UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 1O-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended August 3, 2002
--------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1932
For the transition period from...............to................
Commission File Number: 1-10089
FACTORY 2-U STORES, INC.
(Exact name of registrant as specified in its charter)
Delaware 51-0299573
- -------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4000 Ruffin Road, San Diego, CA 92123-1866
- ------------------------------- ----------
(Address of principal executive office) (Zip Code)
(858) 627-1800
(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. [X] YES [ ] NO
The number of shares outstanding of the registrant's common stock, as of
September 13, 2002 was 12,969,910 shares.
FACTORY 2-U STORES, INC.
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED AUGUST 3, 2002
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Factory 2-U Stores, Inc. Balance Sheets as of August 3, 2002,
August 4, 2001 (Unaudited) and February 2, 2002....................F-1
Factory 2-U Stores, Inc. Statements of Operations (Unaudited) for the
13 weeks and 26 weeks ended August 3, 2002 and August 4, 2001 .....F-3
Factory 2-U Stores, Inc. Statements of Cash Flows (Unaudited) for the
26 weeks ended August 3, 2002 and August 4, 2001 ..................F-4
Factory 2-U Stores, Inc. Notes to Financial Statements (Unaudited) F-5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ...............................................3
Item 3. Quantitative and Qualitative Disclosures About Market Risk..........10
Item 4. Controls and Procedures.............................................10
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ..................................................11
Item 2. Changes in Securities and Use of Proceeds...........................11
Item 3. Defaults Upon Senior Securities.....................................11
Item 4. Submission of Matters to a Vote of Security Holders.................11
Item 5. Other Information ..................................................12
Item 6. Exhibits and Reports on Form 8-K ...................................12
Signatures ...............................................................13
Certifications ..............................................................14
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands, except share and per share data)
August 3, August 4, February 2,
2002 2001 2002
------------ ------------ --------------
(Unaudited) (Unaudited)
ASSETS
Current assets:
Cash $ 7,446 $ 8,229 $ 17,390
Merchandise inventory 76,824 76,558 54,860
Accounts receivable 2,476 3,038 2,013
Income taxes receivable 5,913 1,253 -
Prepaid expenses 6,909 7,246 6,357
Deferred income taxes 3,553 2,503 3,553
--------- --------- ----------
Total current assets $ 103,121 $ 98,827 $ 84,173
Leasehold improvements and equipment, net 36,957 42,265 37,042
Deferred income taxes 7,182 4,992 7,182
Other assets 959 1,096 1,011
Excess of cost over net assets acquired, less
accumulated amortization of $13,344, $12,543
and $13,344, respectively 26,301 27,102 26,301
--------- --------- ----------
Total assets $ 174,520 $ 174,282 $ 155,709
========= ========= ==========
The accompanying notes are an integral part of these financial statements.
(continued)
F-1
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands, except share and per share data)
(continued)
August 3, August 4, February 2,
2002 2001 2002
------------ ------------- --------------
(Unaudited) (Unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt $ 2,001 $ 2,099 $ 2,019
Accounts payable 52,714 48,218 36,271
Taxes payable 3,150 3,262 3,332
Accrued expenses 32,875 15,378 27,918
---------- --------- ----------
Total current liabilities 90,740 68,957 69,540
Revolving credit facility 5,386 11,600 -
Long-term debt 8,906 9,791 8,376
Other long-term obligations 3,578 1,064 3,578
Deferred rent 3,295 3,654 3,649
---------- --------- ----------
Total liabilities 111,905 95,066 85,143
---------- --------- ----------
Stockholders' equity:
Common stock, $0.01 par value; 35,000,000 shares
authorized and 12,968,910 shares, 12,821,779
shares and 12,842,146 shares issued and
outstanding, respectively 130 128 128
Stock subscription notes receivable (2,149) (2,225) (2,225)
Additional paid-in capital 122,319 120,767 121,370
Accumulated deficit (57,685) (39,454) (48,707)
---------- ---------- -----------
Total stockholders' equity 62,615 79,216 70,566
---------- ---------- -----------
Total liabilities and stockholders' equity $ 174,520 $ 174,282 $ 155,709
========== ========== ===========
The accompanying notes are an integral part of these financial statements.
F-2
FACTORY 2-U STORES, INC.
Statements of Operations
(in thousands, except per share data)
(Unaudited)
13 Weeks Ended 26 Weeks Ended
-------------- --------------
August 3, August 4, August 3, August 4,
2002 2001 2002 2001
---------- ---------- ---------- ----------
Net sales $ 128,088 $ 139,254 $ 245,039 $ 265,078
Cost of sales 87,059 89,434 162,852 173,499
---------- ---------- ---------- ----------
Gross profit 41,029 49,820 82,187 91,579
Selling and administrative expenses 50,181 47,791 95,879 90,438
Pre-opening and closing expenses 266 1,038 703 1,892
Amortization of intangibles - 422 - 845
Stock-based compensation expense - 456 - 456
---------- ---------- ---------- ----------
Operating income (loss) (9,418) 113 (14,395) (2,052)
Interest expense, net 310 450 568 781
---------- ---------- ---------- ----------
Loss before income taxes (9,728) (337) (14,963) (2,833)
Income tax benefit (3,891) (142) (5,985) (1,190)
---------- ---------- ---------- ----------
Net loss $ (5,837) $ (195) $ (8,978) $ (1,643)
========== ========== ========== ==========
Loss per share
Basic $ (0.45) $ (0.02) $ (0.69) $ (0.13)
Diluted $ (0.45) $ (0.02) $ (0.69) $ (0.13)
Weighted average common shares outstanding
Basic 12,957 12,806 12,930 12,788
Diluted 12,957 12,806 12,930 12,788
The accompanying notes are an integral part of these financial statements.
F-3
FACTORY 2-U STORES, INC.
Statements of Cash Flows
(in thousands)
(Unaudited)
26 Weeks ended
--------------
August 3, August 4,
2002 2001
---------- ----------
Cash flows from operating activities
Net Loss $ (8,978) $ (1,643)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization 7,466 8,109
Loss on disposal of equipment 51 125
Deferred rent (354) 214
Stock-based compensation expense - 456
Changes in operating assets and liabilities
Merchandise inventory (21,964) (24,114)
Prepaid expenses and other assets (6,902) (2,398)
Accounts payable 16,442 23,024
Accrued expenses and other liabilities 3,098 (4,635)
---------- ----------
Net cash used in operating activities (11,141) (862)
---------- ----------
Cash flows from investing activities
Purchases of leasehold improvements and equipment (5,125) (7,589)
---------- ----------
Net cash used in investing activities (5,125) (7,589)
---------- ----------
Cash flows from financing activities
Borrowings on revolving credit facility 25,760 59,872
Payments on revolving credit facility (20,374) (48,272)
Payments on long-term debt and capital
lease obligations (18) (90)
Payment of deferred debt issuance costs (40) (40)
Proceeds from exercise of stock options 918 471
Payments of stock subscription notes receivable 76 -
---------- ----------
Net cash provided by financing activities 6,322 11,941
---------- ----------
Net increase (decrease) in cash (9,944) 3,490
Cash at the beginning of the period 17,390 4,739
---------- ----------
Cash at the end of the period $ 7,446 $ 8,229
========== ==========
Supplemental disclosure of cash flow information
Cash paid during the period for
Interest $ 97 $ 572
Income taxes $ 1,102 $ 5,521
Supplemental disclosure of non-cash financing activities
Issuance of common stock to board members
as compensation $ 33 $ 69
The accompanying notes are an integral part of these financial statements.
F-4
FACTORY 2-U STORES, INC.
Notes to Financial Statements
(Unaudited)
(1) Unaudited Interim Financial Statements
The accompanying unaudited financial statements do not include all of
the information and footnotes required by accounting principles
generally accepted in the United States for annual financial statements
and should be read in conjunction with the financial statements for the
fiscal year ended February 2, 2002 included in our Form 10-K as filed
with the Securities and Exchange Commission.
We believe that the unaudited financial statements as of and for
the 13 weeks and 26 weeks ended August 3, 2002 and August 4, 2001
reflect all adjustments (which include normal recurring
adjustments) necessary to present fairly the financial position,
results of operations and cash flows for the periods presented.
Due to the seasonal nature of our business, the results of
operations for the interim period may not necessarily be
indicative of the results of operations for a full year.
Certain prior period amounts have been reclassified to conform their
presentation to the current period financial statements.
(2) Recent Accounting Pronouncements
In August 2001, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 143,
"Accounting for Asset Retirement Obligations." This statement addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset
retirement costs. It applies to (a) all entities and (b) legal
obligations associated with the retirement of long-lived assets that
result from the acquisition, construction, development and/or normal
operation of long-lived assets, except for certain obligations of
lessees. This statement is effective for financial statements issued
for fiscal years beginning after June 15, 2002. We do not expect the
adoption of this statement will have a material impact on our financial
position or results of operations.
Also in August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", which establishes one
accounting model to be used for long-lived assets to be disposed of by
sale and broadens the presentation of discontinued operations to
include more disposal transactions. SFAS No. 144 supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and the accounting and reporting
provisions of APB Opinion No. 30, "Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events
and Transactions" for the disposal of a segment of a business (as
previously defined in that Opinion). The provisions of SFAS No. 144 are
effective for financial statements issued for fiscal years beginning
after December 15, 2001. The adoption of SFAS No. 144 had no impact on
our financial position or results of operations.
F-5
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections", which rescinds SFAS No. 4, "Reporting Gains
and Losses from Extinguishment of Debt" and an amendment of that
Statement, and SFAS No. 64, "Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No. 44,
"Accounting for Intangible Assets of Motor Carriers." SFAS No. 145
amends SFAS No. 13, "Accounting for Leases", to eliminate an
inconsistency between the required accounting for sale-leaseback
transactions and the required accounting for certain lease
modifications that have economic effects that are similar to
sale-leaseback transactions. SFAS No. 145 also amends other existing
authoritative pronouncements to make various technical corrections,
clarify meanings, or describe their applicability under changed
conditions. SFAS No. 145 is effective for fiscal years beginning
after May 15, 2002. We do not expect the adoption of this statement
will have a material impact on our financial position or results of
operations.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities", which addresses
significant issues regarding the recognition, measurement, and
reporting of costs associated with exit and disposal activities,
including restructuring activities. This statement requires that costs
associated with exit or disposal activities be recognized when they are
incurred rather than at the date of a commitment to an exit or disposal
plan. SFAS No. 146 is effective for all exit or disposal activities
initiated after December 31, 2002. We do not expect the adoption of
this statement will have a material impact on our financial position or
results of operations.
(3) Restructuring Charge
In January 2002, we recorded a restructuring charge of $21.2 million in
conjunction with the decision to close 28 under-performing stores, as
well as the realignment of our field organization and workforce
reductions. The purpose of these restructuring initiatives is to
improve store profitability, streamline field operations, reduce costs
and improve efficiency.
As of September 17, 2002, we have closed 24 of the 28 under-performing
stores and have completed the realignment of our field organization and
workforce reductions. The balance of the liability related to the
restructuring charge at August 3, 2002 was as follows:
F-6
Balance at Balance at
February 2, Cash Non-cash August 3,
2002 Payments Charges 2002
(in thousands) ----------- -------- -------- ----------
Lease termination costs* $ 13,724 $ (1,540) $ 304 $ 12,488
Inventory liquidation costs 2,870 - (1,289) 1,581
Fixed asset write-downs 2,052 - (1,390) 662
Employee termination costs 1,159 (930) - 229
Other costs 1,349 (849) - 500
----------- --------- --------- ----------
$ 21,154 $ (3,319) $ (2,375) $ 15,460
----------- --------- --------- ----------
* The non-cash charge portion consists primarily of the write-off of deferred
rent.
(4) Adoption of SFAS No. 142, "Goodwill and Other Intangible Assets"
----------------------------------------------------------------
In June 2001, the FASB issued SFAS No. 142 "Goodwill and Other
Intangible Assets", which requires that upon adoption, amortization of
goodwill will cease and instead, the carrying value of goodwill be
evaluated for impairment at least annually using a fair value test.
Identifiable intangible assets will continue to be amortized over their
useful lives and reviewed at least annually for impairment using a
method appropriate to the nature of the intangible asset.
As required, we adopted SFAS No. 142 on February 3, 2002 and ceased
the amortization of goodwill accordingly. The following table presents
the reconciliation of net income and per share data to what we would
have reported had the new rules been in effect during the 13-week and
26-week periods ended August 4, 2001 (in thousands, except per share
data):
13 Weeks Ended 26 Weeks Ended
-------------- --------------
August 3, August 4, August 3, August 4,
2002 2001 2002 2001
--------- --------- --------- ---------
Reported net loss $ (5,837) $ (195) $ (8,978) $ (1,643)
Add back goodwill amortization,
net of tax - 233 - 465
---------- --------- ---------- ---------
Adjusted net income (loss) $ (5,837) $ 38 $ (8,978) $ (1,178)
---------- --------- ---------- ---------
Basic and diluted net income (loss)
per common share:
Reported net loss $ (0.45) $ (0.02) $ (0.69) $ (0.13)
Goodwill amortization,
net of tax $ - $ 0.02 $ - $ 0.04
Adjusted net income (loss) $ (0.45) $ 0.00 $ (0.69) $ (0.09)
F-7
(5) Revolving Credit Facility
We have a $50.0 million revolving credit facility, under which
generally we may borrow up to 70% of our eligible inventory and 85% of
our eligible accounts receivable, as defined. Under the terms of the
credit facility, the interest rate may increase or decrease subject to
earnings before interest, tax obligations, depreciation and
amortization expense (EBITDA), as defined, on a rolling four fiscal
quarter basis. Accordingly, prime rate borrowings could range from
prime to prime plus 0.5% and LIBOR borrowings from LIBOR plus 1.5% to
LIBOR plus 2.5%. The credit facility expires on March 3, 2003, subject
to automatic one-year renewal periods, unless terminated earlier by
either party. We are obligated to pay fees equal to 0.125% per annum on
the unused amount of the credit facility. The credit facility is
secured by a first lien on accounts receivable and inventory and
requires us to maintain specific levels of tangible net worth in the
event that our borrowing availability is less than $7.5 million.
On September 16, 2002, the credit facility was amended to extend the
term until March 3, 2006. The amendment also amended the interest rate
ranges on borrowings from prime to prime plus 1.0% or LIBOR plus 1.5%
to LIBOR plus 3.0%. In addition, the amendment eliminated all
financial covenants and provided for a $7.5 million availability block.
Under the availability block, all borrowings require lender's
authorization while availability under the facility is $7.5 million or
less.
At August 3, 2002, based on eligible inventory and accounts receivable,
we were eligible to borrow $50.0 million under the revolving credit
facility; and we were in compliance with all financial and tangible net
worth covenants, as defined. At August 3, 2002, we had outstanding
borrowings of $5.4 million; and we had a $4.4 million standby letter of
credit outstanding.
(6) Long-Term Debt
Our long-term debt consists of Junior Subordinated Notes (the "Notes"),
which are non-interest bearing and are reflected on our balance sheets
at the present value using a discount rate of 10%. As of August 3,
2002, the Notes had a face value of $13.3 million and a related
unamortized discount of $2.4 million, resulting in a net carrying value
of $10.9 million. The discount is amortized to interest expense as a
non-cash charge over the term of the Notes. We made a principal
payment on the Notes of $2.0 million in December 2001. Additional
principal payments are scheduled on December 31, 2002 ($2.0 million),
December 31, 2003 and December 31, 2004 ($3.0 million) and on May 28,
2005 ($5.3 million).
F-8
(7) Income (loss) per Share
We compute income (loss) per share in accordance with SFAS No. 128,
Earnings Per Share. Under the provisions of SFAS No. 128, basic
earnings (loss) per share is computed based on the weighted average
shares outstanding. Diluted earnings per share is computed based on the
weighted average shares outstanding and potentially dilutive common
equivalent shares.
Common equivalent shares totaaling 13,078,881, 12,997,111, 13,183,665
and 12,976,516, respectively, are not included in the computation of
diluted loss per share for the 13 weeks and 26 weeks ended August 3,
2002 and August 4, 2001 because the effect would be anti-dilutive.
(8) Provision for Income Taxes
Based on our estimated effective tax rate for the entire fiscal year,
which is subject to ongoing review and evaluation, we recorded an
income tax benefit of $3.9 million and $6.0 million for the 13 weeks
and 26 weeks ended August 3, 2002, respectively.
(9) Stock Options and Warrants
As of August 3, 2002, we had outstanding options to purchase 1,254,275
shares of our common stock. Included in these outstanding stock options
are 4,520 performance-based options, which will become exercisable if
the market price hurdle of $49.78 has been achieved and maintained for
60 consecutive trading days. Should this occur, we will incur a
non-cash compensation expense in the minimum amount of $187,000. These
performance-based options will expire on or before April 29, 2003.
During the 13 weeks ended August 4, 2001, we recorded a non-cash charge
of $456,000 in conjunction with the removal of the price target of
$49.78 for 19,361 stock options held by an executive officer who
retired in August 2001.
At August 3, 2002, warrants to purchase 82,690 shares of our common
stock were outstanding. These warrants have an exercise price of $19.91
and expire May 2005.
(10) Other Receivable
In July 2002, we entered into a temporary bridge financing agreement
(the "Agreement") with one of our trade vendors (the "Borrower") in
which we, subject to the terms and conditions of the Agreement, will
provide a $4.0 million revolving line of credit facility to the
Borrower. Advances made to the Borrower under this Agreement are
secured by the Borrower's accounts receivable, inventory, personal
property and other assets including cash. Borrowings under this
facility are also secured by personal guarantees from the principals of
the Borrower. This agreement will terminate on September 27, 2002. As
of August 3, 2002, there were direct borrowings of approximately $1.2
million under this Agreement.
F-9
(11) Legal Matters, Commitments and Contingencies
As disclosed in our financial statements for the fiscal year ended
February 2, 2002 included in our Form 10-K as filed with the Securities
and Exchange Commission, in December 2000, a former employee in our
Alameda, California store filed a lawsuit against us (the "O'Hara
Lawsuit"). This lawsuit alleged that we violated the California Labor
Code and Internal Wage Commission Orders, by classifying store managers
and assistant managers as exempt salaried employees and thereby failing
to pay them overtime. In August 2002, we reached a tentative
settlement, subject to court approval, to settle the O'Hara Lawsuit. On
September 3, 2002, the court gave preliminary approval to the
settlement and has scheduled a hearing on November 7, 2002 to consider
final approval of the settlement. In conjunction with this tentative
settlement, we recorded a charge of $2.1 million during the 13 weeks
ended August 3, 2002.
We are at all times subject to pending and threatened legal actions
that arise in the normal course of business. In the opinion of our
management, based in part on the assessment of legal counsel, the
ultimate disposition of these current matters will not have a material
adverse effect on our financial position or results of operations.
F-10
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion and analysis should be read in conjunction with our
Financial Statements and notes thereto, included elsewhere in this Form 10-Q.
General
As of August 3, 2002, we operated 257 stores compared to 263 stores as of August
4, 2001. We opened 3 new stores and closed 2 stores during the 13-week period
ended August 3, 2002, and opened 12 new stores during the same period last year.
For the 26-week period ended August 3, 2002, we opened 8 new stores and closed
30 stores as compared to 21 new store openings and 1 store closing for the
comparable period last year.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures 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.
Specifically, we must make estimates in the following areas:
o Inventory valuation. Merchandise inventory is stated at the lower of cost
or market determined using the retail inventory method ("RIM") on a
first-in, first-out basis. Under the RIM, the valuation of inventory at
cost and the resulting gross margin are calculated by applying a computed
cost-to-retail ratio to the retail value of inventory. RIM is an averaging
method that has been widely used in the retail industry due to its
practicality. Also, it is recognized that the use of the RIM will result in
valuing inventory at the lower of cost or market if markdowns are currently
taken as a reduction of the retail value of inventory. Inherent in the RIM
calculation are certain significant management judgments and estimates
regarding markdowns and shrinkage, which may from time to time cause
adjustments to the gross margin in the subsequent period. Factors that can
lead to distortion in the calculation of the inventory balance include
applying the RIM to a group of merchandise items that is not fairly uniform
in terms of its cost and selling price relationship and turnover, and
applying RIM to transactions over a period of time that includes different
rates of gross profit, such as those relating to seasonal merchandise items.
To minimize the potential of such distortions in the valuation of inventory
from occurring, we utilize 83 subdepartments in which fairly homogeneous
classes of merchandise items having similar gross margin are grouped. In
addition, failure to take timely markdowns may result in an overstatement
of cost under the lower of cost or market principle. We believe that our RIM
provides an inventory valuation that reasonably approximates cost and results
in carrying inventory at the lower of cost or market.
3
o Valuation of goodwill, intangible and other long-lived assets. We use
certain assumptions in establishing the carrying value and estimated lives
of our long-lived assets and goodwill. The criteria used for these
evaluations include management's estimate of the asset's continuing ability
to generate income from operations and positive cash flows. If assets are
considered to be impaired, the impairment recognized is measured by the
amount that the carrying value of the assets exceeds the fair value of the
assets. Useful lives and related depreciation or amortization expense are
based on our estimate of the period that the assets will generate revenues or
otherwise be used in operations. Factors that would influence the likelihood
of a material change in our reported results include a significant decline in
our stock price and market capitalization compared to our net book value,
significant changes in an asset's ability to generate positive cash flows,
significant changes in our strategic business objectives and utilization of
the asset.
o Accrued restructuring costs. We have estimated an amount for the charge and
the related liability regarding our restructuring initiatives including
store closures, realignment of our field organization and workforce
reductions in accordance with the Emerging Issues Task Force ("EITF") Issue
94-3, "Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." Materially different reported results would be likely if
the timing and extent of the adopted restructuring plan were changed.
o Litigation reserves. Based in part on the assessment of our legal counsel,
estimated amounts for litigation and claims that are probable and can be
reasonably estimated are recorded as liabilities in the balance sheet. The
likelihood of a material change in these estimated reserves would be
dependent on new claims as they may arise and the favorable or unfavorable
outcome of the particular litigation. We anticipate these reserves will be
re-evaluated as new facts come to light in any particular case.
o Worker's compensation accrual. At the beginning of fiscal 2001, we
transitioned to a self-insured worker's compensation program. This new
program has both specific and aggregate stop-loss amounts. The maximum
specific stop-loss is $250,000 per occurrence and the deductible aggregate
stop-loss is $3.2 million for the policy year ended January 31, 2002. We
utilize internal actuarial methods, as well as an independent third-party
actuary for the purpose of estimating ultimate costs for a particular policy
year. Based on these actuarial methods along with current available
information and insurance industry statistics, the ultimate expected losses
for the policy year ended January 31, 2002 were estimated to be approximately
$2.6 million. Our estimate is based on average claims experience in our
industry and our own experience in terms of frequency and severity of claims,
with no explicit provision for adverse fluctuation from year to year and is
subject to inherent variability. This variability may lead to ultimate
payments being either greater or less than the amounts presented above.
For the policy year ending January 31, 2003, our self-insured worker's
compensation program includes a maximum specific stop-loss amount of $250,000
per occurrence with no deductible aggregate stop-loss amount.
4
o Valuation of deferred income taxes. Valuation allowances are established,
if deemed necessary, to reduce deferred tax assets to the amount expected
to be realized. The likelihood of a material change in our expected
realization of these assets is dependent on future taxable income, our
ability to use the net operating loss carryforwards, the effectiveness of
our tax planning and strategies among the various tax jurisdictions that we
operate in, and any significant changes in the tax treatment we currently
receive.
Results of Operations
Net sales were $128.1 million for the 13 weeks ended August 3, 2002 compared to
$139.3 million for the 13 weeks ended August 4, 2001, a decrease of $11.2
million, or 8.0%. Comparable store sales for the 13-week period ended August 4,
2002 decreased 8.7% versus a decrease of 2.4% for the same period last year.
For the 26 weeks ended August 3, 2002, net sales were $245.0 million versus
$265.1 million the same period last year, a decrease of $20.0 million or 7.6%.
Comparable store sales decreased 10.2% in the first 26 weeks of this year
compared to a decrease of 4.2% for the same period last year.
The decline in net sales for the 13 and 26 weeks ended August 3, 2002 from the
comparable periods last year was primarily due to reduced customer traffic and
lower average size in customer purchases.
Gross profit was $41.0 million or 32.0% of net sales for the 13 weeks ended
August 3, 2002 compared to $49.8 million or 35.8% of net sales for the 13 weeks
ended August 4, 2001. For the 26 weeks ended August 3, 2002 and August 4, 2001,
gross profit was $82.2 million or 33.5% of net sales and $91.6 million or 34.5%
of net sales, respectively.
The decline in gross profit as a percentage of net sales for the 13 and 26 weeks
ended August 3, 2002 from the comparable periods last year was primarily related
to higher markdown volume, lower initial mark-up, partially offset by improving
efficiency in distribution operations. The higher markdown volume was primarily
a result of increased promotional activity this year, which included our July
chain-wide grand re-opening event, and clearing of slow-moving inventory.
Included in selling and administrative expenses for the 13 and 26 weeks
ended August 3, 2002 was a charge of $2.1 million related to the tentative
settlement, subject to court approval, of the O'Hara Lawsuit, as previously
discussed in this document. For the 13 and 26 weeks ended August 4, 2001,
selling and administrative expenses included a charge of $1.2 million related to
the retirement and replacement of an executive officer.
5
Excluding these charges, selling and administrative expenses were $48.1 million
or 37.5% of net sales and $46.6 million or 33.5% of net sales for the 13 weeks
ended August 3, 2002 and August 4, 2001, respectively. For the 26 weeks ended
August 3, 2002 and August 4, 2001, selling and administrative expenses,
excluding the charges, were $93.8 million or 38.3% of net sales and $89.3
million or 33.7% of net sales, respectively. The dollar increase in selling and
administrative expenses was primarily a result of increased spending for
advertising, store occupancy and consulting services. Selling and administrative
expenses increased as a percent of net sales due to lower average sales volume
per store and increased spending related to the items cited above.
Pre-opening and closing expenses were $266,000 for the 13 weeks ended August 3,
2002 compared to $1.0 million for the same period last year, a decrease of
approximately $772,000 or 74.3%. For the 26 weeks ended August 3, 2002,
pre-opening and closing expenses were $703,000 versus $1.9 million for the same
period last year, a decrease of approximately $1.2 million.
The decrease in pre-opening and closing expenses for the 13 and 26 weeks ended
August 3, 2002 from the comparable periods last year was due to the opening of
fewer new stores during the current periods versus the same periods last year.
We did not record any amortization of intangibles for the 13 weeks and 26 weeks
ended August 3, 2002 versus $422,000 and $845,000, respectively, recorded during
the same periods last year. This change was due to the elimination of goodwill
amortization in conjunction with the adoption of SFAS No. 142 and cessation of
amortization associated with prior business acquisitions.
Interest expense, net was $310,000 and $568,000 for the 13 weeks and 26 weeks
ended August 3, 2002, respectively, compared to $450,000 and $781,000 for the
comparable periods last year. The decrease in both periods was due to lower
average outstanding borrowings on the revolving credit facility.
We recorded an income tax benefit of $3.9 million and $6.0 million for the 13
weeks and 26 weeks ended August 3, 2002, respectively, compared to $142,000 and
$1.2 million for the 13 weeks and 26 weeks ended August 4, 2001. The increase in
income tax benefit was the result of an increased pre-tax loss versus the same
periods a year ago.
For the 13 weeks and 26 weeks ended August 3, 2002, the net loss was $5.8
million and $9.0 million as compared to $195,000 and $1.6 million for the 13
weeks and 26 weeks ended August 3, 2001. The increase in net loss was a result
of the operating and other factors cited above.
6
Liquidity and Capital Resources
General
We finance our operations through credit provided by vendors and other
suppliers, amounts borrowed under our $50.0 million revolving credit facility
and internally generated cash flow. Credit terms provided by vendors and other
suppliers are usually net 30 days. Amounts which may be borrowed under the
revolving credit facility are based on a percentage of eligible inventory and
accounts receivable, as defined, outstanding from time to time, as more fully
described in Note 5 of Notes to Financial Statements. At August 3, 2002, we had
$5.4 million of outstanding borrowings under our revolving credit facility
versus $11.6 million as of August 4, 2001.
During the 26 weeks ended August 3, 2002, we used $11.1 million in operating
activities, $5.1 million in investing activities and generated $6.3 million from
financing activities. As a result, we had a net decrease in cash of $9.9 million
during the 26 weeks ended August 3, 2002 compared to a net increase in cash of
$3.5 million during the same period last year.
We believe that our sources of cash, including the revolving credit facility,
will be adequate to finance our operations, capital requirements and debt
obligations as they become due for at least the next twelve months.
Capital Expenditures
We anticipate capital expenditures of approximately $8.6 million for the
remainder of the current fiscal year ending February 1, 2003, which includes
costs to open new stores, to renovate and relocate existing stores, to upgrade
information systems and to develop a distribution center in San Diego,
California. This new distribution center will be approximately 600,000 square
feet and service store operations on the west coast, Arizona, Nevada, and parts
of New Mexico. We anticipate that it will become operational in our second
quarter of fiscal 2003. We anticipate capital expenditures of approximately $6.5
million for this facility, approximately $4.0 million of which will occur in
fiscal 2002. We believe the capital expenditures for this facility and other
capital requirements will be financed from internal cash flow.
Store Closures and Restructuring Initiatives
As previously discussed, we have closed 24 of the 28 under-performing stores as
part of our restructuring plan. In addition, we have closed six other stores
which were either due to non-renewable leases or relocation opportunities. The
majority of the store closures were part of our restructuring initiatives
intended to improve future financial performance. The cash charges to close a
store principally consisted of lease termination or sublease costs, employee
severance and tear-down costs. In addition to the closing of under-performing
stores, we also included the realignment of field organization and workforce
reductions as part of our restructuring initiatives. We estimate the cash
requirement during the remainder of fiscal 2002 for the restructuring will be
approximately $5.7 million. We believe that our sources of cash, including the
revolving credit facility, will be adequate to fund our restructuring efforts.
7
Contractual Obligations and Commitments
The following table summarizes our significant contractual obligations, as well
as estimated cash requirements related to our restructuring initiatives, as of
August 3, 2002. These should be read in conjunction with "Note 3 - Restructuring
Charge" and "Note 6 - Long-Term Debt" in the accompanying unaudited financial
statements, as well as our fiscal 2001 Annual Report on Form 10-K as filed with
the Securities and Exchange Commission.
(in thousands)
Junior Accenture
Subordinated Operating Capital Restructuring Consulting
Notes Leases Leases Charge Agreement Total
------------ ---------- ------- ------------- ----------- -----------
Fiscal Year:
2002 (remaining
6 months) $ 2,000 $ 15,822 $ 1 $ 5,702 $ 1,200 $ 24,725
2003 3,000 30,444 - 7,515 - 40,959
2004 3,000 26,865 - - - 29,865
2005 5,300 20,159 - - - 25,459
2006 - 13,836 - - - 13,836
Thereafter - 26,310 - - - 26,310
------------ ---------- ------ ------------- --------- -----------
$ 13,300 $ 133,436 $ 1 $ 13,217 $ 1,200 $ 161,154
------------ ---------- ------ ------------- --------- -----------
In the first quarter of fiscal 2002, we entered into a master Consulting
Services Agreement and a statement of work thereunder (the "Agreement") with
Accenture LLP ("Accenture") to provide consulting services on merchandise
assortment planning and in-season management, advertising effectiveness and
brand development. The consulting services include (1) identification of high
impact opportunities, (2) development of an approach plan to realize and sustain
the associated benefits of the identified opportunities, (3) assistance in the
execution of the approach plan and (4) development of procedures for the
company's management to ensure the continuation of the program on a long-term
basis. Under the Agreement, Accenture would receive approximately $3.9 million
for services scheduled to be completed by January 2003. In addition, Accenture
may become entitled to additional fees of up to $1.3 million for fiscal 2002 and
$1.0 million for fiscal 2003 if we achieve specified financial targets for
fiscal 2002 and fiscal 2003. The Agreement is generally terminable on 30-day
notice. If we terminate without cause, we may be obligated to reimburse
Accenture for specified termination fees. Through August 31, 2002, we paid
Accenture approximately $2.0 million under the Agreement.
Effective August 30, 2002, the Agreement was amended to reflect a reduction in
the scope of services to be provided by Accenture. Under the amended Agreement,
Accenture will receive approximately $1.2 million in fees and expenses for
services provided for the period from September 30, 2002 to January 31, 2003.
8
Forward-Looking Statements
In this Quarterly Report on Form 10-Q, we have made both historical and
forward-looking statements. All of our statements other than those of historical
fact are, or may be deemed to be, forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These forward-looking statements are not based on
historical facts, but rather reflect our current expectations concerning future
results and events. These forward-looking statements generally may be identified
by the use of phrases such as "believe", "expect", "anticipate", "intend",
"plan", "foresee", "likely", "will" or other similar words or phrases.
Similarly, statements that describe our objectives, plans or goals are or may be
forward-looking statements. These forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results, performance or achievements to be different from any future results,
performance or achievements expressed or implied by these statements.
The following important factors, among others, could affect our future results,
causing these results to differ materially from those expressed in any of our
forward-looking statements: general economic and business conditions, trends in
our business and consumer preferences, especially as may be impacted by economic
weakness on consumer spending, the effects of government regulations and
legislation, litigation and other claims that may be asserted against us, the
effects of intense competition, changes in our business strategy or development
plans, including anticipated growth strategies and capital expenditures, the
costs and difficulties of attracting and retaining qualified personnel, the
effects of increasing labor, utility, fuel and other operating costs, our
ability to obtain adequate quantities of suitable merchandise at favorable
prices and on favorable terms and conditions, the effectiveness of our operating
initiatives and advertising and promotional strategies and other risk factors
described in our fiscal 2001 Annual Report on Form 10-K and in our other filings
with the Securities and Exchange Commission.
We do not undertake to publicly update or revise any of our forward-looking
statements, whether as a result of new information, future events and
developments or otherwise, except to the extent that we may be obligated to do
so by applicable law.
9
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to interest rate risk on our Junior Subordinated Notes, which are
non-interest bearing and discounted at an annual rate of 10%. At August 3,
2002, our long-term debt had a face value of $13.3 million with a net carrying
value of $10.9 million. While generally an increase in market interest rates
will decrease the value of this debt, and decreases in interest rates will have
the opposite effect, we are unable to estimate the impact that interest rate
changes will have on the value of this debt as there is no active public market
for the debt and we are unable to determine the market interest rate at which
alternate financing would have been available at August 3, 2002.
Item 4. Controls and Procedures
There have not been any significant changes in our internal controls or in other
factors that could significantly affect these controls subsequent to their
evaluation in connection with our last annual audit, including any corrective
actions with regard to significant deficiencies and material weaknesses.
10
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
As disclosed in our financial statements for the fiscal year ended
February 2, 2002 included in our Form 10-K as filed with the
Securities and Exchange Commission, in December 2000, a former
employee in our Alameda, California store filed a lawsuit against us
(the "O'Hara Lawsuit"). This Lawsuit alelged that we violated the
California Labor Code and Internal Wage Commission Orders, by
classifying store managers and assistant managers as exempt salaries
employees and thereby failing to pay them overtime. In August 2002,
we reached a tentative settlement, subject to court approval, to
settle the O'Hara Lawsuit. On September 3, 2002, the court gave
preliminary approval to the settlement and has scheduled a hearing on
November 7, 2002 to consider final approval of the settlement.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
Our annual meeting of stockholders was held on June 19, 2002.
Michael M. Searles was re-elected at the meeting to hold the office of
director and to serve until the annual meeting of stockholders in 2005
or until his successor is elected. The number of votes cast were as
follows:
Votes for: 8,320,831
Votes withheld: 0
Other directors whose terms of office continued after the meeting were
Willem de Vogel, Peter V. Handal, Ronald Rashkow and Wm. Robert
Wright II.
The other matter voted on and approved at the meeting was the
ratification of Ernst & Young LLP as independent accountants and the
results of that vote were as follows:
Votes for: 11,813,691
Votes against: 240,253
Votes withheld: 26,629
11
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit
10.9 Fourth Amendment to the Financing Agreement between the
CIT Group/Business Credit, Inc. (as Agent and a Lender)
and Factory 2-U Stores, Inc. (as Borrower) dated as of
September 16, 2002.
99.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 by Michael M. Searles, President and Chief
Executive Officer.
99.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002 by Douglas C. Felderman, Executive Vice President
and Chief Financial Officer.
(b) Reports on Form 8-K
Item 5 - On August 20, 2002, we filed a report on Form 8-K
regarding the resignation of Michael M. Searles, the Company's
President and Chief Executive Officer.
12
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.
FACTORY 2-U STORES, INC.
Date: September 17, 2002
By: /s/Douglas C. Felderman
-------------------------
Name: Douglas C. Felderman
Title: Executive Vice President and Chief Financial Officer
(duly authorized officer and principal financial officer)
13
CERTIFICATIONS
I, Michael M. Searles, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Factory 2-U
Stores, Inc. (the "Registrant").
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report.
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the Registrant as of, and for, the periods presented in this quarterly
report.
Date: September 17, 2002 /s/Michael M. Searles
---------------------
Name: Michael M. Searles
Title: President and Chief Executive Officer
I, Douglas C. Felderman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Factory 2-U
Stores, Inc. (the "Registrant").
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report.
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash flows
of the Registrant as of, and for, the periods presented in this quarterly
report.
Date: September 17, 2002 /s/Douglas C. Felderman
-----------------------
Name: Douglas C. Felderman
Title: Executive Vice President and
Chief Financial Officer
14