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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 May 1, 2004
-----------
Commission File Number: 1-10089
FACTORY 2-U STORES, INC. (1)
(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 June 4,
2004 was 17,796,178 shares.
(1) Factory 2-U Stores, Inc. has been operating as a debtor in possession under
Chapter 11 of the United States Bankruptcy Code since January 13, 2004.
FACTORY 2-U STORES, INC.
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MAY 1, 2004
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Factory 2-U Stores, Inc. Balance Sheets as of May 1, 2004 (Unaudited),
May 3, 2003 (Unaudited) and January 31, 2004 ......................F-1
Factory 2-U Stores, Inc. Statements of Operations (Unaudited) for the
13 weeks ended May 1, 2004 and May 3, 2003 .........................F-3
Factory 2-U Stores, Inc. Statements of Cash Flows (Unaudited) for the
13 weeks ended May 1, 2004 and May 3, 2003 .........................F-4
Factory 2-U Stores, Inc. Notes to Financial Statements (Unaudited)..F-5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ................................................3
Item 3. Quantitative and Qualitative Disclosures About Market Risk...........12
Item 4. Controls and Procedures .............................................12
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ...................................................12
Item 6. Exhibits and Reports on Form 8-K ....................................12
Signatures ................................................................13
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Balance Sheets
(in thousands)
May 1, May 3, January 31,
2004 2003 2004
------ ------ -----------
(Unaudited) (Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 5,487 $ 5,414 $ 9,963
Merchandise inventory 46,534 66,012 38,168
Accounts receivable, net 884 623 618
Income tax receivable - 1,756 -
Prepaid expenses 3,863 6,258 2,740
Deferred income taxes - 9,753 -
--------- --------- --------
Total current assets 56,768 89,816 51,489
Leasehold improvements and equipment, net 16,094 26,594 18,186
Deferred income taxes - 10,750 -
Other assets 1,366 936 1,033
Goodwill - 26,301 -
--------- --------- --------
$74,228 $154,397 $70,708
========= ========= ========
The accompanying notes are an integral part of these financial statements.
(continued)
F-1
FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Balance Sheets
(in thousands)
(continued)
May 1, May 3, January 31,
2004 2003 2004
------ ------ -----------
(Unaudited) (Unaudited)
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
DIP financing facility $ 3,015 $ - $ -
Current maturities of long-term debt 36 3,021 36
Junior secured term loans - 7,500 -
Accounts payable 16,013 43,844 8,257
Income tax payable 3,492 - 3,500
Sales tax payable 4,142 2,748 5,615
Accrued expenses 14,670 27,693 12,560
--------- -------- ---------
Total current liabilities 41,368 84,806 29,968
Revolving credit facility - 11,535 -
Long-term debt 83 6,754 92
Accrued restructuring charges - 1,747 -
Deferred rent and other liabilities 2,073 2,822 2,518
--------- --------- ---------
Total liabilities not subject
to compromise 43,524 107,664 32,578
--------- --------- ---------
Liabilities subject to compromise 67,986 - 63,062
Stockholders' equity (deficit):
Common stock, $0.01 par value;
35,000 shares authorized
and 17,796 shares, 15,657 shares
and 17,921 shares issued and
outstanding, respectively 178 157 179
Additional paid-in capital 137,965 126,513 137,964
Accumulated deficit (175,425) (79,937) (163,075)
--------- --------- ----------
Total stockholders' equity (deficit) (37,282) 46,733 (24,932)
--------- --------- ----------
$ 74,228 $154,397 $ 70,708
========= ========= ===========
The accompanying notes are an integral part of these financial statements.
F-2
FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Statements of Operations
(in thousands, except per share data)
(Unaudited)
13 Weeks Ended
--------------
May 1, May 3,
2004 2003
------- ------
Net sales $ 80,326 $ 104,347
Cost of sales 52,913 66,712
---------- ------------
Gross profit 27,413 37,635
Selling and administrative expenses 31,165 41,255
Pre-opening and closing expenses 14 138
---------- ------------
Operating loss (3,766) (3,758)
Interest expense, net 375 634
---------- ------------
Loss before reorganization items
and income tax benefit (4,141) (4,392)
Reorganization items 8,210 -
---------- ------------
Loss before income tax benefit (12,351) (4,392)
Income tax benefit - (1,671)
---------- ------------
Net loss $ (12,351) $ (2,721)
========== ============
Net loss per share, basic and diluted $ (0.70) $ (0.19)
Weighted average common shares outstanding,
basic and diluted 17,696 14,620
The accompanying notes are an integral part of these financial statements.
F-3
FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Statements of Cash Flows
(in thousands)
(Unaudited)
13 Weeks Ended
--------------
May 1, 2004 May 3, 2003
----------- -----------
Cash flows from operating activities
Net loss $ (12,351) $ (2,721)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization 2,349 3,305
Gain on disposal of equipment (4) -
Deferred rent (621) (239)
Reorganization items 7,874 -
Stock subscription notes receivable
valuation adjustment - (708)
Issuance of common stock to board members
as compensation - 5
Other non-cash changes (71) -
Changes in operating assets and liabilities
Merchandise inventory (8,366) (33,840)
Prepaid expenses and other assets (2,225) 8,051
Advances to vendor - (16)
Repayments from vendor 70 4
Accounts payable 7,756 15,883
Income taxes payable (8) (4,848)
Accrued expenses and other liabilities (1,740) (17)
Liabilities subject to compromise (94) -
------------ ------------
Net cash used in operating activities (7,431) (15,141)
Cash flows from investing activities
Purchases of leasehold improvements and equipment (51) (1,032)
------------ -------------
Net cash used in investing activities (51) (1,032)
Cash flows from financing activities
Borrowings on revolving credit facility 66,702 42,507
Payments on revolving credit facility (63,687) (37,272)
Payments on long-term debt (9) -
Proceeds from debt financing - 7,500
Proceeds from issuance of common stock, net - 5,672
Payment of deferred debt issuance costs - (428)
Payments of stock subscription notes receivable - 143
------------ -------------
Net cash provided by financing activities 3,006 18,122
Net increase (decrease) in cash (4,476) 1,949
Cash at the beginning of the period 9,963 3,465
------------ -------------
Cash at the end of the period $ 5,487 $ 5,414
============ =============
Supplemental disclosure of cash flow information
Cash paid during the period for
Interest $ 206 $ 347
Incomes taxes $ 9 $ 88
Supplemental disclosure of non-cash investing
and financing activities
Acquisition of equipment under notes payable $ - $ 92
The accompanying notes are an integral part of these financial statements.
F-4
FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Notes to Financial Statements
(Unaudited)
(1) Basis of Presentation
---------------------
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 January 31, 2004 included in our Form 10-K as filed
with the Securities and Exchange Commission.
We believe that the unaudited financial statements as of and for the 13
weeks ended May 1, 2004 and May 3, 2003 reflect all 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 fiscal 2004 financial statements.
On January 13, 2004 (the "Petition Date"), we filed a voluntary
petition to reorganize under Chapter 11 of the United States Bankruptcy
Code (the "Bankruptcy Code") in the United States Bankruptcy Court for
the District of Delaware (the "Court"), which is currently pending as
case number 04-10111(PJW) (the "Chapter 11 filing"). We remain in
possession of our properties and continue to operate our business as
debtor-in-possession ("DIP") in accordance with the applicable
provisions of the Bankruptcy Code.
Since the Chapter 11 filing, we have applied the provisions of
Statement of Position 90-7 "Financial Reporting by Entities in
Reorganization under the Bankruptcy Code" ("SOP 90-7"), which does not
significantly change the application of accounting principles generally
accepted in the United States; however, it requires the financial
statements for periods including and subsequent to filing Chapter 11
petition distinguish transactions and events that are directly
associated with the reorganization from the ongoing operations of the
business.
The accompanying financial statements are prepared on a going concern
basis, which assumes continuity of operations and realization of assets
and satisfaction of liabilities in the ordinary course of business. In
accordance with SOP 90-7, all pre-petition liabilities subject to
compromise have been segregated in the Balance Sheets as of May 1, 2004
and January 31, 2004 and classified as Liabilities subject to
compromise, at the estimated amount of allowable claims. Liabilities
not subject to compromise are separately classified as current and
non-current. Expenses, realized gains and losses, and provisions for
losses resulting from the reorganization are reported separately as
Reorganization items in the Statement of Operations for the 13 weeks
ended May 1, 2004.
F-5
(2) Accounting Policies
-------------------
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 these estimates.
Stock-based Compensation
We have elected under the provisions of Statement of Financial
Accounting Standard (the "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 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 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
common share if we had applied the fair value recognition provisions of
SFAS No. 148.
(in thousands, except per share data)
13 weeks ended
-------------------------------------
May 1, May 3,
2004 2003
---------- -----------
Net loss before stock-based
compensation, as reported $ (12,351) $ (2,721)
Stock based compensation using the
fair value method, net of tax (546) (809)
----------- ----------
Pro-forma net loss $ (12,897) $ (3,530)
=========== ==========
Pro-forma net loss per share,
basic and diluted $ $ (0.73) $ (0.27)
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 Black-Scholes option valuation model does
not take into account our status as a debtor in possession, which
may have a material effect on the value of our outstanding options.
F-6
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:
13 Weeks Ended
--------------
May 1, May 3,
2004 2003
------ ------
(i) Expected dividend yield 0.00% 0.00%
(ii) Expected volatility 111.81% 103.68%
(iii) Expected life 6 years 7 years
(iv) Risk-free interest rate 3.63 % 3.45%
Income (loss) per Share and Comprehensive Income
We compute 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.
Common stock equivalent shares totaling 0 and 108,437 for the 13 weeks
ended May 1, 2004 and May 3, 2003, respectively, are not included in
the computation of diluted loss per share because the effect would have
been anti-dilutive.
Comprehensive loss for the 13 weeks ended May 1, 2004 and May 3, 2003
did not differ from net loss.
Recent Accounting Pronouncements
In March 2004, the Financial Accounting Standards Board (the "FASB")
issued an exposure draft entitled "Share-Based Payment - an amendment
of Statements No. 123 and 95 (Proposed Statements of Financial
Accounting Standards)" The proposed statement would eliminate an
issuer's ability to account for share-based compensation transactions
using APB Opinion No. 25 and would generally require that such
transactions be accounted for using a fair-value-based method of
accounting. This accounting standard, if approved, will result in
compensation expense charges to our future results of operations. The
proposed statement, if adopted, would be applied to public entities
prospectively for fiscal years beginning after December 15, 2004, as if
all share-based compensation awards granted, modified or settled after
December 15, 1994 had been accounted for using the fair-value method of
accounting. Retrospective application of the proposed statement is not
permitted.
(3) Reorganization Items
--------------------
Reorganization items represent amounts we incurred as a result of the
Chapter 11 filing, and are recorded and presented in accordance with
SOP 90-7. Reorganization items for the 13 weeks ended May 1, 2004 were
$8.2 million and consisted of: (1) a non-cash charge of $5.0 million
for lease rejection claims associated with 31 lease rejections in
conjunction with the 44 stores closed in the quarterly period ended May
1, 2004, as part of our reorganization efforts; (2) $2.8 million of
professional fees and other expenses incurred in our bankruptcy case
and reorganization efforts; and (3) $366,000 of additional costs to
close the 44 stores.
Cash payments resulting from reorganization items during the 13 weeks
ended May 1, 2004 were approximately $221,000.
F-7
(4) Liabilities Subject to Compromise
---------------------------------
Under the Bankruptcy Code, actions by creditors to collect indebtedness
we owe prior to the Petition Date are stayed and certain other
pre-petition contractual obligations may not be enforced against us. We
have received approval from the Court to pay certain pre-petition
liabilities including employee salaries and wages, benefits and other
employee obligations. Except for secured debt, employee payroll and
benefits, sales, use and other taxes, and capital lease obligations,
all pre-petition liabilities have been classified as Liabilities
subject to compromise in the Balance Sheets as of May 1, 2004 and
January 31, 2004. Adjustments to pre-petition liabilities may result
from negotiations, payments authorized by Court order, additional
rejection of executory contracts including leases, or other events.
Therefore, the amounts below in total may vary significantly from the
stated amounts of proofs of claim that will be filed with the Court. We
have mailed notices to all known creditors to inform them that the
deadline for filing proofs of claim with the Court is June 15, 2004.
The following table summarizes the components of Liabilities subject to
compromise in our Balance Sheet as of May 1, 2004.
(in thousands) May 1, January 31,
2004 2004
------ -----------
Trade and other accounts payable $ 41,987 $ 41,734
Junior subordinated notes, net of discount 10,349 10,349
Restructuring costs, primarily lease rejection claims 5,929 6,044
Lease rejection claims 5,065 -
General liability and workers compensation claims 2,273 2,283
Severance claims 1,385 1,385
Other 998 1,267
-------- -----------
Liabilities subject to compromise $ 67,986 $ 63,062
-------- -----------
F-8
(5) Store Closures
--------------
On February 2, 2004, the Court authorized the closure of 44 stores. On
February 11, 2004, the Court approved the agreement between the Great
American Group ("Great American") and us in which Great American acted
as an exclusive agent to conduct store closing sales at the 44 stores
location. The store closing sales started on February 12, 2004. All 44
stores were closed by March 18, 2004 and as of April 23, 2004, we have
terminated or assigned a total of 13 leases of these stores and
rejected the remaining 31 leases. As a result of these lease
rejections, we recorded a non-cash charge of $5.0 million (included in
Reorganization items) related to lease rejection claims per the maximum
amount allowed under the Bankruptcy Code.
Under the terms of the agreement with Great American, we receive a
percentage of the aggregate retail price of the merchandise at the 44
stores as of February 11, 2004, as defined. In addition, we receive
reimbursement of sale expenses, as defined, incurred during the store
closing sales. Sales proceeds, net of sales tax, received during the
store closing sales goes to Great American. As of June 4, 2004, we have
received $3.4 million as partial payment for the sale of inventory to
Great American and are in the process of determining the remaining
amount owed to us. In addition, we have received approximately $1.5
million of sale expense reimbursement.
Other closing costs of approximately $366,000 not reimbursed by Great
American have been included in Reorganization items for the 13 weeks
ended May 1, 2004.
On June 4, 2004, we filed a motion with the Court seeking authorization
to close another 23 under-performing stores. Subject to the Court's
approval, we currently plan to start the going-out-of-business sale
process on or about July 1, 2004 and expect to close these stores by
the end of August 2004.
(6) 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.
As of June 4, 2004, we have closed 20 of these 23 stores. We terminated
the lease obligations on 14 of these closed stores prior to our Chapter
11 filing, and in conjunction with our Chapter 11 filing we rejected
the other 6 leases. The three remaining stores have not been closed at
this time due to lease concessions agreed to by the landlords.
The balance of the liability of $4.6 million as of May 1, 2004
(included in "Liabilities subject to compromise" in the accompanying
Balance Sheet) related to this fiscal 2002 restructuring charge was as
follows:
Balance at Non-cash Balance at
January 31, Cash Charges and May 1,
(in thousands) 2004 Payments Adjustments 2004
----------- -------- ----------- ---------
Lease termination costs $ 4,463 $ - $ - $ 4,463
Employee termination costs 65 (43) - 22
Other costs 147 (58) - 89
----------- --------- ----------- ----------
$ 4,675 $(101) $ - $ 4,574
----------- --------- ----------- ----------
As of May 1, 2004, the balance of non-cash inventory liquidation costs
related to this fiscal 2002 restructuring charge was zero.
F-9
(7) 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.
We closed all 28 stores during fiscal 2002. We had terminated the lease
obligations on 23 of these stores prior to our Chapter 11 filing and
rejected the remaining 5 leases during the bankruptcy proceeding.
The balance of the liability of $1.4 million as of May 1, 2004
(included in "Liabilities subject to compromise" in the accompanying
Balance Sheet) related to the fiscal 2001 restructuring charge was as
follows:
Balance at Balance at
January 31, Cash May 1,
(in thousands) 2004 Payments 2004
----------- --------- ----------
Lease termination costs $ 1,249 $ - $ 1,249
Other costs 120 (14) 106
----------- --------- ----------
$ 1,369 $ (14) $ 1,355
----------- --------- ----------
(8) DIP Financing Facility
----------------------
In conjunction with our Chapter 11 filing, we entered into a financing
agreement with The CIT Group/Business Credit, Inc. (the Tranche A
Lender) and GB Retail Funding, LLC (the Tranche B Lender),
(collectively the "Lenders") in which the Lenders provided us a $45.0
million revolving credit facility for working capital needs and other
general corporate purposes while we operate as a debtor-in-possession
(the "DIP financing facility"). This DIP financing facility with a
maturity date of January 14, 2005 has since been amended three times;
on January 30, 2004, March 10, 2004, and May 27, 2004, respectively.
The most recent amendment is subject to the Court's approval, a hearing
for which is scheduled on June 15, 2004.
The DIP financing facility has a superpriority claim status in our
Chapter 11 case and is collateralized by first liens on substantially
all of our assets, subject to valid and unavoidable pre-petition liens
and certain other permitted liens. Under the terms of the DIP financing
facility, we may borrow up to 85% of our eligible accounts receivable
and up to 70% of our eligible inventory, as defined. However, the DIP
financing facility provides for a $5.0 million availability block
against our availability calculation, as defined. The DIP financing
facility also includes a $20.0 million sub-facility for letters of
credit. Interest on the outstanding borrowings under the DIP financing
facility is payable monthly and accrues at the rate equal to, at our
option, either the prime rate (as announced by JP Morgan Chase Bank)
plus 1.50% per annum or LIBOR plus 3.5% per annum. In the event that
there is any outstanding borrowing provided by the Tranche B Lender,
such borrowing bears interest at 14.5% per annum payable monthly. We
are also obligated to pay a monthly fee equal to 0.375% per annum on
the unused available line of credit and a fee equal to 2.5% per annum
on the outstanding letters of credit.
F-10
Under the terms of the DIP financing facility, capital expenditure for
fiscal 2004 is restricted to $2.0 million. In addition, we are required
to be in compliance with financial covenants and other customary
covenants. As of May 1, 2004, the financial covenants included average
minimum availability, cumulative four-week rolling average of cash
receipts from store sales and cumulative rolling four-week average of
inventory receipts, as defined. The customary covenants include certain
reporting requirements and covenants that restrict our ability to incur
or create liens, indebtedness and guarantees, make dividend payments,
sell or dispose of assets, change the nature of our business and enter
into affiliate transactions, mergers and consolidations. Failure to
satisfy these covenants would (in some cases, after the expiration of a
grace period) result in an event of default that could cause, absent
the receipt of appropriate waivers, the funds necessary to maintain our
operations to become unavailable. The DIP financing facility contains
other customary events of default including certain ERISA events, a
change of control and the occurrence of certain specified events in the
Chapter 11 case. In addition, during the period from December 28, 2004
through January 11, 2005, we are not allowed to have any outstanding
borrowings under the revolving credit facility and our outstanding
letters of credit cannot exceed $11.0 million.
As of May 1, 2004, we were in compliance with our covenants and had
borrowings of $3.0 million outstanding under the revolving credit
facility and outstanding letters of credit of $15.1 million under the
sub-facility for letters for credit. As of May 1, 2004, based on our
eligible inventory and accounts receivable, we were eligible to borrow
$14.7 million under the revolving credit facility and had $8.5 million
available after giving effect for the availability block, as defined.
The May 27, 2004 amendment, still subject to the Court's approval,
modified our financial covenants, whereby covenants will include
minimum availability, five-day availability covenants at each month end
and minimum inventory per store. The Tranche B Lender will fully fund
within five business days of the Court's approval of the amendment and
we may repay the Tranche B amount after October 20, 2004 subject to
certain conditions.
(9) Provision for Income Taxes
--------------------------
Due to our significant net operating losses and our Chapter 11 filing,
we provided for a 100% valuation allowance on all deferred tax assets
as of January 31, 2004 because we cannot conclude that it is more
likely than not that the deferred tax assets will be realized in the
foreseeable future. Accordingly, for the 13 weeks ended May 1, 2004,
our income tax benefit was zero as we established a 100% valuation
allowance to offset such benefit.
(10) Stock Options and Warrants
--------------------------
As of May 1, 2004, options to purchase 950,091 shares of our common
stock and warrants to purchase 270,190 shares of our common stock were
outstanding. The options have exercise prices in the range of $1.61 to
$42.25 and expire on various dates between May 2004 and December 2013.
The warrants have exercise prices in the range of $3.50 to $19.91 and
expire on various dates between May 2005 and August 2006.
(11) Legal Matters, Commitments and Contingencies
--------------------------------------------
On January 13, 2004, we filed a voluntary petition for reorganization
under Chapter 11 of the Bankruptcy Code. We retain control of our
assets and are authorized to operate the business as a
debtor-in-possession while being subject to the jurisdiction of the
Bankruptcy Court. As of the Petition Date, most pending litigation is
stayed, and absent further order of the Court, substantially all
pre-petition liabilitities are subject to settlement under a plan of
reorganization. At this time, it is not possible to predict the outcome
of the Chapter 11 case or its effect on our business. If it is
determined that the liabilities subject to compromise in the Chapter 11
case exceed the fair value of the assets, unsecured claims may be
satisfied at less than 100% of their fair value and the equity
interests of our shareholders may have no value.
F-11
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our
former employees, filed a lawsuit against us entitled Lynda Bray, Masis
Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al.,
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 purported claims
for: (1) "Failure to Record Hours and or Illegally Modify Recorded
Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal
Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair
Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay
Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5)
"False Advertising." The thrust of plaintiffs' claim is that the
Company failed to pay wages and overtime for all hours worked, failed
to document all hours worked, and failed to inform prospective or new
employees of unpaid wage claims. Plaintiffs purport to bring this
action on behalf of all persons who were employed in one of the
California stores at anytime after April 25, 2003. 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.
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. All proceedings in the Bray Lawsuit are
currently stayed pursuant to the automatic stay provisions of Section
362 of the Bankruptcy Code, subject to the entry of an order by the
Court lifting the automatic stay. In the event the Court enters an
order lifting the automatic stay, we will continue to vigorously defend
against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the
potential exposure could be material to our results of operations.
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 Inc., 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 Orders,
California Labor Code, California Business and Profession Code and the
Federal 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, and by wrongfully
converting her property by failing to pay overtime wages owed on the
next payday after they were earned. The plaintiff purports to bring
this as an 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 removed the Camarena Lawsuit to the United
States District Court for the Central District of California, Case No.
CV-03-8880 RGK (SHx), where it is currently pending.
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. All proceedings in the Camarena
Lawsuit are currently stayed pursuant to the automatic stay provisions
of Section 362 of the Bankruptcy Code, subject to the entry of an order
by the Court lifting the automatic stay. In the event the Court enters
an order lifting the automatic stay, we will continue to vigorously
defend against the Camarena Lawsuit.
There are numerous other matters filed with the Court in our
reorganization proceedings by creditors, landlords or other third
parties related to our business operations or the conduct of our
reorganization activities. Although none of these individual matters
which have been filed to date have had or are expected to have a
material adverse effect on us, our ability to successfully manage the
reorganization process and develop an acceptable reorganization plan
could be negatively impacted by adverse determinations by the Court on
certain of these matters.
F-12
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations
Cautionary Statements for Purposes of "Safe Harbor Provisions" of the Private
Securities Litigation Reform Act of 1995
Certain statements in this Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q and in our other filings with
the Securities and Exchange Commission.
In addition to the above general factors, the following bankruptcy related
factors, among others, could also affect our future results, performance or
achievements, causing these results to differ materially from those expressed in
any of our forward-looking statements: our ability to continue as a going
concern; our ability to operate pursuant to the terms of our
debtor-in-possession financing facility; our ability to obtain approval from the
Court with respect to motions in the Chapter 11 case from time to time; our
ability to negotiate, confirm and consummate a plan of reorganization in a
timely manner; risks associated with third parties seeking and obtaining court
approval to terminate or shorten the exclusivity period that we have to propose
and confirm one or more plans of reorganization, for the appointment of a
Chapter 11 trustee or to convert the Chapter 11 case to a case under Chapter 7
of title 11 of the Bankruptcy Code; our ability to offset the negative effects
that the filing for reorganization under Chapter 11 of the Bankruptcy Code has
had on our business, including the loss in customer traffic, the impairment of
vendor relations and the constraints placed on available capital; our ability to
obtain and maintain normal terms with vendors and service providers; the ability
of our vendors to obtain satisfactory credit terms from factors and other
financing sources; our ability to maintain contracts, including leases, which
are critical to our operations; the potential adverse impact of the Chapter 11
case on our liquidity or results of operations; our ability to develop a
long-term strategy to revitalize our business and return to profitability; and
our ability to fund and execute our business plan.
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.
3
Similarly, these and other factors, including the terms of the final plan of
reorganization, if any, ultimately confirmed, can affect the value of our
pre-petition liabilities and common stock. Until a plan of reorganization is
confirmed by the Court, the recoveries of pre-petition claim holders are subject
to change. Accordingly, no assurance can be given as to what values, if any,
will be ascribed in the bankruptcy case to each of these constituencies.
The final plan of reorganization, if any, confirmed by the Court may result in
the cancellation of our existing common stock with holders thereof receiving no
distributions under the plan of reorganization. In light of the foregoing, we
consider the value of our common stock to be highly speculative and caution
equity holders that the stock may ultimately be determined to have no value.
Accordingly, we urge that appropriate caution be exercised with respect to
existing and future investments in our common stock or any claims relating to
pre-petition liabilities.
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.
Despite our efforts in fiscal 2003 to improve sales and our liquidity, we were
unable to improve comparable sales growth and operating margin at a rate that
could generate sufficient cash flow to sustain ongoing operations. Accordingly,
on January 13, 2004, we filed a voluntary petition to reorganize under Chapter
11 of the Bankruptcy Code in the Court, which is currently pending.
We decided to seek judicial reorganization in order to implement a comprehensive
operational and financial restructuring due to the tightening of credit extended
by our vendors and the credit community and a decline in our liquidity caused by
declining sales volume and deteriorating operating margin in a very soft retail
environment. As the debtor, we are authorized to continue to operate as an
ongoing business, but may not engage in transactions outside the ordinary course
of business without the approval of the Court after notice and an opportunity
for a hearing.
At hearings held on January 14, 2004 concerning our first day motions, the Court
entered orders granting us authority, among other things, to (1) continue our
centralized cash management system, (2) pay pre-petition wages and continue our
employee benefit plans and other employee programs, (3) continue customer
related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers
and vendors in full for all goods and services provided on or after the Petition
Date and (6) continue ongoing pre-petition "going out of business sales" for
four store locations completed by January 31, 2004. In addition, the Court also
gave interim approval for a $45.0 million DIP financing facility (DIP financing
facility) that was committed by The CIT Group/Business Credit, Inc. and GB
Retail Funding, LLC.
On February 2, 2004, the Court granted final approval of the $45.0 million DIP
financing facility. We intend to utilize this financing, in addition to cash
flow from operations, to fulfill business obligations during the Chapter 11
process.
Additionally, on February 2, 2004, the Court authorized the closure of 44
stores, or approximately 18% of our 239 stores. Stores were selected by
evaluating their market and financial performance. On February 11, 2004, the
Court approved our appointment of the Great American Group ("Great American") as
exclusive agent to conduct store closing sales at these 44 store locations. The
store closing sales started on February 12, 2004. All 44 stores were closed by
March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total
of 13 leases of these stores and rejected the remaining 31 leases.
On February 17, 2004, we filed with the Court our schedules of assets and
liabilities and statements of financial affairs setting forth, among other
things, the assets and liabilities as shown on our books and records as of the
Petition Date, subject to the assumptions contained in certain notes filed in
connection therewith. The schedules of assets and liabilities and statements of
financial affairs remain subject to further amendment or modification. We have
mailed notices to all known creditors that the deadline for filing proofs of
claim with the Court is June 15, 2004. Differences between amounts we have
scheduled and claims by creditors will be investigated and resolved in
connection with our claims resolution process. As we are at an early stage of
the bankruptcy and we do not yet have a plan of reorganization, the ultimate
distribution with respect to allowed claims is not presently ascertainable.
4
The United States Trustee has appointed an unsecured creditors committee and may
consider the appointment of an equity committee. There can be no assurance that
the unsecured creditors committee or equity committee, if any, will support our
positions in the bankruptcy case or the plan of reorganization once proposed,
and any disagreements could protract the bankruptcy case, negatively impact our
ability to operate during bankruptcy, and/or delay our emergence from
bankruptcy.
Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well
as most other pending litigation, are stayed and other contractual obligations
against us generally may not be enforced. Absent an order of the Court,
substantially all pre-petition liabilities are subject to compromise under a
plan of reorganization to be voted upon and approved by the Court. Although we
expect to file a reorganization plan that provides for emergence from
bankruptcy, there can be no assurance that a plan of reorganization will be
proposed by us or confirmed by the Court, or that any such plan will be
consummated.
We also may assume or reject executory contracts and unexpired leases, including
our store and distribution center leases, subject to the approval of the Court
and our satisfaction of certain other requirements. In the event we choose to
reject an executory contract or unexpired lease, parties affected by these
rejections may file claims with the Court-appointed claims agent as prescribed
by the Bankruptcy Code and/or orders of the Court. Unless otherwise agreed, the
assumption of an executory contract or unexpired lease will require us to cure
all prior defaults under such executory contract or lease, including all
pre-petition liabilities, some of which may be significant. In addition, in this
regard, we expect that liabilities that will be subject to compromise through
the Chapter 11 process will arise in the future as a result of the rejection of
additional executory contracts and/or unexpired leases, and from the
determination by the Court (or agreement by parties in interest) of allowed
claims for items that we now claim as contingent or disputed. Conversely, we
would expect that the assumption of additional executory contracts may convert
some liabilities shown on our financial statements as subject to compromise to
post-petition liabilities. Due to the uncertain nature of many of the potential
claims, we are unable to project the magnitude of such claims with any degree of
certainty. We have incurred, and will continue to incur, significant costs
associated with the reorganization.
Under the priority scheme established by the Bankruptcy Code, certain
post-petition liabilities and pre-petition liabilities need to be satisfied
before shareholders are entitled to receive any distribution. The ultimate
recovery to creditors and shareholders, if any, will not be determined until
confirmation of a plan of reorganization. We can give no assurance as to what
values, if any, will be ascribed in the bankruptcy case to each of these
constituencies.
A plan of reorganization could also result in holders of our common stock
receiving no distribution on account of their interests and cancellation of
their interests. In addition, under certain conditions specified in the
Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its
rejection by an impaired class of equity holders and notwithstanding the fact
that equity holders do not receive or retain property on account of their equity
interests under the plan. Moreover, as discussed above, there can be no
assurance that a plan of reorganization will be confirmed by the Court. In light
of the foregoing, we consider, as described above, the value of the common stock
to be highly speculative and caution equity holders that the stock may
ultimately be determined to have no value. Accordingly, we urge that appropriate
caution be exercised with respect to existing and future investments in our
common stock or in any claims related to pre-petition liabilities and our other
securities.
At this time, it is not possible to predict the effect of the Chapter 11 filing
on our business, various creditors and shareholders or when we will be able to
exit Chapter 11. Our future results are dependent upon our confirming and
implementing a plan of reorganization.
Our ability to continue as a going concern is predicated upon numerous issues,
including our ability to achieve the following:
- developing and implementing a long-term strategy to revitalize our
business and return to profitability; - taking appropriate actions to offset
the negative impact the Chapter 11 filing has had on our business and the
impairment of vendor relations;
- operating within the framework of our DIP financing facility, including
limitations on capital expenditures and compliance with financial covenants,
- generating cash flows from operations or seeking other sources of financing
and the availability of projected vendor credit terms;
- attracting, motivating and retaining key executives and associates; and
- - developing, negotiating, and, thereafter, having a plan of reorganization
confirmed by the Court.
5
These challenges are in addition to other operational and competitive challenges
faced by us in connection with our business as an off-price retailer. See
"Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private
Securities Litigation Reform Act of 1995" immediately preceding this session.
On May 5, 2004, the Court granted us authorization to adopt and implement the
key employee retention, emergence and severance plans.
On June 3, 2004, the Court issued an order, subject to certain conditions,
extending the period in which we have the exclusive right to file a proposed
plan or reorganization through December 3, 2004.
On June 4, 2004, we filed a motion with the Court seeking authorization to close
another 23 under-performing stores. Subject to the Court's approval, we
currently plan to start the going-out-of-business sale process on or about July
1, 2004 and expect to close these stores by the end of August 2004.
As in the last two fiscal years, we continue to operate our business in a very
soft retail environment. Our first quarter in fiscal 2004 started shortly after
we filed for bankruptcy protection under Chapter 11. Our inventory position
during the earlier part of the quarter was below our preferred level due, in
part, to the uncertainties surrounding our Chapter 11 filing. Additionally,
the filing adversely affected our sales in the first quarter. We have
significantly reduced our marketing spend, in accordance with our marketing
strategy, which has also negatively impacted our top line since the beginning of
fiscal 2004, but which we believe will ultimately improve profitability.
As previously disclosed, we started our 44 store closings in mid-February via
a going-out-of-business process conducted by Great American. All 44 stores were
closed by March 18, 2004 and we have terminated the lease obligations of these
store locations either through mutual agreements with landlords or through lease
rejections as allowed by the Court.
As a result of a thorough review of the financial performance of our entire
store base after the completion of the first quarter, we have sought the Court's
approval to close an additional 23 stores to further improve our overall
financial performance and enable us to concentrate on growing our business at
our most productive locations.
Currently, we are focusing our efforts on implementing our inventory strategy,
enhancing distribution and store operating efficiency, and improving store
execution. All these efforts are intended to ensure that we are well prepared
for the upcoming back-to-school season.
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.
The financial statements have been prepared on a going concern basis, which
assumes continuity of operations and realization of assets and satisfaction of
liabilities in the ordinary course of business. Based on guidance in SOP 90-7,
all pre-petition liabilities subject to compromise have been segregated in the
Balance Sheet and are classified as Liabilities subject to compromise, at the
estimated amount of allowable claims. Liabilities not subject to compromise are
separately classified as current and non-current. Expenses, realized losses, and
provision for losses resulting from the reorganization are reported separately
as reorganization items.
6
We believe the following represents the areas where the most critical estimates
and assumptions are used in the preparation of the financial statements:
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 82 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 May 1, 2004, we had an inventory
valuation allowance of approximately $1.1 million representing our estimate of
the cost in excess of the net realizable value of all clearance items. In
addition, we had an allowance of approximately $921,000 representing additional
inventory shrink reserve. 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. In conjunction with our
Chapter 11 filing, at the end of fiscal 2003, we recorded an impairment charge
of $26.3 million for our goodwill and an impairment charge of $2.4 million
regarding fixed assets located at the 44 closed stores.
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)." At the end of fiscal 2003, we evaluated our
accrued restructuring costs and recorded a favorable adjustment of $1.5 million
primarily related to the adjustment of lease termination costs, which is based
on the maximum amount allowed by the Bankruptcy Code.
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.
7
o Liabilities subject to compromise. Under the Bankruptcy Code, actions by
creditors to collect indebtedness we owe prior to the Petition Date are stayed
and certain other pre-petition contractual obligations may not be enforced
against us. Except for secured debt, employee payroll and benefits, sales, use
and other taxes, and capital lease obligations, all pre-petition liabilities per
our best estimate have been classified as liabilities subject to compromise.
Adjustments to pre-petition liabilities may result from negotiations, payments
authorized by Court order, additional rejection of executory contracts,
including leases, or other events. We have mailed notices to all known creditors
that the deadline for filing proofs of claims with the Court is June 15, 2004.
Differences between amounts we have scheduled and claims by creditors will be
investigated and resolved in connection with our claims resolution process, and
any necessary adjustments will be recorded accordingly.
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 years ended January 31, 2004 and 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
years ended January 31, 2004, 2003 and 2002 were estimated to be approximately
$3.6 million, $4.7 million and $4.3 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.
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. In light of our
significant net operating losses and our Chapter 11 filing, we provided for a
100% valuation allowance on our deferred tax assets as of May 1, 2004.
Results of Operations
The financial statements contained herein have been prepared on a going concern
basis, which assumes continuity of operations and realization of assets and
satisfaction of liabilities in the ordinary course of business, and in
accordance with SOP 90-7. Upon emergence from bankruptcy, the amounts reported
in subsequent financial statements may materially change, due to the
restructuring of our assets and liabilities as a result of the plan of
reorganization, if any, and the application of "Fresh Start" accounting.
We operated 195 and 242 stores as of May 1, 2004 and May 3, 2003, respectively.
The average number of stores in operation during the 13-week period ended May 1,
2004 was 198 versus 243 during the same period last year.
Net sales were $80.3 million for the 13 weeks ended May 1, 2004 compared to
$104.3 million for the 13 weeks ended May 3, 2003, a decrease of $24.0 million,
or 23.0%. Comparable store sales for the 13-week period ended May 1, 2004
decreased 11.0% versus a decrease of 7.4% for the same period last year. The
decline in net sales was primarily due to fewer stores in operation and negative
comparable store sales. In addition, we believe reduced marketing efforts, as
provided in our strategic plan, adversely affected net sales.
Gross profit was $27.4 million for the 13 weeks ended May 1, 2004 compared to
$37.6 million for the 13 weeks ended May 3, 2003, a decrease of $10.2 million or
27.2%. As a percentage of net sales, gross profit was 34.1% for the 13 weeks
ended May 1, 2004 versus 36.1% for the same period last year. The decrease in
gross profit as a percentage of net sales for the 13 weeks ended May 1, 2004
from the comparable period last year was primarily due to higher markdowns and
shrink accrual, partially offset by higher initial mark-up.
8
Selling and administrative expenses were $31.2 million for the 13 weeks ended
May 1, 2004 compared to $41.3 million for the 13 weeks ended May 3, 2003, a
decrease of $10.1 million or 24.5%. As a percentage of net sales, selling and
administrative expenses were 38.8% and 39.5% for the 13 weeks ended May 1, 2004
and May 3, 2003, respectively. Selling and administrative expenses decreased as
a result of fewer stores in operation during the current quarter, lower
advertising spend and lower general and administrative costs at corporate. The
lower selling and administrative expenses were in line with our plan.
Pre-opening and closing expenses were $14,000 for the 13 weeks ended May 1, 2004
compared to $138,000 for the same period last year, a decrease of approximately
$124,000 or 89.9%. The decrease in pre-opening and closing expenses was due to
no store opening activity in the first quarter of fiscal 2004, versus one new
store opening during the same period last year and preopening costs incurred for
the Otay Mesa distribution center, which was opened in May 2003.
Reorganization items for the 13 weeks ended May 1, 2004 were $8.2 million and
consisted of: (1) a non-cash charge of $5.0 million for lease rejection claims
associated with 31 lease rejections in conjunction with the 44 stores closed in
the quarterly period ended May 1, 2004, as part of our reorganization efforts;
(2) $2.8 million of professional fees and other expenses incurred in our
bankruptcy case and reorganization efforts; and (3) $366,000 of additional costs
to close the 44 stores.
Interest expense, net was $375,000 for the 13 weeks ended May 1, 2004 compared
to $634,000 for the 13 weeks ended May 3, 2003, a decrease of $259,000 or 40.9%.
The decrease in interest expense for the current quarter was primarily due to
lower borrowings as compared to the same period last year.
Income tax benefit for the 13 weeks ended May 1, 2004 was zero as compared to
$1.7 million for the 13 weeks ended May 3, 2003. Due to our significant net
operating losses and our Chapter 11 filing, we provided for a 100% valuation
allowance on all deferred tax assets as of January 31, 2004 because we cannot
conclude that it is more likely than not that the deferred tax assets will be
realized in the foreseeable future. Accordingly, for the 13 weeks ended May 1,
2004, our income tax benefit was zero as we established 100% valuation allowance
to offset such benefit.
For the 13 weeks ended May 1, 2004, the net loss was $12.4 million as compared
to $2.7 million for the 13 weeks ended May 3, 2003. The increase in net loss was
primarily a result of the reorganization items discussed above.
9
Liquidity and Capital Resources
General
We finance our operations through credit provided by vendors and other
suppliers, amounts borrowed under our DIP financing facility, internally
generated cash flow, and other financing resources. Credit terms provided by
vendors and other suppliers have historically been approximately 30 days net,
although during the pendency of the Chapter 11 case, many of our vendors have
reduced the amount of time in which we must pay for goods. Amounts that may be
borrowed under the DIP financing facility are based on a percentage of eligible
inventory and accounts receivable, as defined.
At May 1, 2004, we were in compliance with all financial covenants under our DIP
financing facility, and had outstanding borrowings of $3.0 million and letters
of credit of $15.1 million under our DIP financing facility. The financial
covenants have since been amended in accordance with the May 27, 2004
amendment, subject to the Court's approval. This amendment modified our
financial covenants, whereby covenants will include minimum availability,
five-day availability covenants at each month end and minimum inventory per
store. The Tranche B Lender will fully fund within five business days of the
Court's approval of the amendment and we may repay the Tranche B amount after
October 20, 2004 subject to certain conditions.
With respect to cash flows for the quarterly period ended May 1, 2004, we used
$7.4 million in operating activities, $51,000 in investing activities and
generated $3.0 million from financing activities, which resulted in a net
decrease in cash of $4.5 million. For the same period last year, we used $15.1
million in operating activities, $1.0 million in investing activities and
generated $18.1 million from financing activities, which resulted a net increase
in cash of $1.9 million. The decrease in cash used in operating activities was
primarily due to the lower number of stores in operation. The decrease in cash
used in investing activities was due to higher spending in the first quarter of
fiscal 2003 related to the equipment acquisition for the Otay Mesa distribution
facility. The decrease in cash generated from the financing activities was a
result of net proceeds received from the private offering and the borrowings on
the junior secured term loan in the same period last year.
Our cash needs are satisfied through working capital generated by our business
and funds available under our DIP financing facility. The level of cash
generated by our business is dependent, to a great extent, on our level of sales
and the credit extended by our vendors and the factor community. If we
experience a significant shortening of payment terms with our vendors, a
significant deterioration of credit terms with our factors, the DIP financing
facility for any reason becomes unavailable, or actual results differ materially
from those projected, our compliance with financial covenants and our cash
resources could be adversely affected.
Capital Expenditures
We anticipate capital expenditures of approximately $800,000 during the
remaining nine months of the fiscal year ending January 29, 2005, which include
necessary costs for replacement capital at existing stores. We intend to fund
the anticipated capital expenditures from our sources of cash, including the DIP
financing facility.
Store Closures and Restructuring Initiatives
On February 2, 2004, the Court authorized the closure of 44 stores. On February
11, 2004, the Court approved the agreement between the Great American Group
("Great American") and us in which Great American acted as an exclusive agent to
conduct store-closing sales at the 44 stores location. The store-closing sales
started on February 12, 2004. All 44 stores were closed by March 18, 2004. As of
June 4, 2004, we have terminated or assigned a total of 13 leases of these
stores and rejected the remaining 31 leases. We do not expect any significant
cash requirements relating to these 44 store closures for the remaining nine
months of fiscal 2004.
10
As of June 4, 2004 we have closed 20 of the 23 stores identified in our Fiscal
2002 restructuring efforts and all 28 of the stores identified in our Fiscal
2001 restructuring efforts. In conjunction with our Chapter 11 filing, we have
ceased to make cash payments for any remaining obligations regarding our Fiscal
2002 or 2001 restructuring plans except for the lease obligation of one of our
former San Diego distribution centers (located in the same building as our
corporate headquarters) and certain satellite communication service fee
obligations. The cash requirements relating to these obligations for the
remaining nine months of fiscal 2004 are expected to be approximately $991,000,
which we intend to fund from our sources of cash, including the DIP financing
facility.
In addition, on June 4, 2004, we filed a motion with the Court seeking
authorization to close another 23 under-performing stores. Subject to the
Court's approval, we currently plan to start the going-out-of-business sale
process on or about July 1, 2004 and expect to close these stores by the end of
August 2004. We do not expect any significant cash requirements relating to
these 23 store closures for the remaining nine months of fiscal 2004.
Contractual Obligations and Commitments
The following table summarizes, as of May 1, 2004, certain of our contractual
obligations, as well as estimated cash requirements related to our fiscal 2002
and 2001 restructuring initiatives. This table should be read in conjunction
with "Note 6 - Fiscal 2002 Restructuring Charge", "Note 7 - Fiscal 2001
Restructuring Charge", and "Note 8 - DIP Financing Facility" in the accompanying
unaudited financial statements, as well as our fiscal 2003 Annual Report on Form
10-K as filed with the Securities and Exchange Commission.
Payments due by period
----------------------
2005 and 2007 and
(in thousands) Total 2004 2006 2008 Thereafter
--------- -------- -------- -------- ----------
Operating lease obligations* $ 109,393 $ 18,649 $ 37,220 $ 22,644 $ 30,880
Restructuing charges 2,000 991 1,009 - -
Notes payable 132 32 86 14 -
--------- -------- -------- -------- --------
$ 111,525 $ 19,672 $ 38,315 $ 22,658 $ 30,880
========= ======== ======== ======== ========
* Operating lease obligations have changed significantly from the disclosure in
our most recent annual report on Form 10-K due to lease rejections associated
with the 44 store closures.
Certain amounts included in the above table are related to executory contracts
or lease obligations, which we have neither assumed nor rejected as of May 1,
2004. Under the Bankruptcy Code, we may assume or reject executory contracts,
including lease obligations. Therefore, the commitments shown in the above table
may not reflect actual cash outlays in the future periods.
Reorganization Items
Reorganization items represent amounts we incurred as a result of the Chapter 11
proceedings in accordance with SOP 90-7. The amounts for Reorganization items in
the Statements of Operations include: (1) a non-cash charge of $5.0 million for
lease rejection claims associated with 31 lease rejections in conjunction with
the 44 stores closed in the quarterly period ended May 1, 2004, as part of our
reorganization efforts; (2) $2.8 million of professional fees and other expenses
incurred in our bankruptcy case and reorganization efforts; and (3) $366,000 of
additional costs to close the 44 stores.
We project cash requirements of approximately $4.5 million of professional fees
and other related expenses for the remaining nine months of fiscal 2004. We
believe that our sources of cash, including the DIP financing facility, should
be adequate to fund the cash requirements for our reorganization efforts.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Currently, our exposure to market risks results primarily from changes in
interest rates, principally with respect to the DIP financing facility, which is
a variable rate financing agreement. We do not use swaps or other interest rate
protection agreements to hedge this risk. As of May 1, 2004, we had $3.0 million
of borrowings outstanding under our DIP financing facility.
Item 4. Controls and Procedures
Evaluation. We 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, as of the end of the period
covered by this report. This evaluation was done under the supervision and with
the participation of management, including our Chief Executive Officer (CEO) and
Chief Financial Officer (CFO).
Conclusions. Based upon our evaluation, our CEO and CFO have concluded that 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 II - OTHER INFORMATION
Item 1. Legal Proceedings
See discussion of legal proceedings at Note 11 of the Notes to
Financial Statements.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.26 Factory 2-U Stores, Inc. 2004 Key Employee Retention Plan.
10.27 Factory 2-U Stores, Inc. 2004 Key Employee Emergence Plan.
10.28 Factory 2-U Stores, Inc. 2004 Key Employee Severance Plan.
31.1 Certification of the Chief Executive Officer filed pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of the Chief Financial Officer filed pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
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, 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
Norman Dowling, Executive Vice President and Chief Financial
Officer.
(b) Reports on Form 8-K
On June 4, 2004, we furnished a report on Form 8-K regarding
the extension of our exclusive right to file a proposed Plan
of Reorganization and the filing of a motion with the Court
seeking authorization to close additional 23 stores. The full
text of our press dated June 4, 2004 was furnished and
attached as an 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: June 10, 2004
By: /s/Norman Dowling
-----------------
Name: Norman Dowling
Title:Executive Vice President and Chief Financial Officer
(duly authorized officer and principal financial officer)
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