -24- PART II. OTHER INFORMATION Item 1. Legal Proceedings We are party to various proceedings from time to time arising in the ordinary course of business. We do not expect that these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition or results of operations. Additionally, as of September 29, 2001, the Company is a defendant in a State Court class action lawsuit brought by certain current or former employees. Management is unable to determine, at this time, the outcome or the loss, if any, that may occur as a result of this litigation. We are not currently involved in any other material legal proceedings. Item 2. Changes in Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders This Item is not applicable. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits -------- None. (b) Reports on Form 8-K ------------------- None. -25- SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MATTRESS DISCOUNTERS CORPORATION /s/ Stephen J. Newton --------------------------------- November 13, 2001 Name: Stephen J. Newton Title: Chief Executive Officer /s/ Christopher P. Stabile --------------------------------- Name: Christopher P. Stabile Title: Chief Accounting Officer -26-

MATTRESS DISCOUNTERS CORP 10-Q