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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 1O-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended November 1, 2003
----------------
Commission File Number: 1-10089
FACTORY 2-U STORES, INC.
(Exact name of registrant as specified in its charter)
Delaware 51-0299573
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4000 Ruffin Road, San Diego, CA 92123-1866
------------------------------- ----------
(Address of principal executive office) (Zip Code)
(858) 627-1800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] YES [ ] NO
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). [X] YES [ ] NO
The number of shares outstanding of the registrant's common stock, as of
December 12, 2003 was 17,946,882 shares.
FACTORY 2-U STORES, INC.
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED NOVEMBER 1, 2003
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets as of November 1, 2003 (Unaudited), November 2,
2002 (Unaudited) and February 1, 2003...............................F-1
Statements of Operations (Unaudited) for the 13 and 39 weeks
ended November 1, 2003 and November 2, 2002 ........................F-3
Statements of Cash Flows (Unaudited) for the 39 weeks ended
November 1, 2003 and November 2, 2002 ..............................F-4
Notes to Financial Statements (Unaudited) ..........................F-5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ................................................3
Item 3. Quantitative and Qualitative Disclosures About Market Risk...........11
Item 4. Controls and Procedures .............................................12
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................13
Item 2. Changes in Securities and Use of Proceeds............................13
Item 4. Submission of Matters to a Vote of Security Holders..................13
Item 6. Exhibits and Reports on Form 8-K ....................................14
Signatures ................................................................16
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands)
November 1, November 2, February 1,
2003 2002 2003
----------- ----------- -----------
(Unaudited) (Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 5,731 $ 5,922 $ 3,465
Merchandise inventory 85,207 83,461 32,171
Accounts receivable, net 481 2,613 884
Income taxes receivable - 7,820 8,200
Prepaid expenses 6,622 6,109 5,436
Deferred income taxes 9,753 3,553 9,732
----------- ----------- ----------
Total current assets 107,794 109,478 59,888
Leasehold improvements and
equipment, net 22,691 34,856 28,602
Deferred income taxes 17,656 7,182 10,750
Other assets 781 985 963
Goodwill 26,301 26,301 26,301
----------- ----------- ----------
Total assets $ 175,223 $ 178,802 $ 126,504
=========== =========== ==========
The accompanying notes are an integral part of these financial statements.
(continued)
F-1
FACTORY 2-U STORES, INC.
Balance Sheets
(in thousands)
(continued)
November 1, November 2, February 1,
2003 2002 2003
----------- ----------- -----------
(Unaudited) (Unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term
debts $ 3,035 $ 2,000 $ 3,000
Junior secured term loans 7,500 - -
Accounts payable 54,180 42,047 27,961
Taxes payable 4,859 3,234 5,840
Accrued expenses and other
liabilities 23,117 26,322 27,831
----------- ----------- ----------
Total current liabilities 92,691 73,603 64,632
Revolving credit facility 17,751 30,046 6,300
Long-term debts 7,280 9,181 6,445
Accrued restructuring charges 4,749 3,578 1,747
Deferred rent 2,974 3,291 3,061
----------- ----------- ----------
Total liabilities 125,445 119,699 82,185
----------- ----------- ----------
Stockholders' equity:
Common stock, $0.01 par value;
35,000 shares authorized and
18,146 shares, 12,970 shares
and 13,476 shares issued and
outstanding, respectively 181 130 135
Stock subscription notes receivable - (2,149) (1,116)
Additional paid-in capital 137,932 122,323 122,516
Accumulated deficit (88,335) (61,201) (77,216)
----------- ----------- ----------
Total stockholders' equity 49,778 59,103 44,319
----------- ----------- ----------
Total liabilities and
stockholders' equity $ 175,223 $ 178,802 $ 126,504
=========== =========== ==========
The accompanying notes are an integral part of these financial statements.
F-2
FACTORY 2-U STORES, INC.
Statements of Operations
(in thousands, except per share data)
(Unaudited)
13 Weeks Ended 39 Weeks Ended
-------------- --------------
November 1, November 2, November 1, November 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net sales $ 121,925 $ 134,506 $ 349,931 $ 379,545
Cost of sales 80,269 89,854 232,071 252,706
----------- ----------- ----------- -----------
Gross profit 41,656 44,652 117,860 126,839
Selling and administrative expenses 45,579 49,057 133,082 144,936
Pre-opening and closing expenses - 366 221 1,069
----------- ----------- ----------- -----------
Operating loss (3,923) (4,771) (15,443) (19,166)
Interest expense, net 928 515 2,497 1,083
----------- ----------- ----------- -----------
Loss before income taxes (4,851) (5,286) (17,940) (20,249)
Income tax benefit (1,843) (1,770) (6,821) (7,755)
Net loss $ (3,008) $ (3,516) $ (11,119) $ (12,494)
=========== =========== =========== ===========
Loss per share
Basic $ (0.17) $ (0.27) $ (0.71) $ (0.97)
Diluted $ (0.17) $ (0.27) $ (0.71) $ (0.97)
Weighted average common shares outstanding
Basic 17,237 12,970 15,688 12,943
Diluted 17,237 12,970 15,688 12,943
The accompanying notes are an integral part of these financial statements.
F-3
FACTORY 2-U STORES, INC.
Statements of Cash Flows
(in thousands)
(Unaudited)
39 Weeks Ended
--------------
November 1, November 2,
2003 2002
----------- -----------
Cash flows from operating activities
Net loss $ (11,119) $ (12,494)
Adjustments to reconcile net loss to
net cash used in operating activities
Depreciation and amortization 10,079 11,424
Loss on disposal of equipment 19 48
Deferred income tax (6,821) -
Deferred rent (63) (330)
Stock subscription notes receivable
valuation adjustment (708) -
Issuance of common stock to board
members as compensation 12 36
Changes in operating assets and liabilities
Merchandise inventory (53,036) (28,601)
Income tax receivable 8,200 (7,820)
Prepaid expenses and other assets (585) 1,183
Advances to vendor (51) (3,314)
Repayments from vendor 86 1,834
Accounts payable 26,219 5,775
Accrued expenses and other liabilities (2,180) (2,044)
----------- -----------
Net cash used in operating activities (29,948) (34,303)
Cash flows from investing activities
Purchases of leasehold improvements and equipment (3,493) (8,065)
----------- -----------
Net cash used in investing activities (3,493) (8,065)
Cash flows from financing activities
Borrowings on revolving credit facility 111,076 74,421
Payments on revolving credit facility (99,625) (44,375)
Payments on long-term debt and capital lease
obligations (14) (19)
Proceeds from debt financing 7,500 -
Payment of deferred debt issuance costs (442) (121)
Proceeds from issuance of common stock, net 17,069 -
Proceeds from exercise of stock options - 918
Payments of stock subscription notes receivable 143 76
----------- -----------
Net cash provided by financing activities 35,707 30,900
Net increase (decrease) in cash 2,266 (11,468)
Cash at the beginning of the period 3,465 17,390
----------- -----------
Cash at the end of the period $ 5,731 $ 5,922
=========== ===========
Supplemental disclosure of cash flow information
Cash paid during the period for
Interest $ 1,287 $ 377
Income taxes $ 94 $ 1,323
Supplemental disclosure of non-cash investing and
financing activities
Acquisition of equipment under notes payable $ 151 $ -
Foreclosure of collateral on stock
subscription notes receivable $ 1,681 $ -
The accompanying notes are an integral part of these financial statements.
F-4
FACTORY 2-U STORES, INC.
Notes to Financial Statements
(Unaudited)
(1) Unaudited Interim Financial Statements
The accompanying unaudited financial statements do not include all of
the information and footnotes required by accounting principles
generally accepted in the United States for annual financial statements
and should be read in conjunction with the financial statements for the
fiscal year ended February 1, 2003 included in our Form 10-K/A as filed
with the Securities and Exchange Commission.
We believe that the unaudited financial statements as of and for the 13
weeks and 39 weeks ended November 1, 2003 and November 2, 2002 reflect
all adjustments (consisting of normal recurring adjustments) necessary
to present fairly the financial position, results of operations and
cash flows for the periods presented. Due to the seasonal nature of our
business, the results of operations for the interim period may not
necessarily be indicative of the results of operations for a full year.
Certain prior period amounts have been reclassified to conform their
presentation to the current period's financial statements.
(2) Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (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. The adoption of
this statement did not have a material impact on our financial position
or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting
Standard (the "SFAS") No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement provides
clarification on the financial accounting and reporting of derivative
instruments and hedging activities and requires contracts with similar
characteristics to be accounted for on a comparable basis. We are
currently in the process of assessing the effect of SFAS No.149 and do
not expect the adoption of it, which will be effective for contracts
entered into or modified after June 30, 2003, to have a material impact
on our financial position or results of operations.
F-5
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and
Equity." This statement establishes standards on the classification and
measurement of financial instruments with characteristics of both
liabilities and equity and is effective for financial instruments
entered into or modified after May 31, 2003. We do not expect the
adoption of this statement will have a material impact on our financial
position or results of operations.
(3) 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.
As of December 12, 2003, we closed 16 of these 23 stores and terminated
the lease obligations of 13 of these closed stores. Of the remaining
seven stores, we have decided to continue to operate four of these
stores as a result of certain landlord concessions; and we plan to
close the other three stores by March 2004. In addition, we have
completed the consolidation of our two former San Diego distribution
centers into one new distribution center, which is also located in San
Diego, California. We are currently seeking disposition of the leases
for these two former San Diego distribution facilities, as well as our
distribution facility in Lewisville, Texas.
The balance of the liability ($2.7 million was included in "Accrued
expenses and other liabilities" and $3.0 million was included in
"Accrued restructuring charges" in the accompanying balance sheets)
related to this fiscal 2002 restructuring charge at November 1, 2003
was as follows:
Balance at Balance at
February 1, Cash Non-cash November 1,
(in thousands) 2003 Payments Charges 2003
----------- -------- -------- -----------
Lease termination costs* $ 6,548 $(2,290) $ 588 $ 4,846
Employee termination costs 908 (562) (115) 231
Other costs 786 (260) 115 641
------- -------- ------ --------
$ 8,242 $(3,112) $ 588 $ 5,718
======= ======== ====== ========
* The non-cash charge portion consists primarily of the write-off of deferred
rent.
F-6
The balances of non-cash inventory liquidation costs and fixed asset
write-downs related to this fiscal 2002 restructuring charge at
November 1, 2003 were as follows:
Balance at Balance at
February 1, Usage/ November 1,
(in thousands) 2003 Adjustments 2003
----------- ----------- -----------
Inventory liquidation costs* $ 517 $ (103) $ 414
Fixed asset write-downs** $ 3,652 $ (656) $ 2,996
* The balance of inventory liquidation costs of approximately $414,000
as of November 1, 2003 was recorded as a valuation allowance for
merchandise inventory.
** The balance of fixed asset write-downs of approximately $3.0 million
as of November 1, 2003 was recorded as a valuation allowance for
leasehold improvements and equipment.
We continually monitor and evaluate the adequacy of this reserve and,
as new facts become available, will adjust this reserve as needed.
(4) 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 the restructuring was to improve store
profitability, streamline field operations, reduce costs and improve
efficiency.
We closed 24 of these 28 stores during the first quarter of fiscal 2002
and the remaining four stores in January 2003. As of December 12, 2003,
we had terminated the lease obligations of 23 of these closed 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, offset by (3) an additional reserve for fixed asset
write-downs of $94,000.
The balance of the liability ($884,000 was included in "Accrued
expenses and other liabilities" and $1.7 million was included in
"Accrued restructuring charges" in the accompanying balance sheets)
related to this fiscal 2001 restructuring charge at November 1, 2003
was as follows:
Balance at Non-cash Balance at
February 1, Cash Charges and November 1,
(in thousands) 2003 Payments Adjustments 2003
----------- -------- ----------- ------------
Lease termination costs $ 4,275 $ (1,765) $ - $ 2,510
Employee termination costs 70 (16) (54) -
Other costs 277 (127) (78) 72
----------- --------- ----------- -------------
$ 4,622 $ (1,908) $ (132) $ 2,582
=========== ========= =========== =============
F-7
The balances of non-cash inventory liquidation costs and fixed asset
write-downs related to this fiscal 2001 restructuring charge at
November 1, 2003 were as follows:
Balance at Balance at
February 1, Usage/ November 1,
(in thousands) 2003 Adjustments 2003
----------- ----------- -----------
Inventory liquidation costs* $ 19 $ - $ 19
Fixed asset write-downs** $ 133 $ 35 $ 168
* The balance of inventory liquidation costs of approximately $19,000
as of November 1, 2003 was recorded as a valuation allowance for
merchandise inventory.
** The balance of fixed asset write-downs of approximately $168,000 as
of November 1, 2003 was recorded as a valuation allowance for leasehold
improvements and equipment.
We continually monitor and evaluate the adequacy of this reserve and,
as new facts become available, adjust this reserve as needed.
(5) Revolving Credit Facility
On March 3, 2000, we entered into a $50.0 million revolving credit
facility agreement (the "Financing Agreement") with a financial
institution. Under the Financing Agreement, 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 revolving credit facility provides
for a $7.5 million availability block against our availability
calculation, as defined. The Financing Agreement also includes a $15.0
million sub-facility for letters of credit. Under the terms of the
revolving 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 1.0 % and LIBOR borrowings from LIBOR plus 1.5% to
LIBOR plus 3.0%. The Financing Agreement expires on March 3, 2006. We
are obligated to pay fees equal to 0.125% per annum on the unused
amount of the credit facility. We are contractually prohibited from
paying cash dividends on our common stock under the terms of the
Financing Agreement without the consent of the lender. As amended on
April 10, 2003, the credit facility is secured by a first lien on all
company assets excluding furniture, fixtures, machinery and equipment.
On February 14, 2003, 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, as defined.
On April 10, 2003, we amended the terms of our Financing Agreement (the
"Amended and Restated Financing Agreement") to add $7.5 million of term
loans, to add financial covenants, and to amend certain reporting
provisions and other terms. The term loans consist of a $6.5 million
junior term note secured by all company assets excluding furniture,
fixtures, machinery and equipment and a $1.0 million junior term note
secured by furniture, fixtures, machinery and equipment. These notes
bear interest at the rate of 14.5% per annum on the then current
F-8
outstanding balance, and mature on April 10, 2004. The $6.5 million
junior term note can be extended for an additional term of twelve
months, provided we are in compliance with certain financial conditions
and requirements, as specified in the Amended and Restated Financing
Agreement. 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 fiscal month commencing on May 3, 2003.
In addition, during the period from December 22 through January 5 of
each fiscal year, there shall be no outstanding direct borrowings and
letters of credit cannot exceed $12.2 million. These two financial
covenants will terminate at such time that the $7.5 million term loans
are no longer outstanding.
At November 1, 2003, we were in compliance with all financial
covenants, as defined, and had outstanding borrowings of $17.8 million
and letters of credit of $12.1 million under our revolving credit
facility. In addition, based on eligible inventory and accounts
receivable, we were eligible to borrow $49.7 million under our
revolving credit facility and had $12.3 million available for future
borrowings after deducting the $7.5 million availability block.
(6) Long-Term Debts
Our long-term debts primarily consist of Junior Subordinated Notes (the
"Notes"), which are non-interest bearing and are reflected on our
balance sheets at the present value using a discount rate of 10%. We
are prohibited from paying cash dividends on our common stock under the
terms of the Notes without the consent of the Notes holders.
As of November 1, 2003, the Notes had a face value of $11.3 million and
a related unamortized discount of $1.2 million, resulting in a net
carrying value of $10.1 million. The discount is amortized to interest
expense as a non-cash charge over the term of the Notes. We made a
principal payment on the Notes of $2.0 million in 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).
We are currently in negotiations with the holders of the Notes to
restructure the terms of the Notes. In the event that a scheduled
principal payment is not made when due, we are permitted to make such
payment within three months from the due date, provided that we pay
interest at ten percent per annum on the outstanding balance of the
Notes.
(7) Loss per Share and Comprehensive Loss
We compute loss per share in accordance with SFAS No. 128, "Earnings
Per Share." Under the provisions of SFAS No. 128, earnings/loss per
share is computed based on the weighted average shares outstanding.
Diluted earnings/loss per share is computed based on the weighted
average shares outstanding and potentially dilutive common equivalent
shares.
F-9
Common stock equivalent shares totaling 195,357 and 192,822 for 13
weeks and 39 weeks ended November 1, 2003, respectively, and 0 and
92,783 for 13 weeks and 39 weeks ended November 2, 2002, respectively,
are not included in the computation of diluted loss per share because
the effect would be anti-dilutive.
Our comprehensive loss equaled our net loss for the 13 weeks and 39
weeks ended November 1, 2003 and November 2, 2002.
(8) 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, "Accounting for Stock Issued to
Employees." Under the intrinsic value method, compensation expense is
recognized only in the event that the exercise 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 loss and net loss per
share if we had applied the fair value recognition provisions of SFAS
No. 148.
(in thousands, except per share data)
13 weeks ended 39 weeks ended
-------------- --------------
November 1, November 2, November 1, November 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net loss before stock-based compensation, $ (3,008) $ (3,516) $ (11,119) $ (12,494)
as reported
Stock-based compensation, using the fair (474) (786) (1,537) (2,377)
value method, net of tax
----------- ----------- ----------- -----------
Pro-forma net loss $ (3,482) $ (4,302) $ (12,656) $ (14,871)
----------- ----------- ----------- -----------
Pro-forma net loss per share $ (0.20) $ (0.33) $ (0.81) $ (1.15)
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.
F-10
The weighted-average fair value of each option grant is estimated on
the date of grant using the Black-Scholes option-pricing model with the
following weighted-average assumptions:
13 weeks ended 39 weeks ended
-------------- --------------
November 1, November 2, November 1, November 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
(i) Expected dividend yield 0.00% 0.00% 0.00% 0.00%
(ii) Expected volatility 103.53% 104.01% 103.61% 104.01%
(iii) Expected life 7 years 8 years 7 years 8 years
(iv) Risk-free interest rate 3.80% 3.55% 3.75% 3.55%
(9) Provision for Income Taxes
Based on our estimated effective tax rate for the entire fiscal year,
which is dependent on our ability to generate future taxable income and
to utilize the net operating loss carryforwards, we recorded an income
tax benefit of $1.8 million and $6.8 million for the 13 weeks and 39
weeks ended November 1, 2003, respectively.
(10) Private Offerings
On March 6, 2003, we completed a private offering of 2,515,379 shares
of our common stock for net proceeds of approximately $5.7 million,
after deducting placement fees and other offering expenses. In addition
to the placement fees, the placement agent received warrants to
purchase 75,000 shares of our common stock at an exercise price of
$3.50 per share, a 30% premium over the closing price of $2.68 on March
6, 2003. These warrants will expire in March 2006.
On August 20, 2003, we completed another private offering of 2,450,000
shares of our common stock for net proceeds of approximately $11.4
million, after deducting placement fees and other offering expenses.
This transaction also provides for warrants to purchase 490,000 shares
at the same price as the initial shares purchased, exercisable until
December 23, 2003. In addition to the placement fees, the placement
agent received warrants to purchase 112,500 shares of our common stock
at an exercise price of $6.00 per share, a 7% premium over the closing
price of $5.62 on August 20, 2003. These warrants will expire in August
2006. Depending on the number of additional shares purchased by
investors, the placement agent is entitled to receive additional fees
and an additional warrant to purchase up to 22,500 shares at $6.00 per
share.
We used the net proceeds of these two private offerings primarily for
working capital purposes.
(11) Stock Subscription Notes Receivable
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, which were secured by
the underlying common stock of the Company, at that time were either
due from current or former members of management with a five-year term
and had maturity dates ranging from April 29, 2003 to July 29, 2003 and
an interest rate of 8.0% per annum.
F-11
On March 21, 2003, two stock subscription notes in the principal amount
of $92,642 and $50,000, respectively, plus accrued interest were paid
in full by current members of management.
On April 29, 2003, the remaining stock subscription notes matured and
we foreclosed on the shares of our common stock that served as
collateral as of the close of business. The principal and accrued
interest on the note due from Michael M. Searles, our former President
and Chief Executive Officer, was $1,458,608 and the collateral's market
value on April 29, 2003 was $1,198,750, resulting in a deficiency of
$259,858, for which Mr. Searles was not personally liable under the
terms of the note. In addition, the principal and accrued interest on
two notes due from Jonathan W. Spatz, our former Chief Financial
Officer, were $688,197 and the collateral's market value on April 29,
2003 was $376,744, resulting in a deficiency of $311,453, for which Mr.
Spatz 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 on the notes due from Tracy W. Parks, our former 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.
In conjunction with the foreclosures as discussed above, we recorded
income of approximately $708,000 to adjust the valuation allowance
established as of February 1, 2003 as a result of the increase in the
market value of our common stock on April 29, 2003 as compared to
February 1, 2003.
In August 2003, we received payment in full from Mr. Parks to repay the
outstanding principal balance of his note plus interest. Based on Mr.
Spatz's current financial condition, we have elected, at this time, to
forbear our collection efforts regarding the amount for which he is
personally liable. The amount of $136,614 plus accrued interest was
fully reserved as of November 1, 2003.
(12) Stock Options and Warrants
As of November 1, 2003, we had outstanding options to purchase
1,533,224 shares of our common stock.
At November 1, 2003, warrants to purchase 760,190 shares of our common
stock were outstanding. These warrants have exercise prices in the
range of $3.50 to $19.91 (weighted average exercise price of $6.62) and
expire on various dates between December 2003 and August 2006.
F-12
(13) 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, agreed
to 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 were also secured by personal guarantees from the principals
of the Borrower. This Agreement expired on October 11, 2002.
Through May 27, 2003, we made cash advances in the aggregate of
approximately $3.1 million to the Borrower and received cash payments
in the aggregate of approximately $811,000. We also received
approximately $1.5 million of inventory from the Borrower to partially
offset the advances. On this date, we filed a lawsuit against the
Borrower and the two guarantors seeking the remaining balance plus
interest of approximately $1.1 million due under the Agreement. As of
November 1, 2003, this amount was fully reserved.
On September 17, 2003, we entered into a settlement agreement with the
Borrower in which the Borrower agreed to make payments in the amount of
$500,000 with interest at the rate of 7.5% per annum as full payment
for the balance due under the Agreement. The first payment of $50,000
under this settlement agreement was due on September 30, 2003 and
through December 12, 2003 we have received $32,000. As a result of this
default, under the settlement agreement, we reserve the right to
reinstate the original amount due under the Agreement.
(14) Legal Matters, Commitments and Contingencies
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.
In April 2003, Lynda Bray and Masis Manougian, two of our then 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
California for the County of San Bernardino (the "Bray Lawsuit"). The
First Amended Complaint in the Bray Lawsuit alleges that we violated
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 April 25, 2003. Plaintiffs
F-13
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.
Although at this stage of the litigation it is difficult to predict the
outcome of the case with certainty, we believe that we have meritorious
defenses to the Bray Lawsuit and we are vigorously defending against
it.
In November 2003, Virginia Camarena, a current employee in one of our
California stores, filed a lawsuit against us entitled "Virginia
Camarena, Plaintiff, vs. Factory 2 U Stores, etc., Defendants", Case
No. BC305173 in the Superior Court of the State of California for the
County of Los Angeles - Central District (the "Camarena Lawsuit"). The
plaintiff alleges that we violated the California Wage for Unpaid Wages
and Overtime Wages, California Labor Code, California Business and
Profession Code and the Fair Labor Standards Act by failing to pay her
wages and overtime for all hours worked, by failing to provide her with
statements showing the proper amount of hours worked, wrongfully
converting the property of plaintiff by failing to pay overtime wages
owed on the next payday after they were earned. Plaintiff purports to
bring this as a class action on behalf of all persons who were employed
in one of our California stores or outside the state of California.
Plaintiffs seek compensatory, punitive and liquidated damages,
restitution, interest, penalties and attorneys' fees. In December 2003,
we filed an answer to the complaint and filed pleadings to remove the
Camarena Lawsuit to the United States District Court for the Central
District of California.
Although at this stage of the litigation it is difficult to predict the
outcome of the case with certainty, we believe that we have meritorious
defenses to the Camarena Lawsuit and we are vigorously defending
against it.
We are at all times subject to pending and threatened legal actions
that arise in the normal course of business. In the opinion of our
management, based in part on the assessment of legal counsel, the
ultimate disposition of these current matters will not have a material
adverse effect on our financial position or results of operations.
(15) Subsequent Event
On December 10, 2003, William R. Fields resigned as Chief Executive
Officer, Chairman and a Director of the company, effective immediately,
to pursue retirement.
In his place, our Board of Directors established an Executive Committee
to manage the day-to-day business affairs and appointed Norman G.
Plotkin to hold the position of interim Chief Executive Officer. In
addition to Mr. Plotkin, the Executive Committee consists of Douglas C.
Felderman, Executive Vice President and Chief Financial Officer; A.J.
Nepa, Executive Vice President and General Merchandise Manager; and
Melvin C. Redman, Executive Vice President-Operations and Distribution.
F-14
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations
Forward-Looking Statements
Certain statements in this Quarterly Report on Form 10-Q are forward-looking
statements, within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934. These forward-looking
statements are not based on historical facts, but rather reflect our current
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; our ability to successfully implement business
strategies and otherwise execute planned changes in various aspects of the
business; 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; our ability to maintain
adequate liquidity; the effectiveness of our operating initiatives and
advertising and promotional strategies and other factors described in the Annual
Report for the fiscal year ended February 1, 2003 on Form 10-K/A 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.
General
The following discussion and analysis should be read in conjunction with our
Financial Statements and notes thereto, included elsewhere in this Form 10-Q.
As of November 1, 2003, we operated 243 "Factory 2-U" off-price retail stores
which sell branded casual apparel for the family, as well as selected domestics
and household merchandise at prices which generally are significantly lower than
the prices offered by other discount chains. We had 261 stores in operation as
of November 2, 2002.
3
During the 13-week period ended November 1, 2003, we did not open or close any
stores. For the same period last year, we opened four new stores. The average
number of stores in operation were 243 and 258 for the 13-week periods ended
November 1, 2003 and November 2, 2002, respectively. In addition, we averaged
230 and 221 comparable stores for the 13 weeks ended November 1, 2003 and
November 2, 2002, respectively.
During the 39-week period ended November 1, 2003, we opened two new stores and
closed three stores. For the same period last year, we opened 12 new stores and
closed 30 stores. The average number of stores in operation were 243 and 260 for
the 39-week periods ended November 1, 2003 and November 2, 2002, respectively.
In addition, we averaged 227 and 214 comparable stores for the 39 weeks ended
November 1, 2003 and November 2, 2002, respectively.
We define comparable stores as follows:
o New stores are considered comparable after 18 months from date of opening.
o When a store relocates within the same market, it is considered comparable
after 6 months of operations.
o Store expansion greater than 25% of the original store size are treated like a
new store and become comparable after 18 months of operations. Store expansion
less than 25% of the original store size remains in the comparable store base.
Operating results for the 13-week period ended November 1, 2003 were lower than
originally anticipated primarily due to a weak back-to-school sale season in
August, unseasonably warmer weather in a number of our markets and the combined
effect of the wildfires and labor strikes in the southern California region in
October. The unfavorable sales impact on operating results was slightly offset
by lower than anticipated markdown volume and distribution costs during the
quarter.
Operating results for the 39-week period ended November 1, 2003 were lower than
originally anticipated as well. In addition to the factors we experienced in the
third quarter, our lower than expected operating results for the first nine
months of fiscal 2003 were due to low inventory levels for most of the first
quarter and a very soft retail environment for retailers in general,
particularly in apparel. Also contributing to the lower than expected operating
results were increased in-store promotional costs and start-up costs associated
with our new distribution center in San Diego, California during the second
quarter.
In an effort to improve our liquidity, obtain more favorable credit terms and
provide for a consistent flow of merchandise, we initiated a series of financing
transactions, and took steps to accelerate the receipt of refunds related to tax
loss carry-back benefits. On March 6, 2003, we completed the private offering of
2,515,379 shares of our common stock for net proceeds of approximately $5.7
million, after deducting the placement fees and other offering expenses. In
addition, during March of 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 and a $1.0 million term note. On August 20, 2003, we completed
4
a private offering of 2,450,000 shares of our common stock for net proceeds of
approximately $11.4 million, after deducting the placement fees and other
offering expenses. We continue to experience a very soft retail environment,
affected by general price deflation and heavy promotion within the retail
industry, particularly in apparel. This has been a very difficult environment
for us, especially during the first quarter, when we experienced lower than
normal inventory levels due to the tightening of credit terms from vendors and
the credit community. Though we experienced a significant improvement in
inventory levels near the end of the first quarter, the soft economy continues
to drive aggressive pricing and a deflationary retail environment. In our second
quarter, in response to a very competitive retail environment, we increased our
advertising expenditures above originally planned levels and equivalent to last
year. We also increased our in-store promotional efforts with weekly in-store
specials. During our third quarter, we continued to experience a soft retail
environment, particularly in fashion oriented apparel. As we look forward to the
remainder of the year, we anticipate a competitive retail environment will
continue as a result of heavy discounting during the holiday season and soft
consumer demand for apparel. In the event that we do not meet our current
financial expectations for the fourth quarter as disclosed in our press release
dated November 12, 2003, which was furnished on Form 8-K, we may experience a
tightening of credit terms from our vendors and/or credit community, encounter a
disruption of inventory flow of our spring and summer merchandise and not be
able to satisfy our current debt obligations.
Critical Accounting Policies and Estimates
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
November 1, 2003, we had an inventory valuation allowance of
5
approximately $1.3 million, which represents our estimate of the cost in
excess of the net realizable value of slow-moving inventory 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.
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. Future
restructuring efforts, if any, will be accounted for in accordance with
SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities." We continuously monitor and evaluate the adequacy of our
reserves for restructuring charges and, as new facts become available, will
adjust these reserves as needed.
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 and policy year ending
January 31, 2004 has 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 years ended January
6
31, 2003 and 2002 were estimated to be approximately $3.4 million and $3.7
million ($3.2 million aggregate stop loss), respectively. We are currently
in the process of performing an actuarial analysis to project the ultimate
expected losses for the policy year ending January 31, 2004. 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.
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
13 weeks ended November 1, 2003 compared to 13 weeks ended November 2, 2002
Net sales were $121.9 million for the 13 weeks ended November 1, 2003 compared
to $134.5 million for the same period last year, a decrease of $12.6 million, or
9.4%. Comparable store sales for the 13-week period ended November 1, 2003
decreased 6.9% versus a decrease of 5.6% for the same period last year. The
decline in net sales was primarily due to fewer stores in operation and negative
comparable store sales. Though we recorded an increase of 4.3% in comparable
transaction counts and an increase of 13.1% in comparable average purchase size
in units, our comparable average unit retail price point was 21.1% lower as
compared to the same period last year.
Gross profit was $41.7 million for the 13 weeks ended November 1, 2003 compared
to $44.7 million for the same period last year, a decrease of $3.0 million or
6.7%. As a percentage of net sales, gross profit was 34.2% for the 13 weeks
ended November 1, 2003 versus 33.2% for the same period last year. The
improvement in gross profit as a percentage of net sales for the 13 weeks ended
November 1, 2003 from the comparable period last year was primarily due to lower
markdown volume and lower distribution costs, partially offset by lower initial
mark-up as a result of lower retail price points.
Selling and administrative expenses were $45.6 million for the 13 weeks ended
November 1, 2003 compared to $49.1 million for the same period last year, a
decrease of $3.5 million or 7.1%. Selling and administrative expenses decreased
as a result of (1) reduced variable costs due to lower sales volume (2) fewer
stores in operation during the current quarter, (3) reduced consulting and legal
fees, and (4) lower advertising spending. As a percentage of net sales, selling
and administrative expenses were 37.4% for the 13 weeks ended November 1, 2003
as compared to 36.5%, for the same period last year. The increase in selling and
administrative expenses as a percentage of net sales was due to the loss of
sales volume.
7
We did not record any pre-opening and closing expenses for the 13 weeks ended
November 1, 2003 compared to $366,000 for the same period last year. The
decrease in pre-opening and closing expenses was due to no store openings during
the current quarter versus four new store openings in the same period last year.
Interest expense, net was $928,000 for the 13 weeks ended November 1, 2003
compared to $515,000 for the 13 weeks ended November 2, 2002, an increase of
$413,000 or 80.2%. The increase in interest expense for the current quarter was
due to higher interest rates.
We recorded an income tax benefit of $1.8 million for both the 13 weeks ended
November 1, 2003 and the 13 weeks ended November 2, 2002.
For the 13 weeks ended November 1, 2003, the net loss was $3.0 million as
compared to $3.5 million for the 13 weeks ended November 2, 2002. The decrease
in net loss was a result of the factors cited above.
39 weeks ended November 1, 2003 compared to 39 weeks ended November 2, 2002
Net sales were $349.9 million for the 39 weeks ended November 1, 2003 compared
to $379.5 million for the same period last year, a decrease of $29.6 million, or
7.8%. Comparable store sales for the 39-week period ended November 1, 2003
decreased 4.7% versus a decrease of 8.5% for the same period last year. The
decline in net sales was due to fewer stores in operation and negative
comparable store sales. Though we recorded an increase of 5.4% in comparable
transaction counts and an increase of 12.8% in comparable average purchase size
in units, our comparable average unit retail price point was 19.8% lower as
compared to the same period last year.
Gross profit was $117.9 million for the 39 weeks ended November 1, 2003 compared
to $126.8 million for the same period last year, a decrease of $9.0 million or
7.1%. As a percentage of net sales, gross profit was 33.7% for the 39 weeks
ended November 1, 2003 versus 33.4% for the same period last year. Compared to
the nine-month period last year, our initial mark-up was lower by approximately
220 basis points as a result of lower retail price points, and our distribution
costs were approximately 40 basis points higher due to the start-up of our new
distribution center in San Diego, California. The effect of these unfavorable
variances was partially offset by the favorable adjustment recorded in the first
quarter to the inventory valuation allowance established at our prior fiscal
year end, and lower markdowns during the year.
Selling and administrative expenses were $133.1 million for the 39 weeks ended
November 1, 2003 compared to $144.9 million for the same period last year, a
decrease of $11.9 million or 8.2%. The decrease in selling and administrative
expenses was primarily a result of (1) reduced variable costs due to lower sales
volume, (2) fewer stores in operation during the current period, (3) reduced
consulting and legal fees, (4) non-recurring income of $708,000 recorded during
the first quarter related to an adjustment to the stock subscription notes
receivable valuation allowance as discussed at Note 11 in the Notes to Financial
Statements, and (5) a charge of $2.1 million related to a legal settlement
recorded in the second quarter of last year. Excluding the non-recurring income
of $708,000 and the legal settlement charge of $2.1 million, selling and
8
administrative expenses, as a percentage of net sales, were 38.2% and 37.7% for
the 39 weeks ended November 1, 2003 and November 2, 2002, respectively. The
increase in selling and administrative expenses as a percentage of net sales was
primarily due to the loss of sales volume.
Pre-opening and closing expenses were $221,000 for the 39 weeks ended November
1, 2003, primarily consisting of start-up expenses incurred for our new
distribution center. Pre-opening and closing expenses for the 39 weeks ended
November 2, 2002 were $1.1 million. The decrease of $848,000 or 79.3% from the
same period last year was due to the opening of ten fewer new stores during the
current 39-week period versus the same period last year.
Interest expense, net was $2.5 million for the 39 weeks ended November 1, 2003
compared to $1.1 million for the 39 weeks ended November 2, 2002, an increase of
$1.4 million or 130.6%. The increase in interest expense from the same period
last year was due to increased borrowings and higher interest rates.
We recorded an income tax benefit of $6.8 million for the 39 weeks ended
November 1, 2003 compared to $7.8 million for the 39 weeks ended November 2,
2002. The decrease in income tax benefit was the result of decreased pre-tax
loss compared to the same period a year ago.
For the 39 weeks ended November 1, 2003, the net loss was $11.1 million as
compared to $12.5 million for the 39 weeks ended November 2, 2002. The decrease
in net loss was a result of factors cited above.
Liquidity and Capital Resources
General
We finance our operations through credit provided by vendors and other
suppliers, amounts borrowed under our 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 inventory and accounts receivable, as defined.
Since February 1, 2003, we have completed a series of financing transactions
designed to improve liquidity and strengthen our financial position. On March 6,
2003, we completed the private offering of 2,515,379 shares of our common stock
for net proceeds of approximately $5.7 million, after deducting the placement
fees and other offering expenses. On April 10, 2003, we completed a $7.5 million
debt financing transaction, which consists of a $6.5 million junior term note
and a $1.0 million term note. In addition, we received a federal tax refund of
$8.2 million in March 2003. On August 20, 2003, we completed a private offering
of 2,450,000 shares of our common stock for net proceeds of approximately $11.4,
after deducting the placement fees and other offering expenses.
9
Following the completion of our private equity offerings, debt financing
transaction and receipt of the federal tax refund, the vendor and credit
community provided support and extended credit terms for merchandise shipments.
Based on the credit support provided by our vendors and the credit community, we
received merchandise on credit terms necessary to meet inventory levels for the
holiday season. Any further extension of credit will be contingent upon improved
operating results and liquidity. We can make no assurance that our revolving
credit facility and internal cash flow will 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.
At November 1, 2003, we were in compliance with all financial covenants, as
defined, and had outstanding borrowings of $17.8 million and letters of credit
of $12.1 million under our revolving credit facility. In addition, based on
eligible inventory and accounts receivable, we were eligible to borrow $49.7
million under our revolving credit facility and had $12.3 million available for
future borrowings after deducting the $7.5 million availability block.
With respect to cash flows for the 39-week period ended November 1, 2003, we
used $29.9 million in operating activities, $3.5 million in investing activities
and generated $35.7 million from financing activities, which resulted in a net
increase in cash of $2.3 million. For the same period last year, we used $34.3
million in operating activities, $8.1 million in investing activities and
generated $30.9 million from financing activities, which resulted a net decrease
in cash of $11.5 million. The decrease in cash used in operating activities was
primarily due to improved vendor payment terms. The decrease in cash used in
investing activities was primarily due to fewer new store openings and
completion of our new distribution center. The increase in cash generated from
financing activities was a result of net proceeds received from the private
equity offerings and the borrowings on the junior secured term loans.
Capital Expenditures
We anticipate capital expenditures of approximately $250,000 for the remaining
three months of the current fiscal year ending January 31, 2004, primarily in
connection with maintenance capital at our stores and corporate office. We
believe the capital expenditures will be financed from internal cash flow and
borrowings under our revolving credit facility.
Store Closures and Restructuring Initiatives
As of December 12, 2003, we had closed 16 of the 23 stores identified in our
Fiscal 2002 restructuring efforts, as well as completed the consolidation of our
corporate overhead structure. Of the remaining seven stores, we have decided to
continue to operate four of these stores as a result of certain landlord
concessions; and we plan to close the other three stores by March 2004. In
addition, we have completed the consolidation of our two former San Diego
distribution centers into one distribution center, which is also located in San
Diego, California. We estimate the cash requirement for the remainder of this
current fiscal year for the Fiscal 2002 restructuring efforts will be
approximately $684,000, which we intend to fund from our sources of cash,
including the revolving credit facility.
10
In regards to our Fiscal 2001 restructuring efforts, we closed 24 of 28
under-performing stores in the first quarter of fiscal 2002 and the remaining
four stores in January 2003. We estimate the cash requirement for the remainder
of this current fiscal year for the Fiscal 2001 restructuring efforts will be
approximately $221,000, which we intend to fund from our sources of cash,
including the revolving credit facility.
Contractual Obligations and Commitments
The following table summarizes our significant contractual obligations, as well
as estimated cash requirements related to our restructuring initiatives, as of
November 1, 2003. These should be read in conjunction with "Note 3 - Fiscal 2002
Restructuring Charge", "Note 4 - Fiscal 2001 Restructuring Charge", "Note 5 -
Revolving Credit Facility", and "Note 6 - Long-Term Debts" in the accompanying
unaudited financial statements, as well as our fiscal 2002 Annual Report on Form
10-K/A as filed with the Securities and Exchange Commission.
(in thousands)
--------------
Revolving Junior
Credit Subordinated Junior Secured Operating Restructuring
Facility Notes Term Loans Leases Charges* Total
--------- ------------ -------------- --------- ------------- -----
Fiscal Year:
2003 (remaining
3 months) $ - $ 3,000 $ 500 $ 7,460 $ 905 $ 11,865
2004 - 3,000 7,000 28,390 5,916 44,306
2005 - 5,300 - 26,488 1,489 33,277
2006 17,751 - - 20,229 - 37,980
2007 - - - 15,034 - 15,034
Thereafter - - - 46,708 - 46,708
-------- --------- -------- --------- -------- ---------
$ 17,751 $ 11,300 $ 7,500 $ 144,309 $ 8,310 $ 189,170
-------- --------- -------- --------- -------- ---------
* Amounts reflect management's estimate to complete store closures and other
previously announced restructuring initiatives.
We can make no assurance that our internal cash flow and borrowings under our
revolving credit facility will provide sufficient funds to service the above
contractual obligations over the next twelve months.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to interest rate risk on our Junior Subordinated Notes, which are
non-interest bearing and discounted at an annual rate of 10%. At November 1,
2003, our Junior Subordinated Notes had a face value of $11.3 million with a net
carrying value of $10.1 million. While generally an increase in market interest
rates will decrease the value of this debt, and decreases in interest rates will
have the opposite effect, we are unable to estimate the impact that interest
rate changes will have on the value of this debt as there is no active public
market for the debt and we are unable to determine the market interest rate at
which alternate financing would have been available at November 1, 2003.
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Item 4. Controls and Procedures
Evaluation. We have evaluated the effectiveness of the design and operation of
our disclosure controls and procedures as defined under Rule 13a-15(e) and Rule
15d-15(e) of the Securities Exchange Act of 1934, as amended, as of the end of
the period covered by this Quarterly Report. This evaluation was done under the
supervision and with the participation of management, including our Interim
Chief Executive Officer (CEO) and Chief Financial Officer (CFO).
Conclusions. Based upon our evaluation, the Interim CEO and CFO have concluded
that our disclosure controls and procedures were effective as of the end of such
period to ensure that material information relating to the Company is made known
to management, including the Inteim CEO and CFO, particularly during the period
when our periodic reports are being prepared.
Changes in Internal Controls. There were no changes during the period covered by
this Quarterly Report in our internal controls over financial reporting that
have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting.
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See discussion of legal proceedings at Note 14 in the Notes to
Financial Statements.
Item 2. Changes in Securities and Use of Proceeds
On August 20, 2003, we completed a private offering of 2,450,000
shares of our common stock for net proceeds of approximately $11.4
million, after deducting the placement fees and other offering
expenses of $0.9 million. We used the net proceeds of this offering
primarily for working capital purposes. This transaction also
provides for warrants to purchase 490,000 shares at the same price as
the initial shares purchased, exercisable until December 23, 2003. In
addition to the placement fees, the placement agent received warrants
to purchase 112,500 shares of our common stock at an exercise price
of $6.00 per share, a 7% premium over the closing price of $5.62 on
August 20, 2003. These warrants will expire in August 2006. Depending
on the number of additional shares purchased by investors, the
placement agent is entitled to receive additional fees and an
additional warrant to purchase up to 22,500 shares at $6.00 per
share. This offering was exempt from registration under Rule 506 of
Regulation D of the Securities Act of 1933.
Item 4. Submission of Matters to a Vote of Security Holders
We held our annual stockholders meeting on September 17, 2003. Willem
de Vogel was re-elected at this meeting to hold the office of
director and to serve until the annual stockholders meeting in 2006
or until his successor is elected. The numbers of votes cast were as
follows:
For 13,102,868
Against 1,260,398
Other directors whose terms of office continued after this meeting
were William R. Fields, Peter V. Handal, Ronald Rashkow and Wm.
Robert Wright II.
The other matters voted on and approved at this meeting were as
follows:
(1) An amendment to the Amended and Restated Factory 2-U Stores, Inc.
1997 Stock Option Plan which increases by 1,000,000 the number of
shares of common stock issuable upon exercise of options from
2,157,980 to 3,157,980 and adds other forms of equity
compensation.
For 8,795,537
Against 5,385,234
Abstain 182,495
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(2) The ratification of Ernst & Young LLP as our independent
accountants.
For 13,909,799
Against 2,473
Abstain 450,994
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit
10.19 Employment Agreement, dated as of November 10, 2003, by and
between Factory 2-U Stores, Inc. and A.J. Nepa.
31.1 Certification pursuant to Rule 13a-14(a) and 15d-14(a) of
the Securities Exchange Act of 1934, as amended, by Norman
G. Plotkin, Interim Chief Executive Officer.
31.2 Certification pursuant to Rule 13a-14(a) and 15d-14(a) of
the Securities Exchange Act of 1934, as amended, by Douglas
C. Felderman, Executive Vice President and Chief Financial
Officer.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by
Norman G. Plotkin, Interim Chief Executive Officer.
32.2 Certification pursuant to 18 U.S. C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 by Douglas C. Felderman, Executive Vice President and
Chief Financial Officer.
(b) Reports on Form 8-K
Item 5:
On November 18, we filed a report on Form 8-K regarding the
appointment of A.J. Nepa as Executive Vice President and
General Merchandise Manager. The full text of our press
release dated November 13, 2003 was attached as an exhibit to
the Form 8-K.
On December 11, we filed a report on Form 8-K regarding the
resignation of William R. Fields as Chief Executive Officer,
Chairman and a Director of the company, effective immediately.
The full text of our press release dated December 10, 2003 was
attached as an exhibit to the Form 8-K.
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Item 12:
On November 6, 2003, we furnished a report on Form 8-K
regarding the announcement of sales for the four-week, 13-week
and 39-week periods ended November 1, 2003. The full text of
our press release dated November 5, 2003 was attached as
exhibit to the Form 8-K.
On November 13, 2003, we furnished a report on Form 8-K
regarding the announcement of operating results for the
13-week and 39-week periods ended November 1, 2003. The full
text of our press release dated November 12, 2003 was attached
as exhibit to the Form 8-K.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FACTORY 2-U STORES, INC.
Date: December 16, 2003
By: /s/Douglas C. Felderman
-------------------------------------------------
Name: Douglas C. Felderman
Title: Executive Vice President and Chief Financial Officer
(duly authorized officer and principal financial officer)
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