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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For fiscal year ended February 1, 2003
Commission File number 0-16309
FACTORY 2-U STORES, INC.
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(Exact Name of Registrant as Specified in its Charter)
Delaware 51-0299573
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(State or Other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
4000 Ruffin Road
San Diego, California 92123
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(Address of Principal Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (858) 627-1800
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Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
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Common Stock, $0.01 par value None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value
(Title of Class)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K [X]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
YES [X] NO [ ]
At April 25, 2003, the aggregate market value of the voting stock of the
Registrant held by non-affiliates was approximately $55,427,082.
At April 25, 2003, the Registrant had outstanding 15,992,953 shares of
Common Stock, $0.01 par value per share.
PART I
Item 1. Business 3
Item 2. Properties 11
Item 3. Legal Proceedings 13
Item 4. Submission of Matters to a Vote of Security Holders 13
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters 14
Item 6. Selected Financial Data 16
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 18
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 28
Item 8. Financial Statements and Supplementary Data 29
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure 29
PART III
Item 10. Directors and Executive Officers of the Registrant 30
Item 11. Executive Compensation 32
Item 12. Security Ownership of Certain Beneficial Owners and Management 40
Item 13. Certain Relationships and Related Transactions 42
Item 14. Controls and Procedures 43
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 44
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Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private
Securities Litigation Reform Act of 1995
In December 1995, Congress enacted the Private Securities Litigation Reform Act
of 1995 (the "Act"). The Act contains amendments to the Securities Act of 1933
and the Securities Exchange Act of 1934 which provide protection from liability
in private lawsuits for "forward-looking" statements made by specified persons.
We desire to take advantage of the "safe harbor" provisions of the Act.
Certain statements in this Annual Report on Form 10-K, or in documents
incorporated by reference into this Annual Report on Form 10-K, are
forward-looking statements, which are 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 expectation concerning future results and events. These
forward-looking statements generally may be identified by the use of phrases
such as "believe", "expect", `estimate", "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 factors, among others, could affect our future results,
performance or achievements, causing these results to differ materially from
those expressed in any of our forward-looking statements: general economic and
business conditions (both nationally and in regions where we operate); trends in
our business and consumer preferences, especially as may be impacted by economic
weakness on consumer spending; the effect 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
challenges and costs associated with maintaining and improving technology; 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 factors
described in this 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.
PART I
Item 1. Business
GENERAL
We operate a chain of off-price retail apparel and housewares stores in Arizona,
Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and
Washington. We sell branded casual apparel for the family, as well as selected
domestic and household merchandise at prices that generally are significantly
lower than other discount stores.
Our stores average approximately 15,000 square feet and are located mostly in
shopping centers. Our products include a broad range of family apparel, domestic
goods and houseware products. Our typical customers are families with more than
the average number of children and average household income of approximately
$35,000, which generally are profiled as discount store shoppers. Our
merchandising strategy is to offer first quality recognizable national and
discount store brands at a substantial discount, generally 20% to 50% below
prices offered by other discount chains. Our stores are well lit and present the
merchandise primarily on hanging fixtures. We also use strategically placed
in-store signage to emphasize savings and create increased customer awareness.
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We define our fiscal year by the calendar year in which most of our business
activity occurs (the fiscal year ended February 1, 2003 is referred to as fiscal
2002).
OPERATIONS
Recent Developments
As in fiscal 2001, we experienced a continuation of declining sales volume in
fiscal 2002 with a decrease of 7.7% in comparable store sales for the year. The
decline in comparable store sales was the result of lower transaction counts and
lower purchase size. We believe there were a number of factors that contributed
to the lower sales in fiscal 2002: (1) general economic malaise on the part of
the consumer, partly exacerbated by the September 11 terrorists attacks and the
threat of war in Iraq, (2) extreme price competition within the retail industry,
which made it more difficult to maintain our price advantage, (3) higher fuel
and utility costs, particularly in the state of California where more than half
of our stores are located, (4) the pronounced effects of the September 11
terrorists attacks on our 17 stores located near the Mexican border, and (5) the
deployment of United States armed forces overseas and the related negative
impacts on our 42 stores located near military bases.
In response to declining sales and operating losses over the last two fiscal
years, we have taken steps designed to improve our future operating performance.
To that end, on February 6, 2002, we announced a restructuring plan (fiscal 2001
restructuring) for the purpose of improving future operating results, which
principally consisted of closing 28 unprofitable stores, realignment of our
field organization and workforce reductions. We recorded a $21.2 million pre-tax
charge in fiscal 2001 related to this restructuring effort.
Beginning in November 2002, we also made a number of changes to our senior
management team. In November 2002, we announced the appointment of William R.
Fields to the position of Chairman and Chief Executive Officer, succeeding
Michael Searles, our former Chairman and Chief Executive Officer. During fiscal
2002, we also appointed Edward Wong to the new position of Executive Vice
President, Supply Chain and Information Technology, Melvin Redman to the
position of Executive Vice President, Store Operations and Distribution and
Larry Kelley to the position of Executive Vice President, Merchandising and
Marketing. In a continuing effort to improve operating results, on December 6,
2002, we announced additional restructuring initiatives, which included the
closure of another 23 under-performing stores, consolidation of our distribution
center network, and reorganization of our corporate overhead structure (fiscal
2002 restructuring). In connection with this fiscal 2002 restructuring, we
recorded a $14.4 million pre-tax charge. In addition, we announced efforts to
liquidate our slow-moving and aged inventory chain-wide. We incurred a pre-tax
charge of $16.1 million related to clearing slow-moving inventory and an
inventory valuation allowance.
As a result of our financial results over the past two fiscal years, bankruptcy
filings by a number of well-known retail chains during calendar year 2002 and
the general weak economic environment, shortly after the Christmas selling
season we experienced a tightening of credit extended to us by our vendors and
the credit community for merchandise purchases. The initial impact of this
credit tightening was a disruption of product flow to our stores in January,
February and to a lesser extent March of 2003. This credit environment required
us, in many cases, to meet accelerated payment terms in order to re-establish a
consistent flow of product and assure a level of inventory for Spring 2003
business. The acceleration of payment terms, in turn, adversely affected our
liquidity and, to some extent, further weakened our existing credit standing.
In an effort to improve our liquidity position, obtain more reasonable credit
terms and provide for a consistent flow of merchandise to our stores, we
initiated a series of financing transactions, in addition to taking steps to
accelerate the recognition of tax loss carry-back benefits. On March 6, 2003, we
completed the private offering of approximately 2.5 million shares of our common
stock for aggregate proceeds of approximately $5.7 million, net of placement
fees. In addition, during March 2003, we received an $8.2 million federal tax
refund as a result of utilizing tax loss carry-back benefits. On April 10,
2003, we completed a $7.5 million debt financing transaction consisting of a
$6.5 million junior term note secured primarily by inventory and accounts
receivable and a $1.0 million term note secured primarily by equipment and other
assets. We also anticipate completing a sale/leaseback transaction covering
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distribution equipment to be located in our new Otay Mesa distribution center
with a value of between $3.0 million and $4.0 million in the second quarter of
fiscal 2003.
In April 2003, we have experienced an improved flow of merchandise product to
our stores, a loosening of credit terms from the credit community and improved
liquidity as a result of our capital raising efforts. To a large extent, our
ability to obtain merchandise in the future on credit terms consistent with
those that we have received historically will depend upon our ability to improve
future operating results as measured by comparable store sales growth and
operating margins.
Operating Strategy
At Factory 2-U, our goal is to become the nation's premier "Extreme Value
Retailer" - providing the lowest price in the marketplace by using our
aggressive, unique buying techniques. More specifically, we seek to be the
leading off-price casual apparel, domestic goods and houseware retailer to
families with more than the average number of children and whose household
income is approximately $35,000 in the markets we serve.
The major element of our operating strategy is to provide value to customers on
national and discount brand apparel and houseware merchandise. We emphasize
providing value to our customers by selling merchandise offered by national
discount chains at savings of generally 20 to 50% below their prices. We buy
excess in-season inventory of recognized brands at bargain prices and pass along
the savings to our customers. We believe we are positioned to help families
dress, decorate their homes and entertain their children at a great value.
Buying and Distribution
We purchase merchandise from domestic manufacturers, jobbers, importers and
other vendors. Historically, our payment terms have typically been net 30 days.
While we continually add new vendors, we have maintained stable and good
business relationships with certain established vendors. However, we do not
maintain any long-term or exclusive purchase commitments or agreements with any
vendors. We believe that there is a substantial number of additional sources of
supply of first quality, national and discount brand merchandise that will meet
our inventory needs.
Unlike traditional department stores and discount retailers (that primarily
purchase merchandise in advance of the selling season, for example, back-to-
school is purchased by March), we purchase approximately 80% of our merchandise
in-season (i.e., during the selling season). These in-season purchases generally
represent closeouts of vendors' excess inventories remaining after the
traditional wholesale selling season and are often created by other retailers'
order cancellations. We believe that in-season buying practices are well suited
to our customers, who tend to make purchases on an as-needed basis during the
season. For years, our customers have substantiated this pattern, which has
helped shape the way Factory 2-U does business.
Our in-season buying practice is facilitated by our ability to quickly process
orders and ship merchandise through our distribution centers to our stores. At
our administrative headquarters, we receive daily store sales and inventory
information from point-of-sale equipment located at each of our stores. This
data is reported by stock keeping unit (SKU), permitting us to tailor purchasing
and distribution decisions on an as-needed basis. Our chain-wide computer
network, which is currently being upgraded with a view to enhanced allocation
and markdown capabilities, also facilitates communications between store
management with timely pricing and distribution information.
Generally, manufacturers ship goods directly to our distribution centers or
freight consolidators who then ship directly to our distribution centers. We
then deliver merchandise from our distribution centers to our stores within just
two or three days of receipt utilizing the services of independent trucking
companies. We do not typically store merchandise at our distribution centers
from season to season. We believe we are a desirable customer for vendors
seeking to liquidate inventory because we can take immediate delivery of large
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quantities of in-season goods. We rarely request markdown concessions,
advertising allowances or special shipping requirements, but insist on the
lowest price possible.
Merchandising and Marketing
Our merchandise selection, pricing strategies and store formats are designed to
reinforce the concept of value and maximize the customer enjoyment of shopping
at our stores. Our stores offer customers a diverse selection of first quality,
in-season merchandise at prices that generally are lower than those of competing
discount stores in their local markets. Our stores generally carry an assortment
of brand name labels, including nationally recognized brands.
We deliver new merchandise to our stores at least weekly to encourage frequent
shopping trips by our customers and to maximize our inventory turn. As a result
of our purchasing practices and the nature of off-price retail industry, store
inventory may not always include a full range of colors, sizes and styles in a
particular item. We believe that price, quality and product mix are more
important to our customers that the availability of a specific item at a given
time.
It is important that we emphasize inventory turns in our merchandising and
marketing strategy. Our merchandise presentation, pricing below discounters,
weekly store deliveries, staggered vendor shipments, promotional advertising,
store-tailored distribution and prompt price reductions on slow-moving items are
all designed to increase inventory turn. We believe that the pace of our
inventory turn leads to increased profits, lower markdowns, and efficient use of
capital and customer urgency to make purchase decisions.
Our stores are characterized by easily accessible merchandise displayed on
hanging fixtures and open shelves in well-lit areas. Our prices are clearly
marked with the comparative retail-selling price often noted on the price tag.
Our major advertising vehicle is the use of a full-color "tab" showing actual
photos of our merchandise and also telling our story. Our print media is
delivered to consumers through both direct mail and newspaper inserts. Some of
our other advertising programs include radio commercials and billboards, as well
as various local promotional activities from time to time.
As we move forward, we will continue to evolve our "Extreme Value Retailing"
position. It is an important, ownable marketing position that we feel will
address more and more customers each day; a growth strategy we have the utmost
confidence in.
Our Stores
Our stores emphasize value to the customer and satisfaction to develop customer
loyalty and generate repeat business. If a customer is not completely satisfied
with any purchase, we will make a full refund or exchange. Most of our sales are
for cash, although we accept checks, debit and credit cards. We do not issue
credit cards, but do offer layaway and gift card programs. Our layaway program
is important to our customers, many of whom do not possess credit cards, because
it permits them to pay for purchases over time. In general, our store business
hours are from 9:00 am to 9:00 pm, seven days a week.
As of April 25, 2003, we operated 243 stores located in Arizona, Arkansas,
California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and Washington,
under various operating leases with third parties. Our stores are located in
rural and lower to moderate income suburban communities and in densely populated
metropolitan areas. Most of our stores are located in shopping centers. Our
stores range in size from 6,000 square feet to 34,800 square feet, averaging
approximately 15,000 square feet.
We generally lease previously occupied store sites on terms that we believe are
more favorable than those available for newly constructed facilities. We select
store sites based on demographic analysis of the market area, sales potential,
local competition, occupancy costs, operational fit and proximity to existing
store locations. After we sign a new store lease, our new store opening team
prepares the store by installing fixtures, signs, dressing rooms, checkout
counters, cash register systems and other items. Once we take possession of a
store site, it takes approximately eight weeks to open a new store.
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Our average store opening costs for equipment, fixtures, leasehold improvements
and pre-opening expenses approximate $295,000. Our average initial inventory for
a new store currently approximates $160,000, net of trade credit. Generally,
during the two to three month grand opening period, our new stores achieve sales
that are 150% to 200% higher than the expected annualized net sales.
Our stores typically employ one store manager, two to three assistant store
managers and/or store supervisors, and 15 to 20 sales associates, most of whom
are part-time employees. We train new store managers, assistant store managers
and store supervisors in all aspects of store operations through our
management-training program. Our other store personnel are trained on site. We
often promote experienced assistant store managers to fill open store manager
positions. Our store managers participate in a bonus plan in which they are
awarded bonuses upon achieving established operating objectives.
We continually review store performance and from time to time close stores that
do not meet our minimal financial performance criteria. The costs associated
with closing stores consist primarily of inventory liquidation costs, provisions
to write down assets to net realizable value, teardown costs and the estimated
cost to terminate the lease. Prior to December 31, 2002, such costs were charged
to operations during the fiscal year in which the decision was made to close a
store. For all closing decisions initiated after December 31, 2002, the closing
costs will be recognized when they are incurred.
We maintain customary workers compensation, commercial liability, fire, theft,
business interruption and other insurance policies for all store, distribution
and corporate office locations.
Employees
As of April 25, 2003, we had 4,577 employees (2,484 of whom were part-time
employees). Of that total, 4,239 were store employees and store field
management, 247 were executives and administrative employees and 91 were
warehouse employees. None of our employees are subject to collective bargaining
agreements and we consider relations with our employees to be good.
Trademarks
Except for the trade names "Factory 2-U" and "Family Bargain Center", which are
federally registered trademarks, we do not have any material trademarks.
Government Regulation
Our business operations are subject to federal, state and local laws,
regulations and administrative practices. We believe we are in substantial
compliance with all federal, state and local laws and regulations governing our
business operations and we have obtained all material licenses and permits
required to operate our business. We believe that the compliance burdens and
risks relating to these laws and regulations do not have a material adverse
effect on our business.
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Risk Factors
New Store Growth
In fiscal 2002, 2001 and 2000, we opened 12, 39 and 70 stores, respectively.
During fiscal 2002 and 2001, we closed 50 stores. As of April 25, 2003, we had
opened one new store and currently expect to open one additional new store in
fiscal 2003. We have significantly reduced our new store growth in fiscal 2003
as a result of our recent financial performance and liquidity position.
New store growth is dependent upon many factors, including general economic
conditions, our financial condition and liquidity, availability and cost of real
estate, and our ability to identify suitable markets and sites for our new
stores. In addition, we must be able to continue to hire, train, motivate and
retain managers and store personnel. Many of these factors are beyond our
control. As a result, we cannot assure that we will be able to achieve our
future expansion goals. Any failure by us to obtain acceptance in markets in
which we currently have limited or no presence, attract and retain management
and other qualified personnel, appropriately upgrade our financial and
management information systems and control or manage operating expenses could
adversely affect our future operating results and our ability to execute our
business strategy.
We also cannot assure that any new store growth will improve our oprating
margins. A variety of factors are critical to the success of our new stores
and such factors include but are not limited to store sales, store location,
store size, lease terms, initial advertising effectiveness and brand
recognition. We cannot assure that our new stores will achieve the sales per
selling square foot and store contributions required to meet our minimum
operational performance criteria. If our new stores on average fail to achieve
our minimum operational performance criteria, new store expansion could produce
a decrease in our overall sales per selling square foot and store contributions.
Increases in advertising and pre-opening expenses associated with the opening of
new stores could also contribute to a decrease in our operating margins.
Our Store Concentration in California Poses Localized Risks
As of April 25, 2003, we operated 127 stores in California, representing over
half of our total store base. Accordingly, our results of operations and
financial condition largely depend upon trends in the California economy.
Operating costs, such as minimum wage, health care, workers' compensation,
utilities and fuel in California have been significantly higher than other
regions in the country where we currently operate. If operating costs continue
to increase in California, they could continue to pose a negative impact to our
overall store contribution and operating margins. In addition, California
historically has been vulnerable to certain natural disasters and other risks,
such as earthquakes, fires, floods and civil disturbance. At times, these events
have disrupted the local economy. These events could also pose physical risks to
our properties.
The costs associated with workers' compensation insurance in the state of
California have increased significantly over the past two years. These cost
increases are related to the average cost per claim and the related state
benefits. In the state of California, the average workers' compensation claim is
significantly higher than the other states where we currently operate. In
January 2003, the state of California increased the maximum workers'
compensation benefits by approximately 20 percent. With these continued workers'
compensation cost increases and the uncertain economy, the continued rise in
benefits could have a material impact on operating results in the future.
In California, we employ, both in our stores and in our corporate headquarters,
a substantial number of employees who earn wages near or at the minimum wage.
Actions by both the federal and California state government have increased and
may continue to increase the minimum wages that we must pay to such employees.
We can make no assurances that these or other future wage increases will not
have a negative impact on operating results in the future.
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Utility costs for electricity and natural gas in California have risen
significantly. These costs may continue to increase due to the actions of
federal and state governments and agencies, as well as other factors beyond our
control. We have attempted to mitigate such increases through energy
conservation measures and other cost cutting steps. However, we can make no
assurances that these measures and other steps taken will be adequate to control
the impact of these utility cost increases in the future. In addition,
increasing utility and fuel costs, together with high unemployment, may
significantly reduce the disposable income of our target customers. There can be
no assurance as to the impact these cost increases may have on sales to our core
customer base in California or elsewhere.
Disruptions in Receiving and Distribution Could Impact Our Business
Well-organized and managed receiving and shipping schedules and the avoidance of
interruptions are vital our success. From time to time, we may face unexpected
demands on our distribution operations that could cause delays in delivery of
merchandise from our distribution centers to our stores. A fire, earthquake or
other disaster at our distribution centers that disrupts the flow of merchandise
for any length of time could negatively impact our operating results and
financial condition. We maintain commercial property and business interruption,
earthquake and flood insurance.
During April and May 2003, we will be closing our two existing distribution
centers in San Diego and consolidating their operations into a single, new
distribution center in San Diego. We may face unexpected or unforeseen demands,
disruptions or costs that could adversely affect our distribution center
operations and delay or interfere with our ability to deliver merchandise from
our distribution facility to our stores in connection with this consolidation.
Relationships with Our Vendors and the Availability of Close-Out and Excess
In-Season Merchandise Affect Our Business
Our success depends in large part on our ability to locate and purchase quality
close-out and excess in-season merchandise at attractive prices. We cannot be
certain that such merchandise will continue to be available in the future.
Further, we may not be able to find and purchase merchandise in quantities
necessary to accommodate our immediate needs or future growth.
Although we believe our relationships with our vendors are good, we do not have
long-term agreements with any vendor. As a result, we must continuously seek out
buying opportunities from our existing suppliers and from new sources. We
compete for these opportunities with other wholesalers and retailers, discount
and deep-discount chains, mass merchandisers and various privately-held
companies and individuals. Although we do not depend on any single vendor or
group of vendors and believe we can successfully compete in seeking out new
vendors, a disruption in the availability of merchandise at attractive prices
could impair our business.
In addition, our ability to purchase merchandise depends upon our receiving
credit support from trade vendors or the credit community that extends financing
terms to certain of our vendors. In light of general economic conditions and our
recent financial performance, the credit community has either withdrawn or
reduced their extension of credit for our purchase orders, which has disrupted
our ability to purchase merchandise and impaired our business. Our recently
completed equity and debt financing transactions have led to increased support
from the credit community and our vendors. However, any further withdrawal or
reduction of the extension of credit from the credit community and our vendors
may negatively impact our ability to purchase merchandise at attractive prices,
disrupt product flow and adversely affect our operating results.
Our Business is Subject to Seasonality
We have historically realized our highest levels of sales and income during the
third and fourth quarters of our fiscal year (the quarters ending in October and
January) as a result of the "Back to School" (July and August) and Christmas
(November and December) seasons. Any adverse events during the third and fourth
quarter could therefore affect our financial performance. Historically, we have
realized a significant portion of our net sales and net income during these two
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quarters. In anticipation of the "Back to School" and Holiday seasons, we may
purchase substantial amounts of seasonal merchandise. If for any reason our net
sales during these seasons were to fall below seasonal norms and/or our
expectations, a seasonal merchandise inventory imbalance could result. If such
an imbalance were to occur, markdowns might be required to clear excess
inventory. Our operating results could be adversely affected by higher than
expected markdowns.
We Face Intense Competition
We operate in a highly competitive marketplace. We compete with large discount
retail chains, such as Wal-Mart, K-Mart, Target and Mervyn's, and other
off-price chains, such as TJ Maxx, Ross Stores, Marshall's and Big Lots, some of
which have substantially greater resources than ours. We also compete with
independent and small chain retailers and flea markets (also known as "swap
meets"), which serve the same low and low-middle income market. In the future,
new companies may also enter the deep-discount retail industry. Although we
believe that we are positioned to compete on the basis of the principal
competitive factors in our markets, which are price, quality and site location,
we cannot assure that we will be able to compete successfully against our
current and future competitors.
Over the past two years, the retail industry has experienced price deflation,
primarily due to a weak economy and intense competition. We compete in the
discount retail merchandise business, which is a highly competitive environment
that subjects us to the price competition, the potential for lower net sales and
decreased operating margins. We expect the competition will continue and
increase in the future. In addressing this competitive environment, we have
initiated new merchandise strategies, including new price point offerings,
better execution of our core businesses and a revised print advertising tab; all
designed to improve customer frequency and attract new customers. However, we
can make no assurances that these strategies and other actions taken will be
adequate to minimize our exposure to any negative impacts due to competition.
Our Business is Vulnerable to Economic Factors Beyond Our Control
Our ability to provide quality merchandise at everyday low prices profitably
could be hindered by certain economic factors beyond our control, including but
not limited to:
o increases in inflation;
o increases in operating costs;
o increases in employee health care and workers' compensation costs;
o increases in prevailing wage levels; and
o decreases in consumer confidence levels.
Terrorism and War May Affect Our Business
Terrorist attacks, such as the attacks that occurred in New York and Washington
D. C. on September 11, 2001, the response by the United States initiated on
October 7, 2001, the war in Iraq that began on March 20, 2003 and other acts of
violence or war may affect the market on which our common stock will trade, the
markets in which we operate, and our operations and operating results. The
near-term and long-term effects of war and any future terrorist attacks may have
for our customers, the market for our common stock, the markets for our products
and the economy of the United States of America are uncertain. The consequence
of any terrorist attack or any armed conflicts that may result are
unpredictable, and we are unable to foresee events that could have an adverse
effect on our markets or our business.
Our Business is Subject to Many Environmental Regulations
Under various federal and local environmental laws and regulations, current or
previous occupants of property may become liable for the costs of removing any
hazardous substances found on the property. These laws and regulations often
impose liability without regard to fault. We lease all of our stores. Although
we have not been notified of, and are not aware of, any current environmental
liability, claim or non-compliance, we could incur costs in the future related
to our leased properties.
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In the ordinary course of our business, we sometimes handle or dispose of
commonplace household products that are classified as hazardous materials under
various environmental laws and regulations. We have adopted policies regarding
the handling and disposal of these products and we train our employees on how to
handle and dispose of them. We cannot assure that our policies and training will
successfully help us avoid potential violations of these environmental laws and
regulations in the future.
Effects of Anti-Takeover Provisions and Control by Our Existing Major
Shareholders
In addition to some governing provisions in our Certificate of Incorporation and
Bylaws, we are also subject to certain Delaware laws and regulations which could
delay, discourage and prevent others from initiating a potential merger,
takeover or other change in control, even if such actions would benefit our
shareholders and us. Moreover, we have a single shareholder that currently owns
more than 20% of our voting stock. As a result, they may have certain ability to
influence all matters requiring the vote of our shareholders, including the
election of Board of Directors and most or our corporate actions. They may also
control our policies and potentially prevent a change in control. This could
adversely affect the voting and other rights of our other shareholders and could
depress the market price of our common stock.
The Market Price of Our Common Stock has had Substantial Fluctuation
The market price of our common stock has fluctuated substantially since our
recapitalization occurred in November 1998. Trading prices for our common stock
could fluctuate significantly due to many factors, including:
o the depth of the market for our common stock;
o changes in expectations of our future financial performance, including
financial estimates by securities analysts and investors;
o variations in our operating results and financial condition;
o conditions or trends in our industry;
o additions or departures of key personnel; and
o future issuances of our common stock.
AVAILABLE INFORMATION
We make available at our web site, www.factory2-u.com, our filings on Form 10-K,
10-Q, 8-K and amendments thereto, as soon as reasonably practical after we file
such materials with the Securities and Exchange Commission. All such materials
are free of charge. Any information that is included on or linked to our
Internet site is not a part of this report or any registration statement that
incorporates this report by reference.
Item 2. Properties
As of April 25, 2003, we operated 243 retail stores located in 10 states, under
various operating leases with third parties. Our store locations include
shopping centers, downtown business districts, malls and freestanding sites.
Each store lease is separately negotiated. The lease term for our stores is
between five to ten years with renewal options typically in five-year
increments. Approximately 98% of our leases are "triple net leases" under which
we are required to reimburse landlords for insurance, real estate taxes and
common area maintenance costs; however, for many of those leases, we have
negotiated reimbursement limitations on common area costs. As well as the
monthly minimum base rent, some of our store leases require additional rent,
which generally is based on an agreed percentage of sales in excess of a
specified sales level. Our store rent expense for the fiscal year ended February
1, 2003 was approximately $38.1 million.
11
At February 1, 2003, we operated 244 stores under the name Factory 2-U. The
number of stores we operated in each quarter during fiscal year 2002, 2001 and
2000 were as follows:
2002 2001 2000
-------- -------- --------
As of the beginning of the first quarter 279 243 187
Open 5 9 25
Close (28) (1) (9)
-------- -------- --------
As of the end of the first quarter 256 251 203
Open 3 12 11
Close (2) - (3)
-------- -------- --------
As of the end of the second quarter 257 263 211
Open 4 12 20
Close - (2) -
-------- -------- --------
As of the end of the third quarter 261 273 231
Open - 6 14
Close (17) - (2)
-------- -------- --------
As of the end of the fourth quarter 244 279 243
Subsequent to February 1, 2003, we opened one new store and closed two stores.
As of April 25, 2003, our stores were located as follows:
State Strip Center Downtown Power Center Freestanding Mall Total
----- ------------ -------- ------------ ------------ ---- -----
Arizona 24 2 4 1 1 32
Arkansas 2 - - - - 2
California 98 6 17 3 3 127
Idaho 1 - - - - 1
Nevada 7 - 1 - - 8
New Mexico 8 - 1 - - 9
Oklahoma 1 - - - - 1
Oregon 10 - 4 1 - 15
Texas 24 - 4 1 5 34
Washington 9 2 2 - 1 14
------------ --------- ------------ ------------ ----- -----
Total 184 10 33 6 10 243
------------ --------- ------------ ------------ ------ -----
Our headquarters are located in a 208,460 square-foot multi-use facility at
4000 Ruffin Road, San Diego, California. This facility consists of 58,460 square
feet of office space and 150,000 square feet of distribution space. The lease on
this facility expires in September 2005. The lease provides for annual base rent
at an average of approximately $1.3 million for the remaining lease term. We
also lease another 150,000 square foot distribution facility located at 7130
Miramar Road, San Diego, California. This lease expires in September 2005 and
provides for annual base rent at an average of approximately $871,000 for the
remaining lease term. Upon the opening of our new Otay Mesa distribution center
in San Diego, California, currently anticipated in the second quarter of fiscal
2003, we will cease distribution activities at Ruffin Road and Miramar Road. The
lease on this new distribution facility expires in July 2015 and provides for an
annual base rent of approximately $2.6 million. We are currently seeking
disposition of the leases for these two distribution facilities, although there
can be no assurance that we will be able to dispose of these leases on favorable
terms or at all.
12
In February 2001, we opened a 300,000 square-foot distribution center at 1875
Waters Ridge Drive, Lewisville, Texas. The lease for this facility expires in
December 2007 and provides for annual base rent at an average of approximately
$1.1 million for the remaining lease term. In conjunction with the expected
opening of the new Otay Mesa distribution center in the second quarter of fiscal
2003, we plan to transfer the Texas distribution function to the new Otay Mesa
distribution center upon the disposition of the lease for the Texas facility,
although there can be no assurance that we will be able to do so.
Item 3. Legal Proceedings
On December 15, 2000, Pamela Jean O'Hara ("O'Hara"), a former employee in our
Alameda, California store, filed a lawsuit against us entitled "Pamela Jean
O'Hara, Plaintiff, vs. Factory 2-U Stores, Inc., et al., Defendants", Case No.
834123-5, in the Superior Court of the State of California for the County of
Alameda (the "O'Hara Lawsuit"). On August 2, 2001, O'Hara and four other former
employees in our Alameda store filed a Second Amended Complaint in the O'Hara
Lawsuit.
The Second Amended Complaint in the O'Hara Lawsuit alleges that we violated the
California Labor Code and Industrial Wage Commission Orders, as well as the
California Unfair Competition Act, by failing to pay overtime to the plaintiffs.
Plaintiffs purport to bring this action on behalf of themselves and all other
store managers, assistant store managers and other undescribed
"similarly-situated employees" in our California stores from December 15, 1996
to present. The Second Amended Complaint sought compensatory damages, interest,
penalties, attorneys' fees, and disgorged profits, all in unspecified amounts.
The Second Amended Complaint also sought injunctive relief requiring payment of
overtime to "non-exempt" employees. On September 4, 2001, we filed an answer in
which we denied the material allegations of the Second Amended Complaint.
Pursuant to an Order dated December 3, 2001, the Court in the O'Hara Lawsuit
granted Plaintiff's motion for certification of two plaintiff classes: (1) all
persons who have been employed as assistant store managers at one of our
California stores at any time after December 15, 1996, and who worked hours
which would have entitled them to overtime had they not been exempt employees;
and (2) all persons who have been employed as store managers at one of our
California stores at any time after December 15, 1995, and who worked hours
which would have entitled them to overtime had they not been exempt employees.
We made a settlement offer to each member of the two plaintiffs classes,
pursuant to which we offered to pay $1,000 for each year of service (or a pro
rata portion of each partial year) after December 15, 1996 and between February
1, 2002 in exchange for a release of all overtime claims. Approximately 263
members of the plaintiff classes accepted the settlement offer.
In August 2002 we reached a tentative settlement of the O'Hara Lawsuit. On
November 7, 2002, the Court entered an order granting final approval of the
settlement agreement. Pursuant to the settlement agreement, we have agreed to
pay the plaintiff class members (and their attorneys) a total of $2,000,000 in
settlement of all their claims. The settlement became effective as of April 25,
2003.
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our
current employees, filed a lawsuit against us entitled "Lynda Bray, Masis
Manougian, etc., Plaintiffs, vs. Factory 2-U Stores, Inc., etc., Defendants",
Case No. RCV071918 in the Superior Court of the State of San Bernardino (the
"Bray Lawsuit"). The complaint in the Bray Lawsuit alleges that we violated the
settlement agreement in the O'Hara Lawsuit, the California Labor Code,
Industrial Wage Commission Orders and the California Unfair Competition Act by
failing to pay wages and overtime for all hours worked, by failing to document
all hours worked, by threatening to retaliate against employees who sought to
participate in the settlement of the O'Hara Lawsuit and by failing to inform
prospective employees of unpaid wage claims. Plaintiffs purport to bring this
action on behalf of all persons who were employed in one of our California
stores at any time after December 15, 1996. Plaintiffs seek compensatory and
exemplary damages, interest, penalties, attorneys' fees and disgorged profits in
an amount which plaintiffs estimated to be not less than $100,000,000.
Plaintiffs also seek injunctive relief requiring correction of the alleged
unlawful practices.
We believe that the material allegations of the complaint in the Bray
Lawsuit are false and that each of the claims asserted in the Bray Lawsuit is
meritless. We also believe that the settlement in the O'Hara Lawsuit bars some
of the claims asserted in the Bray Lawsuit. We intend to vigorously defend
against the Bray Lawsuit.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our security holders during the fourth
quarter of the fiscal year ended February 1, 2003.
13
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Information
Our Common Stock is traded on the NASDAQ National Market under the symbol
"FTUS." The following table sets forth the range of high and low sales prices on
the NASDAQ National Market of the Common Stock for the periods indicated, as
reported by NASDAQ. Such quotations represent inter-dealer prices without retail
markup, markdown or commission and may not necessarily represent actual
transactions.
High Low
---- ---
Fiscal 2001
-----------
13 weeks ended May 5, 2001 $42.62 $21.00
13 weeks ended August 4, 2001 $34.85 $18.00
13 weeks ended November 3, 2001 $23.55 $12.89
13 weeks ended February 2, 2002 $20.90 $14.17
Fiscal 2002
-----------
13 weeks ended May 4, 2002 $18.31 $11.35
13 weeks ended August 3, 2002 $16.49 $10.61
13 weeks ended November 2, 2002 $10.91 $ 1.11
13 weeks ended February 1, 2003 $ 5.64 $ 1.45
Fiscal 2003 ending January 31, 2004
-----------------------------------
Through April 25, 2003 $ 5.17 $ 1.67
As of April 25, 2003, we had approximately 236 stockholders of record and
approximately 2,082 beneficial stockholders.
Dividend Policy
We have never paid cash dividends on our Common Stock and do not anticipate
paying cash dividends in the foreseeable future. The declaration and payment of
any cash dividends on our Common Stock in the future will be determined by the
Board of Directors in light of conditions then existing, including our earnings,
financial condition, cash requirements and contractual, legal and regulatory
restrictions relating to the payments of dividends and any other factors that
our Board of Directors deems relevant. We are contractually prohibited from
paying cash dividends on our Common Stock under the terms of our existing
revolving credit facility and junior subordinated notes without the consent of
the lender and note holders. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources
- - Revolving Credit Facility."
14
Equity Compensation Plan Information
The following table sets forth information with respect to our common stock that
may be issued upon the exercise of stock options under our Amended and Restated
1997 Stock Option Plan, together with information relating to our common stock
that may be issued under plans not approved by stockholders.
(a) (b) (c)
Number of Securities
Remaining Available
Weighted for Future Issuance
Number of Average Under Equity
Securities to be Exerxise Compensation Plans
Issued Upon Exercise Price of (Excluding Securities
of Outstanding Outstanding Reflected in
Plan Category Options Options Column (a))
- ------------------ -------------------- ----------- ---------------------
Equity Compensation 1,273,404 $ 14.25 93,942
Plans Approved by
Stockholders
Equity Compensation Plans 450,000 $ 2.32 Not Applicable
Not Approved by
Stockholders*
- -------------------------------------------------------------------------------
* Represents shares of common stock to be issued under outstanding options in
connection with individual agreements described under "Compensation of
Directors and Executive Officers - Employment Contracts with Named Executive
Officers." All such shares will be issued under our Amended and Restated
1997 Stock Option Plan if approved by our stockholders, but have been
excluded from the calculation of shares to be issued under the Plan for
purposes of this table because we are contractually obligated to issue them
outside of the Plan if an appropriate amendment to the Plan is not approved.
Unregistered Sales of Securities
On March 6, 2003, we completed the private offering of 2,515,379 shares of our
common stock to accredited investors for aggregate proceeds of $5,712,804 (net
of placement agent fees of $217,415), together with a warrant to purchase an
additional 75,000 shares of our common stock. The warrant, issued to the
placement agent, is exercisable at a purchase price of $3.50 per share and
expires on March 6, 2006. This offering was exempt from registration under Rule
506 of Regulation D of the Securities Act of 1933.
15
Item 6. Selected Financial Data
The selected financial data set forth below, except for Operating Data, is
derived from our audited financial information and should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our Financial Statements, including the Notes, and Supplementary
Data included in this Annual Report on Form 10-K.
Fiscal Year Ended
-----------------
February 1, February 2, February 3, January 29, January 30,
2003 (1) 2002 (2) 2001 (3) 2000 (4) 1999 (5)
----------- ----------- ----------- ----------- ----------
(in thousands, except per share and operating data)
Statement of Operations Data
- ----------------------------
Net sales $ 535,270 $ 580,460 $ 555,670 $ 421,391 $ 338,223
Operating income (loss) (45,050) (16,786) 31,868 22,753 10,464
Income (loss) from continuing operations
before income taxes and extraordinary
items (46,661) (17,746) 30,322 20,481 6,275
Net income (loss) (28,509) (10,896) 21,264 12,442 2,269
Dividends on Series A preferred stock - - - - 2,593
Dividends on Series B preferred stock - - - - 2,210
Inducement to convert preferred stock to
common stock - - - - 2,804
Net income (loss) applicable to common stock (28,509) (10,896) 21,264 12,442 (5,338)
Weighted average shares outstanding
Basic 12,957 12,807 12,589 12,214 3,381
Diluted 12,957 12,807 13,066 12,864 3,381
Income (loss) before extraordinary items and
discontinued operations applicable to
common stock
Basic (2.20) (0.85) 1.69 1.02 (0.77)
Diluted (2.20) (0.85) 1.63 0.97 (0.77)
Net income (loss) per common stock
Basic (2.20) (0.85) 1.69 1.02 (1.58)
Diluted (2.20) (0.85) 1.63 0.97 (1.58)
Operating Data
- --------------
Number of stores at fiscal year end 244 279 243 187 168
Total selling square footage at fiscal
year end 3,021,000 3,459,000 2,979,000 2,169,000 1,804,000
Sales per average selling square foot $ 167 $ 178 $ 211 $ 209 $ 192
Comparable store sales increase (decrease) (7.7%) (8.7%) 4.4% 10.3% 10.9%
Balance Sheet Data
- ------------------
Working capital (deficit) $ (2,913) $ 14,633 $ 18,896 $ 1,241 $ (9,179)
Total assets 126,504 155,709 142,265 108,466 90,167
Long-term debt and revolving credit
facility, including current portion 15,746 10,376 11,218 11,067 13,773
Stockholders' equity 44,319 70,566 79,737 46,430 27,765
- ------------------------------------------------------------------------------------------------------
(1) Included the following pre-tax expenses:
(a) $16.1 million related to clearing slow-moving inventory and an
inventory valuation allowance (cost of sales),
(b) $2.8 million related to a long-term consulting project, which was
terminated in November 2002,
(c) $2.1 million related to a litigation settlement,
(d) $14.4 million related to fiscal 2002 restructuring efforts, partially
offset by a $5.0 million reserve reduction related to the fiscal 2001
restructuring efforts (as a result of favorable experience with lease
termination costs),
(e) $0.8 million related to the separation agreement of our former Chief
Executive Officer, and
(f) $2.2 million write-down of shareholders and trade notes receivable.
16
(2) Included pre-tax expenses of $21.2 million related to fiscal 2001
restructuring efforts, $0.5 million non-cash stock option charge, and $1.1
million related to the retirement and replacement of our former General
Merchandising Manager.
(3) Fiscal year included 53 weeks. Included pre-tax expenses of $4.8 million
non-cash charge for performance-based stock options, partially offset by a
$1.2 million condemnation award and $2.9 million after-tax reduction to our
tax valuation allowance.
(4) Included a pre-tax $2.1 million non-cash charge related to performance-
based stock options.
(5) Included pre-tax expenses of $1.0 million related to the merger of our
wholly-owned subsidiary, $2.4 million in connection with the hiring of our
President and Chief Executive Officer, and $2.8 million related to the
exchange of subordinated reorganization notes.
17
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis should be read in conjunction with the
information set forth under "Selected Financial Data" and "Financial Statements
and Supplementary Data."
General
We operate a chain of off-price retail apparel and houseware stores in Arizona,
Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and
Washington. We sell branded casual apparel for the family, as well as selected
domestic and household merchandise at prices that generally are significantly
lower than other discount stores.
During fiscal 2001, we faced a difficult economic environment with a slowing
economy, the impact of terrorist attacks on September 11, 2001 and a highly
promotional environment within the retail industry. In addition, our customers
and we experienced rising utility costs in California where half of our stores
are located. We believe that our core customers were economically disadvantaged
as a result of the difficult economic environment. Fiscal 2001 was a difficult
year for retailers, particularly those with an apparel emphasis. We experienced
declining comparable store sales, increased costs and declining operating
margins in fiscal 2001.
As part of our ongoing store evaluation process, in the fourth quarter of fiscal
2001, we reviewed our real estate portfolio and store operating performance and
decided to close 28 under-performing stores (i.e., stores that did not meet the
minimum financial performance criteria). We learned that in new markets, and
particularly in a difficult economic environment, we initially required a larger
population of our core demographic consumer to achieve our financial objectives.
In conjunction with the store closures, we realigned our field organization and
streamlined our workforce. As a result of these fiscal 2001 restructuring
initiatives, we recorded a pre-tax restructuring charge of $21.2 million,
including lease termination costs of $13.7 million, inventory liquidation costs
of $2.9 million, fixed asset write-downs of $2.1 million, employee termination
costs of $1.2 million and other costs of $1.3 million. As of April 25, 2003, we
had closed all of these under-performing stores and successfully terminated the
lease obligations of 21 stores. In light of the favorable experience related to
the costs of closing these stores, we reduced the reserve for the fiscal 2001
restructuring initiatives by approximately $5.0 million during the fourth
quarter of fiscal 2002.
During fiscal 2002, we continued to experience declining transaction counts,
declining purchase size, increased competition, rising operating costs and a
slow economy. These factors were exacerbated by the lingering effects of the
September 11 terrorist attacks and fear of war in Iraq. We have 59 stores that
are near military bases or the Mexican border that have been negatively impacted
due to increased security at border crossings and troop mobilizations.
We have experienced some significant changes in our senior management team in
fiscal 2002. In November 2002, we announced the appointment of our current
Chairman and Chief Executive Officer, William R. Fields. In addition, we
appointed Melvin Redman, Executive Vice President - Store Operations and
Distribution; Larry Kelley, Executive Vice President - Merchandising and
Marketing; and Edward Wong, Executive Vice President - Supply Chain and
Information Technology.
In December 2002, we announced the fiscal 2002 restructuring initiatives needed
to improve operating results. These initiatives included the closure of another
23 under-performing stores and consolidation of both the Company's distribution
center network and corporate overhead structure. Included in these 23 stores
identified for closing, seven represented management's decision to discontinue
operations in Louisiana and Tennessee. The consolidation of the Company's
distribution center network and corporate overhead structure is a result of the
anticipated opening of a new 600,000 square foot distribution center in San
Diego, California, and the planned reduction in store base. In connection with
the fiscal 2002 restructuring, we recorded a pre-tax restructuring charge of
approximately $14.4 million, including lease termination costs of approximately
$6.5 million, inventory liquidation costs of approximately $1.1 million, fixed
asset write-downs of approximately $5.0 million, employee termination costs of
approximately $1.0 million and other costs of approximately $0.8 million. We
also announced efforts to liquidate our slow-moving and aged inventory
chain-wide. We incurred a pre-tax charge of $16.1 million related to clearing
slow-moving inventory and an inventory valuation allowance.
18
As a result of our financial results over the past two fiscal years, bankruptcy
filings by a number of well-known retail chains during calendar year 2002 and
the general weak economic environment, shortly after the Christmas selling
season we experienced a tightening of credit extended to us by vendors, factors
and others for merchandise purchases. The initial impact of this credit
tightening was a disruption of product flow to our stores in January, February
and to a lesser extent March of 2003. This credit environment required us, in
many cases, to meet accelerated payment terms in order to re-establish a
consistent flow of product and assure a level of inventory for Spring 2003
business. The acceleration of payment terms, in turn, adversely affected our
liquidity and, to some extent, further weakened our existing credit standing.
In an effort to improve our liquidity position, obtain more reasonable credit
terms and provide for a consistent flow of merchandise to our stores, we
initiated a series of financing transactions, as well as initiated steps to
accelerate the recognition of tax loss carry-back benefits. On March 6, 2003, we
completed the private offering of approximately 2.5 million shares of our common
stock for an aggregate gross proceeds of approximately $5.7 million, net of
placement fees. In addition, during March of 2003, we received an $8.2 million
federal tax refund as a result of utilizing a tax loss carry-back benefit. On
April 10, 2003, we completed a $7.5 million debt financing transaction
consisting of a $6.5 million junior term note secured primarily by inventory and
a $1.0 million term note secured primarily by equipment and other assets. We
also anticipate completing a sale/leaseback transaction covering distribution
equipment to be located in our new Otay Mesa distribution center of between $3.0
million and $4.0 million in May 2003.
In April 2003, we have experienced an improved flow of merchandise product to
our stores, a loosening of credit from the credit community and improved
liquidity as a result of our capital raising efforts. To a large extent, our
ability to obtain merchandise in the future under credit terms that we have
received historically will depend upon our ability to improve future operating
results, including as measured by comparable store sales growth and improved
operating margins.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make
estimates, assumptions and judgments 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 sub-departments in which fairly homogeneous classes of
merchandise items having similar gross margin are grouped. In addition, failure
to take markdowns currently may result in an overstatement of cost under the
lower of cost or market principle. As of February 1, 2003, we had an inventory
valuation allowance of approximately $8.4 million, which represents our estimate
of the cost in excess of the net realizable value of all clearance items. 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.
19
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 amounts for the charges
and the related liabilities regarding our fiscal 2002 and fiscal 2001
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)." Depending on our ability to dispose of the
remaining lease obligations for the store and distribution center closures, the
actual costs to complete the restructuring initiatives may be different from our
estimated costs.
o Litigation reserves. Based in part on the advice 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 continuously evaluate the adequacy of these reserves
and, as new facts come to light, adjust these reserves when necessary.
o Workers' compensation accrual. At the beginning of fiscal 2001, we
transitioned to a partially self-insured workers' compensation program. The
program for the policy year ended January 31, 2002 had both a specific and
aggregate stop loss amount of $250,000 and $3.2 million, respectively. The
program for the policy year ended January 31, 2003 had a specific stop loss
amount of $250,000 with no aggregate stop loss limit. 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, 2003 and 2002 were estimated to be approximately $3.4 million and
$3.7 million ($3.2 million aggregate stop loss), respectively. 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.
20
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
We define our fiscal year by the calendar year in which most of our business
activity occurs (the fiscal year ended February 1, 2003 is referred to as fiscal
2002). The following table sets forth operating data expressed as a percentage
of net sales for the fiscal years indicated. Due to operational and strategic
changes, year-to-year comparisons of financial results may not be meaningful and
the historical results of our operations may not be indicative of our future
results.
Fiscal Year
-----------
2002 2001 2000
---- ---- ----
(percentage of net sales)
Net sales 100.0 100.0 100.0
Cost of sales 69.7 66.4 64.5
----- ----- -----
Gross profit 30.3 33.6 35.5
Selling and administrative expenses 36.6 32.4 27.7
Pre-opening expenses 0.2 0.5 1.0
Amortization of intangibles - 0.3 0.4
Restructuring charge 1.9 3.2 -
Condemnation award - - (0.2)
Stock-based compensation expense - 0.1 0.9
----- ----- -----
Operating income (loss) (8.4) (2.9) 5.7
Interest expense, net 0.3 0.2 0.3
----- ----- -----
Income (loss) before income taxes (8.7) (3.1) 5.5
Income taxes (benefit) (3.4) (1.2) 1.6
----- ----- -----
Net income (loss) (5.3) (1.9) 3.8
----- ----- -----
Fiscal 2002 Compared to Fiscal 2001
As of February 1, 2003, we operated 244 stores compared to 279 stores at
February 2, 2002. In fiscal 2002, we opened 12 new stores and closed 47 stores.
In fiscal 2001, we opened 39 new stores and closed three stores. The average
number of stores in operation in fiscal 2002 was 259 versus 262 in fiscal 2001.
Net sales were $535.3 million for fiscal 2002 compared to $580.5 million for
fiscal 2001, a decrease of $45.2 million or 7.8%. Comparable store sales
decreased 7.7% in fiscal 2002 versus a decrease of 8.7% in fiscal 2001. The
decrease in net sales was due to fewer stores in operation as well as negative
comparable store sales. Comparable store sales decreased primarily as a result
of continuing slow economy, threat of terrorist attacks, threat of war with
Iraq, increased price competition, and to a lesser extent, increased utilities
and fuel costs in California, our largest market. As a result of these factors,
we experienced fewer transactions and a reduced purchase size. Compounding this,
apparel is considered a deferrable purchase for our core customers who have
limited discretionary income. Apparel and houseware purchases may be reduced and
deferred in favor of more current needs such as food, housing, utilities and
transportation.
Gross profit was $162.4 million for fiscal 2002 compared to $195.1 million for
fiscal 2001, a decrease of $32.7 million or 16.8%. As a percentage of net sales,
gross profit was 30.3% in fiscal 2002 compared to 33.6% in fiscal 2001, or a 330
basis-point decline versus fiscal 2001. Included in fiscal 2002 cost of sales
were (1) a non-cash charge of $16.1 million related to clearing slow-moving
inventory and an inventory valuation allowance, (2) a non-cash charge of $1.1
million related to the expected inventory liquidation cost for store closings
identified in the previously mentioned fiscal 2002 restructuring, and (3) a
non-cash adjustment of $1.3 million to reduce excess reserve for inventory
liquidation cost related to stores closed under the fiscal 2001 restructuring
plan. The inventory valuation allowance represented a "lower of cost or market"
adjustment related to approximately $16.3 million of aged and slow-moving items
that we decided to liquidate by April 2003. As previously reported, the fiscal
2001 gross margin reflected a non-cash charge of $2.9 million related to the
21
estimated inventory liquidation cost for the closing of 28 under-performing
stores identified in the fiscal 2001 restructuring plan. After giving effect to
restructuring charges in both years, gross profit margin declined primarily due
to higher markdown volume (260 basis points). The higher markdown volume was
related to a very heavy promotional environment and clearance of slow-moving and
aged merchandise.
Selling and administrative expenses were $196.4 million for fiscal 2002 compared
to $188.3 million for fiscal 2001, an increase of $8.1 million or 4.3%. As a
percentage of net sales, selling and administrative expenses were 36.6% for
fiscal 2002 compared to 32.4% for fiscal 2001. The increase in selling and
administrative spending as a percentage of net sales was both spending related
and sales volume related. Included in fiscal 2002 selling and administrative
expenses were (1) consulting fees of $2.8 million in connection with a
consulting agreement, which was terminated in November 2002, (2) a charge of
$2.1 million recorded during the second quarter in conjunction with the
settlement of litigation, (3) a non-cash charge of $1.2 million to adjust the
value of certain shareholders' notes receivable, and (4) a non-cash valuation
allowance of $1.0 million for an uncollectible note receivable due from one of
our vendors. In addition to these items, we experienced an increase of
approximately $3.5 million in advertising expense. The higher advertising
expense was due to increased advertising circulars in response to a very
competitive promotional environment. Other store selling expenses, which
included store labor and store occupancy, were lower than fiscal 2001 primarily
due to the lower average number of stores in operation.
Pre-opening expenses were $1.1 million for fiscal 2002 compared to $3.1 million
for fiscal 2001, a decrease of $2.0 million, or 64.8%. The decrease in
pre-opening expenses was primarily related to 12 new store openings this year
versus 39 new store openings last year. Current year pre-opening expenses
included a $250,000 lease termination fee for a store we decided not to open.
Amortization of intangibles was not recorded for fiscal 2002 compared to $1.7
million for fiscal 2001. The change was due to the elimination of goodwill
amortization in conjunction with the adoption of Statement of Financial
Accounting Standards ("SFAS") No. 142 and cessation of amortization associated
with prior business acquisitions.
During the fourth quarter of this year, we recorded a charge of $14.4 million in
relation to our previously announced fiscal 2002 restructuring efforts. The
charge of $14.4 million included a non-cash inventory liquidation cost of $1.1
million, which was included in cost of sales. In addition, as a result of
favorable experience related to the costs of closing the 28 stores included in
our fiscal 2001 restructuring plan, we recorded a favorable adjustment of
approximately $5.0 million to reduce the reserve established for the fiscal 2001
restructuring plan. Included in this reserve reduction was $1.3 million related
to inventory liquidation cost, which was reported as part of cost of sales. As
such, the total amount reported as a restructuring charge for fiscal 2002 was
$9.9 million versus $18.3 million for fiscal 2001. The restructuring charge of
$18.3 million in fiscal 2001 was part of the $21.2 million charge related to our
restructuring initiatives, as previously discussed. We recorded $2.9 million of
the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which
was included in cost of sales.
We recorded non-cash stock-based compensation expense related to certain
performance-based stock options during fiscal 2001 in the amount of $456,000.
During the second quarter of fiscal 2001, we removed the market price hurdle of
$49.78 for 19,361 stock options held by a former Executive Vice President who
retired in August 2001. As a result of the removal of the market price hurdle,
we incurred a non-cash charge of $456,000. There was no stock-based compensation
expense incurred in fiscal 2002.
Interest expense, net was $1.6 million in fiscal 2002 versus $960,000 in fiscal
2001, an increase of $651,000 or 67.8%. The increase was due to higher average
outstanding borrowings on the revolving credit facility.
We recorded a federal and state income tax benefit of $18.2 million in fiscal
2002 versus $6.9 million in fiscal 2001, an increase of $11.3 million or 165.0%.
The increase was due to an increased pre-tax loss incurred in the current year
compared to the prior year.
22
Fiscal 2001 Compared to Fiscal 2000
As of February 2, 2002, we operated 279 stores compared to 243 stores as of
February 3, 2001. In fiscal 2001, we opened 39 new stores and closed 3 stores.
In fiscal 2000, we opened 70 stores and closed 12 stores. Fiscal 2001 was a
52-week fiscal year as compared to a 53-week fiscal year for fiscal 2000.
Net sales were $580.5 million for fiscal 2001 compared to $555.7 million for
fiscal 2000, an increase of $24.8 million or 4.5%. Excluding the extra week of
sales (53rd week) in fiscal 2000, net sales for fiscal 2001 increased 6.1%.
Comparable store sales decreased 8.7% in fiscal 2001 versus an increase of 4.4%
in fiscal 2000. The increase in net sales was related to new store growth offset
by negative comparable store sales. The average number of stores in operation
was 262 for fiscal 2001 compared to 215 for fiscal 2000, an increase of 21.7%.
Comparable store sales decreased primarily, we believe, due to a slow economy,
increased competition, the effects of September 11 terrorist attacks, and to a
lesser extent, increased utilities and fuel costs in California, our largest
market. These factors weighed heavily on our core customers and resulted in
reduced traffic counts. Compounding this, apparel and housewares are deferrable
purchases for our core customers who have limited discretionary income. Apparel
and houseware purchases may be reduced or deferred in favor of more current
needs such as food, housing, utilities and transportation. In addition, we
experienced a promotional and competitive holiday season. The highly promotional
environment was evidenced by the post-Thanksgiving offerings by many big box
discounters, which enticed consumers in with "close to cost or below cost" items
in the electronics and hard goods categories.
Gross profit was $195.1 million for fiscal 2001 compared to $197.3 million for
fiscal 2000, a decrease of $2.2 million or 1.1%. The fiscal 2001 gross profit
reflected a non-cash charge of $2.9 million related to the anticipated inventory
liquidation cost for the closing of the 28 under-performing stores as previously
mentioned. As a percentage of net sales, gross profit was 33.6% in fiscal 2001
compared to 35.5% in fiscal 2000. After giving effect for the non-cash charge,
the decline in gross profit percentage was primarily attributable to higher
markdown volume, partially offset by improved initial markup and favorable
distribution costs. The higher markdown volume was related to a very heavy
promotional environment during the holiday season and earlier clearance of
merchandise than a year ago.
Selling and administrative expenses were $188.3 million for fiscal 2001 compared
to $154.4 million for fiscal 2000, an increase of $33.9 million or 22.0%. As a
percentage of net sales, selling and administrative expenses were 32.4% for
fiscal 2001 compared to 27.8% for fiscal 2000. The increase in selling and
administrative spending as a percentage of net sales was both spending related
and sales volume related. The unfavorable spending variance was primarily due to
higher store labor, store occupancy and advertising expenses. The increase in
store labor was primarily due to minimum wage increases for both hourly and
salaried associates, higher health care and workers' compensation costs. The
increase in store occupancy was due to higher rent and depreciation expense for
new stores. The increase in advertising was due to increased promotional
activity based on competition in the marketplace.
Pre-opening expenses were $3.1 million for fiscal 2001 compared to $5.4 million
for fiscal 2000, a decrease of $2.3 million, or 42.5%. The decrease in
pre-opening expenses was related to 39 new store openings in fiscal 2001 versus
70 new store openings in fiscal 2000, as well as $1.0 million recorded in fiscal
2000 associated with the opening of our distribution center in Lewisville,
Texas, which became fully operational in February 2001.
Amortization of intangibles was $1.7 million for fiscal 2001 compared to $2.1
million for fiscal 2000. The reduction in amortization of $410,000 represented
the cessation of amortization associated with certain costs incurred in the
ownership change of the company in fiscal 1997.
The restructuring charge of $18.3 million was part of the total $21.2 million
charge related to our restructuring initiatives, as previously discussed. We
recorded $2.9 million of the pre-tax $21.2 million charge as a non-cash
inventory liquidation cost which was included in cost of sales.
23
We recorded a non-recurring gain of $1.2 million during fiscal 2000 related to a
condemnation award from the City of San Diego for a store located in downtown
San Diego, California.
We recorded non-cash stock-based compensation expense related to certain
performance-based stock options during fiscal 2001 in the amount of $456,000
compared to $4.8 million for fiscal 2000. During the second quarter of fiscal
2001, we removed the market price hurdle of $49.78 for 19,361 stock options held
by a former Executive Vice President who retired in August 2001. As a result of
the removal of the market price hurdle, we incurred a non-cash charge of
$456,000. In fiscal 2000, we recorded non-cash stock-based compensation expense
in the amounts of $2.7 million in July 2000 and $2.1 million in August 2000 when
stock options with market price hurdles of $24.89 and $33.19, respectively,
became exercisable.
Interest expense, net was $960,000 in fiscal 2001 versus $1.5 million in fiscal
2000, a decrease of $586,000 or 37.9%. The decrease was attributable to lower
average borrowings and lower interest rates under our revolving credit facility
and interest income received from the Internal Revenue Service related to tax
refund due for prior years.
We recorded a federal and state income tax benefit of $6.9 million in fiscal
2001 and a federal and state income tax provision of $9.1 million in fiscal
2000. The income tax benefit was due to the loss we incurred in fiscal 2001. The
income tax provision recorded in fiscal 2000 included a favorable adjustment of
$2.9 million to our income tax provision for a reduction in our tax valuation
allowance and recognition of additional net operating loss carry forwards.
Liquidity and Capital Resources
General
We finance our operations through credit provided by vendors and other
suppliers, amounts available under our $50.0 million revolving credit facility,
internally generated cash flow and other financing resources. Credit terms
provided by vendors and other suppliers are generally net 30 days. Amounts that
may be borrowed under the revolving credit facility are based on a percentage of
eligible inventories and receivables, as defined, outstanding from time-to-time.
At February 1, 2003, we were in compliance with all financial covenants, as
defined, and had outstanding borrowings of $6.3 million and letters of credit of
$5.1 million under our revolving credit facility. At February 1, 2003, based on
eligible inventory and accounts receivable, we were eligible to borrow $32.5
million under our revolving credit facility and had $13.6 million available for
future borrowings after giving effect for the $7.5 million availability block,
as defined.
Since February 1, 2003, we have completed, or expect to complete, a series of
financing transactions designed to add liquidity and strengthen our financial
position. These financing transactions should, provided we do not experience
continued comparable store sales declines and a tightening of credit from our
vendors and/or the credit community, along with our $50.0 million revolving
credit facility, provide sufficient funds to finance our operations and capital
expenditures, pay our debt obligations, and complete the closing of stores and
distribution centers included in our fiscal 2002 restructuring and fiscal 2001
restructuring efforts over the next twelve months.
On March 6, 2003, we completed the private offering of approximately 2.5 million
shares of our common stock for aggregate proceeds of approximately $5.7 million,
net of placement fees. On April 10, 2003, we completed a $7.5 million debt
financing transaction, which consists of a $6.5 million junior term note secured
primarily by inventory and accounts receivable and a $1.0 million term note
secured primarily by equipment and other assets. In addition, we received a
federal tax refund of $8.2 million in March 2003. We also anticipate completing
a sale/leaseback transaction covering distribution equipment to be located in
our new Otay Mesa distribution center of between $3.0 million and $4.0 million
in the second quarter of fiscal 2003.
24
At April 25, 2003, we were in compliance with all financial covenants, as
defined, and had outstanding borrowings of $7.4 million and letters of credit of
$12.3 million under our revolving credit facility. In addition, based on
eligible inventory and accounts receivable, we were eligible to borrow $45.0
million under our revolving credit facility and had $17.8 million available for
future borrowings after giving effect for the $7.5 million availability block,
as defined.
Cash Flows
In fiscal 2002, net cash used in operating activities was $8.1 million versus
$26.9 million generated in fiscal 2001. The decrease in cash flow from operating
activities was primarily due to the higher cumulative operating loss and the
reduced number of days payables outstanding this year.
In fiscal 2002 and 2001, cash used in investing activities was $11.0 million and
$12.7 million, respectively. Fiscal 2002's investing activities were related to
capital expenditures for the development of our new Otay Mesa distribution
center, new stores development, replacement capital for existing stores,
information system hardware upgrades and replacements, and other general
corporate purposes.
In fiscal 2002, our financing activities produced a net cash flow of $5.2
million, including $6.3 million of net borrowings on our revolving credit
facility, $918,000 in proceeds from the exercise of stock options, partially
offset by $2.0 million in repayments of our junior subordinated notes and
capital lease obligations. In fiscal 2001, we used $1.5 million for our
financing activities, including a payment of $2.2 million for our junior
subordinated notes and capital lease obligations, partially offset by $523,000
in proceeds from the exercise of stock options.
Revolving Credit Facility
We have a $50.0 million revolving credit facility with a financial institution.
Under this revolving credit facility, we may borrow up to 70% of our eligible
inventory and 85% of our eligible accounts receivable, as defined, up to $50.0
million. The credit facility also included a $15.0 million sub-facility for
letters of credit. In September 2002, we extended the term of this revolving
credit facility until March 2006. As of February 1, 2003, interest on the credit
facility was at the prime rate plus 0.50%, or at our election, LIBOR plus 2.50%.
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
1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. The
revolving credit facility provides for a $7.5 million availability block against
our availability calculation as defined. 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.
On February 14, 2003, we obtained the approval from the lender to expand the
scope of the collateral securing the obligations and increased the sub-facility
for letters of credit to $15.0 million. In addition, we obtained the lender's
consent to the incurrence by us of up to $10.0 million in additional
indebtedness, which may be secured by a junior lien on the collateral.
At February 1, 2003, we were in compliance with all financial covenants, as
defined, and had outstanding borrowings of $6.3 million and letters of credit of
$5.1 million under our revolving credit facility. At February 1, 2003, based on
eligible inventory and accounts receivable, we were eligible to borrow $32.5
million under our revolving credit facility and had $13.6 million available
after giving effect for the $7.5 million availability block, as defined.
On April 10, 2003, we amended the terms of our revolving credit facility to add
$7.5 million of term loans, to add one financial covenant, and to amend certain
reporting provisions and other terms. The term loans consist of a $6.5 million
junior term note secured primarily by inventory and accounts receivable and a
$1.0 million term note secured primarily by equipment and other assets. These
notes bear interest at the rate of 14.50% per annum on the then current
outstanding balance, and mature on April 10, 2004. The $6.5 million junior term
note can be extended for one additional year. The financial covenant, which is
related to achieving a minimum earnings before interest, tax obligations,
depreciation and amortization expense (EBITDA), as defined, is subject to
testing only if the Triggering Availability, as defined, is less than $10.0
million on the last three days of each month commencing on May 3, 2003. This
financial covenant will terminate at such time that the $7.5 million term loans
are no longer outstanding.
At April 25, 2003, we were in compliance with all financial covenants, as
defined, and had outstanding borrowings of $7.4 million and letters of credit of
$12.3 million under our revolving credit facility. In addition, based on
eligible inventory and accounts receivable, we were eligible to borrow $45.0
million under our revolving credit facility and had $17.8 million available for
future borrowings after giving effect for the $7.5 million availability block,
as defined.
25
Junior Subordinated Notes
The Junior Subordinated Notes are non-interest bearing and are reflected on our
balance sheets at the present value using a discount rate of 10%. As of February
1, 2003, the Junior Subordinated Notes had a face value of $11.3 million and a
related unamortized discount of $1.9 million, resulting in a net carrying value
of $9.4 million. The discount is amortized to interest expense as a non-cash
charge until the notes are paid in full. We made a principal payment on the
Junior Subordinated Notes of $2.0 million in January 2003. Additional principal
payments are scheduled on December 31, 2003 ($3.0 million), December 31, 2004
($3.0 million) and a final payment on May 28, 2005 ($5.3 million).
Capital Expenditures
We anticipate capital expenditures of approximately $5.0 million in fiscal 2003,
which includes costs to open new stores, replacement capital for existing
stores, information systems software upgrades and hardware replacement and
development of our new San Diego distribution center. This new distribution
center, projected to open during the second quarter of fiscal 2003, will be
approximately 600,000 square feet and will have the capability to service up to
400 stores. The total capital expenditures for this facility will be
approximately $4.5 million, of which we have already paid approximately $4.0
million.
Store Closures and Restructuring Initiatives
In fiscal 2002, we closed a total of 47 stores; 28 of them were under-performing
stores identified in our fiscal 2001 restructuring initiatives, 13 of them were
under-performing stores identified in our fiscal 2002 restructuring initiatives,
and six of them were due to lease expirations. Subsequent to February 1, 2003,
we closed two under-performing stores identified in our fiscal 2002
restructuring initiatives. In addition, we have decided to keep operating two of
the under-performing stores as a result of entering into agreements with the
landlords to reduce the rent expense for these two locations. We plan to close
the remaining six under-performing stores identified in our fiscal 2002
restructuring initiatives by January 2004.
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 our field organization and workforce
reductions as part of our restructuring initiatives. As of April 25, 2003, we
had substantially completed the realignment and workforce reductions in our
field organization and corporate overhead structure.
Upon the opening of the new San Diego distribution center during the second
quarter of fiscal 2003, we will close the two existing San Diego distribution
facilities. The next distribution consolidation initiative will be to transfer
our Texas distribution function to the new San Diego distribution center. We are
currently marketing our Texas distribution facility and intend to close this
facility if we are able to successfully terminate our lease or sublet the
facility. No date for this closure has been established.
Currently, we estimate the cash requirement in fiscal 2003 related to our
restructuring efforts will be approximately $11.1 million. We believe that our
sources of cash, including the revolving credit facility and other financing
resources, should be adequate to fund our restructuring cash requirements.
26
Contractual Obligations and Commitments
The following table summarizes, as of February 1, 2003, certain of our
contractual obligations, as well as estimated cash requirements related to our
restructuring initiatives. This table should be read in conjunction with "Note 2
Fiscal 2002 Restructuring Charge", "Note 3 Fiscal 2001 Restructuring Charge",
"Note 8 Long-Term Debt and Revolving Credit Facility" and "Note 10 Lease
Commitments" in the accompanying financial statements.
Junior
Subordinated Operating Restructuring
Notes Leases Charges Total
------------- --------- ------------- -----
Fiscal Year:
2003 $ 3,000 $ 29,903 $ 11,117 $ 44,020
2004 3,000 27,626 1,747 32,373
2005 5,300 24,264 - 29,564
2006 - 18,111 - 18,111
2007 - 13,076 - 13,076
Thereafter - 44,422 - 44,422
------------- --------- ------------- ---------
Total $ 11,300 $ 157,402 $ 12,864 $ 181,566
------------- --------- ------------- ---------
Recent Accounting Pronouncements
In April 2002, the Financial Accounting Standards Board (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.
In November 2002, the FASB issued Interpretation No. ("FIN") 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" ("FIN 45"), which requires elaborating on
the disclosures that must be made by a guarantor in financial statements about
its obligations under certain guarantees. It also requires that a guarantor
recognize, at the inception of certain types of guarantees, a liability for the
fair value of the obligation undertaken in issuing the guarantee. The disclosure
requirements of FIN 45 are effective for financial statements issued after
December 15, 2002, and have been applied in the presentation of the accompanying
consolidated financial statements. The recognition requirements of FIN 45 are
applicable for guarantees issued or modified after December 31, 2002. We have
not yet determined the effect, if any, the recognition requirement for
guarantees issued or modified after December 31, 2002 will have on our business,
results of operations and financial condition.
27
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123,
"Accounting for Stock-Based Compensation" to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. We will continue to apply the
disclosure-only provisions of SFAS No. 123. Furthermore, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based compensation and the effect of the method used on reported results.
Certain of the disclosure modification are required for fiscal years ending
after December 15, 2002. We adopted the annual disclosure provision of SFAS No.
148 for our fiscal 2002 ended February 1, 2003. The interim disclosure
provisions are effective for financial reports containing condensed financial
statements for interim periods beginning after December 15, 2002. We will adopt
the disclosure requirement for interim financial statements in the first quarter
of fiscal 2003.
In January 2003, the FASB issued FIN 46 - "Consolidation of Variable Interest
Entities." FIN 46 clarifies the application of Accounting Research Bulletin No.
51 - Consolidated Financial Statements to those entities defined as "Variable
Interest Entities" (more commonly referred to as special purpose entities) in
which equity investors do not have the characteristics of a "controlling
financial interest" or do not have sufficient equity at risk for the entity to
finance its activities without additional subordinated financial support from
other parties. FIN 46 applies immediately to all Variable Interest Entities
created after January 31, 2003, and by the beginning of the first interim or
annual reporting period commencing after June 15, 2003 for Variable Interest
Entities created prior to February 1, 2003.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to interest rate risk on our fixed rate debt obligations. At
February 1, 2003, fixed rate debt obligations totaled approximately $11.3
million. The fixed rate debt obligations are non-interest bearing and are
discounted at a rate of 10%, resulting in a net carrying value of $9.4 million.
Maturities are $3.0 million, $3.0 million and $5.3 million in fiscal 2003, 2004
and 2005, respectively. While generally an increase in market interest rates
will decrease the value of this debt, and decreases in 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 February 1, 2003.
28
Item 8. Financial Statements and Supplementary Data
INDEX TO FINANCIAL STATEMENTS Page
- ----------------------------- ----
FACTORY 2-U STORES, INC.
Report of Independent Public Accountants F-1
Report of Independent Public Accountants (Arthur Andersen LLP) F-2
Balance Sheets as of February 1, 2003 and February 2, 2002 F-3
Statements of Operations for Fiscal Years Ended February 1, 2003,
February 2, 2002 and February 3, 2001 F-5
Statements of Stockholders' Equity for Fiscal Years Ended February 1, 2003,
February 2, 2002 and February 3, 2001 F-6
Statements of Cash Flows for Fiscal Years Ended February 1, 2003,
February 2, 2002 and February 3, 2001 F-7
Notes to Financial Statements F-9
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
On April 24, 2002, the Board of Directors of the Company, on the recommendation
of the Audit Committee, determined not to renew the engagement of its
independent public accountants, Arthur Andersen LLP ("Andersen"), for the fiscal
year ended February 1, 2003.
During the Company's fiscal years ended February 2, 2002 and February 3, 2001,
and the subsequent interim period through April 24, 2002, there were no
disagreements between the Company and Andersen on any matter of accounting
principles or practices, financial statement disclosures, or auditing scope or
procedure, which disagreements, if not resolved to the satisfaction of Andersen,
would have caused Andersen to make reference to the matter of the disagreement
in connection with their reports. Andersen's reports on the Company's financial
statements for each fiscal year ended February 2, 2002 and February 3, 2001 did
not contain an adverse opinion or disclaimer of opinion, nor were they qualified
or modified as to uncertainty, audit scope or accounting principles.
Andersen's report on the Company's financial statements for the fiscal year
ended February 2, 2002, dated February 27, 2002, was issued on an unqualified
basis in conjunction with the filing of Factory 2-U's Annual Report on Form 10-K
for the fiscal year ended February 2, 2002 filed on April 19, 2002 with the
Securities and Exchange Commission.
None of the reportable events described under Item 304 (a) (1) (v) of Regulation
S-K occurred within Factory 2-U's two most recent fiscal years and subsequent
interim period through April 24, 2002.
29
PART III
Item 10. Directors and Executive Officers of the Registrant
Directors
The following table sets forth as of April 25, 2003 certain information
concerning our directors.
Served on the Expiration of
Name Age Position Board Since Term as Director
---- --- -------- ------------- ----------------
Peter V. Handal 60 Director 1997 2004
Ronald Rashkow 62 Director 1997 2004
Wm. Robert Wright II 35 Director 1998 2004
William R. Fields 53 Director, Chairman of the Board 2002 2005
and Chief Executive Officer
Willem F.P. de Vogel 52 Director 2000 2003
Peter V. Handal has been a director since February 1997. Mr. Handal is
President and Chief Executive Officer of Dale Carnegie & Associates. Since 1990,
he has been President of COWI International Group (a management consulting
firm). Mr. Handal is also Chief Executive Officer of J4P Associates LP (a real
estate developer). He serves on the Board of Directors of Dale Carnegie &
Associates, Cole National Corporation and W. Kruk, S.A.
Ronald Rashkow was appointed by the Board of Directors to the position of
Lead Director effective November 2002. Mr. Rashkow has been a director since
February 1997. He has been a principal of Chapman Partners, L.L.C., an
investment banking firm, since its founding in September 1995. For more than
five years prior to that, he served as Chief Executive Officer and Chairman of
the Board of Directors of Handy Andy Home Improvement Centers, Inc. (a building
supply retailer started by his family in 1946).
Wm. Robert Wright II has been a director since November 1998. He has been a
managing partner of Grey Mountain Partners, LLC, a private equity firm that
invests in middle market companies, since its founding in January 2003. Prior to
that, he was employed by TCR from 1992 through 2002, except for a period from
July 1993 to August 1995 when he was in a graduate program at Harvard
University. His last position with TCR was "managing partner", a title he held
from 1999 to 2002.
William R. Fields has been a director, Chairman of the Board and Chief
Executive Officer since November 2002. Prior to joining us, from 1999 to October
2002, Mr. Fields served as Chairman and Chief Executive Officer of Apec China
Asset Management, Ltd. From 1997 to 1999, he served as President and Chief
Executive Officer of Hudson's Bay Company. Prior to that, from 1996 to 1997, Mr.
Fields served as Chairman and Chief Executive Officer of Blockbuster
Entertainment Group. From 1993 to 1996, Mr. Fields served as President and Chief
Executive Officer of Wal-Mart Stores Division. Mr. Fields currently serves on
the Boards of Directors of Lexmark International, a publicly traded company, and
The University of Texas Pan-American Foundation.
Willem F.P. de Vogel has been a director since December 2000. Mr. de Vogel
has served as the President of Three Cities Research, Inc., a firm engaged in
the investment and management of private capital, since 1982.
30
Executive Officers
The following table sets forth as of April 25, 2003 certain information
concerning our executive officers at the end of fiscal 2002, who are not
directors.
Name Age Position Officer Since
---- --- -------- -------------
Norman G. Plotkin 49 Executive Vice President - Store 1998
Development, Human Resources and
General Counsel
Douglas C. Felderman 50 Executive Vice President and 1999
Chief Financial Officer
Michael J. Hein 54 Senior Vice President - 2002
Distribution and Transportation
Edward Wong 46 Executive Vice President - 2002
Supply Chain and Information
Technology
Larry I. Kelley 58 Executive Vice President - 2003
Merchandising and Marketing
Melvin C. Redman 52 Executive Vice President - Store 2003
Operations and Distribution
Norman G. Plotkin is Executive Vice President - Store Development, Human
Resources and General Counsel. In addition to his responsibilities of Store
Development and General Counsel, Mr. Plotkin assumed responsibility over Human
Resources as of January 2003. Mr. Plotkin joined us in July 1998 in the position
of Senior Vice President - Store Development and General Counsel. Prior to
joining us, Mr. Plotkin was the President of Normark Real Estate Services, Ltd.,
a commercial real estate firm based in Des Plaines, Illinois. Prior to that,
from 1988 until 1996, Mr. Plotkin was the Senior Vice President of Finance and
Administration and General Counsel of Handy Andy Home Improvement Centers, Inc.
Douglas C. Felderman is Executive Vice President and Chief Financial
Officer. Mr. Felderman joined us in May 1999. Prior to joining us, from July
1997 to May 1999, Mr. Felderman served as Senior Vice President - Finance and
Chief Financial Officer of Strouds, Inc. and from 1995 to 1997, he was the Vice
President - Finance of Strouds, Inc. Mr. Felderman served as Vice President,
Chief Financial Officer for Crocodile Enterprises, Inc. from April 1994 to
September 1995 (a restaurant operator of casual full service and quick service
restaurants). From September 1990 to April 1994, he was a business consultant.
Michael J. Hein is Senior Vice President - Distribution and Transportation.
Mr. Hein joined us in March 2000 as Vice President of Transportation and
Distribution and served in that position until his promotion to Senior Vice
President of Distribution and Transportation in August 2002. Prior to joining
us, from April 1995 to March 2000, Mr. Hein served as the Director of
Distribution for Petco Animal Supplies, Inc.
Edward Wong is Executive Vice President - Supply Chain and Information
Technology. Mr. Wong joined us in May 2002 as Vice President - Planning and
Allocation and was promoted to his current position in August 2002. Prior to
joining us, from July 2001 to May 2002, Mr. Wong served as the Vice President of
Solution Design for ProfitLogic, Inc. From January 2001 to May 2001, he served
as Vice President, Retail Engagement Executive for i2 Technologies. From August
1998 to December 2000, Mr. Wong served as Senior Vice President of Supply Chain
and Technology for Gymboree Corporation. Prior to that, Mr. Wong served as
Divisional Vice President of Retail Planning and Allocation for Eddite Bauer,
Inc. from May 1997 to July 1998.
31
Larry I. Kelley is Executive Vice President - Merchandising and Marketing.
Mr. Kelley joined us in January 2003. Prior to joining us, from February 2001 to
December 2002, Mr. Kelley served as a principal of Renaissance Partners, LC, a
consulting firm for the retail industry. Mr. Kelley served as President and
Chief Executive Officer for One Price Clothing Stores from May 1997 through
January 2001. From April 1991 through April 1997, Mr. Kelley served as President
and Chief Executive Officer of Casual Male Big and Tall, a retail apparel chain.
Melvin C. Redman is Executive Vice President - Store Operations and
Distribution. Mr. Redman joined us in January 2003. Prior to joining us, from
October 1995 to January 2003, Mr. Redman served as President and Managing
Partner of Redman and Associates, a management consulting firm. Mr. Redman was
the President and Chief Operating Officer of MSC Industrial Supply from January
1999 to March 1999. From October 1991 to June 1995, Mr. Redman was the Senior
Vice President of Store Operations for Wal*Mart Stores and from December 1984 to
October 1991 he was the Regional Vice President of Store Operations for Wal*Mart
Stores.
Item 11. Executive Compensation
Compensation of Directors
We pay each director who is not an employee of ours or of TCR an annual fee of
$12,000 plus $1,250 for attendance at each meeting of the Board of Directors.
In addition, at the end of each fiscal quarter, we grant each director who is
not an employee 250 shares of common stock. Prior to June 19, 2002, at the end
of each fiscal quarter, we also granted each director who is not an employee
options to purchase 500 shares of our common stock. Since June 19, 2002, the
directors who were not employees of the Company, no longer received quarterly
grants of options to purchase our common stock, but instead received at the end
of each fiscal quarter, a cash payment equal to the closing market price on such
date times 500. Mr. Rashkow received the above-described compensation until
November 4, 2002 when he was appointed to the position of Lead Director, at
which time he received the compensation described below.
We reimburse all directors for any out-of-pocket travel expenses incurred in
attending meetings.
Ronald Rashkow Lead Director Agreement
On November 4, 2002, Mr. Rashkow was appointed to the newly created position of
Lead Director by our Board of Directors under the terms of an agreement. Mr.
Rashkow's service as Lead Director will continue at the pleasure of the Board of
Directors for up to three years. Under the terms of his agreement, Mr. Rashkow
receives monthly compensation of $12,500, plus reimbursement of all reasonable
out-of-pocket travel and other expenses related to the performance of his duties
as Lead Director. He is also entitled to receive $3,500 per day, plus
reimbursement of all reasonable out-of-pocket travel and other expenses related
to the performance of his duties as Lead Director, for each day of service in
excess of six days per quarter.
As an inducement to secure his services as Lead Director, Mr. Rashkow also
received options to purchase 50,000 shares of our common stock at an exercise
price of $1.61, the fair market value of our common stock on the date of grant.
The options vested immediately and are exercisable for five years from the date
of grant. As a further inducement to secure his services, Mr. Rashkow also
received 25,000 shares of restricted common stock, subject to his completion of
12 months of service as Lead Director. Mr. Rashkow has a target grant of 25,000
similar shares of restricted common stock, subject to his completion of 24
months of service, and another 25,000 shares subject to his completion of 36
months of service. His receipt of these restricted shares, in addition to the
length of service requirement, will be commensurate with our Chief Executive
Officer's achievement of his performance goals for the applicable year.
32
Compensation of Executive Officers
Employment Contracts with Named Executive Officers
Compensation of the Chief Executive Officer
Mr. Fields' annual base salary is $750,000, which the Compensation Committee
believes is commensurate with the salaries paid to other executives with similar
experience in comparable companies. We base Mr. Fields' annual bonus on the
achievement of corporate objectives set annually by the Compensation Committee
after consultation with Mr. Fields.
William Fields Employment Agreement
We employed Mr. Fields, Chairman of our Board of Directors and Chief Executive
Officer, pursuant to a one-year employment agreement dated November 7, 2002 that
expires on November 6, 2003, provided that at the scheduled end of the initial
employment term, and on each anniversary thereafter, his employment term will be
automatically extended for an additional one-year period unless either Mr.
Fields or we give notice to the other at least 90 days before an extension is to
take effect that either does not desire the employment term to be extended.
Under the employment agreement, Mr. Fields' base salary is $750,000 annually.
For the first year of his employment term, Mr. Fields is entitled to a bonus of
$375,000, payable in 12 monthly installments. Mr. Fields was required to prepare
and present to the Compensation Committee written performance objectives for the
fiscal year ending January 31, 2004. Following approval by the Compensation
Committee of the performance objectives, Mr. Fields' target bonus for the fiscal
year ending January 31, 2004 is 75% of his annual base salary for that year. For
each subsequent fiscal year in which he meets performance objectives approved in
advance by the Compensation Committee, Mr. Fields' target bonus will be based on
100% of his base salary in effect as of the start of that fiscal year.
As an inducement necessary to secure his services, we granted Mr. Fields
non-qualified options to purchase 250,000 shares of our common stock at an
exercise price per share of $1.68, the fair market value of our stock on the
date of grant. These options vest in tranches of 15,625 shares on each December,
March, June and September 30 during the first four years of his employment term.
The options in each tranche will be exercisable for a period of five years after
the vesting of that tranche. In the event that an amendment to our stock option
plan has not been approved by our stockholders, we are nevertheless
contractually obligated with respect to such options which would not be granted
under our stock option plan.
As a further inducement necessary to secure his services, we also granted
Mr. Fields 250,000 restricted shares of our common stock for $2,500. The
restricted stock will vest in installments as follows: 83,333 shares when the
closing market price of our common stock equals or exceeds $10 per share for 20
consecutive trading days in any three-month period; an additional 83,333 shares
will vest when the closing market price of our common stock equals or exceeds
$20 per share for 20 consecutive trading days in any three-month period; and
83,334 shares will vest when the closing market price equals or exceeds $30 per
share for 20 consecutive trading days in any three-month period. Mr. Fields'
right to receive any shares of restricted stock that have not vested prior to
November 7, 2007 will terminate and the restricted stock will be returned to us.
Mr. Fields will not be entitled to sell any vested shares of restricted stock
until the expiration of two years from the effective date of his employment
agreement. In the event that an amendment to our stock option plan has not been
approved by our stockholders, we are nevertheless contractually obligated with
respect to such stock which would not be granted under our stock option plan.
Melvin Redman Employment Agreement
We employed Melvin Redman, Executive Vice President - Store Operations and
Distribution, pursuant to a one-year employment agreement dated January 6, 2003
that expires on January 6, 2004, provided that at the scheduled end of the
initial employment term, and on each anniversary thereafter, his employment term
will be automatically extended for an additional one-year period unless either
Mr. Redman or we give notice to the other at least 90 days before an extension
is to take effect that either does not desire the employment term to be
extended.
33
Under the employment agreement, Mr. Redman's base salary is $500,000 annually.
Mr. Redman received a signing bonus in the amount of $100,000. Mr. Redman was
required to prepare and present to the Chief Executive Officer written
performance objectives for the fiscal year ending January 31, 2004. Following
approval by the Chief Executive Officer of the performance objectives, Mr.
Redman's target bonus for the fiscal year ending January 31, 2004 is 50% of his
annual base salary for that year. For each subsequent fiscal year in which he
meets performance objectives approved in advance by the Compensation Committee,
Mr. Redman's target bonus will be based on 50% of his base salary in effect as
of the start of that fiscal year. If the performance objectives accepted by the
Chief Executive Officer are exceeded in any year, the annual bonus will be
increased by 1% of his base salary for each 1% of excess, up to a maximum bonus
of 100% of his base salary for the achievement of 150% of the performance
objectives. If the performance objectives are not met, Mr. Redman will not be
entitled to any bonus.
As an inducement necessary to secure his services, we granted Mr. Redman
non-qualified options to purchase 125,000 shares of our common stock at an
exercise price per share of $3.13, the fair market value of our stock on the
date of grant. These options vest in tranches of 7,812.5 shares on each
December, March, June and September 30 during the first four years of his
employment term. The non-qualified options in each tranche will be exercisable
for a period of five years after the vesting of that tranche. In the event that
an amendment to our stock option plan has not been approved by our stockholders,
we are nevertheless contractually obligated with respect to such options which
would not be granted under our stock option plan.
As a further inducement necessary to secure his services, we also granted Mr.
Redman 125,000 restricted shares of our common stock for $1,250. The restricted
stock will vest in installments as follows: 41,666.7 shares when the closing
market price of our common stock equals or exceeds $10 per share for 20
consecutive trading days in any three-month period; an additional 41,666.7
shares will vest when the closing market price of our common stock equals or
exceeds $20 per share for 20 consecutive trading days in any three-month period;
and 41,666.7 shares will vest when the closing market price equals or exceeds
$30 per share for 20 consecutive trading days in any three-month period. Mr.
Redman's right to receive any shares of restricted stock that has not vested
prior to January 6, 2008 will terminate and the restricted stock will be
returned to us. Mr. Redman will not be entitled to sell any vested shares of
restricted stock until the expiration of two years from the effective date of
his employment agreement. In the event that an amendment to our stock option
plan has not been approved by our stockholders, we are nevertheless
contractually obligated with respect to such stock which would not be granted
under our stock option plan.
Larry Kelley Employment Agreement
We employed Larry Kelley, Executive Vice President - Merchandising and
Marketing, pursuant to a one-year employment agreement dated January 6, 2003
that expires on January 6, 2004, provided that at the scheduled end of the
initial employment term, and on each anniversary thereafter, his employment term
will be automatically extended for an additional one-year period unless either
Mr. Kelley or we give notice to the other at least 90 days before an extension
is to take effect that either does not desire the employment term to be
extended.
Under the employment agreement, Mr. Kelley's base salary is $400,000 annually.
Mr. Kelley was required to prepare and present to the Chief Executive Officer
written performance objectives for the fiscal year ending January 31, 2004.
Following approval by the Chief Executive Officer of the performance objectives,
Mr. Kelley's target bonus for the fiscal year ending January 31, 2004 is 50% of
his annual base salary for that year. For each subsequent fiscal year in which
he meets performance objectives approved in advance by the Compensation
Committee, Mr. Kelley's target bonus will be based on 50% of his base salary in
effect as of the start of that fiscal year. If the performance objectives
accepted by the Chief Executive Officer are exceeded in any year, the annual
bonus will be increased by 1% of his base salary for each 1% of excess, up to a
maximum bonus of 100% of his base salary for the achievement of 150% of the
performance objectives. If the performance objectives are not met, Mr. Kelley
will not be entitled to any bonus, except that Mr. Kelley will receive a minimum
annual bonus of $100,000 for the fiscal year ending January 31, 2004, payable in
twelve equal monthly installments beginning February 2003 as long as Mr. Kelley
remains employed by us.
34
As an inducement to secure his services, we granted Mr. Kelley non-qualified
options to purchase 75,000 shares of our common stock at an exercise price per
share of $3.13, the fair market value of our stock on the date of grant. These
options vest in tranches of 4,687.5 shares on each March, June, September and
December 30 during the first four years of his employment term. The options in
each tranche will be exercisable for a period of five years after the vesting of
that tranche. In the event that an amendment to our stock option plan has not
been approved by our stockholders, we are nevertheless contractually obligated
with respect to such options which would not be granted under our stock option
plan.
As a further inducement to secure his services, we also granted Mr. Kelley
75,000 restricted shares of our common stock for $750. The restricted stock will
vest in installments as follows: 25,000 shares when the closing market price of
our common stock equals or exceeds $10 per share for 20 consecutive trading days
in any three-month period, an additional 25,000 shares will vest when the
closing market price of our common stock equals or exceeds $20 per share for 20
consecutive trading days in any three-month period; and 25,000 shares will vest
when the closing market price equals or exceeds $30 per share for 20 consecutive
trading days in any three-month period. Mr. Kelley's right to receive any shares
of restricted stock that has not vested prior to January 6, 2008 will terminate
and the restricted stock will be returned to us. Additionally, Mr. Kelley will
not be entitled to sell any vested shares of restricted stock until the
expiration of two years from the effective date of his employment agreement. In
the event that an amendment to our stock option plan has not been approved by
our stockholders, we are nevertheless contractually obligated with respect to
such stock which would not be granted under our stock option plan.
Severance Agreements
Michael Searles Severance Agreement
On November 7, 2002, Mr. Searles' employment with us was terminated without
cause. Under the terms of his Amended Employment Agreement with us, he is
entitled to twelve months of his base salary in the total amount of $750,000. He
is also entitled to all accrued but unpaid compensation, vacation pay and
reimbursable business expenses through his termination date, payable in a lump
sum. In addition, he is entitled to the amounts or benefits owing under benefit
plans and policies, exclusive of cash severance policies and up to three years
of COBRA premiums. As of April 25, 2003, Mr. Searles has received $319,731 in
severance payments. All of Mr. Searles' stock options expired three months after
his termination date.
On November 7, 2002, Mr. Searles resigned as a member of the Board of Directors.
Spencer Insolia Severance Agreement
On January 6, 2003, Mr. Insolia's employment as Executive Vice President -
Marketing and Chief Strategy Officer with us was terminated. Under the terms of
his severance agreement, Mr. Insolia received an initial payment of $3,846. He
is also to receive a stream of bi-weekly payments through July 18, 2003,
totaling $128,654, unless he becomes employed prior to that date. If he becomes
employed prior to July 18, 2003, any payments we would otherwise be obligated to
pay him will be reduced by the amount of compensation he receives for services
performed through July 18, 2003. We also paid Mr. Insolia bonuses totaling
$137,500 to which he was entitled on January 6, 2003 and agreed to pay Mr.
Insolia's COBRA premiums through July 2003.
35
Louis Leidelmeyer Severance Agreement
On January 6, 2003, Mr. Leidelmeyer's employment as Executive Vice President -
Human Resources with us was terminated. Under the terms of his severance
agreement, Mr. Leidelmeyer is entitled to a sum equal to his annual base salary
in the amount of $225,000 and his annual automobile allowance in effect at the
time of his termination, both payable in equal bi-weekly installments. If he
becomes employed prior to January 6, 2004, any payments we would otherwise be
obligated to pay him will be reduced by the amount of compensation he receives
for services performed through January 6, 2004. He was also entitled to all
accrued but unpaid vacation pay, payable in a lump sum. In addition, we agreed
to pay Mr. Leidelmeyer's COBRA premiums for twelve months following the
termination of his employment. As of April 25, 2003, Mr. Leidelmeyer has
received $67,038 in severance payments.
Compensation Committee Report on Executive Compensation
The Compensation Committee of the Board of Directors is composed entirely of
outside directors. The Compensation Committee is responsible for establishing
and administering the compensation policies applicable to our executive
officers. All decisions by the Compensation Committee are subject to review and
approval by the full Board of Directors.
Our executive compensation philosophy and specific compensation plans tie a
significant portion of executive compensation to our success in meeting specific
profit, growth and performance goals.
Our compensation objectives include attracting and retaining the best possible
executive talent, motivating executive officers to achieve our performance
objectives, rewarding individual performance and contributions, and linking
executives' and stockholders' interests through equity based plans.
Our executive compensation consists of three key components: base salary, annual
incentive compensation and stock options, each of which is intended to
complement the others and, taken together, to satisfy our compensation
objectives. The Compensation Committee's policies with respect to each of the
three components are discussed below.
Base Salary. In the early part of each fiscal year, the Compensation Committee
reviews the base salary of the Chief Executive Officer (subject to requirements
of his employment agreement) and the recommendations of the Chief Executive
Officer with regard to the base salary of all other executive officers, and
approves, with any modifications it deems appropriate, annual base salaries for
each of our executive officers. We base the recommended base salaries of the
executive officers on an evaluation of the individual performance of the
executive officer, including satisfaction of annual objectives. The recommended
base salary of the Chief Executive Officer is based on achievement of our annual
goals relating to financial objectives, including earnings growth and return on
capital employed, and an evaluation of individual performance.
Recommended base salaries of the executive officers are also based in part upon
an evaluation of the salaries of executives who hold comparable positions at
comparable companies.
Annual Incentive Compensation. Our executive officers participate in a
discretionary incentive bonus plan which provides for the payment of annual
bonuses in cash or stock (or both), based on our success in attaining financial
objectives, and subjective factors established from time to time by the
Compensation Committee or the Board of Directors. With the exception of those
executives who have separate employment agreements with us, the Compensation
Committee normally considers aggregate incentive cash and stock bonus payments
to the executive officers, as a group, of up to 50% of their base salaries, and
any bonus payments in excess of 50% of the aggregate base salaries, may be paid
in cash or stock, at the discretion of the Compensation Committee. The
Compensation Committee did not award annual incentive bonus payments to any of
our executive officers for fiscal 2002.
Stock Options. The primary objective of the stock option program is to link our
interests and those of our executive officers and other selected employees to
those of the stockholders through significant grants of stock options. The
Compensation Committee bases the aggregate number of options it recommends on
practices of comparable companies, while grants of stock options to specific
employees reflect their expected long-term contribution to our success.
Compensation Committee:
Willem F.P. de Vogel, Chairman
Peter V. Handal
36
Compensation Committee Interlocks and Insider Participation
No member of the Compensation Committee of the Board of Directors was, during
fiscal 2002 or at any other time, one of our officers or employees or an officer
or employee of our subsidiaries.
Summary of Cash and Other Compensation
The following table contains information about the compensation during fiscal
2002 of our former principal executive officer, current principal executive
officer, each of our four other most highly paid executive officers who served
as executive officers at the end of fiscal 2002 and two other named executive
officers who were not serving as executive officers at the end of fiscal 2002:
SUMMARY COMPENSATION TABLE
Long-Term Compensation
Fiscal Restricted Securities All Other
Name and Principal Year Annual Compensation Stock Underlying Compensation
Position (1) Salary ($) Bonus ($) Award(s) ($) Options ($) (3)
-------- --- ---------- --------- ------------ ---------- ------------
Michael M. Searles 2002 $ 605,769 $ - $ - - $ 390,777
Former President, Chief 2001 747,564 - - - 206,532
Executive Officer and 2000 600,000 300,000 - - 210,005
Chairman of the Board(4)
William R. Fields 2002 158,754 62,500 417,500 250,000 40,328
Chief Executive Officer - - - - - -
and Chairman of the - - - - - -
Board(5)
Douglas C. Felderman 2002 285,000 94,271 - - 987
Executive Vice President 2001 283,250 - - - 66,195
and 2000 241,346 125,000 - 19,474 310,127
Chief Financial Officer
Michael J. Hein 2002 147,308 - - - 875
Senior Vice President - - - - - -
- - Distribution and - - - - - -
Transportation
Spencer Insolia (6) 2002 196,154 137,500 - 60,000 37,786
Executive Vice President - - - - - -
- -Marketing and Chief - - - - - -
Strategy Officer
Louis A. Leidelmeyer (7) 2002 212,730 - - 5,000 39,135
Executive Vice President - - - - - - -
Human Resources - - - - - -
Norman G. Plotkin 2002 285,000 112,468 - - 2,200
Executive Vice President - 2001 282,500 - - - 15,689
Store Development and 2000 222,884 117,500 - 21,262 13,501
General Counsel
Edward Wong 2002 165,500 25,000 - 36,000 7,355
Executive Vice President - - - - - - -
Supply Chain and Technology - - - - - -
- ---------------------------------------------------------------------------------------------------------
(1) We refer to a fiscal year by the year in which most of the activity
occurred (for example, we refer to fiscal year ended February 1, 2003 as
fiscal 2002).
(2) The aggregate amount of other annual compensation is less than the
lesser of $50,000 or 10% of such person's total annual salary and bonus.
37
(3) "All Other Compensation" for fiscal 2002 includes (i) matching
contributions under our 401(k) Savings Plan of $2,200 for Mr. Searles,
$987 for Mr. Felderman, $875 for Mr. Hein, $1,289 for Mr. Leidelmeyer
and $2,200 for Mr. Plotkin; (ii) forgiveness of interest in the amount
of $157,808 for Mr. Searles; (iii) reimbursement of moving expenses of
$40,328 to Mr. Fields and $7,355 to Mr. Wong; (iv) cost of living
adjustment of $18,771 for Mr. Insolia; (v) final vacation pay of $86,538
for Mr. Searles, $28,615 for Mr. Leidelmeyer and $5,553 for Mr. Insolia;
and (vi) severance payments of $144,231 for Mr. Searles, $13,462 for Mr.
Insolia and $9,231 for Mr. Leidelmeyer.
(4) Mr. Searles was President, Chief Executive Officer and Chairman of the
Board until his termination of employment on November 7, 2002.
(5) Mr. Fields was appointed Chief Executive Officer and Chairman of the
Board effective November 7, 2002. During fiscal 2002, Mr. Fields
received $62,500 of his guaranteed first year bonus of $375,000 under the
terms of his employment agreement.
Mr. Fields received a restricted stock grant of 250,000 shares of
common stock on November 7, 2002 when the closing market price of our
common stock was $1.68 per share. The restricted shares vest as
follows: 83,333 shares when the closing market price of our common
stock equals or exceeds $10 per share for 20 consecutive trading days
in any three-month period, an additional 83,333 shares will vest when
the closing market price of our common stock equals or exceeds $20 per
share for 20 consecutive trading days in any three-month period; and
83,334 shares will vest when the closing market price equals or exceeds
$30 per share for 20 consecutive trading days in any three-month
period. Mr. Fields' right to receive any shares of restricted stock
that have not vested prior to November 7, 2007 will terminate and the
restricted stock will be returned to us. Additionally, Mr. Fields will
not be entitled to sell any vested shares of restricted stock until the
expiration of two years from the effective date of his employment
agreement. Mr. Fields is entitled to receive dividends that are paid on
common stock and he has the right to vote his restricted shares.
As of February 1, 2003, the value of Mr. Fields' restricted stock
holdings was $677,500 (which is calculated as 250,000 shares times
$2.72 per share, minus the $2,500 that Mr. Fields paid for the stock).
(6) As of January 6, 2003, Mr. Insolia was no longer an employee.
(7) As of January 6, 2003, Mr. Leidelmeyer was no longer an employee.
38
Grants of Stock Options
The following table sets forth information concerning the award of stock options
during fiscal 2002. We have never granted stock appreciation rights.
Potential Realizable
% of Total Value at Assumed
Number of Options Annual Rates of
Securities Granted to Exercise Stock Price Appreciation
Underlying Employees or Base For Option Term (1)
Options in Fiscal Price Expiration ------------------------
Name Granted (#) Year ($/Share) Date 5% ($) 10%($)
---- ----------- --------- --------- ---------- ------ ------
Michael M. Searles (2) - - - - - -
William R. Fields 250,000 30.96% $ 1.68 9/29/2011 $ 231,558 $ 570,338
Douglas C. Felderman - - - - - -
Michael J. Hein - - - - - -
Spencer Insolia (3) 60,000 7.43% 15.62 3/19/2012 589,400 1,493,655
Louis A. Leidelmeyer (3) 5,000 0.62% 2.81 9/18/2012 8,836 22,392
Norman G. Plotkin - - - - - -
Edward Wong 18,000 2.23% 12.86 6/19/2012 145,577 368,920
18,000 2.23% 2.81 9/18/2012 31,809 80,611
- ------------------------------------------------------------------------------------------------------------
(1) Amounts shown represent the potential value of granted options if the
assumed annual rates of stock appreciation are maintained over the
terms of the granted options. The assumed rates of appreciation are
established by regulation and are not intended to be a forecast of our
performance or to represent our expectations with respect to the
appreciation, if any, of the common stock.
(2) As of November 7, 2002, Mr. Searles was no longer an employee.
(3) As of January 6, 2003, Messrs. Insolia and Leidelmeyer were no longer
employees. All such options expired unexercised 60 days after that date.
39
Exercise of Stock Options and Holdings
The following table sets forth information concerning exercises of stock options
during fiscal 2002 and the fiscal year-end value of unexercised options. We have
never granted stock appreciation rights.
Aggregated Option Exercises in Fiscal 2002
Fiscal 2002 Year-End Option Values
Number of Securities
Underlying Unexercised Value of Unexercised
Shares Options at Fiscal Year End In-the-Money Options at
Acquired Value (#) Fiscal Year End ($)
On Realized -------------------------- -----------------------
Name Exercise ($) Exercisable Unexercisable Exercisable Unexercisable
---- -------- -------- ----------- ------------- ----------- -------------
Michael M. Searles (1) - $ - 283,517 18,080 $ - $ -
William R. Fields - - 15,625 234,375 16,250 243,750
Douglas C. Felderman - - 64,315 35,685 - -
Michael J. Hein - - 7,200 10,800 - -
Spencer Insolia (2) - - - 60,000 - -
Louis A. Leidelmeyer (2) - - 20,000 25,000 - -
Norman G. Plotkin - - 60,936 26,758 - -
Edward Wong - - - 36,000 - -
- --------------------------------------------------------------------------------------------------------------
(1) As of November 7, 2002, Mr. Searles was no longer an employee. All such
options expired unexercised 3 months after that date.
(2) As of January 6, 2003, Messrs. Insolia and Leidelmeyer were no longer
employees. All such options expired unexercised 60 days after that date.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Principal Stockholders
The following persons are known by us, based solely upon information filed by
such persons with the Securities and Exchange Commission, to have owned
beneficially more than 5% of any class of our voting securities as of the April
25, 2003:
Common Stock
Name and Address ------------
of Beneficial Owner Number Percent of Class
------------------- ------ ----------------
Three Cities Fund II L.P (1) 1,383,914 8.7%
Three Cities Offshore II C.V. (1) 2,340,020 14.6%
The TCW Group, Inc. (2) 1,685,050 10.5%
Kennedy Capital Management, Inc. (3) 789,900 4.9%
Shumway Capital Partners LLC (4) 731,900 4.6%
- --------------------------------------------------------------------------------
40
(1) The address of the beneficial owners is c/o Three Cities Research,
Inc., 650 Madison Avenue, New York, NY 10022. As the investment advisor
to both Three Cities Fund II L.P. and Three Cities Offshore II C.V.,
with power to direct voting and disposition by both those Funds, Three
Cities Research, Inc. ("TCR") may be deemed to be the beneficial owner
of the total 3,723,934 shares owned by both funds. In addition, because
Willem F.P. de Vogel is a general partner of TCR Associates, L.P., the
general partner of Three Cities Fund II L.P., he may be deemed to be a
beneficial owner of the shares owned by Three Cities Fund II L.P.
(2) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is 865 South Figueroa
Street, Los Angeles, California 90017. The TCW Group, Inc., a Nevada
corporation ("TCW"), filed the Schedule 13G on behalf of itself and its
direct and indirect subsidiaries, which collectively constitute The TCW
Group, Inc. business unit (the "TCW Business Unit"). The TCW Business
Unit is primarily engaged in the provision of investment management
services. TCW is the parent holding company and its relevant subsidiaries
are (i) Trust Company of the West, a California corporation and a bank as
defined in Section 3(a)(6) of the Securities Exchange Act of 1934,
(ii) TCW Asset Management Company, a California corporation and an
investment adviser registered under Section 203 of the Investment Advisers
Act of 1940, and (iii) TCW Investment Management Company, a California
corporation and an investment adviser registered under Section 203 of the
Investment Advisers Act of 1940. As of July 6, 2001, the ultimate parent
company of TCW is Societe Generale, S.A., a corporation formed under the
laws of France ("SG"). The principal business of SG is acting as a holding
company for a global financial services group, which includes certain
distinct specialized business units that are independently operated,
including the TCW Business Unit. S.G., for purpose of the federal
securities laws, may be deemed ultimately to control TCW and the TCW
Business Unit. SG, its executive officers and directors, and its direct
and indirect subsidiaries (including all business units except the TCW
Business Unit), may beneficially own shares of the securities of the
issuer to which this schedule relates and such shares are not reported
in this statement. In accordance with Securities and Exchange Commission
Release No. 34-39538 (January 12, 1998), and due to the separate
management and independent operation of its business units, SG disclaims
beneficial ownership of shares beneficially owned by the reporting person.
The reporting person disclaims beneficial ownership of shares beneficially
owned by SG and any of SG's other business units.
(3) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is 10829 Olive Blvd.,
St. Louis, MO 63141. Kennedy Capital Management, Inc. filed its Schedule
13G with the SEC on February 18, 2003 and claimed beneficial ownership of
789,900 shares, or 6% of our common stock.
(4) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is 600 Steamboat Rd.,
Greenwich, CT 06830. Shumway Capital Partners LLC filed its Schedule 13G
with the SEC on February 28, 2003 and claimed beneficial ownership of
731,900 shares, or 5.5% of our common stock. The statement was filed by
Shumway Capital Partners LLC ("SCP"), a limited liability company
organized under the laws of the State of Delaware, which serves as the
investment manager to SCP Domestic Fund, LP ("SCP-D"), a Delaware limited
partnership and SCP Overseas Fund, Ltd. ("SCP-O"), a Cayman Islands
exempted company, with respect to the shares of common stock directly
owned by them. SCP exercises investment discretion with regard to the
common stock held by SCP-D and SCP-O. The statement was also filed by
Chris W. Shumway ("Mr. Shumway"), with respect to the shares of common
stock directly owned by SCP by virtue of SCP having investment discretion
over the accounts of SCP-D and SCP-O.
On April 25, 2003, The Depository Trust Company owned of record 9,384,384 shares
of common stock, constituting 58.68% of our outstanding common stock. We
understand those shares were held beneficially for members of the New York Stock
Exchange, some of whom may in turn have been holding shares beneficially for
customers.
41
Management Stockholders
As of April 25, 2003, our directors and executive officers beneficially owned
the following amounts of our voting securities:
Amount and
Nature of
Beneficial Percent of
Name of Beneficial Owner Ownership (1) Class
------------------------ ------------- ----------
Willem F.P. de Vogel (2) 8,552 *
Douglas C. Felderman 88,620 *
William R. Fields 281,250 1.8%
Peter V. Handal 93,146 *
Michael J. Hein 11,091 *
Larry I. Kelley 79,687 *
Norman G. Plotkin 96,078 *
Ronald Rashkow (3) 318,506 2.0%
Melvin C. Redman 132,812 *
Edward Wong 3,600 *
Wm. Robert Wright II 12,589 *
Directors and Officers as a Group (11 persons) 1,125,931 7.0%
- ----------------------------------------------------------------------------
* Less than 1%.
(1) Includes shares which may be acquired within 60 days through the exercise
of stock options or warrants, as follows: Mr. de Vogel, 3,000 shares;
Mr. Felderman, 80,210 shares; Mr. Fields, 31,250 shares; Mr. Handal, 8,129
shares; Mr. Hein, 10,800; Mr. Kelley, 4,687 shares; Mr. Plotkin, 72,188
shares; Mr. Rashkow, 56,500 shares; Mr. Redman, 7,812 shares; Mr. Wong,
3,600 shares; and Mr. Wright, 7,000 shares; all officers and directors as
a group, 285,176 shares.
(2) Does not include shares owned by Three Cities Fund II L.P. Mr. de Vogel
is a general partner of TCR Associates, L.P., the general partner of
Three Cities Fund II L.P. TCR, of which Mr. de Vogel is the president,
is the advisor to Three Cities Fund II L.P. and to Three Cities
Offshore II C.V., which own a total of 3,723,934 shares, and has the
power to direct the voting and disposition of those shares.
(3) Includes 57,091 shares of common stock held by members of Mr. Rashkow's
family, 458 shares of common stock held by a limited partnership of
which Mr. Rashkow is the general partner and 56,500 shares which Mr.
Rashkow may acquire within 60 days through the exercise of stock options.
Item 13. Certain Relationships and Related Transactions
Transactions with Management
In March 1997, we entered into an agreement for TCR to act as our financial
advisor. Under this agreement, we pay TCR an annual fee of $50,000 and reimburse
TCR all of its out-of-pocket expenses incurred for services rendered, up to an
aggregate of $50,000 annually. We reimbursed TCR for out-of-pocket expenses in
the amounts of $47,000, $34,000 and $37,000 during fiscal 2002, 2001 and 2000,
respectively.
42
On March 6, 2003, Three Cities Fund II L.P. purchased 240,793 shares of our
common stock and Three Cities Offshore II C.V. purchased 407,207 shares of our
common stock in a private placement at a purchase price of $2.75 per share (a
price in excess of the closing market price of our common stock on such date),
for an aggregate purchase price of $1,782,000. TCR controls approximately 23.3%
of our outstanding common stock and Mr. de Vogel, a member of our Board of
Directors, is the President of TCR.
Also on March 6, 2003, Mr. Rashkow purchased 72,700 shares of our common stock
in the private placement at a price of $2.75 per share (a price in excess of the
closing market price of our common stock on such date), for an aggregate
purchase price of $199,925.
Indebtedness of Management
During fiscal years 1997 and 1998, we sold to our executive management shares of
our Series B Preferred Stock, which were subsequently converted to common stock.
With the exception of Mr. Searles, each of the executives paid for his or her
shares by giving us a full-recourse promissory note secured by the purchased
stock. Each note accrues interest at 8% per annum and requires principal
payments equivalent to 16.25% of the annual bonus paid to the purchaser (if such
bonus is actually paid in a given year) and a balloon payment of the unpaid
principal and interest at maturity. Each of the notes matures five years after
the date it was made.
Mr. Searles' promissory note in the principal amount of $1,400,000 is partial-
recourse and was due on April 29, 2003. Mr. Searles is liable for the payment
of principal and accrued but unpaid interest on his note up to $600,000
(including the value of the shares of our stock securing the note) and we will
have the right to retain the stock securing his note with respect to the balance
of any principal and accrued interest on his note to the extent such stock has a
value in excess of $600,000 (but not in excess of the outstanding balance of
principal and accrued interest). We had forgiven interest payments aggregating
$157,808 through November 7, 2002, but Mr. Searles' note accrued interest from
November 7, 2002 to April 29, 2003. On April 29, 2003, the principal and
accrued interest due on Mr. Searles' note was $1,458,608 and we foreclosed on
the collateral which had a market value of $1,198,750, resulting in a deficiency
of $259,858, for which Mr. Searles does not have personal liability for this
deficiency under the terms of the note.
Mr. Plotkin's promissory note was outstanding during fiscal 2002, but as of
March 21, 2003, Mr. Plotkin had repaid his promissory note in full in the amount
of $101,008.
Additionally, on April 29, 2003, the principal and accrued interest due on the
notes for Tracy W. Parks, our former Executive Vice President and Chief
Operating Officer, was $117,042. On April 29, 2003, we foreclosed on the
collateral which had a market value of $82,197, resulting in a deficiency of
$34,845, for which Mr. Parks is personally liable under the terms of his notes.
During fiscal 2002, we loaned Spencer Insolia, our former Executive Vice
President - Marketing and Chief Strategy Officer, $100,000 at the time of his
hire. Mr. Insolia's promissory note accrued interest at a rate of 7% per annum
and was to be paid in two installments of $50,000 plus all accrued interest to
date, on May 1, 2003 and May 1, 2004. Under the terms of his note, Mr. Insolia
paid the entire balance of $105,619 on January 6, 2003, when he ceased to be
employed by us.
Item 14. Controls and Procedures
Evaluation. Within 90 days prior to the date of this Annual Report on Form 10-K,
we have evaluated the effectiveness of the design and operation of our
disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14
of the Securities Exchange Act of 1934, as amended. This evaluation was done
under the supervision and with the participation of management, including our
Chief Executive Officer (CEO) and Chief Financial Officer (CFO).
Limitations. Our management, including the CEO and CFO, does not expect that our
disclosure controls and procedures will necessarily prevent all errors. Such
controls and procedures, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that their objectives are met.
43
Conclusions. Based upon our evaluation, we have concluded that, subject to the
limitations noted above, our disclosure controls and procedures are effective to
ensure that material information relating to the Company is made known to
management, including the CEO and CFO, particularly during the period when our
periodic reports are being prepared.
Changes in Internal Controls. There have not been any significant changes in our
internal controls or in other factors that could significantly affect these
controls subsequent to the date of our last evaluation of such internal
controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) 1. Financial Statements.
See Index to Financial Statements contained in Item 8.
2. Financial Statement Schedules.
Schedule II Valuation and Qualifying Accounts contained on page 45.
All other schedules are omitted because of the absence of conditions
under which they are required or because the required information is set
forth in the financial statements and notes thereto.
3. Exhibits.
See Item 15(c).
(b) Reports on Form 8-K.
Item 5 - On November 19, 2002, we filed a report on Form 8-K regarding the
appointment of William R. Fields as Chairman and Chief Executive Officer of
the Company effective November 7, 2002 and the appointment of Ronald Rashkow
as the Lead Director of the Board of Directors effective November 4, 2002.
(c) Exhibits.
Reference is made to the Index to Exhibits immediately preceding the
exhibits thereto.
44
Schedule II
Factory 2-U Stores, Inc.
Valuation and Qualifying Accounts
Fiscal Year Ended February 1, 2003, February 2, 2002 and February 3, 2001
(in thousands)
Additions
---------
Balance at Charged to Charged to Balance at
Beginning Costs and Other End of
Description of Period Expenses Accounts Deductions Period
----------- ---------- ---------- ---------- ---------- ----------
As of February 1, 2003
Notes Receivable Allowance $ - $ 2,340 $ - $ - $ 2,340
Inventory Valuation Allowance 1,152 7,210 - - 8,362
FY02 Restructuring Reserve - 14,398 - (1,987) 12,411
FY01 Restructuring Reserve 21,154 (4,969) - (11,411) 4,774
As of February 2, 2002
Inventory Valuation Allowance $ 1,265 $ - $ - $ (113) $ 1,152
FY01 Restructuring reserve - 21,231 - (77) 21,154
As of February 3, 2001
Inventory Valuation Allowance $ 1,265 $ - $ - $ - $ 1,265
45
Index to Exhibits
Exhibit
Number Document
- ------- --------
2.1 (1) Plan and Agreement of Merger dated June 18, 1998 between Family
Bargain Corporation and General Textiles, Inc.
3.1 (2) (i) Restated Certificate of Incorporation
(ii) Bylaws
4.1 (1) Junior Subordinated Note Agreement dated April 30, 1998 among
General Textiles, American Endeavour Fund Limited and London
Pacific Life & Annuity Company
4.2 (1) Form of Warrant dated April 30, 1998
10.1 (3) Factory 2-U Stores, Inc. Employee Stock Purchase Plan
10.2 (4) Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option
Plan
10.3 (5) Factory 2-U Stores, Inc. Employee Compensation Agreements
10.4 (6) 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 March 3, 2000
10.5 (6) First 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 March 3, 2000
10.6 (6) Amended Employment Agreement between Factory 2-U Stores, Inc. and
Michael M. Searles
10.7 (7) Second 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 April 10, 2001
10.8 (7) Third 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 April 9, 2002
10.9 (8) 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
10.10 * Fifth 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 February 14, 2003
10.11 * Sixth Amendment to the Financing Agreement by and among The CIT
Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U
Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender),
dated as April 10, 2003
10.12 (9) Employment Agreement, dated as of November 7, 2002, by and between
Factory 2-U Stores, Inc. and William R. Fields
10.13 (9) Letter Agreement, dated as of November 4, 2002, by and between
Factory 2-U Stores, Inc. and Ronald Rashkow
10.14 * Employment Agreement, dated as of January 6, 2003, by and between
Factory 2-U Stores, Inc. and Melvin Redman
10.15 * Employment Agreement, dated as of January 6, 2003, by and between
Factory 2-U Stores, Inc. and Larry I. Kelley
10.16 * Industrial/Commercial Single-Tenant Lease as of March 8, 2002, by
and between Factory 2-U Stores, Inc. (as Tenant) and ORIX Otay,
LLC (as Landlord)
23.1 * Consent of Ernst & Young LLP, Independent Public Accountants
23.2 * Information regarding consent of Arthur Andersen LLP
99.1 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
by William R. Fields, Chief Executive Officer
99.2 ** Certification furnished 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
- --------------------------------------------------------------------------------
46
(1) Incorporated by reference to Registration Statement on Form S-2, No.
333-58797 filed with the SEC on October 14, 1998.
(2) Incorporated by reference to Registration Statement on Form S-1,
No. 33-77448 filed with the SEC on April 7, 1994.
(3) Incorporated by reference to Registration Statement on Form S-8 No.
333-94123 filed with the SEC on January 5, 2000.
(4) Incorporated by reference to Registration Statement on Form S-8 No.
333-40682 filed with the SEC on June 30, 2000.
(5) Incorporated by reference to Registration Statement on Form S-8 No.
333-89267 filed with the SEC on October 19, 1999.
(6) Incorporated by reference to Form 10-K for the fiscal year ended
January 29, 2000 filed with the SEC on April 24, 2000.
(7) Incorporated by reference to Form 10-K for the fiscal year ended
February 2, 2002 filed with the SEC on April 19, 2002.
(8) Incorporated by reference to Form 10-Q for the quarterly period ended
August 3, 2002 filed with the SEC on September 17, 2002.
(9) Incorporated by reference to Form 8-K for report dated November 7, 2002
filed with the SEC on November 19, 2002.
* Filed herewith.
** Furnished herewith.
47
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, hereunto duly authorized.
FACTORY 2-U STORES, INC.
By: /s/ William R. Fields
---------------------
William R. Fields
Chairman of the Board
Dated: May 2, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of this Company
and in the capacities and on the date indicated.
Signature Title Date
--------- ----- ----
/s/ William R. Fields Chief Executive Officer May 2, 2003
- ------------------------- and Chairman of the Board
William R. Fields (Principal Executive Officer)
/s/ Douglas C. Felderman Executive Vice President, May 2, 2003
- ------------------------- Chief Financial Officer
Douglas C. Felderman (Principal Financial and
Accounting Officer)
/s/ Ronald Rashkow Lead Director May 2, 2003
- -------------------------
Ronald Rashkow
/s/ Willem de Vogel Director May 2, 2003
- -------------------------
Willem de Vogel
/s/ Peter V. Handal Director May 2, 2003
- -------------------------
Peter V. Handal
/s/ Wm. Robert Wright II Director May 2, 2003
- -------------------------
Wm. Robert Wright II
48
CERTIFICATION
I, William R. Fields, certify that:
1. I have reviewed this annual report on Form 10-K of Factory 2-U Stores, Inc.
(the "Registrant").
2. Based on my knowledge, this annual 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 annual report.
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
aspects the financial condition, results of operations and cash flows of
the Registrant as of, and for, the periods presented in this annual report.
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
(b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the Registrant's auditors and the audit
committee of Registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the Registrant's internal
controls; and
6. The Registrant's other certifying officer and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 2, 2003 /s/ William R. Field
--------------------
Name: William R. Fields
Title: Chief Executive Officer
49
CERTIFICATION
I, Douglas C. Felderman, certify that:
1. I have reviewed this annual report on Form 10-K of Factory 2-U Stores, Inc.
(the "Registrant").
2. Based on my knowledge, this annual 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 annual report.
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
aspects the financial condition, results of operations and cash flows of
the Registrant as of, and for, the periods presented in this annual report.
4. The Registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
(b) evaluated the effectiveness of the Registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the Registrant's auditors and the audit
committee of Registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Registrant's ability to
record, process, summarize and report financial data and have
identified for the Registrant's auditors any material weaknesses in
internal controls; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the Registrant's internal
controls; and
6. The Registrant's other certifying officer and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 2, 2003 /s/ Douglas C. Felderman
-------------------------
Name: Douglas C. Felderman
Title: Executive Vice President,
Chief Financial Officer
50
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and the
Board of Directors of Factory 2-U Stores, Inc.
We have audited the accompanying balance sheet of Factory 2-U Stores, Inc. (the
"Company") as of February 1, 2003 and the related statements of operations,
stockholders' equity and cash flows for the year ended February 1, 2003 ("fiscal
2002"). Our audit also included the financial statement schedule listed in the
Index at Item 15(a). These financial statements and the financial statement
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audit. The financial statements and financial statement schedule of the Company
for the fiscal years ended February 2, 2002 and February 3, 2001, were audited
by other auditors who have ceased operations. Those auditors expressed an
unqualified opinion on those statements in their report dated February 27, 2002.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the fiscal 2002 financial statements referred to above present
fairly, in all material respects, the financial position of the Company as of
February 1, 2003 and the results of its operations and its cash flows for the
year ended February 1, 2003 in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related fiscal 2002
financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Note 6 to the financial statements, the Company changed its
method of accounting for goodwill and other intangible assets in
accordance with Statement of Financial Accounting Standards ("Statement") No.
142 during the first quarter of fiscal 2002.
As discussed above, the financial statements of the Company as of February 2,
2002 and February 3, 2001, and for the years then ended were audited by other
auditors who have ceased operations. As described in Note 6, these financial
statements have been updated to include the transitional disclosures required by
Statement No. 142, "Goodwill and Other Intangible Assets," which was adopted by
the Company as of February 3, 2002. Our audit procedures with respect to the
disclosures in Note 6 for fiscal 2001 and 2000 included (i) agreeing the
previously reported net income (loss) to the previously issued financial
statements and the adjustments to reported net income (loss) representing
amortization expense (including any related tax effects) recognized in those
periods related to goodwill that are no longer being amortized to the Company's
underlying records obtained from management, and (ii) testing the mathematical
accuracy of the reconciliation of adjusted net income (loss) to reported net
income (loss), and the related net income (loss)-per-share amounts. In our
opinion, the disclosures for fiscal 2001 and 2000 in Note 6 related to the
transitional disclosures of Statement 142 are appropriate. However, we were not
engaged to audit, review, or apply any procedures to the Company's financial
statements for fiscal 2001 and 2000 other than with respect to such disclosures
and, accordingly, we do not express an opinion or any other form of assurance on
the Company's fiscal 2001 and 2000 financial statements taken as a whole.
/s/ ERNST & YOUNG LLP
San Diego, California
February 24, 2003
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN
LLP IN CONNECTION WITH FACTORY 2-U STORES, INC.'S FILING ON FORM 10-K
FOR THE YEAR ENDED FEBRUARY 2, 2002. THIS AUDIT REPORT HAS NOT BEEN
REISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH THIS FILING ON FORM
10-K. SEE EXHIBIT 23.2 FOR FURTHER DISCUSSION. THE BALANCE SHEET AS OF
FEBRUARY 3, 2001, REFERRED TO IN THIS REPORT HAS NOT BEEN INCLUDED IN
THE ACCOMPANYING FINANCIAL STATEMENTS.
To Factory 2-U Stores, Inc.:
We have audited the accompanying balance sheets of Factory 2-U Stores, Inc.
(a Delaware corporation) as of February 2, 2002 and February 3, 2001, and the
related statements of operations, stockholders' equity and cash flows for each
of the three years in the period ended February 2, 2002. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Factory 2-U Stores, Inc. as
of February 2, 2002 and February 3, 2001 and the results of its operations and
its cash flows for each of the three years in the period ended February 2, 2002
in conformity with accounting principles generally accepted in the United
States.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements and supplementary data is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not a
required part of the basic financial statements. This schedule has been
subjected to the auditing procedures applied in our audits of the basic
financial statements and, in our opinion, is fairly stated in all material
aspects in relation to the basic financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP
San Diego, California
February 27, 2002
F-2
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands, except share data)
February 1, February 2,
2003 2002
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 3,465 $ 17,390
Merchandise inventory 32,171 54,860
Accounts receivable, net 884 2,013
Income taxes receivable 8,200 -
Prepaid expenses 5,436 6,357
Deferred income taxes 9,732 3,553
-------- --------
Total current assets 59,888 84,173
Leasehold improvements and equipment, net 28,602 37,042
Deferred income taxes 10,750 7,182
Other assets 963 1,011
Excess of cost over net assets acquired, less
accumulated amortization of $13,344 26,301 26,301
-------- --------
Total assets $126,504 $155,709
======== ========
The accompanying notes are an integral part of these financial statements.
F-3
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands, except share data)
February 1, February 2,
2003 2002
----------- -----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt and
capital lease $ 3,000 $ 2,019
Accounts payable 27,961 36,271
Taxes payable 5,840 3,332
Accrued expenses 27,831 27,918
-------- --------
Total current liabilities 64,632 69,540
Revolving credit facility 6,300 -
Long-term debt 6,445 8,376
Accrued restructuring charges 1,747 3,578
Deferred rent 3,061 3,649
-------- --------
Total liabilities 82,185 85,143
-------- --------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value; 35,000,000 shares
authorized and 13,475,705 shares and 12,842,146
shares issued and outstanding, respectively 135 128
Stock subscription notes receivable (1,116) (2,225)
Additional paid-in capital 122,516 121,370
Accumulated deficit (77,216) (48,707)
-------- --------
Total stockholders' equity 44,319 70,566
-------- --------
Total liabilities and stockholders' equity $126,504 $155,709
======== ========
The accompanying notes are an integral part of these financial statements.
F-4
FACTORY 2-U STORES, INC.
Statements of Operations
(in thousands, except per share data)
Fiscal Year Ended
-----------------
February 1, February 2, February 3,
2003 2002 2001*
----------- ----------- -----------
Net sales $535,270 $580,460 $555,670
Cost of sales 372,885 385,390 358,393
----------- ----------- -----------
Gross profit 162,385 195,070 197,277
Selling and administrative expenses
(exclusive of non-cash stock-based
compensation expense shown below) 196,435 188,272 154,379
Pre-opening expenses 1,086 3,086 5,371
Amortization of intangibles - 1,682 2,092
Restructuring charge 9,914 18,360 -
Condemnation award - - (1,240)
Stock-based compensation expense - 456 4,807
----------- ----------- -----------
Operating income (loss) (45,050) (16,786) 31,868
Interest expense, net 1,611 960 1,546
----------- ----------- -----------
Income (loss) before income taxes (46,661) (17,746) 30,322
Income taxes (benefit) (18,152) (6,850) 9,058
----------- ----------- -----------
Net income (loss) $(28,509) $(10,896) $ 21,264
=========== =========== ===========
Net income (loss) per share
Basic $ (2.20) $ (0.85) $ 1.69
Diluted $ (2.20) $ (0.85) $ 1.63
Weighted average common shares outstanding
Basic 12,957 12,807 12,589
Diluted 12,957 12,807 13,066
* 53-week fiscal year.
The accompanying notes are an integral part of these financial statements.
F-5
FACTORY 2-U STORES, INC.
Statements of Stockholders' Equity
(in thousands, except share data)
Stock
Common Stock Subscription Additional
------------ Notes Paid-in Accumulated
Shares Amount Receivable Capital Deficit Total
------ ------ ---------- ------- ------- -----
Balance at January 29, 2000 12,390,817 $ 124 $(2,710) $108,091 $(59,075) $46,430
---------- ------- -------- -------- --------- -------
Issuance of common stock for
exercise of stock options 341,932 3 - 2,595 - 2,598
Compensation expense related to
performance-based stock options - - - 4,807 - 4,807
Tax effect related to non-qualified
stock options - - - 3,454 - 3,454
Issuance of common stock to Board
members and management as
compensation 19,407 - - 519 - 519
Issuance of common stock under
employee stock purchase plan 7,148 - - 180 - 180
Payments of notes receivable - - 485 - - 485
Net income - - - - 21,264 21,264
----------- ------- -------- -------- --------- -------
Balance at February 3, 2001 12,759,304 127 (2,225) 119,646 (37,811) 79,737
----------- ------- -------- -------- --------- -------
Issuance of common stock for
exercise of stock options 66,456 1 - 522 - 523
Compensation expense related to
the removal of price hurdle
for performance-based stock
options - - - 456 - 456
Tax effect related to non-qualified
stock options - - - 389 - 389
Issuance of common stock to Board
members as compensation 4,000 - - 106 - 106
Issuance of common stock under
employee stock purchase plan 12,386 - - 251 - 251
Net loss - - - - (10,896) (10,896)
----------- ------- -------- -------- --------- ---------
Balance at February 2, 2002 12,842,146 128 (2,225) 121,370 (48,707) 70,566
----------- ------- -------- -------- --------- ---------
Issuance of common stock for
exercise of stock options 124,764 1 - 917 - 918
Issuance of common stock to Board
members and management as
compensation 478,000 5 - 78 - 83
Issuance of common stock under
employee stock purchase plan 30,795 1 - 151 - 152
Payments of notes receivable - - 76 - - 76
Write-down of stock subscription
notes receivable to fair value - - 1,033 - - 1,033
Net loss - - - - (28,509) (28,509)
----------- ------- -------- -------- --------- ---------
Balance at February 1, 2003 13,475,705 135 $(1,116) 122,516 $(77,216) $ 44,319
----------- ------- -------- -------- --------- ---------
The accompanying notes are an integral part of these financial statements.
F-6
FACTORY 2-U STORES, INC.
Statements of Cash Flows
(in thousands)
Fiscal Year Ended
-----------------
February 1, February 2, February 3,
2003 2002 2001*
----------- ----------- -----------
Cash flows from operating activities
Net income (loss) from operating
activities $ (28,509) $ (10,896) $ 21,264
Adjustments to reconcile net income
(loss) to net cash provided by
(used in) operating activities
Depreciation and amortization 15,160 14,773 13,594
Loss on disposal of equipment 76 205 581
Deferred rent expense (550) 264 1,098
Stock-based compensation expense - 456 4,807
Restructuring charge 4,734 4,922 -
Other 1,204 - -
Changes in operating assets and
liabilities
Merchandise inventory 22,454 (5,286) (17,396)
Prepaid expenses and other
assets (15,741) (3,609) (7,984)
Accounts payable (8,310) 11,077 5,200
Accrued expenses and other
liabilities 1,399 14,967 (3,840)
---------- ---------- -----------
Net cash provided by (used in)
operating activities (8,083) 26,873 17,324
---------- ---------- -----------
Cash flows used in investing activities
Purchase of leasehold improvements and
equipment (11,001) (12,694) (23,818)
---------- ---------- -----------
Net cash used in investing activities (11,001) (12,694) (23,818)
---------- ---------- -----------
(continued)
The accompanying notes are an integral part of these financial statements.
F-7
FACTORY 2-U STORES, INC.
Statements of Cash Flows
(in thousands)
Fiscal Year Ended
-----------------
February 1, February 2, February 3,
2003 2002 2001*
----------- ----------- -----------
Cash flows provided by (used in)
financing activities
Borrowings on revolving credit
facility 94,794 88,044 111,711
Payments on revolving credit
facility (88,494) (88,044) (111,711)
Payments of long-term debt and
capital lease obligations (2,019) (2,171) (1,253)
Proceeds from issuance of common
stock, net 5 160 180
Payments of deferred debt issuance
costs (121) (40) (250)
Proceeds from exercise of stock
options 918 523 2,598
Payments of stock subscription notes
receivable 76 - 485
---------- ---------- -----------
Net cash provided by (used in)
financing activities 5,159 (1,528) 1,760
---------- ---------- -----------
Net increase (decrease) in cash and
cash equivalents (13,925) 12,651 (4,734)
Cash and cash equivalents at the
beginning of the period 17,390 4,739 9,473
---------- ---------- -----------
Cash and cash equivalents at the
end of the period $ 3,465 $ 17,390 $ 4,739
========== ========== ===========
Supplemental disclosure of cash flow information
Cash paid during the period for
Interest $ 613 $ 387 $ 651
Income taxes $ 1,328 $ 5,698 $ 9,559
Supplemental disclosures of non-cash investing
and financing activities
Tax effect related to non-qualified
stock options $ - $ 389 $ 3,454
Issuance of common stock to board
members and management as
compensation $ 78 $ 106 $ 519
* 53-week fiscal year.
The accompanying notes are an integral part of these financial statements.
F-8
FACTORY 2-U STORES, INC.
Notes to Financial Statements
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
We operate a chain of off-price retail apparel and houseware stores
in Arizona, Arkansas, California, Idaho, Nevada, New Mexico,
Oklahoma, Oregon, Texas and Washington. We sell branded casual apparel
for the family, as well as selected domestics and household
merchandise at prices, which generally are significantly lower than
other discount stores. At February 1, 2003, we operated 244 stores
under the name Factory 2-U.
Fiscal Year
Our fiscal year is based on a 52/53 week year ending on the Saturday
nearest January 31. Fiscal years ended February 1, 2003, February 2,
2002 and February 3, 2001 included 52 weeks, 52 weeks and 53 weeks,
respectively. We define our fiscal year by the calendar year in which
most of the activity occurs (e.g. the fiscal year ended February 1,
2003 is referred to as fiscal 2002).
Cash Equivalents
We consider all liquid investments with original maturities of three
months or less to be cash equivalents.
Merchandise Inventory
Merchandise inventory is stated at the lower of cost or market
determined using the retail inventory method on a first-in, first-out
basis. In addition, consistent with industry practice, we capitalize
certain buying, warehousing, storage and transportation costs. At
February 1, 2003 and February 2, 2002, such costs included in inventory
were $3.4 million and $4.6 million, respectively. As of February 1,
2003 and February 2, 2002, we had an inventory valuation allowance of
$8.4 million and $1.1 million, respectively, which represented our
estimate of the cost in excess of the net realizable value of all
clearance and slow-moving items.
Leasehold Improvements and Equipment
Leasehold improvements and equipment are stated at original cost less
accumulated depreciation and amortization. Tenant improvement
allowances, offered by landlords from time to time, are recorded as a
reduction to the original cost of leasehold improvements. Equipment
under capital leases is stated at the present value of minimum lease
payments at the date of acquisition. Depreciation expense for the years
ended February 1, 2003, February 2, 2002 and February 3, 2001 was $14.0
million, $14.0 million, and $10.4 million, respectively. We calculate
depreciation and amortization using the straight-line method over the
estimated useful lives as follows:
Leasehold improvements the shorter of the asset's useful
life or the lease term, generally
five years
Furniture, fixtures and three to five years
other equipment
Excess of Cost over Net Assets Acquired ("Goodwill")
At the beginning of fiscal 2002, we adopted Statement of Financial
Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible
Assets", which ceases the amortization of goodwill and instead, the
carrying value of goodwill will be evaluated for impairment at least
annually using a fair value test. As required, we have completed an
impairment analysis using present value of future cash flow method and
concluded that our goodwill was not impaired as of February 1, 2003.
Prior to fiscal 2002, goodwill was amortized on a straight-line basis
over 25 years. Goodwill amortization was $1.6 million for each of the
fiscal years ended February 2, 2002 and February 3, 2001.
F-9
Comprehensive Income
We have adopted Statement of Financial Accounting Standards (SFAS) No.
130, "Reporting Comprehensive Income." This statement establishes the
disclosure requirements for comprehensive income and its components
within the financial statements. We had no items of comprehensive
income for the fiscal years ended February 1, 2003, February 2, 2002
and February 3, 2001.
Asset Impairment
We assess potential asset impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets", which
establishes an accounting model to be used for long-lived assets to be
disposed of by sale or held for use 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. This statement retains the
requirements of SFAS 121 that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of an asset to be held and used
is measured by comparing the carrying amount of the asset to future net
cash flows expected to be generated by the asset. If such asset is
considered to be impaired, the impairment to be recognized is measured
by the amount that the carrying value of the asset exceeds the fair
value of the asset.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, receivables,
payables and accrued expenses approximate fair value due to the
short-term nature of such instruments. The carrying amount of the
revolving credit facility approximates fair value due to the floating
rate on such instrument. The carrying value of long-term debt with
fixed payment terms approximates fair value.
Self-Insurance
We self-insure or retain a portion of the exposure for losses related
to workers' compensation and general liability costs. The self-insured
policies provide for both specific and aggregate stop-loss limits. The
workers' compensation program for the policy year ended January 31,
2003 had a specific stop loss amount of $250,000 with no aggregate stop
loss limit. The general liability program provided for a specific stop
loss of $35,000 per claim with no aggregate stop loss limit. It is our
policy to record our self-insurance reserves, as determined
actuarially, based upon claims filed and an estimate of claims incurred
but not reported. Based on the actuarial methods used, we estimate our
ultimate aggregate loss for workers' compensation and general liability
in the amount of $3.4 million and $500,000, respectively. These amounts
are subject to adjustment based on actual costs being greater or less
than expected.
F-10
Revenue Recognition
Retail merchandise sales are recognized at the point of sale. We defer
the recognition of layaway sales and the related cost of sales until
the time the merchandise is fully paid by the customer. Deferred
revenue is included in the accounts payable in the accompanying balance
sheets.
Costs of Sales
Costs of sales include merchandise cost, transportation cost,
markdowns, shrink, direct distribution and processing costs, and
inventory capitalization cost.
Advertising Costs
Advertising costs are expensed as incurred. Advertising costs for the
fiscal years ended February 1, 2003, February 2, 2002 and February 3,
2001 were approximately $24.7 million, $20.9 million and $17.7 million,
respectively.
Deferred Rent
Rent expense under non-cancelable operating lease agreements is
recorded on a straight-line basis over the life of the respective
leases. The excess rent expense over rent paid is accounted for as
deferred rent.
Store Pre-opening and Closing Costs
Store pre-opening costs (costs of opening new stores, including grand
opening promotions, training and store set-up costs) are expensed as
incurred.
Costs associated with closing stores, consisting primarily of inventory
liquidation costs, non-recoverable investment in fixed assets and any
future lease obligations, are recognized as operating expense at the
date of a commitment to an exit or disposal plan. Closing costs related
to exit or disposal activities initiated after December 31, 2002 will
be expensed as incurred.
Debt Issuance Costs
Debt issuance costs are amortized to interest expense evenly over the
life of the related debt. For fiscal year ended February 1, 2003,
February 2, 2002 and February 3, 2001, amortization for debt issuance
costs was $118,000, $132,000 and $84,000, respectively.
Income Taxes
Income taxes are accounted for under the asset and liability method
required by SFAS No. 109, "Accounting for Income Taxes." Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying
amounts of existing assets and liabilities and their respective tax
bases and operating losses and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date.
Stock-based Compensation
We have elected under the provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" to continue using the intrinsic value method
of accounting for employee stock- based compensation in accordance with
Accounting Principles Board No. 25 ("APB No. 25"), "Accounting for
Stock Issued to Employees." Under the intrinsic value method,
compensation expense is recognized only in the event that the exercise
F-11
price of options granted is less than the market price of the
underlying stock on the date of grant. The fair value method generally
requires entities to recognize compensation expense over the vesting
period of options based on the estimated fair value of the options
granted. We have disclosed the pro forma effect of using the fair value
based method to account for our stock-based compensation as required by
SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure."
The following table illustrates the effect on net income (loss) and net
income (loss) per common share if we had applied the fair value
recognition provisions of SFAS No. 148.
(in thousands)
--------------
2002 2001 2000
---- ---- ----
Net income (loss) before
stock-based compensation, as reported $ (28,509) $ (10,896) $ 21,264
Stock based compensation using the fair
value method, net of tax (3,159) (5,877) (2,505)
---------- ---------- ----------
Pro-forma net income (loss) available to
common shareholders $ (31,668) $ (16,773) $ 18,759
========== ========== ==========
Pro-forma basic income (loss) per common
share $ (2.44) $ (1.31) $ 1.49
Pro-forma diluted income (loss) per common
share $ (2.44) $ (1.31) $ 1.44
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. Option valuation models also
require the input of highly subjective assumptions such as expected
option life and expected stock price volatility. Because our employee
stock-based compensation plan has characteristics significantly
different from those of traded options and because changes in the
subjective input assumptions can materially affect the fair value
estimate, we believe that the existing option valuation models do not
necessarily provide a reliable single measure of the fair value of
awards from those plans.
The weighted-average fair value of each option grant is estimated on
the date of grant using the Black-Scholes option pricing model using
the following weighted-average assumptions: (i) expected dividend yield
of 0.00%, (ii) expected volatility of 104.0%, 96.86% and 98.75% for
fiscal 2002, 2001 and 2000, respectively, (iii) expected life of eight
years for fiscal 2002, nine years for fiscal 2001 and seven years for
fiscal 2000, and (iv) risk-free interest rate of 3.55%, 5.71% and 5.01%
for fiscal 2002, 2001 and 2000, respectively.
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 income (loss) per share is computed based
on the weighted average shares outstanding and potentially dilutive
common stock equivalent shares. Approximately 127,242 shares of common
stock equivalent shares are not included in the computation of diluted
loss per share for fiscal 2002 because the effect would have been
anti-dilutive.
F-12
Weighted average number of common shares outstanding for each fiscal
year are determined as follows:
(in thousands)
--------------
2002 2001 2000
---- ---- ----
Weighted average number of
common shares outstanding 12,957 12,807 12,589
Effect of dilutive securities:
Warrants that are common stock
equivalents - - 33
Options that are common stock
equivalents - - 444
------ ------ ------
Adjusted weighted average number
of common shares outstanding
for diluted computations 12,957 12,807 13,066
------ ------ ------
Use of Estimates
Our management has made a number of estimates and assumptions relating
to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period to prepare these financial statements in conformity
with generally accepted accounting principles in the United States.
Actual results could differ from those estimates.
Reclassifications
Certain prior period amounts have been reclassified to conform their
presentation to the fiscal 2002 financial statements.
Recent Accounting Pronouncements
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.
In November 2002, the FASB issued Interpretation No. ("FIN") 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others", which
requires elaborating on the disclosures that must be made by a
guarantor in financial statements about its obligations under certain
guarantees. It also requires that a guarantor recognize, at the
inception of certain types of guarantees, a liability for the fair
F-13
value of the obligation undertaken in issuing the guarantee. The
disclosure requirements of FIN 45 are effective for financial
statements issued after December 15, 2002, and have been applied in the
presentation of the accompanying consolidated financial statements. The
recognition requirements of FIN 45 are applicable for guarantees issued
or modified after December 31, 2002. We have not yet determined the
effect, if any; the recognition requirement for guarantees issued or
modified after December 31, 2002 will have on our business, results of
operations and financial condition.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure." This statement
amends SFAS No. 123, "Accounting for Stock-Based Compensation" to
provide alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee
compensation. SFAS No. 148 also amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for
stock-based compensation and the effect of the method used on reported
results. Certain of the disclosure modification are required for
fiscal years ending after December 15, 2002. We have not yet completed
the final evaluation of the transitioning options presented by SFAS
No. 148. However, during fiscal 2003, we expect to reach a
determination of whether and, if so, when to change our existing
accounting for stock-based compensation to the fair value method in
accordance with the transition alternatives of SFAS No. 148.
In January 2003, the FASB issued FIN 46 - "Consolidation of Variable
Interest Entities." FIN 46 clarifies the application of Accounting
Research Bulletin No. 51 - Consolidated Financial Statements to those
entities defined as "Variable Interest Entities" (more commonly
referred to as special purpose entities) in which equity investors do
not have the characteristics of a "controlling financial interest" or
do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. FIN 46 applies immediately to all Variable Interest Entities
created after January 31, 2003, and by the beginning of the first
interim or annual reporting period commencing after June 15, 2003 for
Variable Interest Entities created prior to February 1, 2003.
2. FISCAL 2002 RESTRUCTURING CHARGE
In December 2002, we recorded a restructuring charge of $14.4 million
in conjunction with the decision to close 23 stores as well as to
consolidate both our distribution center network and corporate overhead
structure. The purpose of these restructuring initiatives was to
improve store profitability, reduce costs and improve efficiency.
The charge and the related liability are recognized in accordance with
the Emerging Issues Task Force ("EITF") No. 94-3 "Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." EITF
No. 94-3 provides specific requirements as to the appropriate
recognition of costs associated with employee termination and other
exit costs.
Employee termination costs are recognized when, prior to the date of
the financial statements, management having the appropriate level of
authority to involuntarily terminate employees approves and commits us
to the plan of termination and establishes the benefits that current
employees will receive upon termination and the benefit is communicated
to employees. Other exit costs are costs resulting from an exit plan
that are not associated with or that do not benefit activities that
will be continued.
The components of the restructuring charge are computed based on our
estimate of the realizable value of the affected tangible assets,
including non-cash fixed asset write-downs and inventory liquidation
costs and estimated exit costs, including lease termination or sublease
costs, employee severance based on existing severance policies and
local laws and tear-down costs. The restructuring charge is described
in more detail in the following table.
F-14
(in thousands)
--------------
Lease termination costs $ 6,513
Inventory liquidation costs (non-cash)* 1,082
Fixed asset write-downs (non-cash)** 4,969
Employee termination costs 1,027
Other cash costs 807
--------------
$ 14,398
--------------
* A non-cash inventory liquidation cost of $1.1 million is recorded as
a component of cost of sales.
** Non-cash fixed asset write-downs of $5.0 million is recorded as a
valuation allowance for leasehold improvements and equipment.
As of February 1, 2003, we had closed 13 of the 23 identified stores.
Subsequent to February 1, 2003, we closed two additional stores; and
we, to date, had terminated the lease obligations of 11 of these closed
stores.
The balance of liability related to the fiscal 2002 restructuring
charge at February 1, 2003 was as follows:
(in thousands)
-------------
Balance at
Restructuring Cash Non-cash February 1,
Charge Payments Charges 2003
------------- -------- -------- -----------
Lease termination costs $ 6,513 $ - $ 35 $ 6,548
Inventory liquidation costs
(non-cash) 1,082 - (565) 517
Fixed asset write-downs
(non-cash) 4,969 - (1,317) 3,652
Employee termination costs 1,027 (119) - 908
Other cash costs 807 (21) - 786
------------- -------- -------- -----------
$ 14,398 $ (140) $(1,847) $ 12,411
------------- -------- -------- -----------
3. FISCAL 2001 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 was to
improve store profitability, streamline field operations, reduce costs
and improve efficiency.
The components of the restructuring charge are computed based on our
estimate of the realizable value of the affected tangible assets,
including non-cash fixed asset write-downs and inventory liquidation
costs and estimated exit costs, including lease termination or sublease
costs, employee severance based on existing severance policies and
local laws and tear-down costs. The restructuring charge is described
in more detail in the following table.
(in thousands)
--------------
Lease termination costs $ 13,724
Inventory liquidation costs (non-cash)* 2,870
Fixed asset write-downs (non-cash)** 2,052
Employee termination costs 1,206
Other cash costs 1,379
--------------
$ 21,231
--------------
* A non-cash inventory liquidation cost of $2.9 million is recorded as
a component of cost of sales.
** Non-cash fixed asset write-downs of $2.1 million is recorded as a
valuation allowance for leasehold improvements and equipment.
F-15
We closed 24 of these 28 stores during the first quarter of fiscal 2002
and the remaining four stores in January 2003. To date, we had
terminated the lease obligations of 21 of these stores. In light of the
favorable experience related to the costs of closing these stores, we
recorded a non-cash adjustment to reduce the reserve for the fiscal
2001 restructuring initiatives by approximately $5.0 million during the
fourth quarter of fiscal 2002. The adjustment included (1) reduction of
reserve for lease termination costs by $3.8 million, (2) reduction of
reserve for inventory liquidation costs by $1.3 million, and (3) an
additional reserve for fixed asset write-downs of $94,000.
The balance of liability related to the fiscal 2001 restructuring
charge at February 1, 2003 was as follows:
(in thousands)
-------------
Balance at
Restructuring Cash Non-cash February 1,
Charge Payments Charges 2003
------------- -------- -------- -----------
Lease termination costs $ 13,724 $(5,953) $ (3,496) $ 4,275
Inventory liquidation costs
(non-cash) 2,870 - (2,851) 19
Fixed asset write-downs
(non-cash) 2,052 - (1,919) 133
Employee termination costs 1,206 (1,136) - 70
Other cash costs 1,379 (1,102) - 277
------------- -------- -------- -----------
$ 21,231 $(8,191) $ (8,266) $ 4,774
------------- -------- -------- -----------
4. NOTE 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, would
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 expired on October 11, 2002, and we have
not made any direct advances to the Borrower thereafter.
As of February 1, 2003, the outstanding borrowings plus accrued
interest under this Agreement were approximately $1.1 million, which
was fully reserved.
F-16
5. LEASEHOLD IMPROVEMENTS AND EQUIPMENT
Leasehold improvements and equipment consist of the following:
(in thousands)
--------------
February 1, February 2,
2003 2002
----------- -----------
Furniture, fixtures and equipment $ 59,455 $ 57,971
Leasehold improvements 14,263 13,683
Automobiles 890 823
Equipment under capital leases 2,549 3,153
----------- -----------
77,157 75,630
Less: accumulated depreciation, amortization
and valuation allowance
(48,555) (38,588)
----------- -----------
$ 28,602 $ 37,042
----------- -----------
6. GOODWILL
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 would have been
reported had the new rules been in effect during the fiscal years ended
February 1, 2003, February 2, 2002 and February 3, 2001 (in thousands,
except per share data):
2002 2001 2000
---- ---- ----
Reported net income (loss) $ (28,509) $ (10,896) $ 21,264
Add back goodwill amortization, net of tax - 984 1,124
---------- ---------- --------
Adjusted net income (loss) $ (28,509) $ (9,912) $ 22,388
---------- ---------- --------
Basic net income (loss) per common share
Reported net income (loss) $ (2.20) $ (0.85) $ 1.69
Goodwill amortization, net of tax - 0.08 0.09
---------- ---------- ---------
Adjusted net income (loss) $ (2.20) $ (0.77) $ 1.78
---------- ---------- ---------
7. ACCRUED EXPENSES
Accrued expenses consist of the following:
(in thousands)
--------------
February 1, February 2,
2003 2002
----------- -----------
Accrued compensation and related costs $ 4,070 $ 4,554
Accrued restructuring charges 11,117 12,653
Accrued workers compensation 4,741 2,341
Other accrued expenses 7,903 8,370
----------- -----------
$ 27,831 $ 27,918
----------- -----------
F-17
8. LONG-TERM DEBT AND REVOLVING CREDIT FACILITY
Long-term debt and revolving credit facility consist of the following:
(in thousands)
--------------
February 1, February 2,
2003 2002
----------- -----------
Junior subordinated notes, non-interest bearing, $ 9,445 $ 10,376
discounted at a rate of 10%, principal payments
in annual installments of $3.0 million and final
balloon payment of $5.3 million due May 2005
Less current maturities (3,000) (2,000)
----------- -----------
Long-term debt, net of current maturities $ 6,445 $ 8,376
----------- -----------
Revolving credit facility $ 6,300 $ -
Revolving Credit Facility
We have a $50.0 million revolving credit facility with a financial
institution. Under this revolving credit facility, we may borrow up to
70% of our eligible inventory and 85% of our eligible accounts
receivable, as defined, up to $50.0 million. The credit facility also
included a $15.0 million sub-facility for letters of credit. In
September 2002, we extended the term of this revolving credit facility
until March 2006. As of February 1, 2003, interest on the credit
facility was at the prime rate plus 0.50%, or at our election, LIBOR
plus 2.50%. 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 1.00% and LIBOR
borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. The revolving
credit facility provides for a $7.5 million availability block against
our availability calculation as defined. 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.
At February 1, 2003, we were in compliance with all financial
covenants, as defined, and had outstanding borrowings of $6.3 million
and letters of credit of $5.1 million under our revolving credit
facility. At February 1, 2003, based on eligible inventory and accounts
receivable, we were eligible to borrow $32.5 million under our
revolving credit facility and had $13.6 million available after giving
effect for the $7.5 million availability block, as defined.
Junior Subordinated Notes
The Junior Subordinated Notes are non-interest bearing and are
reflected on our balance sheets at the present value using a discount
rate of 10%. As of February 1, 2003, the Junior Subordinated Notes had
a face value of $11.3 million and a related unamortized discount of
$1.9 million, resulting in a net carrying value of $9.4 million. The
discount is amortized to interest expense as a non-cash charge until
the notes are paid in full. We made a principal payment on the Junior
Subordinated Notes of $2.0 million in December 2002. Additional
principal payments are scheduled on December 31, 2003 ($3.0 million)
and December 31, 2004 ($3.0 million) and a final payment on May 28,
2005 ($5.3 million).
F-18
9. INCOME TAXES
Significant components of income taxes (benefit) are as follows:
(in thousands)
--------------
2002 2001 2000
---- ---- ----
Federal income taxes (benefit)
Current $ (8,200) $ (3,069) $ 11,249
Deferred (8,321) (2,754) (3,596)
---------- ---------- ----------
(16,521) (5,823) 7,653
---------- ---------- ----------
State income taxes (benefit)
Current (204) (541) 2,088
Deferred (1,427) (486) (683)
---------- ---------- ----------
(1,631) (1,027) 1,405
---------- ---------- ----------
$(18,152) $ (6,850) $ 9,058
---------- ---------- ----------
We have received the federal tax refund of $8.2 million in March 2003.
The principal temporary differences that give rise to significant
portions of the deferred tax assets and liabilities are presented
below:
(in thousands)
--------------
February 1, February 2,
2003 2002
----------- -----------
Deferred tax assets
Net operating loss carryforwards $ 10,483 $ 7,644
Compensated absences and bonuses 3,002 2,719
Deferred rent 1,325 1,807
Closed store accrual 101 299
Excess of tax over book inventory 3,648 1,649
Accrued expenses 12,255 7,552
Fixed assets 490 313
Other 1,174 748
------------ -----------
Total gross deferred tax assets 32,478 22,731
Less: valuation allowance (7,647) (7,647)
------------ -----------
Net deferred tax assets 24,831 15,084
------------ -----------
Deferred tax liabilities
Tax basis difference 4,349 4,349
------------ -----------
Deferred tax liabilities 4,349 4,349
------------ -----------
Net deferred tax asset $ 20,482 $ 10,735
------------ -----------
We have established a valuation allowance because we are uncertain when
we may realize the benefits of our deferred tax assets and annual
limitations on the usage of net operating loss carryforwards.
F-19
The difference between the expected income taxes (benefit) computed by
applying the U.S. federal income tax rate of 35% to net income (loss)
from continuing operations for each of the fiscal years 2002, 2001 and
2000, and actual taxes (benefit) is a result of the following:
(in thousands)
--------------
2002 2001 2000
---- ---- ----
Computed "expected" taxes (benefit) $(16,331) $ (6,211) $10,612
Amortization of goodwill - 656 656
Change in valuation allowance - - (3,064)
Business credits (195) (238) (86)
State income taxes, net of federal
income tax credit (1,586) (1,064) 1,819
Refund of taxes - - (900)
Other, net (40) 7 21
--------- --------- --------
$(18,152) $ (6,850) $ 9,058
--------- -------- --------
At February 1, 2003, we had net operating loss carryforwards for
federal income tax purposes of approximately $26.2 million that expire
starting in fiscal 2012. A portion of these losses is limited under
Section 382 of the Internal Revenue Code due to prior ownership
changes.
10. LEASE COMMITMENTS
We operate retail stores, distribution centers and administrative
offices under various operating leases. Total rent expense was
approximately $42.5 million, $40.7 million and $29.9 million, including
contingent rent expense of approximately $98,000, $228,000 and
$435,000, for fiscal years ended February 1, 2003, February 2, 2002 and
February 3, 2001, respectively.
Rent expense is recorded on a straight-line basis over the life of the
lease. For fiscal 2002, cash payment requirements exceeded rent expense
by approximately $414,000. For fiscal 2001 and 2000, rent expense
charged to operations exceeded cash payment requirements by
approximately $264,000 and $1.1 million, respectively, and resulted in
an increase to the deferred rent liability for the same amount.
We were obligated under various capital leases for equipment that
expired at various dates during fiscal 2003. Equipment and related
accumulated depreciation recorded under capital leases are as follows:
(in thousands)
--------------
February 1, February 2,
2003 2002
----------- -----------
Equipment $ - $ 584
Less: accumulated depreciation - (575)
----------- -----------
$ - $ 9
----------- -----------
F-20
At February 1, 2003, the future minimum lease payments under operating
leases with remaining non-cancelable terms are as follows:
(in thousands)
--------------
Fiscal year:
2003 $ 29,903
2004 27,626
2005 24,264
2006 18,111
2007 13,076
Thereafter 44,422
--------------
Total minimum lease payments $ 157,402
--------------
11. STOCKHOLDERS' EQUITY
We have 35,000,000 shares of common stock authorized for issuance at a
par value of $0.01 per share. At February 1, 2003, we have reserved
1,367,346 shares of common stock for issuance in connection with our
stock option plan and 450,000 shares of common stock for issuance
related to stock options issued outside our stock option plan. We have
also reserved 299,643 shares for issuance under the employee stock
purchase plan and 82,690 shares for issuance related to outstanding
warrants.
We have never paid cash dividends on our common stock and do not
anticipate paying cash dividends in the foreseeable future. Currently,
we are contractually prohibited from paying cash dividends on the
common stock under the terms of our existing revolving credit facility
and junior subordinated notes without the consent of the lenders.
As of February 1, 2003, the outstanding stock subscription notes
receivable balance was $1.1 million, net of a valuation allowance. All
outstanding stock subscription notes receivable are either due from
current or former members of management with a five-year term with
maturity dates from April 29, 2003 to July 29, 2003 and an interest
rate of 8.0% per annum. At February 1, 2003, based on the current stock
price compared to the principal notes receivable balance plus accrued
interest, we incurred a non-cash charge of approximately $1.0 million
to reflect the fair value of these stock subscription notes receivable.
The valuation allowance relates to three notes with a maturity date of
April 29, 2003 and due from two former members of management in the
original principal amount of $1.4 million, $250,000 and $250,000
respectively, with certain limitations on their personal liability to
repay these notes. The first note, due from Michael M. Searles, our
former President and Chief Executive Officer, in the principal amount
of $1.4 million is secured by 242,662 shares of our common stock, and
he has personal liability to repay up to $600,000, including accrued
interest. The second note, due from Jonathan W. Spatz, our former Chief
Financial Officer, in the principal amount of $250,000 is secured by
32,932 shares of our common stock, and he has personal liability to
repay up to $107,000, including accrued interest. The third note, also
due from Mr. Spatz, in the principal amount of $250,000 is secured by
43,332 shares of our common stock, and he has personal liability for
the entire principal balance plus accrued interest. The remaining
outstanding stock subscription notes receivable are believed to be
fully collectible with recourse.
In fiscal 2002, we issued a total of 450,000 restricted shares of
common stock to certain of our new senior management members as
inducement to accept employment at the time they were hired. These
restricted shares shall vest in installments; 150,000 shares at such
time as the closing market price of our common stock equals or exceeds
$10.00 per share for 20 consecutive trading days in any three-month
period, 150,000 shares at such time as the closing market price of our
F-21
common stock equals or exceeds $20.00 per share for 20 consecutive
trading days in any three-month period, and the final 150,000 shares at
such time as the closing market price of our common stock equals or
exceeds $30.00 per share for 20 consecutive trading days in any
three-month period. In the event that the closing market price of our
common stock equals or exceeds $10.00, $20.00 and $30.00 per share for
20 consecutive trading days in any three-month period, at a minimum we
may incur non-cash charges of approximately $1.5 million, $3.0 million,
and $4.5 million, respectively.
12. STOCK OPTIONS AND WARRANTS
At February 1, 2003, warrants to purchase 82,690 common shares were
outstanding. These warrants have an exercise price of $19.91 and expire
in May 2005.
We have a stock option plan, the Amended and Restated Factory 2-U
Stores, Inc. 1997 Stock Option Plan (the "Plan"). Options may be
granted as incentive or nonqualified stock options. We may grant up to
2,157,980 options under this Plan. The options are issued at fair
market value with exercise prices equal to our stock price on the date
of grant. Options vest over three to five years; are exercisable in
whole or in installments; and expire from five to ten years from the
date of grant.
Our Board of Directors has granted stock options to members of the
Board and to our management. A summary of our stock option activity and
related information is as follows:
Number of Weighted average
options exercise price
--------- ----------------
Balance at January 29, 2000 1,380,438 $ 10.53
Granted 335,584 28.35
Exercised (341,932) 7.60
Canceled (88,658) 16.85
---------- ----------------
Balance at February 3, 2001 1,285,432 15.52
Granted 238,323 20.64
Exercised (66,456) 7.90
Canceled (41,141) 24.38
---------- ----------------
Balance at February 2, 2002 1,416,158 16.49
Granted 807,556* 5.34
Exercised (124,764) 7.36
Canceled (375,546) 20.09
---------- ----------------
Balance at February 1, 2003 1,723,404 $ 11.14
Exercisable at February 1, 2003 734,196 $ 12.13
F-22
The following table summarizes information about the stock options
outstanding at February 1, 2003:
Weighted-
average Weighted- Weighted-
Number of contractual average Number of average
Range of options life exercise options exercise
exercise prices outstanding (Years) price exercisable price
- --------------- ----------- ----------- -------- ----------- ----------
$0.00 - $4.23 612,366* 7.3 $ 2.38 115,625 $ 2.14
$4.23 - $8.45 343,160 2.6 $ 6.75 320,560 $ 6.75
$8.45 - $12.68 92,243 6.0 $ 12.06 52,111 $ 12.05
$12.68 - $16.90 277,670 8.5 $ 14.88 47,798 $ 15.13
$16.90 - $21.13 76,410 6.8 $ 20.19 27,202 $ 19.69
$21.13 - $25.35 148,825 7.1 $ 24.21 64,878 $ 24.13
$25.35 - $29.58 130,287 5.9 $ 26.81 83,045 $ 26.46
$29.58 - $33.80 10,193 7.7 $ 31.89 5,277 $ 31.83
$33.80 - $38.03 25,750 6.9 $ 36.94 13,000 $ 37.06
$38.03 - $42.25 6,500 4.8 $ 40.22 4,700 $ 40.92
----------- ----------- -------- ----------- ---------
1,723,404 6.3 $ 11.14 734,196 $ 12.13
----------- -----------
* Including 450,000 stock options granted to certain of our new senior
management members as an inducement to accept employment at the time when
they were hired, subject to shareholder approval of an appropriate amendment
to the Plan. In the event that such an amendment is not approved, we are
nevertheless contractually obligated with respect to such options which will
not be granted under the Plan.
In fiscal 2000, we recorded non-cash stock-based compensation expense
of $4.8 million when 92,961 stock options with a market price hurdle of
$24.89 became exercisable in July 2000 and 71,419 stock options with a
market price hurdle of $33.19 became exercisable in August 2000.
In fiscal 2001, we recorded non-cash stock-based compensation expense
of $456,000 as a result of the removal of the market price hurdle of
19,361 stock options held by former Executive Vice President who
retired in August 2001.
In fiscal 2002, there was no event related to our stock options
triggered by the market price hurdle; and therefore, we did not record
any non-cash stock-based compensation expense.
13. EMPLOYEE BENEFITS
We sponsor a defined contribution plan, qualified under Internal
Revenue Code Section 401(k), for the benefit of employees who have
completed twelve months of service and who work a minimum of 1,000
hours during that twelve-month period. We make a matching contribution
equal to 20% of participating employees' voluntary contributions.
Participants may contribute from 1% to 15% of their compensation
annually, subject to IRS limitations. We contributed approximately
$238,000, $232,000 and $208,000 in fiscal 2002, 2001 and 2000,
respectively.
We also sponsor the Factory 2-U Stores, Inc. Employee Stock Purchase
Plan which allows eligible employees to acquire shares of our Common
Stock at a discount from market price, at periodic intervals, paid for
with accumulated payroll deductions. The discount is 15% of the lower
of the market price per share as quoted on the NASDAQ National Market
on the first and last day of an offering period. The Plan will
terminate when all 350,000 shares available for issuance under the Plan
are sold although the Plan may be terminated earlier by us at any time.
As of February 1, 2003, eligible employees had purchased 50,357 shares
of our Common Stock under the Plan.
F-23
14. LEGAL MATTERS, COMMITMENTS AND CONTINGENCIES
On December 15, 2000, Pamela Jean O'Hara ("O'Hara"), a former employee
in our Alameda, California store, filed a lawsuit against us entitled
"Pamela Jean O'Hara, Plaintiff, vs. Factory 2-U Stores, Inc., et al.,
Defendants", Case No. 834123-5, in the Superior Court of the State of
California for the County of Alameda (the "O'Hara Lawsuit"). On August
2, 2001, O'Hara and four other former employees in our Alameda store,
filed a Second Amended Complaint in the O'Hara Lawsuit.
The Second Amended Complaint in the O'Hara Lawsuit alleges that we
violated the California Labor Code and Industrial Wage Commission
Orders, as well as the California Unfair Competition Act, by failing to
pay overtime to the plaintiffs. Plaintiffs purport to bring this action
on behalf of themselves and all other store managers, assistant store
managers and other undescribed "similarly-situated employees" in our
California stores from December 15, 1996 to present. The Second Amended
Complaint sought compensatory damages, interest, penalties, attorneys'
fees, and disgorged profits, all in unspecified amounts. The Second
Amended Complaint also sought injunctive relief requiring payment of
overtime to "non-exempt" employees. On September 4, 2001, we filed an
answer in which we denied the material allegations of the Second
Amended Complaint.
Pursuant to an Order dated December 3, 2001, the Court in the O'Hara
Lawsuit granted Plaintiff's motion for certification of two plaintiff
classes: (1) all persons who have been employed as assistant store
managers at one of our California stores at any time after December 15,
1996, and who worked hours which would have entitled them to overtime
had they not been exempt employees; and (2) all persons who have been
employed as store managers at one of our California stores at any time
after December 15, 1995, and who worked hours which would have entitled
them to overtime had they not been exempt employees.
We made a settlement offer to each member of the two plaintiffs
classes, pursuant to which we offered to pay $1,000 for each year of
service (or a pro rata portion of each partial year) after December 15,
1996 and between February 1, 2002 in exchange for a release of all
overtime claims. Approximately 263 members of the plaintiff classes
accepted the settlement offer.
In August 2002 we reached a tentative settlement of the O'Hara Lawsuit.
On November 7, 2002, the Court entered an order granting final approval
of the settlement agreement. Pursuant to the settlement agreement, we
have agreed to pay the plaintiff class members (and their attorneys) a
total of $2,000,000 in settlement of all their claims. The settlement
became effective as of April 25, 2003.
In conjunction with the settlement of this O'Hara litigation, we
recorded a charge of approximately $2.1 million in fiscal 2002, and we
have paid approximately $869,000 as of February 1, 2003.
We are 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 advice 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.
We have entered into an employment contracts with three of our
officers, which defines their duties and compensation and which could
provide severance in the event of their termination of employment.
F-24
15. RELATED PARTY TRANSACTIONS
In March 1997, we entered into an agreement with Three Cities Research,
Inc. ("TCR") engaging TCR to act as financial advisor to us. Under this
agreement, we pay TCR an annual fee of $50,000 and reimburse TCR for
all of its out-of-pocket expenses incurred for services rendered, up to
an aggregate of $50,000 annually. We reimbursed TCR for out-of-pocket
expenses in the approximate amounts of $47,000, $34,000 and $37,000
during fiscal 2002, 2001 and 2000, respectively. As of February 1,
2003, TCR controlled approximately 22.8% of our outstanding common
stock and a principal of TCR is a member of our Board of Directors.
On November 4, 2002, with the approval of the Board of Directors, we
appointed Ronald Rashkow to a newly-created position as the Lead
Director to our Board for three years. In connection with his Lead
Director duties, we granted 50,000 options at an exercise price of
$1.68 per share, the fair market value of our common stock on the date
of grant. These options are fully vested and are exercisable for five
years from the date of grant. We also issued 25,000 shares of
restricted common shares to Mr. Rashkow at a price of $0.01 per share,
subject to his completion of 12 months of service. In addition to this
equity compensation, we are also required to pay monthly fee of $12,500
plus reimbursement of all reasonable out-of-pocket expenses.
16. SUBSEQUENT EVENTS (UNAUDITED)
Subsequent to February 1, 2003, the following events occurred:
Revolving Credit Facility
On February 14, 2003, we obtained the approval from the lender to
expand the scope of the collateral securing the obligations under our
revolving credit facility and increased the sub-facility for letters of
credit to $15.0 million. In addition, we obtained the lender's consent
to the incurrence by us of up to $10.0 million in additional
indebtedness, which may be secured by a junior lien on the collateral.
On April 10, 2003, we amended the terms of our revolving credit
facility to add $7.5 million of term loans, to add one financial
covenant, and to amend certain reporting provisions and other terms.
The term loans consist of a $6.5 million junior term note secured
primarily by inventory and accounts receivable and a $1.0 million term
note secured primarily by equipment and other assets. These notes bear
interest at the rate of 14.50% per annum on the then current
outstanding balance, and mature on April 10, 2004. The $6.5 million
junior term note can be extended for one additional year. The
financial covenant, which is related to achieving a minimum earnings
before interest, tax obligations, depreciation and amortization expense
(EBITDA), as defined, is subject to testing only if the Triggering
Availability, as defined, is less than $10.0 million on the last three
days of each month commencing on May 3, 2003. This financial covenant
will terminate at such time that the $7.5 million term loans are no
longer outstanding.
At April 25, 2003, we were in compliance with all financial covenants,
as defined, and had outstanding borrowings of $7.4 million and letters
of credit of $12.3 million under our revolving credit facility. In
addition, based on eligible inventory and accounts receivable, we were
eligible to borrow $45.0 million under our revolving credit facility
and had $17.8 million available for future borrowings after giving
effect for the $7.5 million availability block, as defined.
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Stockholders' Equity
On March 6, 2003, we completed a private offering of 2,532,679 shares
of our common stock for aggregate proceeds of approximately $5.7
million, net of placement fees. The placement agent also received
warrants to purchase 75,000 shares of our common stock at an exercise
price of $3.50 per share. These warrants will expire in March 2006.
On March 21, 2003, two stock subscription notes in the principal amount
of $99,548 and $50,000, respectively, plus accrued interest, were paid
in full by current members of management.
On April 29, 2003, certain shareholder notes matured and we foreclosed
on the collateral as of the close of business. The principal and
accrued interest due on Mr. Searles' note was $1,458,608 and the
collateral had a market value on April 29, 2003 of $1,198,750,
resulting in a deficiency of $259,858, for which he is not personally
liable for the deficiency under the terms of the note. In addition,
the principal and accrued interest on Mr. Spatz's notes were $688,197
and the collateral had a market value on April 29, 2003 of $376,744,
resulting in a deficiency of $311,453, for which he is personally
liable for $136,614 of the deficiency under the terms of his notes.
Additionally, on April 29, 2003, the principal and accrued interest due
on the notes for Tracy W. Parks, our former Executive Vice President
and Chief Operating Officer, was $117,042 and the collateral had a
market value of $82,197, resulting in a deficiency of $34,845, for
which he is personally liable under the terms of his notes.
Related Party Transactions
On March 6, 2003, two individual investment entities controlled by
TCR, Three Cities Offshore II, C.V. and Three Cities Fund II, L.P.,
participated in our private offering transaction and acquired 407,207
shares and 240,793 shares of our common stock, respectively, at a
purchase price of $2.75 per share (a price in excess of the closing
market price of our common stock on such date), for an aggregate
purchase price of $1,782,000. Including these additional shares
acquisition, TCR currently owns approximately 23.3% of our
outstanding common stock. Mr. Rashkow, our Lead Director, also
participated in this private offering transaction and acquired
72,700 shares of our common stock at a price of $2.75 per share
(a price in excess of the closing market price of our common stock on
such date), for an aggregate purchase price of $199,925. Including
these 72,700 shares, Mr. Rashkow's total current direct and indirect
ownership of our outstanding common stock is approximately 1.6%.
Settlement Agreement
On March 19, 2003, we entered into a settlement agreement with a former
candidate for an executive level position who alleged that we breached
an oral agreement to employ him for one year. Under the terms of the
settlement agreement, we are obligated to pay $390,000 payable in 52
equal bi-weekly installments.
Legal Matters
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of
our current employees, filed a lawsuit against us entitled
"Lynda Bray, Masis Manougian, etc., Plaintiffs, vs. Factory 2-U Stores,
Inc., etc., Defendants", Case No. RCV071918 in the Superior Court of
the State of San Bernardino (the "Bray Lawsuit"). The complaint in the
Bray Lawsuit alleges that we violated the settlement agreement
in the O'Hara Lawsuit, the California Labor Code, Industrial Wage
Commission Orders and the California Unfair Competition Act by
failing to pay wages and overtime for all hours worked, by failing
to document all hours worked, by threatening to retaliate against
employees who sought to participate in the settlement of the O'Hara
Lawsuit and by failing to inform prospective employees of unpaid wage
claims. Plaintiffs purport to bring this action on behalf of all
persons who were employed in one of our California stores at any
F-26
time after December 15, 1996. Plaintiffs seek compensatory and
exemplary damages, interest, penalties, attorneys' fees and disgorged
profits in an amount which plaintiffs estimated to be not less than
$100,000,000. Plaintiffs also seek injunctive relief requiring
correction of the alleged unlawful practices.
We believe that the material allegations of the complaint in the Bray
Lawsuit are false and that each of the claims asserted in the Bray
Lawsuit is meritless. We also believe that the settlement in the
O'Hara Lawsuit bars some of the claims asserted in the Bray Lawsuit.
We intend to vigorously defend against the Bray Lawsuit.
17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The results of operations for fiscal 2002 and 2001 were as follows:
(in thousands, except per share data)
-------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- -------- ------- -------
Fiscal 2002
-----------
Net sales $116,951 $128,088 $134,506 $155,725
Gross profit 41,158 41,029 44,652 35,546
Operating income (4,977) (9,418) (4,771) (25,884)
Net loss (3,141) (5,837) (3,516) (16,015)
Loss per share
Basic $ (0.24) $ (0.45) $ (0.27) $ (1.23)
Diluted (0.24) (0.45) (0.27) (1.23)
Fiscal 2001
-----------
Net sales $125,824 $139,254 $145,568 $169,814
Gross profit 41,759 49,820 50,260 53,231
Operating income (loss) (2,165) 113 (216) (14,518)
Net loss (1,448) (195) (324) (8,929)
Loss per share
Basic $ (0.11) $ (0.02) $ (0.03) $ (0.70)
Diluted (0.11) (0.02) (0.03) (0.70)
As a result of rounding differences, total amounts disclosed in the
Statements of Operations may not agree to the sum of the amounts
disclosed above for the four quarters.
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