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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
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FORM 10-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
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-26732
GADZOOKS, INC.
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
TEXAS 74-2261048
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(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OR ORGANIZATION)
4121 INTERNATIONAL PARKWAY
CARROLLTON, TX 75007
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 972-307-5555
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(FORMER NAME, FORMER ADDRESS AND FISCAL YEAR, IF CHANGED SINCE LAST REPORT.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes (X) No ( )
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).Yes (_) No (X)
As of December 15, 2003, the number of shares outstanding of the registrant's
common stock is 9,139,620.
GADZOOKS, INC.
FORM 10-Q
For the Quarter Ended November 1, 2003
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Condensed Consolidated Balance Sheets as of
November 1, 2003 and February 1, 2003 3
Condensed Consolidated Statements of Operations
for the Third Quarter and Nine Months Ended
November 1, 2003 and November 2, 2002 4
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended November 1, 2003 and November 2, 2002 5
Notes to Consolidated Financial Statements 6-9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10-21
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 21
Item 4. Controls and Procedures 22
PART II. OTHER INFORMATION 22-23
SIGNATURE PAGE 24
INDEX TO EXHIBITS 25
2
PART 1-- FINANCIAL INFORMATION
GADZOOKS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
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(IN THOUSANDS)
(UNAUDITED)
NOVEMBER 1, FEBRUARY 1,
2003 2003
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 1,723 $ 20,769
Accounts receivable 1,566 1,321
Inventory 53,204 56,191
Other current assets 12,505 7,137
--------- ---------
68,998 85,418
--------- ---------
Leaseholds, fixtures and equipment, net 35,982 34,824
Other assets 861 4,885
--------- ---------
36,843 39,709
--------- ---------
$ 105,841 $ 125,127
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Line of credit $ 4,363 $ --
Accounts payable 22,796 26,953
Accrued expenses and other current liabilities 8,440 7,616
Income taxes payable -- 77
--------- ---------
35,599 34,646
--------- ---------
Convertible subordinated notes 12,650 --
Accrued rent 3,956 4,124
--------- ---------
16,606 4,124
--------- ---------
Commitments and contingencies
Shareholders' equity
Common stock 92 92
Additional paid-in capital 46,266 44,942
Retained earnings 7,339 41,450
Treasury stock (61) (127)
--------- ---------
53,636 86,357
--------- ---------
$ 105,841 $ 125,127
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
GADZOOKS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
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(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THIRD QUARTER ENDED NINE MONTHS ENDED
-------------------------- --------------------------
NOVEMBER 1, NOVEMBER 2, NOVEMBER 1, NOVEMBER 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net sales $ 49,190 $ 73,734 $ 188,405 $ 228,706
Cost of goods sold including buying,
distribution and occupancy costs 43,747 56,785 160,028 170,823
--------- --------- --------- ---------
Gross profit 5,443 16,949 28,377 57,883
Selling, general and administrative
expenses 18,683 18,360 61,120 56,308
--------- --------- --------- ---------
Operating income (loss) (13,240) (1,411) (32,743) 1,575
Interest income (expense), net (208) 19 (225) 85
--------- --------- --------- ---------
Income (loss) before income taxes (13,448) (1,392) (32,968) 1,660
Provision (benefit) for income taxes 8,659 (536) 1,144 644
--------- --------- --------- ---------
Net income (loss) $ (22,107) $ (856) $ (34,112) $ 1,016
========= ========= ========= =========
Net income (loss) per share
Basic $ (2.42) $ (0.09) $ (3.73) $ 0.11
========= ========= ========= =========
Diluted $ (2.42) $ (0.09) $ (3.73) $ 0.11
========= ========= ========= =========
Weighted average shares outstanding
Basic 9,132 9,132 9,135 9,121
========= ========= ========= =========
Diluted 9,132 9,132 9,135 9,255
========= ========= ========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
GADZOOKS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
--------------------------
NOVEMBER 1, NOVEMBER 2,
2003 2002
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(34,112) $ 1,016
Adjustments to reconcile net income (loss) to cash
provided by (used in) operating activities:
Loss (gain) on disposal of assets (47) 486
Depreciation and amortization 7,197 7,045
Deferred income taxes 1,185 --
Changes in operating assets and liabilities (3,835) (13,046)
------- ------
NET CASH USED IN OPERATING ACTIVITIES (29,612) (4,499)
------- ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (7,060) (8,663)
Proceeds from the sale of fixtures 122 --
Purchase of short-term investments -- (5,957)
Proceeds from redemption of short-term investments -- 5,957
------- ------
NET CASH USED IN INVESTING ACTIVITIES (6,938) (8,663)
------- ------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from line of credit 42,068 --
Repayment of line of credit (37,705) --
Proceeds from issuance of convertible subordinated debt 14,000 --
Debt issue costs (877) --
Purchase of treasury stock (102) --
Issuance of common stock -- 460
Sale of treasury stock under employee benefit plans 120 181
------- ------
NET CASH PROVIDED BY FINANCING ACTIVITIES 17,504 641
------- ------
Net decrease in cash and cash equivalents (19,046) (12,521)
Cash and cash equivalents at beginning of period 20,769 14,868
------- ------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,723 $ 2,347
======== ========
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING ACTIVITIES:
Accrued capital expenditures for store fixtures $ 1,322 $ --
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
GADZOOKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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1. BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements contain
all adjustments necessary to present fairly the financial position of
the Company as of November 1, 2003 and February 1, 2003, and the
results of operations and cash flows for the third quarter and nine
months ended November 1, 2003 and November 2, 2002. The results of
operations for the third quarter and nine months then ended are not
necessarily indicative of the results to be expected for the full
fiscal year. The condensed consolidated balance sheet as of February 1,
2003 is derived from audited financial statements. The condensed
consolidated financial statements should be read in conjunction with
the financial statement disclosures contained in the Company's Annual
Report on Form 10-K for the fiscal year ended February 1, 2003.
Fiscal year: The Company's fiscal year is the 52- or 53-week period
that ends on the Saturday closest to the end of January. "Fiscal 2003"
is the 52-week period ending January 31, 2004.
Stock Option Plans: The following table shows Gadzooks' net income
(loss) for the quarters and nine months ended November 1, 2003 and
November 2, 2002, as if compensation expense for Gadzooks' stock option
plans applicable to the Company's employees had been determined based
upon the fair value at the grant date for awards consistent with the
methodology prescribed by SFAS 123 (these pro forma effects may not be
representative of expense in future periods since the estimated fair
value of stock options on the date of grant is amortized to expense
over the vesting period, and additional options may be granted or
cancelled in future years):
QUARTER ENDED NINE MONTHS ENDED
-------------------------- ---------------------------
NOVEMBER 1, NOVEMBER 2, NOVEMBER 1, NOVEMBER 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
PRO FORMA NET INCOME (LOSS):
(in thousands)
Reported net income (loss) $ (22,107) $ (856) $ (34,112) $ 1,016
Less: Total stock-based employee
compensation expense determined
under fair value based methods for all
awards, net of related tax effects (581) (554) (1,713) (1,323)
--------- --------- --------- ---------
Pro forma net income (loss) $ (22,688) $ (1,410) $ (35,825) $ (307)
========= ========= ========= =========
NET INCOME (LOSS) PER SHARE:
Basic $ (2.42) $ (0.09) $ (3.73) $ 0.11
========= ========= ========= =========
Basic - pro forma $ (2.48) $ (0.15) $ (3.92) $ (0.03)
========= ========= ========= =========
Diluted $ (2.42) $ (0.09) $ (3.73) $ 0.11
========= ========= ========= =========
Diluted - pro forma $ (2.48) $ (0.15) $ (3.92) $ (0.03)
========= ========= ========= =========
6
2. LONG-TERM DEBT AND CREDIT AGREEMENT
Long-term debt at November 1, 2003 and February 1, 2003 consisted of
the following:
NOVEMBER 1, FEBRUARY 1,
2003 2003
------------ ------------
5% Convertible Subordinated Notes due
October 9, 2008, net of unamortized discount
of $1,349,682 $ 12,650,318 $ --
------------ ------------
Less current maturities -- --
------------ ------------
$ 12,650,318 $ --
============ ============
On October 9, 2003, the Company issued $14,000,000 of 5% Convertible
Subordinated Notes ("Notes") due October 9, 2008 with interest payable
semi-annually commencing April 1, 2004. The Notes, as well as unpaid
accrued interest, are convertible at any time at the option of the
holder into common stock at a conversion price of $5.00 per share.
However, the investors are contractually prohibited from converting
Notes into shares of common stock without receiving prior shareholder
approval if such issuance of common stock would exceed 20 percent of
the Company's outstanding shares of common stock or result in the
ownership by any one shareholder of greater than 20 percent of the
Company's outstanding shares of common stock. The Company has recorded
a beneficial conversion discount of $1,372,000 as a credit to
additional paid-in capital based on the difference between the fair
value and the conversion price (calculated as the intrinsic value) as
of October 9, 2003. The discount will be amortized over a three-year
period using the effective interest method. At the option of the
Company, the Notes, as well as unpaid accrued interest, may be
converted into shares of common stock at any time after April 9, 2005
if the closing price of the Company's common stock is greater than
$6.00 for 20 trading days during a 30 consecutive trading day period.
At any time after October 9, 2006, the Company has the right to prepay
the Notes and the holders have the right to put the Notes back to the
Company at the face value of the Notes, plus unpaid accrued interest.
As of November 1, 2003, the Notes, and unpaid accrued interest, were
convertible into 2,807,778 shares of common stock with a fair value of
$18,447,101.
On April 11, 2003, the Company and Wells Fargo Retail Finance LLC
("Wells Fargo") entered into a three-year $30 million revolving credit
agreement (the "Facility"), which is secured by an exclusive and first
priority, perfected interest in all assets of the Company. The credit
agreement also provides for the issuance of letters of credit that are
used in connection with merchandise purchases. Outstanding letters of
credit issued by the bank reduce amounts otherwise available for
borrowing under the revolving line of credit.
On October 31, 2003, the Company and Wells Fargo entered into an
amendment of the three-year $30 million revolving line of credit
agreement. This amendment temporarily increased the Facility to a
maximum of $35 million through December 31, 2003, adjusted certain
other terms of the Facility, which effectively increased the Company's
borrowing capacity under the line, and imposed specific covenants. The
covenants imposed by the amendment require minimum levels of earnings
before interest, taxes, depreciation and amortization ("EBITDA"),
minimum accounts payable balances and a capital infusion of not less
than $7.5 million. The EBITDA and accounts payable balance covenants
become effective only in the event of a measurement event as defined by
the amendment. If the Company breaches any of the covenants, the line
maximum reverts back to $30 million and the terms of the original
Facility are immediately restored. At November 1, 2003, the Company was
in compliance with all covenants under the Facility. As of November 1,
2003, amounts available to borrow under the amended credit line, as
limited as described above, by the outstanding line balance of $4.4
million and by outstanding letters of credit of $13.6 million, totaled
$15.2 million. The weighted average interest rate for the quarter ended
November 1, 2003 on these borrowings was 4.48%.
7
3. DEFERRED TAX ASSETS
The Company recognized a valuation allowance of $8.7 million to reduce
its deferred tax assets during the third quarter ending November 1,
2003, as a result of continued same store sales declines since its
conversion to an all-female concept and a $13.2 million operating loss
in the third quarter of fiscal 2003. In addition, the Company did not
record a tax benefit for its third quarter operating loss, nor does it
anticipate recording any tax benefit associated with operating losses
in the foreseeable future. At November 1, 2003, the Company has tax
receivables and deferred tax assets totaling $5.6 million, net of the
valuation allowance, representing the amount of the current year
estimated operating loss that can be carried back to prior years'
taxable income to obtain a tax refund.
4. EARNINGS PER SHARE
The following table outlines the Company's calculation of weighted
average shares outstanding (in thousands):
QUARTER ENDED NINE MONTHS ENDED
--------------------------- ---------------------------
NOVEMBER 1, NOVEMBER 2, NOVEMBER 1, NOVEMBER 2,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Weighted average common
shares outstanding (basic) 9,132 9,132 9,135 9,121
Effect of dilutive options -- -- -- 134
----- ----- ----- -----
Weighted average common
shares outstanding
(diluted) 9,132 9,132 9,135 9,255
===== ===== ===== =====
The treasury stock method is used to determine dilutive potential
common shares outstanding related to stock options. Options, that are
antidilutive, are not considered in the treasury stock method
calculation. Options excluded from the earnings per share calculation
due to their antidilutive nature totaled 1,604,651 and 1,309,980 for
the quarters ended November 1, 2003 and November 2, 2002; and
1,604,651 and 772,729 for the nine months ended November 1, 2003 and
November 2, 2002, respectively. The Company had $14.0 million in
convertible debt, plus unpaid accrued interest outstanding for the
quarter and nine months ended November 1, 2003, which was convertible
into 2,807,778 shares of common stock (see Note 2). These shares have
been excluded from the earnings per share calculation for the quarter
and nine months ended November 1, 2003 due to their anti-dilutive
effect under the if-converted method.
5. STORE CLOSING COSTS
During the third quarter of fiscal 2003, the Company closed 12 stores
that had been identified as under-performing, for a total of 25 stores
closed during the nine months ended November 1, 2003. The total costs
incurred as a result of the store closings and lease termination
agreements totaled $209,000 and $2.9 million for the quarter and nine
months ended November 1, 2003, respectively. These costs, primarily
composed of lease termination costs, are included in selling, general
and administrative expenses.
6. INVENTORY LIQUIDATION COSTS
The Company entered into an agreement with a consulting firm to help
with the complete liquidation of its men's inventory. Under the terms
of the agreement, the Company reimbursed the firm for certain operating
costs and paid the firm a portion of the sales proceeds based on
certain specified levels of sales performance as defined in the
contract. All amounts paid to the firm or accrued under the contract
were contingent upon the firm's ability to meet certain minimum levels
of sales
8
performance. A total of $3.0 million was recorded as selling, general
and administrative expenses during the first half of the year pursuant
to this agreement. As of August 2, 2003, the men's inventory
liquidation was completed; therefore, no additional costs will be
incurred pursuant to the agreement.
7. LIQUIDITY
The Company converted its Gadzooks stores to an all-female concept in
July 2003. During the transition phase, the Company has generated
significant operating losses primarily as a result of continued same
store sales declines. However, without a substantial improvement in the
operating results of business, the Company may not be able to fund its
future operations without further infusions of capital. Accordingly,
Gadzooks is considering all available alternatives to address its
liquidity concerns, including but not limited to, implementing
aggressive promotional strategies to increase inventory turn and
seeking additional funding. The Company is currently meeting its cash
requirements through proceeds from its recent offering of convertible
subordinated notes and its revolving line of credit, which are
discussed in Note 2. At December 15, 2003, the available borrowing
capacity under the revolving line of credit totaled approximately $2.8
million.
The Company's ability to fund its future operations and expenditures
will depend upon its access to funding, including its ability to access
the capital markets and its future financial and operating performance,
which will be affected by prevailing economic conditions and financial,
business and other factors, many of which are beyond the Company's
control. There can be no assurance (i) that additional funding will
become available to the Company on either a short term or long term
basis, (ii) that the terms of any additional funding would not be
materially adverse to the Company including substantial interest rates,
the imposition of restrictive covenants, the pledging of assets, the
sale of assets, the dilution of existing stockholders' interest or
otherwise, or (iii) that the Company will not be required to consider
reductions in capital and other expenditures, the sale of assets or
other strategic alternatives, including a potential reorganization
under Chapter 11 of the U.S. bankruptcy code.
9
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
GENERAL
Gadzooks is a mall-based specialty retailer of casual clothing, accessories and
shoes for young women, principally between the ages of 16 and 22. Historically,
the Company has catered to the clothing needs of both young men and women. The
conversion of the Gadzooks stores to an all-female merchandise assortment took
place in July 2003. In the second half of fiscal 2001, the Company began testing
a new retail concept with the opening of four Orchid stores. The Orchid concept
caters to the innerwear and sleepwear needs of females between the ages of 14
and 22. As of November 1, 2003, the Company had closed 24 Gadzooks stores and
one Orchid store since the beginning of the fiscal year and operated 411
Gadzooks stores and three Orchid stores for a total of 414 stores in 41 states.
The Company's business is subject to seasonal influences with higher sales
during the Christmas holiday, back-to-school and spring break seasons.
Management's discussion and analysis should be read in conjunction with the
Company's financial statements and the notes related thereto.
CRITICAL ACCOUNTING POLICIES
The preparation of Gadzooks' consolidated financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the balance sheet date, as well as the reported amounts of
revenues and expenses during the reporting period. On an ongoing basis,
management evaluates such estimates including sales return rates, inventory
reserves, impairment of long-lived assets, income taxes and accrued expenses.
Actual results may differ from estimates.
Gadzooks' accounting policies are generally straightforward; however, the
following issues require more significant management judgments and estimates.
REVENUE RECOGNITION. Retail merchandise sales are recognized at the point of
sale less sales returns and employee discounts. Management records a provision
for estimated sales returns based on historical return rates. If sales return
rates change, an additional allowance may be required.
INVENTORY VALUATION. Inventories are valued at the lower of average cost or
market. Cost is determined using the weighted-average method. Markdown
allowances received from vendors are recorded as a reduction of inventory cost
and therefore as a reduction of cost of goods sold in the period in which the
related merchandise is sold. In addition, inventories include an allocation of
buying and distribution costs to prepare product for the stores. This inventory
valuation method requires certain management estimates and judgments, including
estimates of merchandise markdowns, which could significantly affect gross
margin. Management estimates the markdown reserve based on several factors,
including but not limited to, merchandise quantities, historical markdown
percentages, aged seasonal merchandise and future merchandise plans. If future
demand or merchandise markdowns are less favorable than those projected by
management, additional inventory adjustments may be required. On a monthly
basis, management estimates shrink based on historical shrink rates. These
estimates are compared to actual results as inventory counts are taken and
reconciled to the general ledger. Gadzooks has not experienced significant
fluctuations in historical shrink rates.
LONG-TERM ASSET IMPAIRMENT. Management periodically reviews its long-lived
assets for impairment and records a provision whenever events or circumstances
indicate that the net book value of the asset may not be recoverable. Impairment
is determined based on several factors, including but not limited to, current
year operating loss or cash flow loss combined with a history and forecast of
operating or cash flow losses, significant negative industry or economic trends
and a current expectation, that more likely than not, the asset will be disposed
of significantly before the end of its previously estimated useful life. If
management
10
determines that impairment exists, an impairment loss is recognized if the sum
of the expected future cash flows (undiscounted and before interest) from the
use of the assets is less than the net book value of the assets. The amount of
the impairment loss is measured as the difference between the net book value of
the assets and the estimated fair market value of the related assets.
DEFERRED TAX ASSETS. Deferred income taxes are provided on the liability method.
Under this method, deferred tax assets and liabilities are recognized based on
differences between the financial statement and the tax basis of assets and
liabilities using presently enacted tax rates. The Company reviewed its deferred
tax assets for realization and recognized a valuation allowance of $8.7 million
to reduce its deferred tax assets during the third quarter ending November 1,
2003, as a result of a $13.2 million operating loss in the third quarter of
fiscal 2003 and continued same store sales declines since its conversion to an
all-female concept. In addition, the Company did not record a tax benefit for
its third quarter operating loss, nor does it anticipate recording any tax
benefit associated with operating losses in the foreseeable future. At November
1, 2003, the Company has tax receivables and deferred tax assets totaling $5.6
million, net of the valuation allowance, representing the amount of the current
year estimated operating loss that can be carried back to prior years' taxable
income to obtain a tax refund.
ACCRUED EXPENSES. On a monthly basis, certain expenses are estimated in an
effort to reflect these expenses in the proper period. Gadzooks' most material
estimates relate to self-insurance reserves, store level operating expenses and
bonuses. The self-insurance reserves for medical and worker's compensation
claims are recorded based on historical claim levels adjusted for growth in the
employee base. If the historical claims used to calculate these estimates are
not reflective of actual results, additional expenses may be incurred up to the
point that the Company's stop loss insurance begins. The Company is self-insured
for property and casualty claims at the store level. Property and casualty
claims at a store level are estimated and recognized as incurred. Accrued store
level operating expenses are estimated based on current activity and historical
results. Bonuses are based on performance and projected performance for the
remainder of the bonus period. If actual results are significantly different
from Gadzooks' expectations, an adjustment to expenses may be required.
CONVERSION TO ALL-FEMALE MERCHANDISE ASSORTMENT
The conversion of all Gadzooks stores to an all-female merchandise assortment
took place in July 2003. The Company has experienced and expects to continue to
experience an operating loss during the transition phase in fiscal 2003.
Although it is not possible to predict all the costs associated with the
transition, the Company does plan to spend at least $2.0 million to $2.5 million
in fiscal 2003 to market the new concept, of which $2.0 million has been spent
through November 1, 2003. The Company hired a consulting firm to help with the
liquidation of its men's inventory. Under the terms of the agreement, the
Company reimbursed the firm for certain operating costs and paid the firm a
portion of the sales proceeds based on certain specified levels of sales
performance as defined in the contract. A total of $3.0 million was recorded as
selling, general and administrative expenses during the first half of the year
pursuant to this agreement. As of August 2, 2003, the men's inventory
liquidation was completed; therefore, no additional costs will be incurred
pursuant to this agreement. No assurance can be given that the conversion will
be successful, or that the Company will return to profitability.
STORE CLOSINGS
The Company has closed 24 Gadzooks stores in fiscal 2003. The Company is also
pursuing the closure of up to 15 additional under-performing stores during the
remainder of fiscal 2003. In addition to the Gadzooks closings, the Company
closed one Orchid store during the third quarter and replaced it with a more
suitably sized location in another mall. The costs associated with closing these
stores, including, but not limited to, lease termination costs and employee
severance, is expected to be between $2.9 million and $3.5 million in the
aggregate, of which $2.9 million has been incurred through November 1, 2003.
Costs and expenses associated with store closures are recognized at the time the
liability is incurred. No assurance can be given, however, that these stores
will be closed during fiscal 2003, that additional stores will not be closed
during fiscal 2003 or that the costs related to closing stores will not exceed
the range provided.
11
RESULTS OF OPERATIONS
The third quarter ended November 1, 2003 compared to the third quarter ended
November 2, 2002.
Net sales
Net sales decreased approximately $24.5 million, or 33.2 percent, to $49.2
million during the third quarter of fiscal 2003 from $73.7 million during the
comparable quarter of fiscal 2002. The total Company sales decrease was due to a
comparable store sales decrease of $22.1 million and a sales decrease of $2.6
million due to closed stores, partially offset by $123,000 of sales from the
three new stores not yet included in the comparable store sales base. Comparable
store sales decreased 31.4 percent for the third quarter of fiscal 2003. Sales
by category in the average store changed as follows versus the prior year
quarter: accessories - increased by 68 percent; shoes - increased by 66 percent;
apparel - increased by 43 percent; and men's merchandise - decreased by 99
percent. The decrease in comparable store sales is attributed to the conversion
to an all-female merchandise assortment and a difficult retail environment. The
Company's average transaction size decreased 11.1 percent, and the number of
transactions per average store decreased by 21.3 percent.
Comparable store sales for fiscal November 2003 decreased by 28.1 percent from
the prior year. No assurance can be given that comparable store sales will
improve.
Gross profit
Gross profit decreased approximately $11.5 million to $5.4 million during the
third quarter of fiscal 2003 from $16.9 million during the comparable quarter of
fiscal 2002. As a percentage of net sales, gross profit decreased 11.9
percentage points to 11.1 percent from 23.0 percent for the comparable quarter
of last year. Merchandise margins as a percentage of sales declined 3.0 percent
from the prior year. This decrease is attributable to increased markdown
activity during the period. Occupancy costs as a percentage of sales increased
by 7.7 percent, and buying and distribution costs as a percentage of sales
increased by 1.2 percent. The increase in occupancy costs (which are relatively
fixed in nature) and buying and distribution costs as a percentage of sales was
due to the negative leverage effect of the comparable store sales decrease.
Selling, general and administrative expenses
Selling, general and administrative expenses ("SG&A") increased approximately
$0.3 million to $18.7 million during the third quarter of 2003 from $18.4
million during the comparable quarter of fiscal 2002. The aggregate increase in
SG&A is primarily attributable to lease termination costs of $209,000 and
additional advertising and marketing expenses of $1.0 million related to the
transition to an all female merchandise assortment. These costs were offset in
part by a reduction in payroll costs. As a percentage of net sales, SG&A
increased by 13.1 percentage points to 38.0 percent during the third quarter of
fiscal 2003 from 24.9 percent during the third quarter of last year. The
increase in the SG&A percentage was due primarily to negative leverage from the
comparable store sales decrease, and to a lesser extent, the increase in
advertising and marketing costs related to the transition.
Interest
The Company recorded $208,000 in net interest expense during the third quarter
of fiscal 2003 compared to $19,000 in net interest income in the comparable
period of last year. The change is due primarily to an increase in the amounts
borrowed under the credit facility and, to a lesser extent, interest on the
notes issued in the latter part of the third quarter and increased letter of
credit activity.
Income taxes
The provision for income taxes increased approximately $9.2 million to $8.7
million during the third quarter of fiscal 2003 compared to a $536,000 tax
benefit during the comparable quarter of fiscal 2002. The increase in the
provision is due to the Company's recognition of a valuation allowance of $8.7
million to reduce its deferred tax assets during the third quarter ended
November 1, 2003, as a result a $13.2 million operating loss in the third
quarter of fiscal 2003 and continued same store sales declines since its
conversion to an all-
12
female concept. In addition, the Company did not record a tax benefit for its
third quarter operating loss, nor does it anticipate recording any tax benefit
associated with operating losses in the foreseeable future. At November 1, 2003,
the Company has tax receivables and deferred tax assets totaling $5.6 million,
net of the valuation allowance, representing the amount of the current year
estimated operating loss that can be carried back to prior years' taxable income
to obtain a tax refund.
The nine months ended November 1, 2003 compared to the nine months ended
November 2, 2002
Net sales
Net sales decreased approximately $40.3 million, or 17.6 percent, to $188.4
million during the first nine months of fiscal 2003 from $228.7 million during
fiscal 2002. The total Company sales decrease for the first nine months of
fiscal 2003 was attributable to a comparable store sales decrease of $37.6
million, or 17.0 percent, and a sales decrease of $4.5 million due to closed
stores, partially offset by $1.8 million of sales for the new stores not yet
included in the comparable store sales base. The Company experienced comparable
store sales increases in all its major categories except men's merchandise,
which has now been completely liquidated as a result of the Company's transition
to an all-female merchandise assortment. The Company's average transaction size
decreased by 8.3 percent, and the number of transactions per average store
decreased by 8.3 percent.
Gross profit
Gross profit decreased approximately $29.5 million to $28.4 million during the
first nine months of fiscal 2003 from $57.9 million during the comparable nine
months of fiscal 2002. As a percentage of net sales, gross profit decreased 10.2
percentage points to 15.1 percent from 25.3 percent for the comparable nine
months of last year. Merchandise margins as a percentage of sales were 6.2
percent lower than the prior year. This decrease is primarily attributable to
the liquidation of the men's inventory and increased markdown activity in the
junior category during the period. Additionally, there was a 3.3 percent
increase in occupancy costs as a percentage of sales and a 0.6 percent increase
in buying and distribution costs as a percentage of sales. The increase in
occupancy, buying and distribution costs as a percentage of sales was due
primarily to the negative leverage effect of the comparable store sales
decrease.
Selling, general and administrative expenses
Selling, general and administrative expenses increased approximately $4.8
million to $61.1 million during the first nine months of 2003 from $56.3 million
during the comparable nine months of fiscal 2002. The aggregate increase in SG&A
is primarily attributable to costs of $3.0 million associated with the
liquidation of the men's merchandise, lease termination costs of $2.9 million
and additional advertising and marketing expenses of $2.0 million related to the
transition offset in part by a reduction in payroll costs, a gain on sale of
assets and a reduction in inventory services costs. As a percentage of net
sales, SG&A increased 7.8 percent to 32.4 percent during the first nine months
of fiscal 2003 from 24.6 percent during the comparable nine months of last year.
The increase in the SG&A percentage is a result of the negative leverage effect
of the comparable store sales decrease, costs associated with the liquidation of
the men's merchandise, lease termination costs and the increase in advertising
and marketing costs related to the transition.
Interest
The Company recorded $225,000 in net interest expense during the first nine
months of fiscal 2003 compared to $85,000 in net interest income in the
comparable period of last year. The change is due primarily to an increase in
the amounts borrowed under the credit facility, and to a lesser extent, interest
on the notes issued in the latter part of the third quarter, increased letter of
credit activity and lower average cash balances.
13
Income taxes
The provision for income taxes increased approximately $500,000 to $1.1 million
during the first nine months of fiscal 2003 from $644,000 during the comparable
nine months of fiscal 2002. The increase in the provision is due to the
recognition of a valuation allowance of $8.7 million to reduce the Company's
deferred tax assets during the third quarter of fiscal 2003. In addition the
Company did not record a tax benefit for its third quarter operating loss, nor
does it anticipate recording any tax benefit associated with operating losses in
the foreseeable future.
LIQUIDITY AND CAPITAL RESOURCES
General
The Company is currently meeting its cash requirements through proceeds from its
recent offering of convertible subordinated notes and its line of credit.
However, without a substantial improvement in the operating results of the
business, the Company may not be able to fund its future operations without
further infusions of capital. Accordingly, Gadzooks is considering all available
alternatives to address its liquidity concerns, including, but not limited to,
implementing aggressive promotional strategies to increase inventory turns and
seeking additional funding.
The Company's ability to fund its future operations and expenditures will depend
upon its access to funding, including its ability to access the capital markets
and its future financial and operating performance, which will be affected by
prevailing economic conditions and financial, business and other factors, many
of which are beyond the Company's control. There can be no assurance (i) that
additional funding will become available to the Company on either a short term
or long term basis, (ii) that the terms of any additional funding would not be
materially adverse to the Company including substantial interest rates, the
imposition of restrictive covenants, the pledging of assets, the sale of assets,
the dilution of existing stockholders' interest or otherwise, or (iii) that the
Company will not be required to consider reductions in capital and other
expenditures, the sale of assets or other strategic alternatives, including a
potential reorganization under Chapter 11 of the U.S. bankruptcy code.
Cash Flows
At November 1, 2003, cash and cash equivalents were $1.7 million, a decrease of
$19.0 million since February 1, 2003. The primary uses of cash were a net loss
before depreciation, amortization and income tax valuation allowance of $25.7
million, capital expenditures of $7.1 million and net working capital changes of
$3.8 million partially offset by net proceeds from issuance of long-term debt of
$13.1 million and a net line of credit advance of $4.4 million.
Long-Term Debt and Credit Agreement
On October 9, 2003, the Company issued $14,000,000 of 5% Convertible
Subordinated Notes ("Notes") due October 9, 2008 with interest payable
semi-annually commencing April 1, 2004. The Notes, as well as unpaid accrued
interest, are convertible at any time at the option of the holder into common
stock at a conversion price of $5.00 per share. However, the investors are
contractually prohibited from converting Notes into shares of common stock
without receiving prior shareholder approval if such issuance of common stock
would exceed 20 percent of the Company's outstanding shares of common stock or
result in the ownership by any one shareholder of greater than 20 percent of the
Company's outstanding shares of common stock. The Company has recorded a
beneficial conversion discount of $1,372,000 as a credit to additional paid-in
capital based on the difference between the fair value and the conversion price
(calculated as the intrinsic value) as of October 9, 2003. The discount will be
amortized over a three-year period using the effective interest method. At the
option of the Company, the Notes, as well as unpaid accrued interest, may be
converted into shares of common stock at any time after April 9, 2005 if the
closing price of the Company's common stock is greater than $6.00 for 20 trading
days during a 30 consecutive trading day period. At any time after October 9,
2006, the Company has the right to prepay the Notes and the holders have the
right to put the Notes back to the Company at the face value of the Notes, plus
unpaid accrued interest. As of November 1, 2003, the
14
Notes, and unpaid accrued interest, were convertible into 2,807,778 shares
of common stock with a fair value of $18,447,101.
On April 11, 2003, the Company and Wells Fargo Retail Finance LLC ("Wells
Fargo") entered into a three-year $30 million revolving credit agreement (the
"Facility"), which is secured by an exclusive and first priority, perfected
interest in all assets of the Company. The credit agreement also provides for
the issuance of letters of credit that are used in connection with merchandise
purchases. Outstanding letters of credit issued by the bank reduce amounts
otherwise available for borrowing under the revolving line of credit.
On October 31, 2003, the Company and Wells Fargo entered into an amendment of
the three-year $30 million revolving line of credit agreement. This amendment
temporarily increased the Facility to a maximum of $35 million through December
31, 2003, adjusted certain other terms of the Facility, which effectively
increased the Company's borrowing capacity under the line, and imposed specific
covenants. The covenants imposed by the amendment require minimum levels of
earnings before interest, taxes, depreciation and amortization ("EBITDA"),
minimum accounts payable balances and a capital infusion of not less than $7.5
million. The EBITDA and accounts payable balance covenants become effective only
in the event of a measurement event as defined by the amendment. If the Company
breaches any of the covenants, the line maximum reverts back to $30 million and
the terms of the original Facility are immediately restored. At November 1,
2003, the Company was in compliance with all covenants under the Facility. As of
November 1, 2003, amounts available to borrow under the amended credit line, as
limited as described above, by the outstanding line balance of $4.4 million and
by outstanding letters of credit of $13.6 million, totaled $15.2 million. The
weighted average interest rate for the quarter ended November 1, 2003 on these
borrowings was 4.48%. At December 15, 2003, the current availability on the
Facility totaled approximately $2.8 million.
Factoring
We believe that the majority of our merchandise vendors either enter into
factoring arrangements whereby factors purchase the vendor's invoices, or enter
into agreements with factors to insure the payment of their invoices. This
financing mechanism allows Gadzooks' vendors to receive payment in a shorter
period of time. Certain of these factors have modified the terms of agreements
with some of Gadzooks' vendors and are accelerating the due dates for payments
by us, requiring us to provide standby letters of credit or refusing to approve
shipments altogether. We believe that these factors may continue to materially
modify our payment terms until our results of operations improve. Further
material modifications by factors could materially adversely affect our ability
to obtain new inventory, meet our cash requirements and maintain necessary
liquidity going forward.
Conversion to All-Female Merchandise Assortment
The conversion of all Gadzooks stores to an all-female merchandise assortment
took place in July 2003. The Company has experienced and expects to continue to
experience an operating loss during the transition phase in fiscal 2003.
Although it is not possible to predict all of the costs associated with the
transition, the Company plans to spend at least $2.0 million to $2.5 million in
fiscal 2003 to market the new concept, of which $2.0 million has been spent
through November 1, 2003. The Company hired a consulting firm to help with the
liquidation of its men's inventory. Under the terms of the agreement, the
Company reimbursed the firm for certain operating costs and paid the firm a
portion of the sales proceeds based on certain specified levels of sales
performance as defined in the contract. A total of $3.0 million was recorded as
selling, general and administrative expenses during the first half of the year
pursuant to this agreement. As of August 2, 2003, the men's inventory
liquidation was completed; therefore, no additional costs will be incurred
pursuant to this agreement. No assurance can be given that the conversion will
be successful, or that the Company will return to profitability.
Store Closings
The Company has already closed 24 Gadzooks stores in fiscal 2003. The Company is
also pursuing the closure of up to 15 additional under-performing stores during
the remainder of fiscal 2003. In addition to the Gadzooks closings, the Company
closed one Orchid store during the third quarter and replaced it with a more
suitably sized location in another mall during the fourth quarter. The costs
associated with closing these
15
stores, including, but not limited to, lease termination costs and employee
severance, is expected to be between $2.9 million and $3.5 million in the
aggregate, of which $2.9 million has been spent through November 1, 2003. Costs
and expenses associated with store closures will be recognized at the time the
liability is incurred. No assurance can be given, however, that these stores
will be closed during fiscal 2003, that additional stores will not be closed
during fiscal 2003 or that the costs related to the closing of the stores will
not exceed the range provided.
Capital Expenditures
The Company anticipates capital expenditures of $1.6 million to $1.9 million
(including the $1.3 million accrued capital expenditures for the third quarter)
for the remainder of fiscal 2003 to pay for fixtures related to the conversion
to an all-female concept and the relocation/remodeling of two stores.
Risk Factors
In addition to the other information included in this report, the following risk
factors should be considered in evaluating our business and future prospects.
We may not realize the increase in female business anticipated by converting to
an all female merchandise assortment.
In July 2003 we converted our Gadzooks stores to an all-female merchandise
assortment. Although we believe that the conversion will have a positive impact
on our business due to our historical performance and expertise in the junior's
category, we cannot assure you that sales and operating results will increase as
planned or that the conversion will be successful. If the anticipated increase
in female business does not occur as planned, our sales and operating results
will suffer.
We have had significant fluctuations in comparable store sales results.
Our comparable store sales results have varied significantly due to a variety of
factors, including economic conditions, fashion trends, the retail sales
environment, competition, sourcing and distribution of products and our ability
to execute our business strategy efficiently. The liquidation of our men's
inventory and subsequent change to an all-female merchandise assortment has
caused unusual fluctuations in comparable store sales results particularly in
fiscal 2003. Our comparable store sales results were (10.6)%, (9.9)% and (31.4)%
in the first, second and third quarters of fiscal 2003, respectively, (2.2)%,
(3.3)%, (5.1)% and (3.1)% in the first, second, third and fourth quarters of
fiscal 2002, respectively, and (4.6)%, (8.9)%, (3.2)% and (3.9)% in the first,
second, third and fourth quarters of fiscal 2001, respectively. If our
comparable store sales results continue to fluctuate, it may cause our stock
price to be volatile.
The financing mechanisms used by certain vendors could result in changes in our
payment obligations, which could adversely affect our liquidity.
We believe that the majority of our merchandise vendors either enter into
factoring arrangements whereby factors purchase the vendor's invoices, or enter
into agreements with factors to insure the payment of their invoices. This
financing mechanism allows Gadzooks' vendors to receive payment in a shorter
period of time. Certain of these factors have modified the terms of agreements
with some of Gadzooks' vendors and are accelerating the due dates for payments
by us, requiring us to provide standby letters of credit or refusing to approve
shipments altogether. We believe that these factors may continue to materially
modify our payment terms. Further material modifications by factors could
materially adversely affect our ability to obtain new inventory, meet our cash
requirements and maintain necessary liquidity going forward.
16
If our sales continue to decline, our business, financial condition, results of
operations and liquidity may suffer.
Comparable store sales for November, October and September of fiscal 2003
decreased by 28.1 percent, 26.6 percent and 32.5 percent from the prior year,
respectively. In addition, we have generated operating losses of $32.7 million
for the first nine months of fiscal 2003 and expect to report an operating loss
for the year as a whole. No assurance can be given that comparable store sales
will improve. Continuing declines in comparable store sales or continuing
operating losses could have a material adverse effect on our business, financial
condition, results of operations and liquidity.
In addition, we have tax receivables and deferred tax assets totaling
approximately $5.6 million, net of the valuation allowance, as of November 1,
2003. Due to our same store sales declines since conversion to an all-female
concept, we recognized a valuation allowance of approximately $8.7 million to
reduce our deferred tax assets during our third quarter ending November 1, 2003.
In addition, we do not anticipate recording any tax benefit associated with
operating losses in the foreseeable future.
Any failure to meet our debt obligations could harm our business.
If our cash flow and capital resources are insufficient to fund our debt
obligations, we may be forced to seek alternatives to address our liquidity
concerns, including seeking additional equity or debt capital, restructuring our
debt or a potential reorganization under Chapter 11 of the U.S. bankruptcy code.
In addition, any failure to make scheduled payments of interest and principal on
any of our indebtedness could harm our ability to incur additional indebtedness
on acceptable terms. We cannot assure you that our cash flow and capital
resources will be sufficient for payment of interest and principal on our debt
in the future or that any such alternative methods would be successful or would
permit us to meet our debt obligations.
We have substantial debt obligations that could restrict our operations.
We have substantial indebtedness. As of December 15, 2003, our outstanding debt
was approximately $32.2 million. Our substantial indebtedness could have adverse
consequences, including the following: increasing our vulnerability to adverse
economic and industry conditions; limiting our flexibility in planning for, or
reacting to, changes in our business and the industry in which we operate; and
limiting our ability to borrow additional funds.
Our debt service requirements will require the use of a portion of our operating
cash flow to pay interest on our debt instead of other corporate purposes. If
our cash flow and capital resources are insufficient to fund our debt
obligations, we may be forced to seek alternatives to address our liquidity
concerns, including seeking additional equity or debt capital, restructuring our
debt or a potential reorganization under Chapter 11 of the U.S. bankruptcy code.
We cannot assure you that our cash flow and capital resources will be sufficient
for payment of interest on and principal of our debt in the future, or that any
such alternative measures would be successful or would permit us to meet
scheduled debt service obligations. Any failure to meet our debt obligations
could harm our business, profitability and growth prospects.
If we are unable to successfully anticipate changes in fashion trends, our
business, sales and image could suffer.
Gadzooks' profitability is largely dependent upon our ability to anticipate the
fashion tastes of our customers and to provide merchandise and brands that
appeal to their preferences in a timely manner. The fashion tastes of our
customers may change frequently. Our failure to anticipate, identify or react
appropriately to changes in styles, trends or brand preferences could lead to,
among other things, excess inventories and higher markdowns, which could have a
material adverse effect on our operating results, comparable store sales
results, liquidity and our image with our customers.
If we are unable to successfully anticipate fashion trends with our private
label merchandise, our business, financial condition, results of operations and
liquidity may suffer.
Sales from private label merchandise, including merchandise designed and sourced
by Gadzooks under the Candie's label, accounted for approximately 17% and 13% of
net sales in fiscal 2002 and fiscal 2001,
17
respectively. We expect to increase the percentage of net sales in private label
merchandise in the future, although there can be no assurance that we will be
able to achieve increases in private label merchandise sales as a percentage of
net sales. Because our private label merchandise generally carries higher
merchandise margins than our other merchandise, our failure to anticipate,
identify and react in a timely manner to fashion trends with our private label
merchandise, particularly if the percentage of net sales derived from private
label merchandise increases, may have a material adverse affect on our business,
financial condition, results of operations and liquidity.
Competition in the teen retailing market is intense and could reduce our
profitability, sales and liquidity.
We operate in a highly competitive environment, which has experienced aggressive
growth in the number of competitors, the number of stores and the amount of
square footage dedicated specifically to teen retailing. We currently compete
with traditional and department stores, with national specialty chains such as
Old Navy and certain divisions of The Limited, with numerous other teen
retailers, such as American Eagle Outfitters, The Buckle, Pacific Sunwear,
Abercrombie & Fitch, Charlotte Russe, Forever 21, Wet Seal and Hot Topic, with
smaller chains and local specialty stores, and to a lesser extent, with mass
merchandisers and companies providing shopping sites via the internet. Many of
these competitors are larger and have substantially greater resources than
Gadzooks. Direct competition with these and other retailers may increase
significantly in the future, which could require us, among other things, to
lower our prices and/or increase our advertising expenses. Increased competition
could have a material adverse effect on our profitability, sales and liquidity.
If our key vendors are unable to adequately supply us with our desired
merchandise on acceptable terms, our business and sales may suffer.
Our business depends on our ability to purchase current season, brand name
apparel in sufficient quantities at competitive prices. The inability or failure
of key vendors to supply us with adequate quantities of desired merchandise, the
loss of one or more key vendors or a material change in our current purchase
terms could have a material adverse effect on our business and liquidity. Many
of our smaller vendors have limited resources, production capacities and
operating histories, and many have limited the distribution of their merchandise
in the past. We have no long-term purchase contracts or other contractual
assurances of continued supply, pricing or access to new products. There can be
no assurance that we will be able to acquire desired merchandise in sufficient
quantities on terms acceptable to us in the future. During our 2002 fiscal year,
no single vendor accounted for more than 10% of our merchandise purchases.
Depressed economic conditions or a decrease in mall traffic could adversely
affect our growth, sales, liquidity and profitability.
Certain economic conditions affect the level of consumer spending on merchandise
we offer, including business conditions, interest rates, taxation and consumer
confidence in future economic conditions. If the demand for apparel and related
merchandise by our female customers declines, our business, comparable store
sales results, results of operations and liquidity would be materially and
adversely affected. Although we advertise on our website, through e-mail blasts
and to a limited extent in national magazines through cooperative agreements
with certain of our vendors, our stores rely principally on mall traffic for
customers. Therefore, we are dependent upon the continued popularity of malls as
a shopping destination and the ability of mall anchor tenants and other
attractions to generate customer traffic for our stores. A decrease in mall
traffic or a decline in economic conditions in the markets in which our stores
are located would adversely affect our growth, net sales, comparable store sales
results, liquidity and profitability.
Any disruption in our distribution facility or growth beyond its capabilities
could cause our business and financial condition to suffer.
Our distribution functions for all our stores are handled from a single facility
in Carrollton, Texas. Any significant interruption in the operation of the
distribution facility due to natural disasters, accidents, system failures or
other unforeseen causes could have a material adverse effect on our business,
financial condition and results of operations. There can be no assurance that
our distribution center will be adequate to support our anticipated future
growth.
18
If our quarterly results fluctuate significantly, the price of our common stock
may be volatile.
Our quarterly results of operations may fluctuate materially depending on, among
other things, the timing of new store openings, net sales contributed by new
stores, increases or decreases in comparable store sales, shifts in timing of
certain holidays and changes in our merchandise mix. Our business is also
subject to seasonal influences, with heavier concentrations of sales during the
Christmas holiday, back-to-school and spring break seasons. We have experienced
quarterly losses for each of the past four consecutive quarters and are likely
to experience such losses in the future, especially during the conversion to an
all-female merchandise assortment. Because of these fluctuations in net sales
and net income, the results of operations of any quarter are not necessarily
indicative of the results that may be achieved for a full fiscal year or any
future quarter. It is also possible that in future quarters our operating
results will fall below our expectations or the expectations of market analysts
or investors. If we do not meet these expectations, the price of our common
stock may decline significantly.
Declines in tourism and mall traffic resulting from threats of, concerns about
and terrorist attacks could result in decreased sales.
As a result of the war in Iraq and the lingering effects of the attacks on
September 11, 2001, security has been heightened in public areas, including the
regional shopping malls where our stores are located. Any further threat of
terrorist attacks or actual terrorist events could lead to lower customer
traffic in regional shopping malls. The decline in tourism has also had a
negative impact on stores located in Florida. A continued decline in tourism in
this market could have a material effect on our sales, profitability and
liquidity. In addition, local authorities or mall management could close
regional shopping malls in response to any immediate security concern. For
example, on September 11, 2001, substantially all our stores were closed early
due to closure of the malls in response to the terrorist attacks. Mall closures,
as well as lower customer traffic due to security concerns, could result in
decreased sales that would have a material adverse effect on our business,
financial condition, results of operations and liquidity.
If we lose key employees on whom we depend, or are unable to attract additional
qualified personnel, our business could suffer.
Our success depends largely on the efforts and abilities of senior management.
The loss of the services of any member of senior management could have a
material adverse effect on our business, financial condition and results of
operations. There can be no assurance that our existing management team will be
able to manage Gadzooks or our growth or that we will be able to retain current
and attract additional qualified personnel as needed in the future.
If the market price of our common stock fluctuates significantly, you could lose
all or part of your investment.
The market price of our common stock has fluctuated substantially since our
initial public offering in October 1995. Our common stock is quoted on The
Nasdaq Stock Market, which has experienced, and is likely to experience in the
future, significant price and volume fluctuations which could adversely affect
the market price of the common stock without regard to our operating
performance. In addition, we believe that factors such as quarterly fluctuations
in our financial results, our comparable store sales results, announcements by
other apparel retailers, the overall economy and the condition of the financial
markets could cause the price of our common stock to fluctuate substantially.
The price of our common stock could fluctuate based upon factors that have
little or nothing to do with our company and these fluctuations could materially
reduce our stock price.
If we are unable to satisfy Nasdaq listing criteria, there may no longer be an
active trading market for our common stock.
Gadzooks' ability to remain listed on the Nasdaq National Market depends on our
ability to satisfy applicable Nasdaq criteria including our ability to maintain
a minimum bid price per share of $1.00. If our stock price continues to decline
and we are unable to continue to satisfy this and other criteria, Nasdaq may
begin procedures to remove our common stock from the Nasdaq National Market. If
we are delisted from the Nasdaq National Market, an active trading market for
Gadzooks' common stock may no longer exist.
19
We have implemented anti-takeover provisions that may discourage a change of
control.
Our Restated Articles of Incorporation and Bylaws contain provisions that may
have the effect of delaying, deterring or preventing a takeover of Gadzooks that
shareholders may consider to be in their best interests. Our Restated Articles
of Incorporation and Bylaws provide for a classified board of directors serving
staggered terms of three years, the prohibition of shareholder action by written
consent in certain circumstances and certain "fair price provisions."
Additionally, the board of directors has the authority to issue up to 1,000,000
shares of preferred stock having such rights, preferences and privileges as
designated by the board of directors without shareholder approval. We also have
a Shareholder Rights Plan, which is intended to deter an unfriendly takeover of
Gadzooks and to help ensure that current shareholders receive fair value upon
the sale of their stock to another party seeking control of Gadzooks. These
provisions and the rights plan may have the effect of discouraging takeovers,
even if the change of control might be beneficial to our shareholders.
Our discretion in some matters is limited by our credit facility restrictive
covenants, and any default on our debt agreements could harm our business,
profitability and growth prospects.
Our credit facility contains a number of covenants that limit the discretion of
our management with respect to certain business matters. The credit facility
covenants, among other things, restrict our ability to:
o incur additional indebtedness;
o declare or pay dividends or other distributions;
o create liens;
o make certain investments or acquisitions;
o enter into mergers and consolidations;
o make sales of assets; and
o engage in certain transactions with affiliates.
The occurrence of an event of default under the agreements governing our debt
would permit acceleration of the related debt, which could harm our business,
profitability and growth prospects.
Certain shareholders own a significant amount of our stock, giving them
influence over certain corporate matters.
Liberty Wanger Asset Management, L.P., or Liberty, which controls shares held by
Liberty Acorn Fund and Evergreen Investment Management Company, or Evergreen,
which controls shares held by Evergreen Special Values Fund currently own 13.2%
and 7.7%, respectively, of our outstanding common stock. Liberty Acorn Fund and
Evergreen Special Values Fund each participated in our recent private placement
of convertible subordinated notes. Assuming conversion of the notes into common
stock, Liberty and Evergreen would beneficially own additional shares of common
stock and could influence certain corporate matters. The investors in the
private placement are contractually prohibited from converting notes into shares
of common stock without receiving prior shareholder approval if such issuance of
common stock would exceed 20% of our outstanding shares of common stock or
result in the ownership by any one shareholder of greater than 20% of our
outstanding shares of common stock. Upon the conversion of the entire principal
balance of the notes into shares of common stock, following shareholder
approval, Liberty and Evergreen would beneficially own in the aggregate
approximately 20.1% and 12.4% of our outstanding shares of common stock,
respectively. Prior to receiving shareholder approval, if the maximum allowable
principal amount of the notes are converted into shares of common stock, Liberty
and Evergreen would beneficially own in the aggregate approximately 18.1% and
11.0% of our outstanding shares of common stock, respectively. Accordingly,
these shareholders may be able to substantially influence the outcome of
shareholder votes and otherwise have influence over our business. The interests
of these investors may differ from other investors.
Shareholders may experience dilution of their investment.
As a result of our efforts to raise additional capital, our shareholders may
experience dilution of their investment due to the additional number of shares
of our common stock in the public market. This dilution could cause the market
price of our common stock to decline. In addition, the sale of these shares
could impair our ability to raise capital through the sale of additional common
or preferred stock. Assuming we
20
receive shareholder approval for the issuance of shares over 20% of our shares
outstanding and the conversion of the principal balance of the notes into
2,800,000 shares, we will have 11,939,620 shares of common stock outstanding,
which represents an increase of 30.6% over the 9,139,620 shares outstanding as
of December 12, 2003. In addition, you may experience further dilution if
interest accrues on the notes and is subsequently converted into shares of
common stock.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Our disclosure and analysis in this report, including information incorporated
by reference, includes forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, or the Securities Act, Section
21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and
the Private Securities Litigation Reform Act of 1995, that are subject to risks
and uncertainties. Forward-looking statements give our current expectations and
projections relating to the financial condition, results of operations, plans,
objectives, future performance and business of Gadzooks. You can identify these
statements by the fact that they do not relate strictly to historical or current
facts. These statements may include words such as "anticipate," "estimate,"
"expect," "project," "intend," "plan," "predict," "will," "believe" and other
words and terms of similar meaning in connection with any discussion of the
timing or nature of future operating or financial performance or other events.
All statements other than statements of historical facts included in, or
incorporated into, this report that address activities, events or developments
that we expect, believe or anticipate will or may occur in the future are
forward-looking statements and include, among other things, statements relating
to:
o cash flow, anticipated liquidity and prospects for growth;
o operating costs and other expenses;
o store closings and costs associated therewith;
o the transition of our business to an all-female concept; and
o the amount, nature and timing of capital expenditures.
These forward-looking statements are based on our expectations and beliefs
concerning future events affecting us and are subject to uncertainties and
factors relating to our operations and business environment, all of which are
difficult to predict and many of which are beyond our control. Although we
believe that the expectations reflected in our forward-looking statements are
reasonable, we do not know whether our expectations will prove correct. Any or
all of our forward-looking statements in this report may turn out to be wrong.
They can be affected by inaccurate assumptions we might make or by known or
unknown risks and uncertainties. Many factors mentioned in our discussion in
this report, including the risks outlined under "Risk Factors" will be important
in determining future results. Actual future results may vary materially from
those reflected in our forward-looking statements. Because of these factors, we
caution that investors should not place undue reliance on any of our
forward-looking statements. Further, any forward-looking statement speaks only
as of the date on which it is made, and except as required by law we undertake
no obligation to update any forward-looking statement to reflect events or
circumstances after the date on which it is made or to reflect the occurrence of
anticipated or unanticipated events or circumstances.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not engage in trading market risk sensitive instruments and
does not purchase as investments, as hedges, or for purposes "other than
trading" instruments that are likely to expose the Company to market risk,
whether it be from interest rate, foreign currency exchange, commodity price or
equity price risk. The Company has entered into no forward or futures contracts,
purchased no options and entered into no swaps.
The Company's primary market risk exposure is that of interest rate risk. Total
outstanding borrowings under our credit agreement at November 1, 2003 were $4.4
million. Interest rates on amounts outstanding on the credit facility are based
on Wells Fargo's prime rate or LIBOR. The weighted-average interest rate for the
quarter ended November 1, 2003 on these borrowings, was 4.48%. A change in
LIBOR, or the prime rate as set by Wells Fargo, would affect the rate at which
the Company could borrow funds under its credit facility.
21
CONTROLS AND PROCEDURES
Gadzooks' management, with the participation of our Chairman of the Board and
Chief Executive Officer (our principal executive officer) and our Chief
Financial Officer (our principal financial officer) have concluded, based on
their evaluation as of the end of the period covered by this report, that our
disclosure controls and procedures are effective (a) to ensure that information
required to be disclosed by us in the reports filed or submitted by us under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported within the time periods specified in the SEC's rules and forms, and
(b) include controls and procedures designed to ensure that information required
to be disclosed by us in such reports is accumulated and communicated to our
management, including our principal executive officer and financial officer, as
appropriate to allow timely decisions regarding required disclosure.
There were no changes in our internal controls during the period covered by this
report that have materially affected or are reasonably likely to materially
affect our internal controls over financial reporting going forward.
PART II - OTHER INFORMATION
Item 1. Legal proceedings. None.
Item 2. Change in Securities and Use of Proceeds.
On October 9, 2003, we completed a private placement of $14,000,000 of
5% Convertible Subordinated Notes (the "Notes") due October 9, 2008,
with interest payable semi-annually commencing April 1, 2004. The
Notes were sold to several accredited investors. The Notes, as well as
unpaid accrued interest, are convertible at any time at the option of
the holder into common stock at a conversion price of $5.00 per share.
However, the investors are contractually prohibited from converting
Notes into shares of common stock without receiving prior shareholder
approval if such issuance of common stock would exceed 20 percent of
our outstanding shares of common stock or result in the ownership by
any one shareholder of greater than 20 percent of our outstanding
shares of common stock. At the option of the Company, the Notes, as
well as unpaid accrued interest, may be converted into shares of
common stock at any time after April 9, 2005 if the closing price of
the Company's common stock is greater than $6.00 for 20 trading days
during a 30 consecutive trading day period. At any time after October
9, 2006, Gadzooks has the right to prepay the Notes and the holders
have the right to put the Notes back to the Company at the face value
of the Notes, plus unpaid accrued interest. We received net proceeds
of approximately $13.1 million, which are being used for working
capital and general corporate purposes. The placement agent for the
private placement was SunTrust Robinson Humphrey Capital Markets. We
believe this transaction was exempt from the registration requirements
of the Securities Act of 1933, as amended, by virtue of Section 4(2)
thereof. The recipients of the Notes represented their intention to
acquire the securities for investment only, had access to all relevant
material information regarding Gadzooks necessary to evaluate the
investment and were accredited investors with sufficient knowledge and
experience to evaluate the transaction.
Item 3. Defaults Upon Senior Securities. None.
Item 4. Submission of Matters to a Vote of Security Holders. None.
Item 5. Other Definitions. None.
22
Item 6 Exhibits and Reports on Form 8-K.
(a) See Index of Exhibits.
(b) Item 5 - Other Events and Required FD Disclosure
On October 14, 2003, Gadzooks filed a Form 8-K reporting a press
release issued by Gadzooks announcing that it had completed a
private placement of $14 million of convertible subordinated
notes and also obtained a $5 million seasonal increase in its
senior secured credit facility.
Item 12 - Results of Operations and Financial Condition
On August 19, 2003, Gadzooks filed a Form 8-K reporting a press
release issued by Gadzooks announcing its financial and operating
results for the second quarter ended August 2, 2003.
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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.
GADZOOKS, INC.
Registrant)
DATE: December 15, 2003 By: /s/ JAMES A. MOTLEY
------------------------------------------
James A. Motley
Vice President / Chief Financial Officer
(Chief Accounting Officer and
Duly Authorized Officer of the Registrant)
24
INDEX TO EXHIBITS
EXHIBIT
NO. DESCRIPTION OF DOCUMENTS
- ------- ------------------------
3.1 -- Second Restated Articles of Incorporation of the Company (filed
as Exhibit 4.1 to the Company's Form S-8 (No. 33-98038) filed
with the Commission on October 12, 1995 and incorporated herein
by reference).
3.2 -- Amended and Restated Bylaws of the Company (filed as Exhibit 4.2
to the Company's Form S-8 (No. 33-98038) filed with the
Commission on October 12, 1995 and incorporated herein by
reference).
3.3 -- First Amendment to the Amended and Restated Bylaws of the Company
(filed as Exhibit 3.3 of the Company's Quarterly Report on Form
10-Q for the quarter ended August 2, 1997 filed with the
Commission on September 16, 1997 and incorporated herein by
reference).
4.1 -- Specimen Certificate for shares of Common Stock, $.01 par value,
of the Company (filed as Exhibit 4.1 to the Company's Amendment
No. 2 to Form S-1 (No. 33-95090) filed with the Commission on
September 8, 1995 and incorporated herein by reference).
4.2 -- Rights Agreement dated as of September 3, 1998, between the
Company and Mellon Investor Services, LLC (filed as Exhibit 1 to
the Company's Form 8-A filed with the Commission on September 4,
1998 and incorporated herein by reference).
4.3 -- First Amendment to Rights Agreement dated as of October 7, 2003
between the Company and Mellon Investor Services, LLC (filed as
Exhibit 2 to the Company's Form 8-A/A filed with the Commission
on October 17, 2003 and incorporated herein by reference).
4.4 -- Form of 5% Convertible Subordinated Note due October 9, 2008
(filed as Exhibit 4.1 to the Company's Form 8-K filed with the
Commission on October 14, 2003 and incorporated herein by
reference).
4.5 -- Form of Note Purchase Agreement dated on or about October 7, 2003
by and between certain investors and the Company (filed as
Exhibit 99.2 to the Company's Form 8-K filed with the Commission
on October 14, 2003 and incorporated herein by reference).
10.1 -- Second Amendment to Loan and Security Agreement dated October 9,
2003 by and between the Company and Wells Fargo Retail Finance,
LLC (filed as Exhibit 99.3 to the Company's Form 8-K filed with
the Commission on October 14, 2003 and incorporated herein by
reference).
31.1* -- Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of Chief Executive Officer.
31.2* -- Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of 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 of
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 of
Chief Financial Officer.
- -----------------
* Filed herewith.
25