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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JULY 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________________ to _____________________
Commission File number: 0-028176
Whitehall Jewellers, Inc.
(Exact name of registrant as specified in its charter)
Delaware 36-1433610
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
155 N. Wacker Drive, Suite 500, Chicago, IL 60606
(Address of principal executive offices) (zip code)
312/782-6800
(Registrant's telephone number, including area code)
(Former name, former address and former 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 X No
--- ---
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
The number of shares of the Registrant's common stock, $.001 par value
per share, outstanding as of September 7, 2004 was 13,942,185 and the number of
shares of the Registrant's Class B common stock, $1.00 par value per share,
outstanding as of September 7, 2004 was 142.
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Whitehall Jewellers, Inc.
Statements of Operations
for the three months and six months ended July 31, 2004 and 2003
(unaudited, in thousands, except per share data)
Three months ended Six months ended
July 31, July 31, July 31, July 31,
2004 2003 2004 2003
---------- --------- --------- ---------
Net sales $ 72,284 $ 72,732 $ 145,312 $ 141,881
Cost of sales (including buying and occupancy
expenses) 48,220 48,540 96,971 94,578
--------- --------- --------- ---------
Gross profit 24,064 24,192 48,341 47,303
Selling, general and
administrative expenses 26,972 26,509 54,007 52,644
Professional fees and other
charges 1,644 714 4,298 1,349
--------- --------- --------- ---------
Loss from operations (4,552) (3,031) (9,964) (6,690)
Interest expense 1,094 1,564 2,000 2,472
--------- --------- --------- ---------
Loss before income taxes (5,646) (4,595) (11,964) (9,162)
Income tax benefit (2,463) (1,792) (5,085) (3,572)
--------- --------- --------- ---------
Net loss $ (3,183) $ (2,803) $ (6,879) $ (5,590)
========= ========= ========= =========
Basic earnings per share:
Net loss $ (0.23) $ (0.20) $ (0.49) $ (0.39)
========= ========= ========= =========
Weighted average common share and common
share equivalents 13,947 14,215 13,937 14,210
========= ========= ========= =========
Diluted earnings per share:
Net loss $ (0.23) $ (0.20) $ (0.49) $ (0.39)
========= ========= ========= =========
Weighted average common share and common
share equivalents 13,947 14,215 13,937 14,210
========= ========= ========= =========
The accompanying notes are an integral part of the financial statements.
2
Whitehall Jewellers, Inc.
Balance Sheets
As of July 31, 2004, January 31, 2004 and July 31, 2003
(unaudited, in thousands, except share data)
July 31, January 31, July 31,
2004 2004 2003
---------- ----------- ---------
ASSETS
Current Assets:
Cash $ 1,433 $ 1,901 $ 1,399
Accounts receivable, net 2,295 2,544 333
Merchandise inventories 199,241 206,146 204,926
Other current assets 797 875 2,127
Current income tax benefit 4,255 2,294 4,435
Deferred financing costs 301 261 261
Deferred income taxes, net 6,273 5,712 2,522
--------- --------- ---------
Total current assets 214,595 219,733 216,003
Property and equipment, net 57,750 60,948 63,709
Goodwill, net 5,662 5,662 5,662
Deferred financing costs 603 654 781
--------- --------- ---------
Total assets $ 278,610 $ 286,997 $ 286,155
========= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Revolver loan $ 97,496 $ 80,340 $ 86,375
Current portion of long-term debt 640 640 --
Accounts payable 42,559 60,538 61,078
Customer deposits 3,047 3,601 3,355
Accrued payroll 3,474 4,457 3,036
Other accrued expenses 25,828 24,479 12,023
--------- --------- ---------
Total current liabilities 173,044 174,055 165,867
Subordinated debt -- -- 640
Deferred income taxes, net 2,990 3,639 3,879
Other long-term liabilities 3,589 3,535 3,338
--------- --------- ---------
Total liabilities 179,623 181,229 173,724
--------- --------- ---------
Commitments and contingencies
Stockholders' equity:
Common stock 18 18 18
Class B common stock -- -- --
Additional paid-in capital 106,162 106,091 105,830
Retained earnings 32,432 39,311 42,435
Treasury stock, at cost (4,117,172; 4,134,143 and
3,815,900 shares, respectively)
(39,625) (39,652) (35,852)
--------- --------- ---------
Total stockholders' equity, net 98,987 105,768 112,431
--------- --------- ---------
Total liabilities and stockholders' equity
$ 278,610 $ 286,997 $ 286,155
========= ========= =========
The accompanying notes are an integral part of the financial statements.
3
Whitehall Jewellers, Inc.
Statements of Cash Flows
for the six months ended July 31, 2004 and 2003
(unaudited, in thousands)
Six months ended
----------------------------
July 31, July 31,
2004 2003
---------- ----------
Cash flows from operating activities:
Net loss $ (6,879) $ (5,590)
Adjustments to reconcile net loss to net
cash (used in) provided by operating
activities:
Depreciation and amortization 6,253 5,923
Loss on disposition of assets 148 409
Deferred compensation 64 --
Write-off of deferred loan cost -- 516
Changes in assets and liabilities:
Decrease in accounts receivable, net 249 1,288
Decrease (increase) in merchandise
inventories 6,905 (8,232)
Decrease (increase) in other current assets 78 (657)
(Increase) in current income tax benefit (1,961) (4,435)
(Decrease) increase in deferred income
taxes, net (1,210) 377
(Decrease) in customer deposits (554) (99)
(Decrease) increase in accounts payable (16,135) 23,382
(Decrease) in accrued payroll (983) (246)
(Decrease) in income taxes payable -- (3,303)
Increase in accrued liabilities 1,349 643
Increase in other long-term liabilities 54 200
--------- ---------
Net cash (used in) provided by operating activities (12,622) 10,176
Cash flows from investing activities:
Capital expenditures (3,060) (8,125)
--------- ---------
Net cash used in investing activities (3,060) (8,125)
Cash flows from financing activities:
Borrowing on revolver loan 536,257 363,810
Repayment of revolver loan (519,101) (371,925)
Repayment of term loan -- (4,500)
Proceeds from exercise of stock options 7 75
Proceeds under employee stock purchase plan 27 45
Financing costs (132) (1,117)
Increase(decrease) in outstanding checks, net (1,844) 10,912
--------- ---------
Net cash provided by (used in) financing
activities 15,214 (2,700)
--------- ---------
Net change in cash and cash equivalents (468) (649)
Cash and cash equivalents at beginning of period 1,901 2,048
--------- ---------
Cash and cash equivalents at end of period $ 1,433 $ 1,399
========= =========
The accompanying notes are an integral part of the financial statements.
4
Whitehall Jewellers, Inc.
Notes to Financial Statements
1. DESCRIPTION OF OPERATIONS
The financial statements of Whitehall Jewellers, Inc. (the "Company")
include the results of the Company's chain of specialty retail fine jewelry
stores. The Company operates exclusively in one business segment, specialty
retail jewelry. The Company has a national presence with 386 stores as of July
31, 2004, located in 38 states, operating in regional or superregional shopping
malls. The consolidated financial statements include the accounts and
transactions of the Company and its subsidiaries. Intercompany accounts and
transactions have been eliminated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis for Presentation
The accompanying unaudited financial statements have been prepared in
accordance with Rule 10-01 of Regulation S-X. Consequently, they do not include
all of the disclosures required under accounting principles generally accepted
in the United States of America for complete financial statements. The interim
financial statements reflect all adjustments (consisting only of normal
recurring accruals) which are, in the opinion of management, necessary for a
fair presentation of financial position, results of operations and cash flows
for the interim periods presented. For further information regarding the
Company's accounting policies, refer to the financial statements and footnotes
thereto included in the Whitehall Jewellers, Inc. Annual Report on Form 10-K for
the fiscal year ended January 31, 2004. References in the following Notes to
Financial Statements to years and quarters are references to fiscal years and
fiscal quarters.
Merchandise Inventories
Merchandise inventories are stated principally at the lower of weighted
average cost or market. Purchase cost is reduced to reflect certain allowances
and discounts received from merchandise vendors. Periodic credits or payments
from merchandise vendors in the form of consignment buydowns, volume or other
purchase discounts and other vendor consideration are reflected in the carrying
value of the inventory and recognized as a component of cost of sales as the
merchandise is sold. Additionally, to the extent it is not addressed by
established vendor return privileges, and if the amount of cash consideration
received from the vendor exceeds the estimated fair value of the goods returned,
that excess amount is reflected as a reduction in the purchase cost of the
inventory acquired. Allowances for inventory shrink, scrap and other provisions
are recorded based upon analysis and estimates by the Company.
To the extent the Company's agreements with merchandise vendors provide
credits for co-op advertising, the Company has historically classified such
credits as a reduction to advertising expense in selling, general and
administrative expenses. Emerging Issues Task Force Issue ("EITF") No. 02-16,
"Accounting by a Customer (Including a Reseller) for Certain Consideration
Received from a Vendor" ("EITF 02-16"), which was effective for all arrangements
entered into after December 31, 2002, requires certain merchandise vendor
allowances to be classified as a reduction to inventory cost unless evidence
exists supporting an alternative classification. The Company has recorded such
merchandise vendor allowances as a reduction of inventory cost. In prior years,
certain vendors reimbursed the Company for certain co-op advertising costs that
were incurred. In 2003, the Company
5
changed the terms of its Vendor Trading Agreements to include a vendor allowance
for advertising calculated as a percentage of net merchandise purchases. The
Company earned $978,000 and $1,068,000 of vendor allowances for advertising for
the first six months of fiscal years 2004 and 2003, respectively. The Company
records such allowances as a reduction of inventory cost and as the inventory is
sold, the Company will recognize a lower cost of sales.
The Company also obtains merchandise from vendors under various
consignment agreements. The consigned inventory and related contingent
obligations associated with holding and safekeeping such consigned inventory are
not reflected in the Company's financial statements. At the time of sale of
consigned merchandise to customers, the Company records the purchase liability
and the related consignor cost of such merchandise in cost of sales.
Legal Contingencies
The Company is involved in certain legal matters and other claims
including those discussed in Note 8 to the financial statements. As required by
Financial Accounting Standards Board ("FASB") Statement of Financial Accounting
Standards No. 5, "Accounting for Contingencies," the Company determines whether
an estimated loss from a loss contingency should be accrued by assessing whether
such loss is deemed probable and can be reasonably estimated. The Company
analyzes its legal matters and other claims based on available information to
assess potential liability. The Company consults with outside counsel involved
in the Company's legal matters when analyzing potential outcomes. The accrual
for these matters totaled $9.5 million at July 31, 2004.
Based on the nature of such estimates, it is possible that future
results of operations or net cash flows could be materially affected if actual
outcomes are significantly different from management's estimates related to
these matters.
Advertising and Marketing Expense
The Company expenses the production costs of advertising the first time
the advertising takes place, except for direct-response advertising, which is
capitalized and amortized over the expected period of future benefit.
Advertising expense was $3.3 million and $2.9 million for the first six months
of fiscal years 2004 and 2003, respectively.
Direct-response advertising consists primarily of special offers,
flyers and catalogs that include value off coupons for merchandise.
Income Taxes
Due to the seasonal nature of its business, the Company tends to
generate all or a significant majority of its income in the fourth quarter. The
Company's current estimate of the effective income tax rate for fiscal year 2004
is 42.5%. To the extent that income is significantly more or less than expected,
the Company's effective income tax rate for the remainder of fiscal year 2004
could vary significantly from that of the first six months of fiscal year 2004.
Stock-Based Compensation
The FASB issued Statement of Financial Accounting Standards No. 148
("SFAS 148"), "Accounting for Stock-Based Compensation-Transition and
Disclosure," during 2002. SFAS 148 amends Statement of Financial Accounting
Standards No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation," to
6
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation and
amends the disclosure requirements to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company adopted the disclosure requirements of SFAS 148 as of
January 31, 2003.
The Company accounts for stock-based compensation according to
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees," which results in no charge to earnings when options are issued at
fair market value.
The following table illustrates the effect on net income and earnings
per share for the three and six months ended July 31, 2004 and 2003 as if the
Company had applied the fair value recognition provisions of SFAS 123, as
amended by SFAS 148, to stock-based employee compensation.
Three months ended Six months ended
July 31, July 31, July 31, July 31,
2004 2003 2004 2003
---------------------------------------------------------------
(in thousands, except for per share amounts)
---------------------------------------------------------------
Net loss, as reported $ (3,183) $ (2,803) $ (6,879) $ (5,590)
Deduct: Total stock-based
employee compensation expense
determined under fair value
based method, net of related tax
effects 125 265 281 532
--------- -------- --------- ---------
Pro forma net loss $ (3,308) $ (3,068) $ (7,160) $ (6,122)
========= ======== ========= =========
Earnings per share:
Basic-as reported $ (0.23) $ (0.20) $ (0.49) $ (0.39)
========= ======== ========= =========
Basic-pro forma $ (0.24) $ (0.22) $ (0.51) $ (0.43)
========= ======== ========= =========
Diluted-as reported $ (0.23) $ (0.20) $ (0.49) $ (0.39)
========= -------- ========= =========
Diluted-pro forma $ (0.24) $ (0.22) $ (0.51) $ (0.43)
========= ======== ========= =========
For purposes of the pro forma net income and earnings per share
calculation in accordance with SFAS 123, for each option granted during the
three months ended July 31, 2003 and six months ended July 31, 2004 and 2003 the
fair value is estimated using the Black-Scholes option-pricing model. The
Company did not grant options during the three months ended July 31, 2004. The
assumptions used are as follows:
For the three months For the six months ended
ended July 31, 2003 July 31, 2004 July 31, 2003
-------------------- --------------------------------
Risk-free interest
rate 3.0% 3.3% 3.0%
Dividend yield 0 0 0
Option life 5.5 years 5.5 years 5.5 years
Volatility 60% 58% 61%
7
Accounting for Guarantees
In November 2002, the Financial Accounting Standards Board issued FASB
Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others," an interpretation of FASB Statements Nos. 5, 57 and 107 and a
rescission of FASB Interpretation No. 34. The Company has adopted the guidance
of FIN 45 and has reflected the required disclosures in its financial statements
commencing with the financial statements for the fiscal year ended January 31,
2003.
Under its bylaws, the Company has agreed to indemnify its officers and
directors for certain events or occurrences while the officer or director is
serving, or was serving, at its request in such capacity. The maximum potential
amount of future payments the Company could be required to make pursuant to
these indemnification obligations is unlimited; however, the Company has
purchased a directors and officers liability insurance policy that, under
certain circumstances, enables it to recover a portion of any future amounts
paid. The Company has no liabilities recorded for these obligations as of July
31, 2004; however, reference should be made to Note 8 to the financial
statements with respect to legal contingencies.
3. ACCOUNTS RECEIVABLE, NET
As of July 31, 2004, January 31, 2004 and July 31, 2003, accounts
receivable consisted of (in thousands):
July 31, January 31, July 31,
2004 2004 2003
-------- ----------- --------
Accounts receivable $ 2,668 $ 3,082 $ 805
Less: allowance for
doubtful accounts (373) (538) (472)
------- ------- -------
Accounts receivable, net $ 2,295 $ 2,544 $ 333
======= ======= =======
4. MERCHANDISE INVENTORIES
As of July 31, 2004, January 31, 2004 and July 31, 2003, merchandise
inventories consisted of (in thousands):
July 31, January 31, July 31,
2004 2004 2003
-------- ----------- --------
Raw Materials $ 10,386 $ 9,827 $ 11,171
Finished Goods 188,855 196,319 193,755
-------- -------- --------
Merchandise Inventories $199,241 $206,146 $204,926
======== ======== ========
Raw materials primarily consist of diamonds, precious gems,
semi-precious gems and gold. Included within finished goods inventory were
allowances for inventory shrink, scrap, and miscellaneous costs of $4,872,000;
$3,731,000; and $3,022,000 as of July 31, 2004, January 31, 2004 and July 31,
2003, respectively. As of July 31, 2004, January 31, 2004 and July 31, 2003,
consignment inventories held by the Company that were not included in the
balance sheets totaled $71,035,000; $91,635,000; and $76,777,000, respectively.
8
Certain merchandise procurement, distribution and warehousing costs
were allocated to inventory. As of July 31, 2004, January 31, 2004 and July 31,
2003, the amounts included in inventory were $3,520,000; $3,500,000 and
$3,608,000, respectively.
5. ACCOUNTS PAYABLE
Accounts payable includes outstanding checks, which were $2,322,000,
$4,166,000 and $17,424,000 as of July 31, 2004, January 31, 2004 and July 31,
2003, respectively.
6. FINANCING ARRANGEMENTS
Effective July 29, 2003, the Company entered into a Second Amended and
Restated Revolving Credit and Gold Consignment Agreement (the "Credit
Agreement") with certain members of its prior bank group to provide for a total
facility of up to $125.0 million through July 28, 2007. Interest rates and the
commitment fee charged on the unused portion of the facility float based upon
the Company's financial performance as calculated quarterly.
Under the Credit Agreement, the banks have a collateral security
interest in substantially all of the assets of the Company. The Credit Agreement
contains certain restrictions, including restrictions on investments, payment of
dividends, assumption of additional debt, acquisitions and divestitures. The
Credit Agreement also requires the Company to maintain a specified ratio of the
sum of earnings before interest, taxes, depreciation and amortization plus
minimum store rent to the sum of minimum store rent plus cash interest expense.
As of July 31, 2004, the calculated revolver availability, pursuant to the
Credit Agreement, was $121.9 million. The Company had $97.5 million of
outstanding borrowings under the revolving loan facility as of July 31, 2004.
The Company amended the Credit Agreement effective March 23, 2004 in
order to, among other things, (i) add a reserve for customer deposits to the
Borrowing Base (as defined in the Credit Agreement), (ii) add and amend certain
financial covenants, including amending the Fixed Charge Coverage Ratio (as
defined in the Credit Agreement) and adding a covenant to maintain a Net Worth
(as defined in the Credit Agreement) of at least $90.0 million at January 31,
2005, (iii) cap the borrowings under the facility to a maximum of $85.0 million
for at least thirty consecutive calendar days during the period from December
15, 2004 through and including February 15, 2005, (iv) increase the interest
rate at which LIBOR based borrowings are available under the Credit Agreement to
LIBOR plus 2.5% through April 30, 2005, (v) set the Commitment Fee Rate (as
defined in the Credit Agreement) at 0.5% through April 30, 2005, and (vi) set
the Standby Letter of Credit Fee Rate (as defined in the Credit Agreement) at
2.0% through April 30, 2005.
As of March 22, 2004, the Company and its lenders entered into a letter
agreement pursuant to which the lenders under the Credit Agreement have agreed
that, as of March 23, 2004, the consolidated Capital Factors actions, the
Securities and Exchange Commission (the "SEC") investigation and the United
States Attorney's investigation, each as described in Note 8 have not resulted
in a breach of the Credit Agreement. In addition, the lenders have agreed that
none of these matters will give rise to a default or event of default under the
Credit Agreement so long as the resolution of such matters does not involve the
payment by the Company of Restitution (which is defined below) in an amount in
excess of $15.0 million and does not result in the indictment of the Company or
any of its current officers, directors or employees with principal financial or
accounting responsibilities. The letter agreement also
9
states that any settlement involving the payment of Restitution in excess of
$15.0 million shall constitute a default under the Credit Agreement and any
indictment of the Company or any of the persons described above may constitute a
default under the Credit Agreement.
"Restitution" is defined as any restitution paid by the Company
(whether cash or non-cash or current or deferred consideration) arising from a
civil litigation settlement or award and/or criminal penalties paid or payable
in connection with the Capital Factors litigation, the SEC investigation, and/or
the United States Attorney investigation and any other actions or proceedings
directly related thereto; excluding however, (i) amounts paid by the Company for
consignment inventory held on behalf of the parties involved in the Capital
Factors litigation, (ii) amounts already accrued on the books of the Company for
the purchase of merchandise from the parties involved in the Capital Factors
litigation and (iii) the value of any consigned inventory returned to parties
involved in the Capital Factors actions.
At this time, the Company does not expect the payment of Restitution to
exceed $15.0 million and, based on the Company's current financial plan, expects
to be in compliance with all financial covenants as set forth in the Credit
Agreement for the remainder of fiscal year 2004.
Subject to the contingencies identified in Note 8 to the financial
statements and other risks, including those identified in Forward-Looking
Statements, management expects that based on the Company's current financial
plan the cash flow from operating activities and funds available under the
Company's revolving loan facility should be sufficient to support the Company's
current new store expansion program, seasonal working capital needs and
liabilities that may arise with respect to the consolidated Capital Factors
actions and the investigations by the United States Attorney's Office and the
SEC. The Company intends to contest vigorously the putative class action
complaints and the shareholder derivative complaint described in Note 8 and
exercise all of its available rights and remedies. Given that these class action
cases and the shareholder derivative complaint are in their early stages, and no
substantive proceedings have occurred, it is not possible to evaluate the
likelihood of an unfavorable outcome in any of these matters, or to estimate any
amount or range of potential loss, if any. While there are many potential
outcomes, an adverse outcome in these actions could have a material adverse
effect on the Company's results of operations, financial condition and/or
liquidity. It cannot be determined at this stage whether the putative class
action complaints or the shareholder derivative complaint will be resolved in
the fiscal year ending January 31, 2005.
If an event of default occurs pursuant to the March 22, 2004 letter
agreement or otherwise, the Company may be required to negotiate relief with its
lenders or to seek new financing. There is no assurance that new financing
arrangements would be available on acceptable terms or at all. If the existing
lenders were to cease funding under the revolving loan facility or require
immediate repayment and if the Company were not able to arrange new financing on
acceptable terms, this would have a material adverse effect on the Company,
which could affect the underlying valuation of its assets and liabilities.
Revolver Loan
The revolving loan facility under the Credit Agreement is available up
to a maximum of $125.0 million, including amounts consigned under the gold
consignment facility, and is limited by a borrowing base computed based on the
value of the Company's inventory and accounts receivables. Availability under
the revolver is based on amounts outstanding thereunder, including the value of
consigned gold, if any, which fluctuates based on gold prices. Interest
10
rates and commitment fees on the unused facility float based on the Company's
quarterly financial performance.
The interest rates for borrowings under the Credit Agreement are, at
the Company's option, based on LIBOR rates or the United States banks' prime
rate. Interest is payable monthly for prime borrowings and upon maturity for
LIBOR borrowings.
Gold Consignment Facility
The Company has the opportunity to enter into gold consignments with
certain third party financial institutions. At this time the Company has no
obligations under the gold consignment facility. In the event of a consignment
of gold, the Company provides the third party financial institution with title
to a certain number of troy ounces of gold held in the Company's existing
merchandise inventory in exchange for cash at the current market price of gold.
The Company then consigns the gold from the third party financial institution,
pursuant to a gold consignment agreement. This agreement entitles the Company to
use the gold in the ordinary course of its business. The gold consignment
facility is a transfer of title in specified quantities of the gold content of
the Company's inventory (a non-financial asset) to a financial institution in
exchange for cash. The Company continues to bear responsibility for damage to
the inventory, as is the case in all of its consigned inventory arrangements
with its other vendors.
The Company accounts for gold consignment transactions as a reduction
in its inventories, because it transfers title to the gold to the financial
institution. Similar to other consigned inventories in the possession of the
Company (for which the Company bears risk of loss but does not possess title),
the value of the inventory is not included in the assets of the Company. The
terms of the gold consignment agreement require the Company to deliver the
specified quantities of consigned gold back to the third party financial
institution at the end of the facility (which currently expires in 2007).
Physical delivery can be made from the Company's inventory or from gold acquired
by the Company in the open market. As an alternative to physical delivery of
these specific troy ounces of gold, the Company can elect to purchase the
consigned quantities at the current market price for gold on that date. The
Company currently has no gold consignment obligations to the banks under the
Credit Agreement.
11
7. DILUTIVE SHARES THAT WERE OUTSTANDING DURING THE PERIOD
The following table summarizes the reconciliation of the numerators and
denominators for the basic and diluted earnings per share ("EPS") computations
for the three and six months ended July 31, 2004 and 2003.
Three months ended Six Months Ended
July 31, 2004 July 31, 2003 July 31, 2004 July 31, 2003
- ---------------------------------------------------------------------------------------------------
(in thousands)
Net loss $ (3,183) $ (2,803) $ (6,879) $ (5,590)
Weighted average shares for
basic EPS 13,947 14,215 13,937 14,210
Incremental shares upon
conversions:
Stock options -- -- -- --
Weighted average shares for
diluted EPS 13,947 14,215 13,937 14,210
Stock options excluded from the
calculation of diluted earnings
per share due to
their antidilutive effect
on the calculations 2,664 1,408 2,341 2,412
8. COMMITMENTS AND CONTINGENCIES
The Company has been named as one of 14 defendants in a lawsuit
originally filed in the United States District Court for the Southern District
of New York, now pending in New York State Supreme Court, Commercial Division.
The case is brought by Capital Factors, Inc. ("Capital Factors"), which provided
financing to defendant Cosmopolitan Gem Corp. ("Cosmopolitan"), an entity with
which the Company has certain consignment and other commercial arrangements. The
complaint alleges that Cosmopolitan defrauded Capital Factors into advancing
funds to Cosmopolitan by misrepresenting Cosmopolitan's finances and the
profitability of its operations, and that the Company, along with other persons
and entities, including other jewelry retailers, aided and abetted or
participated in the alleged fraud. The complaint asserts against the defendants,
including the Company, claims under common law and the Racketeer Influenced and
Corrupt Organizations Act ("RICO"). Capital Factors seeks aggregate damages from
all of the defendants, including the Company, of $30,000,000, plus unspecified
punitive damages, interest and fees. Damages, excluding punitive damages,
awarded pursuant to claims asserted under RICO as well as interest on such
damages are subject to trebling, within the discretion of the court.
The Company has also been named as one of 13 defendants in an amended
complaint filed on December 2, 2003 by International Diamonds, L.L.C.
("International") and its affiliate, Astra Diamonds Manufacturers, Ltd.
("Astra"). Astra is an Israeli diamond wholesaler that supplied diamonds to
Cosmopolitan; International is a joint venture formed by Cosmopolitan and Astra
to sell high quality finished diamond jewelry in the United States. The amended
complaint, consolidated with the Capital Factors action described above (the
"consolidated Capital Factors actions"), alleges that the Company, along with
other jewelry retailers and business affiliates of Cosmopolitan, participated in
Cosmopolitan's fraudulent scheme to defraud Capital Factors, and thus injured
International and Astra. The complaint asserts claims under common law and RICO,
seeking aggregate damages from all of the defendants,
12
including the Company, of $6,800,000 plus interest and fees. Damages awarded
pursuant to claims asserted under RICO as well as interest on such damages are
subject to trebling, within the discretion of the court. In addition, the
complaint alleges claims against the Company for breach of contract for
approximately $2,520,000 in goods delivered and invoiced to the Company, for
which International has not received payment.
In connection with the consolidated Capital Factors actions in New York
state court, the Company has filed an interpleader action for declaratory
relief, asking the Court to determine the proper parties to whom the Company
must pay amounts and deliver goods that are not in dispute related to goods
received from Cosmopolitan and certain other entities. In its answer to the
interpleader, Capital Factors has asserted that the Company owes Cosmopolitan
$8,600,000 in accounts receivable on invoices assigned to Capital Factors. This
amount is included in the $30,000,000 of losses that Capital Factors seeks in
its RICO claims. In addition, Ultimo, Inc. ("Ultimo"), a jewelry supplier, is a
defendant in the International action and in the interpleader action. Ultimo
provided certain items of jewelry to the Company on a consignment basis and
asserts that: (1) the Company has sold approximately $450,000 worth of such
items, the proceeds of which it claims remain in the Company's possession; and
(2) the Company continues to possess approximately $1,780,000 worth of its
consignment goods. Ultimo asserts that it should receive these consignment
proceeds and goods. Capital Factors also has asserted claims to these proceeds
and goods. The Company has segregated the remaining consignment goods from its
inventory and has placed such goods into an off-site safe deposit box to hold
them until such time as the New York State Supreme Court determines the proper
distribution of these consignment goods. In addition to the Ultimo consignment
goods discussed above, other consignment proceeds and the amount of accounts
payable due already have been placed in the Company's outside counsel's escrow
account pending court determination of the proper recipient. The Company is not
currently aware of any accounts payable due and owing to any of the claimants in
this action that are not already reflected in the Company's accounts payable and
accrued liabilities or that have been placed in the Company's outside counsel's
escrow account.
In these consolidated Capital Factors actions, document discovery has
begun and certain depositions have been taken. In addition, the Company has
filed motions to dismiss both the Capital Factors and International/Astra
complaints. The motions are currently pending before the court.
As previously disclosed, the United States Attorney for the Eastern
District of New York is conducting a criminal investigation regarding matters
that include those alleged in the consolidated Capital Factors actions. The
Company, among others, is a subject of this criminal investigation and is
cooperating fully with the United States Attorney.
In addition, subsequent to the filing of the complaint by Capital
Factors and as previously disclosed, the SEC initiated an informal inquiry into
matters that are the subject of the consolidated Capital Factors actions. On
November 3, 2003, the Company received a subpoena issued by the SEC as a part of
a formal investigation by the SEC with respect to the matters that are the
subject of the consolidated Capital Factors actions. The Company produced
documents to the SEC in response to the SEC's subpoena and information requests.
The Company is cooperating fully with the SEC in connection with this formal
investigation.
In accordance with Financial Accounting Standards Board Statement No.
5, "Accounting for Contingencies," the Company determines whether an estimated
loss from a loss contingency should be accrued by assessing whether a loss is
deemed probable and can be reasonably estimated. For the fourth quarter of
13
the fiscal year ended January 31, 2004 and the first quarter of fiscal year
2004, the Company recorded a total litigation accrual of $8.9 million for the
consolidated Capital Factors actions and the United States Attorney and SEC
investigations. As previously disclosed in a press release furnished to the SEC
under cover of a Current Report on Form 8-K dated August 26, 2004, for the
second quarter of fiscal year 2004, the Company recorded an additional accrual
in the amount of $310,000 with respect to these matters in light of ongoing
settlement discussions. There are no assurances that the Company will be able to
reach a settlement with any of the parties to the consolidated Capital Factors
actions or that such a settlement or settlements, as the case may be, will be
for the amount recorded as a reserve. However, the Company currently believes
that it is more likely than not that it will reach a settlement or settlements,
as the case may be, pertaining to the consolidated Capital Factors actions in
the near term. Given the amounts sought in the consolidated Capital Factors
actions, and the inherent unpredictability of litigation, it is possible that an
adverse outcome in excess of the amount recorded could occur and these actions
could have a material adverse effect on the Company's results of operations,
financial condition and/or liquidity. The Company is unable at this time to
predict the ultimate outcome of the consolidated Capital Factors actions or the
United States Attorney and SEC investigations.
As of March 22, 2004, the Company and its lenders entered into a letter
agreement pursuant to which the lenders under the Credit Agreement have agreed
that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC
investigation and the United States Attorney's investigation have not resulted
in a breach of the Credit Agreement. In addition, the lenders have agreed that
none of these matters will give rise to a default or event of default under the
Credit Agreement so long as the resolution of such matters does not involve the
payment by the Company of Restitution (which is defined below) in an amount in
excess of $15.0 million, and does not result in the indictment of the Company or
any of its current officers, directors or employees with principal financial or
accounting responsibilities. The letter agreement also states that any
settlement involving the payment of Restitution in excess of $15.0 million shall
constitute a default under the Credit Agreement and any indictment of the
Company or any of the persons described above may constitute a default under the
Credit Agreement.
"Restitution" is defined as any restitution paid by the Company
(whether cash or non-cash or current or deferred consideration) arising from a
civil settlement or award and/or criminal penalties paid or payable in
connection with the Capital Factors litigation, the SEC investigation and/or the
United States Attorney investigation and any other actions or proceedings
directly related thereto; excluding, however, (i) amounts paid by the Company
for consignment inventory held on behalf of the parties involved in the Capital
Factors litigation and (ii) amounts already accrued on the books of the Company
for the purchase of merchandise from the parties involved in the Capital Factors
litigation and (iii) the value of any consigned inventory returned to parties
involved in the Capital Factors actions.
At this time the Company does not expect the payment of Restitution to
exceed $15.0 million and, based on the Company's current financial plan, expects
to be in compliance with all financial covenants as set forth in the Credit
Agreement for the remainder of fiscal year 2004.
On February 12, 2004, a putative class action complaint captioned
Greater Pennsylvania Carpenters Pension Fund, et al. v. Whitehall Jewellers,
Inc. et al., Case No. 04 C 1107, was filed in the U.S. District Court for the
Northern District of Illinois against the Company and certain of the Company's
current and former officers. The complaint makes reference to the litigation
filed by Capital Factors, Inc. above and to the Company's November 21, 2003
14
announcement that it had discovered violations of Company policy by the
Company's Executive Vice President, Merchandising, with respect to Company
documentation regarding the age of certain store inventory. The complaint
further makes reference to the Company's December 22, 2003 announcement that it
would restate results for certain prior periods. The complaint purports to
allege that the Company and its officers made false and misleading statements
and falsely accounted for revenue and inventory during the putative class period
of November 19, 2001 to December 10, 2003. The complaint purports to allege
violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934
("1934 Act") and Rule 10b-5 promulgated thereunder.
On February 18, 2004, a putative class action complaint captioned
Michael Radigan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C
1196, was filed in the U.S. District Court for the Northern District of Illinois
against the Company and certain of the Company's current and former officers,
charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue and inventory
during the putative class period of November 19, 2001 to December 10, 2003. The
factual allegations of this complaint are similar to those made in the Greater
Pennsylvania Carpenters Pension Fund complaint discussed above.
On February 20, 2004, a putative class action complaint captioned
Milton Pfeiffer, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C
1285, was filed in the U.S. District Court for the Northern District of Illinois
against the Company and certain of the Company's current and former officers,
charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue, accounts
payable, inventory, and vendor allowances during the putative class period of
November 19, 2001 to December 10, 2003. The factual allegations of this
complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On April 6, 2004, the District Court in the Greater Pennsylvania
Carpenters case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints
with the Greater Pennsylvania Carpenters action, and dismissed the Radigan and
Pfeiffer actions as separate actions. On April 14, 2004, the court granted the
plaintiffs up to 60 days to file an amended consolidated complaint. The Court
also designated the Greater Pennsylvania Carpenters Pension Fund as the lead
plaintiff in the action and designated Greater Pennsylvania's counsel as lead
counsel.
On June 10, 2004, a putative class action complaint captioned Joshua
Kaplan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 3971, was
filed in the U.S. District Court for the Northern District of Illinois against
the Company and certain of the Company's current and former officers, charging
violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue, accounts
payable, inventory, and vendor allowances during the putative class period of
November 19, 2001 to December 10, 2003. The factual allegations of this
complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On June 14, 2004, lead plaintiff Greater Pennsylvania Carpenters
Pension Fund in Case No. 04C 1107 filed a consolidated amended complaint. On
July 14, 2004, the District Court in the Greater Pennsylvania Carpenters action
consolidated the Kaplan complaint with the Greater Pennsylvania Carpenters
action, and dismissed the Kaplan action as a separate action. On August 2, 2004,
15
Whitehall filed a motion to dismiss the consolidated amended complaint, and
briefing on the motion is expected to be completed by early October 2004.
On June 15, 2004, a shareholder derivative action complaint captioned
Richard Cusack v. Hugh Patinkin, et al., Case No. 04 CH 09705, was filed in the
Circuit Court of Cook County, Illinois, for the alleged benefit of the Company
against certain of the Company's officers and directors. The complaint asserts
claims for breach of fiduciary duty, abuse of control, gross mismanagement,
waste of corporate assets, unjust enrichment, breach of fiduciary duties for
insider selling and misappropriation of information, and contribution and
indemnification. The factual allegations of the complaint are similar to those
made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed
above. The plaintiff has agreed to the filing of a joint motion to stay the
proceedings in this case pending the District Court's determination of the
Defendants' motions to dismiss in the federal securities class actions. On
September 8, 2004, the Court granted a stay motion without argument. The Court
also set a status hearing for January 26, 2005.
The Company intends to vigorously contest these putative class action
complaints and the shareholder derivative complaint and exercise all of its
available rights and remedies. Given that these cases are in their early stages,
and no substantive proceedings have occurred, it is not possible to evaluate the
likelihood of an unfavorable outcome in any of these matters, or to estimate any
amount or range of potential loss, if any. While there are many potential
outcomes, an adverse outcome in any of these actions could have a material
adverse effect on the Company's results of operations, financial condition or
liquidity. It cannot be determined at this stage whether these claims will be
resolved in the fiscal year ending January 31, 2005.
On January 16, 2004, the Company was named as a defendant in a
copyright infringement lawsuit filed in the United States District Court for the
District of Minnesota by Janel Russell Designs, Inc. ("Janel Russell Designs").
Janel Russell Designs asserted that the Company infringed its copyright in a
jewelry design by selling infringing merchandise. Two of the allegedly
infringing pieces are supplied to the Company by Samuel Aaron Inc. and one is
supplied by Princess Pride Creations. Each of the suppliers had also been sued
by Janel Russell Designs in separate lawsuits. Pursuant to language in certain
Vendor Trading Agreements the Company entered into with each supplier, the
Company tendered the defense of the cases to Samuel Aaron and Princess Pride and
demanded indemnification. Both vendors agreed to defend and indemnify the
Company. The Company filed its answer on March 3, 2004. (See Note 11 Subsequent
Event.)
The Company is also involved from time to time in certain other legal
actions and regulatory investigations arising in the ordinary course of
business. Although there can be no certainty, it is the opinion of management
that none of these other actions or investigations will have a material adverse
effect on the Company's results of operations or financial condition.
16
9. RELATED PARTY TRANSACTIONS
In the past, the Company provided certain office services to Double P
Corporation, PDP Limited Liability Company and CBN Limited Liability Company or
other companies, from time to time, which own and operate primarily mall-based
snack food stores, and in which Messrs. Hugh Patinkin, John Desjardins and
Matthew Patinkin own in the aggregate a 52% equity interest. A substantial
portion of the remaining equity interest is owned by the adult children and
other family members of Norman Patinkin, a member of the Company's Board of
Directors. For these services, Double P Corporation paid the Company $700 per
month. Effective February 1, 2004, the Company no longer provides these
services. Matthew Patinkin previously served as a director of Double P
Corporation and one of Norman Patinkin's adult children is a director and chief
executive officer of Double P Corporation. Messrs. Hugh Patinkin, John
Desjardins and Matthew Patinkin spend a limited amount of time providing
services to Double P Corporation, PDP Limited Liability Company and CBN Limited
Liability Company. Such services are provided in accordance with the Company's
Code of Conduct. In the case of Hugh Patinkin and John Desjardins, these
services are performed solely in their capacities as shareholders of Double P
Corporation. In the case of Matthew Patinkin, these services are performed in
his capacity as a shareholder of Double P Corporation and were previously
performed in his capacities as a director and a shareholder of Double P
Corporation. Messrs. Hugh Patinkin and John Desjardins receive no remuneration
for these services other than reimbursement of expenses incurred. Matthew
Patinkin receives no remuneration for these services other than the fee he
previously received for his services as a director of Double P Corporation. In
several cases, the Company and Double P Corporation agreed to divide and
separately lease contiguous mall space. The Company and Double P Corporation
concurrently negotiated separately with each landlord ("Simultaneous
Negotiations") to reach agreements for their separate locations. Since the
Company's initial public offering, its policy had required that the terms of any
such leases must be approved by a majority of the Company's outside directors.
The Company had conducted such negotiations in less than ten situations since
the Company's initial public offering in 1996. The Company's current policy is
that it will no longer enter into such Simultaneous Negotiations.
The Company offers health insurance coverage to the members of its
Board of Directors. The health insurance policy options and related policy cost
available to the Directors are the same as those available to the Company's
senior level employees.
The Company operates a program under which executive officers and
directors, and parties introduced to the Company by its executive officers and
directors, are permitted to purchase most Company merchandise at approximately
ten percent above the Company's cost. During the first six months of fiscal
2004, no such purchases were made under this program as compared to $127,000 of
such purchases in the first six months of fiscal 2003.
17
10. RECLASSIFICATIONS
Certain Balance Sheet amounts from prior periods were reclassified to conform to
the current year presentation. These reclassifications had no impact on earnings
or equity.
11. SUBSEQUENT EVENT
On or about August 2, 2004, the lawsuit filed by Janel Russell designs
was settled and dismissed with prejudice. The Company was not required to make
any payments in connection with the settlement.
18
PART I - FINANCIAL INFORMATION
Item 2 - Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis of the Company's financial
condition and results of operations should be read in conjunction with the
Company's unaudited financial statements, including the notes thereto. This
section contains statements that constitute "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. See the
Forward-Looking Statements disclosure in Part II, Item 5 of this quarterly
report.
Overview
The Company is a leading national retailer of fine jewelry (based on
number of stores) operating 386 stores in 38 states as of July 31, 2004. The
Company offers a selection of merchandise in the following categories: diamond,
gold, precious and semi-precious jewelry and watches. This merchandise selection
is oriented toward the Company's target customer base, middle to upper-middle
income men and women over 25 years of age. Jewelry purchases are discretionary
for consumers and may be particularly affected by adverse trends in the general
economy and perceptions of such conditions which affect disposable consumer
income. During the first three months of fiscal 2004, increased sales from
certain sales-focused programs, a strong Valentine's holiday performance and
improvements in general economic conditions and consumer confidence resulted in
higher comparable store sales than in comparison to the first three months of
fiscal year 2003. However, for the first six months of fiscal year 2004, the
sales increase experienced in the first quarter of fiscal year 2004 was
partially offset by a decline in sales during the second quarter of fiscal year
2004 as compared to sales during the second quarter of fiscal year 2003.
Overall, comparable store sales for the first six months of fiscal year 2004
increased 1.3% over the prior year period.
The Company reported a net loss of $6.9 million for the first six
months of fiscal 2004, as compared to a net loss of $5.6 million for first six
months of fiscal 2003. The increase in the Company's net loss for the first six
months of fiscal 2004 is due in part to an increase in professional fees and
other charges incurred primarily in connection with the consolidated Capital
Factors actions and the related investigations by the United States Attorney and
the Securities and Exchange Commission (the "SEC"), as described in Note 8 to
the financial statements. For the fourth quarter of the fiscal year ended
January 31, 2004 and the first quarter of fiscal 2004, the Company accrued a
total litigation reserve of $8.9 million for the consolidated Capital Factors
actions and the United States Attorney and SEC investigations. Since that time,
the Company has engaged in additional settlement discussions relating to these
matters. In light of developments in these discussions, the Company has recorded
an additional accrual in the quarter ended July 31, 2004 in the amount of
$310,000. There are no assurances that the Company will be able to reach a
settlement with any of the parties to the consolidated Capital Factors actions,
or that such a settlement or settlements, as the case may be, will be for the
amount recorded as a reserve. However, the Company currently believes that it is
more likely than not that it will reach a settlement or settlements, as the case
may be, pertaining to the consolidated Capital Factors actions in the near term.
The Company is unable at this time to predict the ultimate outcome of the
consolidated Capital Factors actions or the United States Attorney and SEC
investigations.
The Company's business is highly seasonal. Historically, income
generated in the fourth fiscal quarter ending each January 31 represents all
19
or a significant majority of the income generated during the fiscal year. The
Company has historically experienced lower net sales in each of its first three
fiscal quarters and expects this trend to continue. The Company's quarterly and
annual results of operations may fluctuate significantly as a result of factors
including, among others: increases or decreases in comparable store sales; the
timing of new store openings; net sales contributed by new stores; timing of
certain holidays and Company-initiated special events; changes in the Company's
merchandise; marketing or credit programs; general economic, industry, weather
conditions and disastrous national events that affect consumer spending as well
as pricing, merchandising, marketing, credit and other programs of competitors.
Results of Operations
The following table sets forth for the periods indicated certain
information derived from the unaudited statements of operations of the Company
expressed as a percentage of net sales for such periods.
Three months ended Six months ended
- --------------------------------------------------------------------------------
July 31, July 31, July 31, July 31,
Percentage of net sales 2004 2003 2004 2003
- --------------------------------------------------------------------------------
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales (including buying
and occupancy expenses) 66.7 66.7 66.7 66.7
- --------------------------------------------------------------------------------
Gross profit 33.3 33.3 33.3 33.3
Selling, general and
administrative expenses 37.3 36.4 37.2 37.1
Professional fees and other
charges 2.3 1.0 2.9 1.0
- --------------------------------------------------------------------------------
Loss from operations (6.3) (4.1) (6.8) (4.8)
Interest expense 1.5 2.2 (1.4) (1.7)
- --------------------------------------------------------------------------------
Loss before income taxes (7.8) (6.3) (8.2) (6.5)
Income tax benefit (3.4) (2.5) (3.5) (2.5)
- --------------------------------------------------------------------------------
Net loss (4.4%) (3.8%) (4.7%) (4.0%)
- --------------------------------------------------------------------------------
Three Months Ended July 31, 2004 Compared to Three Months Ended July 31, 2003
NET SALES
Net sales for the second quarter of fiscal 2004 decreased $0.4 million,
or 0.6%, to $72.3 million from $72.7 million in the second quarter of fiscal
2003. Comparable store sales decreased $0.4 million, or 0.6%, in the second
quarter of fiscal 2004 from the second quarter of fiscal 2003. Additionally,
there was a sales decrease of $1.1 million related to closed stores. These
decreases were partially offset by sales from new stores of $1.1 million. The
total number of merchandise units sold decreased by approximately 6.7% in the
second quarter of fiscal 2004 from the second quarter of fiscal 2003 while the
average price per merchandise sale increased to $302 in the second quarter of
fiscal 2004 from $285 in the second quarter of fiscal 2003. Credit sales as a
percentage of net sales increased to 43.6% in the second quarter of fiscal 2004
compared to 42.9% in the second quarter of fiscal 2003. The Company opened one
new store in the second quarter of fiscal 2004, increasing the number of stores
open to 386 as of July 31, 2004 compared to 383 as of July 31, 2003.
20
GROSS PROFIT
Gross profit for the second quarter of fiscal 2004 decreased $0.1
million, or 0.5%, to $24.1 million from $24.2 million in the same period in
fiscal 2003. Gross profit as a percentage of net sales was unchanged at 33.3% in
both the second quarter of fiscal years 2004 and 2003. Merchandise gross margins
declined by approximately 30 basis points, which was primarily driven by lower
margins as a result of price reductions on certain merchandise, beginning in
mid-July 2004 and an increase in reserves for certain damaged inventory. These
declines were partially offset as a result of tighter control over discounting,
particularly in the diamond category, and price increases on numerous items
implemented during March 2004, motivated in part by higher raw material prices.
The Company has historically offered clearance merchandise for sale,
representing merchandise identified from time to time that will not be part of
its future merchandise presentation. During the second quarter of fiscal year
2004, the Company, led by its new Executive Vice President of Merchandise,
reviewed its merchandise inventory presentation and determined that in addition
to its existing clearance merchandise $47.0 million of its merchandise inventory
at cost would not be part of its future merchandise presentation. Price
reductions were taken on these items which will result in lower than historical
margins on such merchandise. Sales of these items totaled approximately $5.2
million with an approximate cost of $3.1 million during the last three weeks of
July 2004. The impact of these sales accounted for a margin decline of
approximately 90 basis points during the second quarter of fiscal year 2004. In
early September 2004, the Company took limited price reductions on approximately
$17.0 million of merchandise in its existing clearance program. The price
reductions taken on these items were significantly smaller than on the
merchandise which was repriced in July 2004. The Company intends to focus its
sales effort on the above described merchandise during the third quarter of
fiscal year 2004 and in January 2005. Based on currently anticipated selling
prices, the Company expects to achieve positive but lower than historical
merchandise margins on such merchandise, which may negatively effect sales and
gross margin. It is the Company's current expectation to continue to offer for
sale in all or a portion of its stores the remaining amount of this merchandise
during 2005 and, if appropriate, beyond, which will negatively impact margins on
such merchandise.
EXPENSES
Selling, general and administrative expenses, excluding professional
fees and other charges, for the second quarter of fiscal 2004 increased $0.5
million, or 1.7%, to $27.0 million from $26.5 million in the second quarter of
fiscal 2003. As a percentage of net sales, selling, general and administrative
expenses increased to 37.3% in the second quarter of fiscal 2004 from 36.4% in
the second quarter of fiscal 2003. The dollar increase was primarily related to
higher personnel expense ($0.5 million) and higher credit expense ($0.1 million)
which were partially offset by lower other expense ($0.1 million). The increase
in personnel expense is primarily attributable to higher salary and wage rates,
an increase in medical benefit costs and an increase in the number of stores.
Professional fees and other charges increased by $0.9 million to a
total of $1.6 million in the second quarter of fiscal 2004 from $0.7 million in
the prior year period, primarily associated with the consolidated Capital
Factors actions and the related United States Attorney and SEC investigations as
described in Note 8 of the financial statements. In light of developments in the
ongoing settlement discussions, the Company recorded an additional accrual of
$310,000 during the second quarter of fiscal 2004. The Company also recorded an
accrual of $250,000 in connection with a settlement of certain
21
actions brought by former employees of the Company for employment related
matters.
LOSS FROM OPERATIONS
As a result of the factors discussed above, loss from operations was
$4.6 million in the second quarter of fiscal 2004 compared to a loss of $3.0
million in the second quarter of fiscal 2003. As a percentage of net sales, loss
from operations was 6.3% in the second quarter of fiscal 2004 compared to 4.1%
in the second quarter of fiscal 2003.
INTEREST EXPENSE
Interest expense decreased $0.5 million, or 30.1%, to $1.1 million in
the second quarter of fiscal 2004 from $1.6 million in the second quarter of
fiscal 2003. In second quarter of fiscal 2004, higher average revolver loan
borrowings and higher interest rates were offset by lower amortization of
deferred financing costs and the elimination of the term loan interest in
connection with the new loan facility as well as the write-off of $516,000 of
deferred financing fees related to the refinancing of the prior credit facility
in the second quarter of fiscal 2003.
INCOME TAX BENEFIT
Income tax benefit of $2.5 million in the second quarter of 2004
compared to an income tax benefit of $1.8 million in the second quarter of 2003
reflects an expected annual effective income tax rate of 42.5% for fiscal 2004.
The Company's current estimate of the effective income tax rate for fiscal year
2004 is 42.5%. To the extent that income is significantly more or less than
expected, the Company's effective income tax rate for the remainder of fiscal
year 2004 could vary significantly from that of the first six months of fiscal
year 2004. The Company's annual effective income tax rate was 35.8% for fiscal
2003.
22
Six Months Ended July 31, 2004 Compared to Six Months Ended July 31, 2003
NET SALES
Net sales for the six months ended July 31, 2004 increased $3.4
million, or 2.4%, to $145.3 million from $141.9 million in the six months ended
July 31, 2003. Comparable store sales increased $1.8 million, or 1.3%, in the
first six months of fiscal 2004 from the same period in fiscal 2003. New store
sales accounted for an increase in sales of $3.7 million. Additionally, sales
were $0.3 million higher due to changes in sales returns and allowances. These
increases were partially offset by a sales decrease of $2.4 million primarily
related to closed stores. The somewhat higher comparable store sales in the
first six months of fiscal year 2004 in comparison to the first six months of
fiscal year 2003 was due in part to increased sales generated from certain
sales-focused initiatives, a strong Valentine's holiday sales performance and
improvements in general economic conditions and improved consumer confidence
experienced during the first quarter of fiscal year 2004 as compared to the
prior year period. The total number of merchandise units sold decreased by
approximately 1.4% in the first six months of fiscal 2004 from the first six
months of fiscal 2003 while the average price per merchandise sale increased to
$289 in the first six months of fiscal 2004 from $281 in the same period in
fiscal year 2003. Credit sales as a percentage of net sales decreased slightly
in the first six months of fiscal 2004 compared to the first six months of
fiscal 2003. The Company opened six new stores in the first six months of fiscal
2004, increasing the number of stores open to 386 as of July 31, 2004 compared
to 383 as of July 31, 2003.
GROSS PROFIT
Gross profit for the first six months of fiscal 2004 increased $1.0
million, or 2.2%, to $48.3 million from $47.3 million compared to the same
period in fiscal 2003. Gross profit as a percentage of sales was relatively
unchanged at 33.3% in the first half of each of fiscal years 2004 and 2003.
Merchandise gross margins improved by approximately 40 basis points as a result
of tighter control over discounting, particularly in the diamond category, and
price increases on numerous items implemented during March 2004, motivated in
part by higher raw material prices. These margin improvements were partially
offset in part by lower margins resulting from price reductions on certain
merchandise beginning mid-July 2004 and an increase in reserves for certain
damaged inventory.
The Company has historically offered clearance merchandise for sale,
representing merchandise identified from time to time that will not be part of
its future merchandise presentation. During the second quarter of fiscal year
2004, the Company, led by its new Executive Vice President of Merchandise,
reviewed its merchandise inventory presentation and determined that in addition
to its existing clearance merchandise $47.0 million of its merchandise inventory
at cost would not be part of its future merchandise presentation. Price
reductions were taken on these items which will result in lower than historical
margins on such merchandise. Sales of these items totaled approximately $5.2
million with an approximate cost of $3.1 million during the last three weeks of
July 2004. The impact of these sales accounted for a margin decline of
approximately 50 basis points during the first six months of fiscal year 2004.
In early September 2004 the Company took limited price reductions on
approximately $17.0 million of merchandise in its existing clearance program.
The price reductions taken on these items were significantly smaller than on the
merchandise which was repriced in July 2004. The Company intends to focus its
sales effort on the above described merchandise during the third quarter of
fiscal year 2004 and in January 2005. Based on currently anticipated selling
prices, the Company expects to achieve positive, but lower than historical
merchandise margins on such merchandise, which may negatively
23
effect sales and gross margin. It is the Company's current expectation to
continue to offer for sale in all or a portion of its stores the remaining
amount of this merchandise during 2005 and, if appropriate, beyond, which will
negatively impact margins on such merchandise.
EXPENSES
Selling, general and administrative expenses, excluding professional
fees and other charges, for the first six months of fiscal 2004 increased $1.4
million, or 2.6%, to $54.0 million from $52.6 million for the first six months
of fiscal 2003. As a percentage of net sales, selling, general and
administrative expenses increased slightly to 37.2% in the first half of fiscal
2004 from 37.1% in the first half of fiscal 2003. The dollar increase was
primarily related to higher personnel expense ($1.1 million) and higher
advertising expense ($0.4 million), which were partially offset by lower other
expense ($0.1 million). The increase in personnel expenses is primarily
attributable to higher salary and wage rates, an increase in medical benefit
costs and an increase in the number of stores.
Professional fees and other charges increased by $3.0 million to a
total of $4.3 million in the first six months of fiscal 2004 from $1.3 million
in the prior year period, primarily associated with the consolidated Capital
Factors actions and the related United States Attorney and SEC investigations as
described in Note 8 of the financial statements. In light of developments in the
ongoing settlement discussions, the Company recorded an additional accrual of
$660,000 during the first half of fiscal 2004. The Company recorded an accrual
of $250,000 in connection with the settlement of certain actions brought by
former employees of the Company for employment related matters.
LOSS FROM OPERATIONS
As a result of the factors discussed above, loss from operations was
$10.0 million in the first six months of fiscal 2004 compared to a loss of $6.7
million in the first six months of fiscal 2003. As a percentage of net sales,
loss from operations was 6.8% in the first six months of fiscal 2004 as compared
to 4.8% in the prior year period.
INTEREST EXPENSE
Interest expense decreased $0.5 million, or 19.1%, to $2.0 million in
the first six months of fiscal 2004 from $2.5 million in the first six months of
fiscal 2003. In first six months of fiscal 2004, higher average revolver loan
borrowings and higher interest rates were offset by lower amortization of
deferred financing costs and the elimination of the term loan interest in
connection with the new loan facility as well as the write-off of $516,000 of
deferred financing fees related to the refinancing of the prior credit facility
in the first six months of fiscal 2003.
INCOME TAX BENEFIT
Income tax benefit of $5.1 million in the first six months of fiscal
2004 compared to an income tax benefit of $3.6 million in the first six months
of fiscal 2003, reflects an expected annual effective tax rate of 42.5% for
fiscal 2004. The Company's current estimate of the effective income tax rate for
fiscal year 2004 is 42.5%. To the extent that income is significantly more or
less than expected, the Company's effective income tax rate for the remainder of
fiscal year 2004 could vary significantly from that of the first six months of
fiscal 2004. The Company's annual effective income tax rate was 35.8% for fiscal
2003.
24
Liquidity and Capital Resources
The Company's cash requirements consist principally of funding
inventory for existing stores, capital expenditures and working capital
(primarily inventory) associated with the Company's new stores. The Company's
primary sources of liquidity have historically been cash flow from operations
and bank borrowings under the Company's Second Amended and Restated Revolving
Credit and Gold Consignment Agreement dated July 29, 2003 (the "Credit
Agreement"), as amended effective March 23, 2004. The Company had $97.5 million
of outstanding borrowings under the revolving loan facility as of July 31, 2004.
The Company's inventory levels and working capital requirements have
historically been highest in advance of the Christmas season. The Company has
funded these seasonal working capital needs through borrowings under the
Company's revolver and increases in trade payables and accrued expenses. As of
July 31, 2004, the maximum availability under the Credit Agreement was $121.9
million based on the borrowing base formula. The credit facility covenants also
require the Company to attain certain operating results.
The Company's cash flow used in operating activities was $12.6 million
in the first six months of 2004 compared to $10.2 million provided by operating
activities in the first six months of fiscal 2003. Depreciation and amortization
($6.3 million), a decrease in merchandise inventories ($6.9 million), and an
increase in accrued liabilities ($1.3 million) were offset by decreases in
accounts payable ($16.1 million), an increase in current income tax benefit
($2.0 million), and loss from operations ($6.9 million). The decrease in
merchandise inventories is due in part to the introduction of a number of
programs implemented by the Company during the first half of fiscal 2004 focused
on reducing less productive inventory, including the introduction of price
reductions taken in July 2004 on approximately $47.0 million of merchandise
inventory at cost. The decrease in accounts payable is primarily attributable to
lower inventory levels and the timing of the payment of merchandise inventory
invoices as compared with the prior year period.
Cash generated by financing activities included revolver borrowings
($17.2 million). The Company utilized cash in the first six months of 2004 to
fund capital expenditures ($3.1 million) primarily related to the opening of six
new stores as well as store remodels in the first six months of 2004, to reduce
outstanding checks ($1.8 million) and to pay financing costs ($0.1 million)
associated with the Credit Agreement.
The Company amended the Credit Agreement effective March 23, 2004 in
order to, among other things, (i) add a reserve for customer deposits to the
Borrowing Base (as defined in the Credit Agreement), (ii) add and amend certain
financial covenants, including amending the Fixed Charge Coverage Ratio (as
defined in the Credit Agreement) and adding a covenant to maintain a Net Worth
(as defined in the Credit Agreement) of at least $90.0 million at January 31,
2005, (iii) cap the borrowings under the facility to a maximum of $85.0 million
for at least thirty consecutive calendar days during the period from December
15, 2004 through and including February 15, 2005, (iv) increase the interest
rate at which LIBOR based borrowings are available under the Credit Agreement to
LIBOR plus 2.5% through April 30, 2005, (v) set the Commitment Fee Rate (as
defined in the Credit Agreement) at 0.5% through April 30, 2005, and (vi) set
the Standby Letter of Credit Fee Rate (as defined in the Credit Agreement) at
2.0% through April 30, 2005.
As of March 22, 2004, the Company and its lenders entered into a letter
agreement pursuant to which the lenders under the Credit Agreement have agreed
that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC
investigation and the United States Attorney's investigation have not resulted
in a breach of the Credit Agreement. In addition, the lenders have agreed
25
that none of these matters will give rise to a default or event of default under
the Credit Agreement so long as the resolution of such matters does not involve
the payment by the Company of Restitution (which is defined below) in an amount
in excess of $15.0 million, and does not result in the indictment of the Company
or any of its current officers, directors or employees with principal financial
or accounting responsibilities. The letter agreement also states that any
settlement involving the payment of Restitution in excess of $15.0 million shall
constitute a default under the Credit Agreement and any indictment of the
Company or any of the persons described above may constitute a default under the
Credit Agreement.
"Restitution" is defined as any restitution paid by the Company
(whether cash or non-cash or current or deferred consideration) arising from a
civil settlement or award and/or criminal penalties paid or payable in
connection with the Capital Factors litigation, the SEC investigation and/or the
United States Attorney investigation and any other actions or proceedings
directly related thereto; excluding, however, (i) amounts paid by the Company
for consignment inventory held on behalf of the parties involved in the Capital
Factors litigation, (ii) amounts already accrued on the books of the Company for
the purchase of merchandise from the parties involved in the Capital Factors
litigation and (iii) the value of any consigned inventory returned to parties
involved in the Capital Factors actions.
At this time the Company does not expect the payment of Restitution to
exceed $15.0 million and, based on the Company's current financial plan, expects
to be in compliance with all financial covenants as set forth in the Credit
Agreement for the remainder of fiscal year 2004.
Subject to the contingencies identified in Note 8 to the financial
statements and other risks, including those identified in Forward-Looking
Statements, management expects that based on the Company's current financial
plan the cash flow from operating activities and funds available under the
Company's revolving loan facility should be sufficient to support the Company's
current new store expansion program, seasonal working capital needs and
liabilities that may arise with respect to the consolidated Capital Factors
actions and the investigations by the United States Attorney's Office and the
SEC. The Company intends to contest vigorously the putative class action
complaints and the shareholder derivative complaint and exercise all of its
available rights and remedies. Given that these class action cases and the
shareholder derivative complaint are in their early stages and no substantive
proceedings have occurred, it is not possible to evaluate the likelihood of an
unfavorable outcome in any of these matters or to estimate any amount or range
of potential loss, if any. While there are many potential outcomes, an adverse
outcome in these actions could have a material adverse effect on the Company's
results of operations, financial condition and/or liquidity. It cannot be
determined at this stage whether the putative class action complaints or the
shareholder derivative complaint will be resolved in the fiscal year ending
January 31, 2005.
If an event of default occurs pursuant to the March 22, 2004 letter
agreement, the Company may be required to negotiate relief with its lenders or
to seek new financing. There is no assurance that new financing arrangements
would be available on acceptable terms or at all. If the existing lenders were
to cease funding under the revolving loan facility or require immediate
repayment and if the Company were not able to arrange new financing on
acceptable terms, this would have a material adverse effect on the Company,
which could affect the underlying valuation of its assets and liabilities.
26
Contractual Obligations
The following summarizes the Company's contractual obligations at July
31, 2004:
PAYMENTS DUE BY PERIOD
- -------------------------------------------------------------------------------------------------------------------------
Less than More than
(in thousands) Total 1 year 1 - 3 years 4 - 5 years 5 years
- -------------------------------------------------------------------------------------------------------------------------
Revolver $ 97,496 $ -- $ -- $ 97,496 $ --
Accrued interest 335 335 -- -- --
Subordinated debt 640 640 -- -- --
Operating leases 175,585 29,614 79,532 37,733 28,706
- -------------------------------------------------------------------------------------------------------------------------
Total contractual
obligations $ 274,056 $ 30,589 $79,532 $ 135,229 $ 28,706
- -------------------------------------------------------------------------------------------------------------------------
In the normal course of business, the Company issues purchase orders to
vendors for the purchase of merchandise inventories. The outstanding amount of
these purchase orders is not included in the above table, as the purchase orders
may be cancelled prior to delivery at the option of the Company without penalty.
Gold Price Risk
The Company does not hedge gold price changes. Current increases in
gold prices have had and may have a future negative impact on gross margin to
the extent sales prices for such items do not increase commensurately.
Diamond Price Risk
Recent increases in diamond prices may have a future negative impact on
gross margin to the extent that sales prices for such items do not increase
commensurately.
Inflation
The Company believes that inflation generally has not had a material
effect on the results of its operations. There is no assurance, however, that
inflation will not materially affect the Company in the future.
Critical Accounting Policies and Estimates
The Company's critical accounting policies and estimates, including the
assumptions and judgments underlying them, are disclosed in the notes to the
Financial Statements and Management's Discussion and Analysis of Financial
Condition and Results of Operations in the Form 10-K filing for the year ended
January 31, 2004. These policies have been consistently applied in all material
respects and address such matters as revenue recognition, inventory valuation,
depreciation methods and asset impairment recognition. While the estimates and
judgments associated with the application of these policies may be affected by
different assumptions or conditions, the Company believes the estimates and
judgments associated with the reported amounts are appropriate in the
circumstances. Management has discussed the development and selection of these
critical accounting estimates with the audit committee of the Company's Board of
Directors.
Due to the seasonal nature of the business, the Company tends to
generate all or a significant majority of its income in the fourth quarter. The
Company's current estimate of the effective income tax rate for fiscal year 2004
is 42.5%. To the extent that income is significantly more or less than expected,
the Company's effective income tax rate for the remainder of
27
fiscal 2004 could vary significantly from that of the first six months of fiscal
2004.
Merchandise inventories are stated principally at the lower of weighted
average cost or market. Purchase cost is reduced to reflect certain allowances
and discounts received from vendors. Periodic credits or payments from
merchandise vendors in the form of consignment buydowns, volume or other
purchase discounts and other vendor considerations are reflected in the carrying
value of the inventory and recognized as a component of cost of sales as the
merchandise is sold. Additionally, to the extent it is not addressed by
established vendor return privileges, and if the amount of cash consideration
received from the vendor exceeds the estimated fair value of the goods returned,
that excess amount is reflected as a reduction in the purchase cost of the
inventory acquired. Allowances for inventory shrink, scrap and other provisions
are recorded based upon analysis and estimates by the Company.
To the extent the Company's agreements with merchandise vendors provide
credits for co-op advertising, the Company has historically classified such
credits as a reduction to advertising expense in selling, general and
administrative expenses. Emerging Issues Task Force ("EITF") Issue No. 02-16,
"Accounting by a Customer (Including a Reseller) for Certain Consideration
Received from a Vendor" ("EITF 02-16"), which was effective for all arrangements
entered into after December 31, 2002, requires certain merchandise vendor
allowances to be classified as a reduction to cost of sales unless evidence
exists supporting an alternative classification. In prior years, certain vendors
reimbursed the Company for certain co-op advertising costs that were incurred.
In 2003, the Company changed the terms of its Vendor Trading Agreements to
include a vendor allowance for advertising calculated as a percentage of net
merchandise purchases. The Company earned $978,000 and $1,069,000 of vendor
allowances for advertising for the first six months of fiscal years 2004 and
2003, respectively. The Company records such allowances as a reduction of
inventory cost and as the inventory is sold, the Company will recognize a lower
cost of sales.
The Company also obtains merchandise from vendors under various
consignment agreements. The consigned inventory and related contingent
obligations associated with holding and safekeeping such consigned inventory are
not reflected in the Company's financial statements. At the time of sale of
consigned merchandise to customers, the Company records the purchase liability
and the related consignor cost of such merchandise in cost of sales.
Transactions with Affiliates and Related Parties
In the past, the Company provided certain office services to Double P
Corporation, PDP Limited Liability Company and CBN Limited Liability Company or
other companies, from time to time, which own and operate primarily mall-based
snack food stores, and in which Messrs. Hugh Patinkin, John Desjardins and
Matthew Patinkin own in the aggregate a 52% equity interest. A substantial
portion of the remaining equity interest is owned by the adult children and
other family members of Norman Patinkin, a member of the Company's Board of
Directors. For these services, Double P Corporation paid the Company $700 per
month. Effective February 1, 2004, the Company no longer provides these
services. Matthew Patinkin previously served as a director of Double P
Corporation and one of Norman Patinkin's adult children is a director and chief
executive officer of Double P Corporation. Messrs. Hugh Patinkin, John
Desjardins and Matthew Patinkin spend a limited amount of time providing
services to Double P Corporation, PDP Limited Liability Company and CBN Limited
Liability Company. Such services are provided in accordance with the Company's
Code of Conduct. In the case of Hugh Patinkin and John Desjardins, these
services are performed solely in their capacities as shareholders of
28
Double P Corporation. In the case of Matthew Patinkin, these services are
performed in his capacity as a shareholder of Double P Corporation and were
previously performed in his capacities as a director and a shareholder of Double
P Corporation. Messrs. Hugh Patinkin and John Desjardins receive no remuneration
for these services other than reimbursement of expenses incurred. Matthew
Patinkin receives no remuneration for these services other than the fee he
previously received for his services as a director of Double P Corporation. In
several cases, the Company and Double P Corporation agreed to divide and
separately lease contiguous mall space. The Company and Double P Corporation
concurrently negotiated separately with each landlord ("Simultaneous
Negotiations") to reach agreements for their separate locations. Since the
Company's initial public offering, its policy had required that the terms of any
such leases must be approved by a majority of the Company's outside directors.
The Company had conducted such negotiations in less than ten situations since
the Company's initial public offering in 1996. The Company's current policy is
that it will no longer enter into such Simultaneous Negotiations.
The Company offers health insurance coverage to the members of its
Board of Directors. The health insurance policy options and related policy cost
available to the Directors are the same as those available to the Company's
senior level employees.
The Company operates a program under which executive officers and
directors, and parties introduced to the Company by its executive officers and
directors, are permitted to purchase most Company merchandise at approximately
ten percent above the Company's cost. During the first six months of fiscal
2004, no such purchases were made under this program as compared to $127,000 of
such purchases in the first six months of fiscal 2003.
Accounting for Guarantees
In November 2002, the Financial Accounting Standards Board ("FASB")
issued FASB Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others," an interpretation of FASB Statements Nos. 5, 57 and 107
and a rescission of FASB Interpretation No. 34. The Company has adopted the
guidance of FIN 45 and has reflected the required disclosures in its financial
statements commencing with the financial statements for the year ended January
31, 2004.
Under its bylaws, the Company has agreed to indemnify its officers and
directors for certain events or occurrences while the officer or director is
serving, or was serving, at its request in such capacity. The maximum potential
amount of future payments the Company could be required to make pursuant to
these indemnification obligations is unlimited; however, the Company has a
directors and officer liability insurance policy that, under certain
circumstances, enables it to recover a portion of any future amounts paid. The
Company has no liabilities recorded for these obligations as of July 31, 2004,
however, reference should be made to Note 8 to the financial statements with
respect to legal contingencies.
Item 3. - Quantitative and Qualitative Disclosure About Market Risk
Interest Rate Risk
The Company's exposure to changes in interest rates relates primarily
to its borrowing activities to fund business operations. The Company principally
uses floating rate borrowings under its revolving credit facility. The Company's
private label credit card provider charges the Company varying
29
discount rates for its customers' credit program purchases. These discount rates
are sensitive to changes in interest rates. The Company currently does not use
derivative financial instruments to protect itself from fluctuations in interest
rates.
Gold Price Risk
The Company does not hedge gold price changes. Current increases in
gold prices have had and may have a future negative impact on gross margin to
the extent sales prices do not increase commensurately.
Diamond Price Risk
Recent increases in diamond prices may have a future negative impact on
gross margin to the extent that sales prices for such items do not increase
commensurately.
Inflation
The Company believes that inflation generally has not had a material
effect on the results of its operations. There is no assurance, however, that
inflation will not materially affect the Company in the future.
Item 4. - Controls and Procedures
The Company's management, with the participation of its Chief Executive
Officer and its Chief Financial Officer, have carried out an evaluation of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures (as defined in Rule 13a-15(e) promulgated under the Securities
Exchange Act of 1934, as amended). Based upon this evaluation, the Company's
Chief Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective as of July 31, 2004 to provide
reasonable assurance that information required to be disclosed by the Company in
reports filed or submitted 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. There were no changes in the
Company's internal control over financial reporting that occurred during the
Company's fiscal quarter ended July 31, 2004 that have materially affected, or
are reasonably likely to materially affect, the Company's internal control over
financial reporting.
30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company has been named as one of 14 defendants in a lawsuit
originally filed in the United States District Court for the Southern District
of New York, now pending in New York State Supreme Court, Commercial Division.
The case is brought by Capital Factors, Inc. ("Capital Factors"), which provided
financing to defendant Cosmopolitan Gem Corp. ("Cosmopolitan"), an entity with
which the Company has certain consignment and other commercial arrangements. The
complaint alleges that Cosmopolitan defrauded Capital Factors into advancing
funds to Cosmopolitan by misrepresenting Cosmopolitan's finances and the
profitability of its operations, and that the Company, along with other persons
and entities, including other jewelry retailers, aided and abetted or
participated in the alleged fraud. The complaint asserts against the defendants,
including the Company, claims under common law and the Racketeer Influenced and
Corrupt Organizations Act ("RICO"). Capital Factors seeks aggregate damages from
all of the defendants, including the Company, of $30,000,000, plus unspecified
punitive damages, interest and fees. Damages, excluding punitive damages,
awarded pursuant to claims asserted under RICO as well as interest on such
damages are subject to trebling, within the discretion of the court.
The Company has also been named as one of 13 defendants in an amended
complaint filed on December 2, 2003 by International Diamonds, L.L.C.
("International") and its affiliate, Astra Diamonds Manufacturers, Ltd.
("Astra"). Astra is an Israeli diamond wholesaler that supplied diamonds to
Cosmopolitan; International is a joint venture formed by Cosmopolitan and Astra
to sell high quality finished diamond jewelry in the United States. The amended
complaint, consolidated with the Capital Factors action described above (the
"consolidated Capital Factors actions"), alleges that the Company, along with
other jewelry retailers and business affiliates of Cosmopolitan, participated in
Cosmopolitan's fraudulent scheme to defraud Capital Factors, and thus injured
International and Astra. The complaint asserts claims under common law and RICO,
seeking aggregate damages from all of the defendants, including the Company, of
$6,800,000 plus interest and fees. Damages awarded pursuant to claims asserted
under RICO as well as interest on such damages are subject to trebling, within
the discretion of the court. In addition, the complaint alleges claims against
the Company for breach of contract for approximately $2,520,000 in goods
delivered and invoiced to the Company, for which International has not received
payment.
In connection with the consolidated Capital Factors actions in New York
state court, the Company has filed an interpleader action for declaratory
relief, asking the Court to determine the proper parties to whom the Company
must pay amounts and deliver goods that are not in dispute related to goods
received from Cosmopolitan and certain other entities. In its answer to the
interpleader, Capital Factors has asserted that the Company owes Cosmopolitan
$8,600,000 in accounts receivable on invoices assigned to Capital Factors. This
amount is included in the $30,000,000 of losses that Capital Factors seeks in
its RICO claims. In addition, Ultimo, Inc. ("Ultimo"), a jewelry supplier, is a
defendant in the International action and in the interpleader action. Ultimo
provided certain items of jewelry to the Company on a consignment basis and
asserts that: (1) the Company has sold approximately $450,000 worth of such
items, the proceeds of which it claims remain in the Company's possession; and
(2) the Company continues to possess approximately $1,780,000 worth of its
consignment goods. Ultimo asserts that it should receive these consignment
proceeds and goods. Capital Factors also has asserted claims to these proceeds
and goods. The Company has segregated the remaining consignment goods from its
inventory and has placed such goods into an off-site safe deposit box to hold
them until such time as the New York
31
State Supreme Court determines the proper distribution of these consignment
goods. In addition to the Ultimo consignment goods discussed above, other
consignment proceeds and the amount of accounts payable due already have been
placed in the Company's outside counsel's escrow account pending court
determination of the proper recipient. The Company is not currently aware of any
accounts payable due and owing to any of the claimants in this action that are
not already reflected in the Company's accounts payable and accrued liabilities
or that have been placed in the Company's outside counsel's escrow account.
In these consolidated Capital Factors actions, document discovery has
begun and certain depositions have been taken. In addition, the Company has
filed motions to dismiss both the Capital Factors and International/Astra
complaints. The motions are currently pending before the court.
As previously disclosed, the United States Attorney for the Eastern
District of New York is conducting a criminal investigation regarding matters
that include those alleged in the consolidated Capital Factors actions. The
Company, among others, is a subject of this criminal investigation and is
cooperating fully with the United States Attorney.
In addition, subsequent to the filing of the complaint by Capital
Factors and as previously disclosed, the SEC initiated an informal inquiry into
matters that are the subject of the consolidated Capital Factors actions. On
November 3, 2003, the Company received a subpoena issued by the SEC as a part of
a formal investigation by the SEC with respect to the matters that are the
subject of the consolidated Capital Factors actions. The Company produced
documents to the SEC in response to the SEC's subpoena and information requests.
The Company is cooperating fully with the SEC in connection with this formal
investigation.
In accordance with Financial Accounting Standards Board Statement No.
5, "Accounting for Contingencies," the Company determines whether an estimated
loss from a loss contingency should be accrued by assessing whether a loss is
deemed probable and can be reasonably estimated. For the fourth quarter of the
fiscal year ended January 31, 2004 and the first quarter of fiscal year 2004,
the Company recorded a total litigation accrual of $8.9 million for the
consolidated Capital Factors actions and the United States Attorney and SEC
investigations. As previously disclosed in a press release furnished to the SEC
under cover of a Current Report on Form 8-K dated August 26, 2004, for the
second quarter of fiscal year 2004, the Company recorded an additional accrual
in the amount of $310,000 with respect to these matters in light of ongoing
settlement discussions. There are no assurances that the Company will be able to
reach a settlement with any of the parties to the consolidated Capital Factors
actions or that such a settlement or settlements, as the case may be, will be
for the amount recorded as a reserve. However, the Company currently believes
that it is more likely than not that it will reach a settlement or settlements,
as the case may be, pertaining to the consolidated Capital Factors actions in
the near term. Given the amounts sought in the consolidated Capital Factors
actions, and the inherent unpredictability of litigation, it is possible that an
adverse outcome in excess of the amount recorded could occur and these actions
could have a material adverse effect on the Company's results of operations,
financial condition and/or liquidity. The Company is unable at this time to
predict the ultimate outcome of the consolidated Capital Factors actions or the
United States Attorney and SEC investigations.
As of March 22, 2004, the Company and its lenders entered into a letter
agreement pursuant to which the lenders under the Credit Agreement have agreed
that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC
investigation and the United States Attorney's investigation have not resulted
32
in a breach of the Credit Agreement. In addition, the lenders have agreed that
none of these matters will give rise to a default or event of default under the
Credit Agreement so long as the resolution of such matters does not involve the
payment by the Company of Restitution (which is defined below) in an amount in
excess of $15.0 million, and does not result in the indictment of the Company or
any of its current officers, directors or employees with principal financial or
accounting responsibilities. The letter agreement also states that any
settlement involving the payment of Restitution in excess of $15.0 million shall
constitute a default under the Credit Agreement and any indictment of the
Company or any of the persons described above may constitute a default under the
Credit Agreement.
"Restitution" is defined as any restitution paid by the Company
(whether cash or non-cash or current or deferred consideration) arising from a
civil settlement or award and/or criminal penalties paid or payable in
connection with the Capital Factors litigation, the SEC investigation and/or the
United States Attorney investigation and any other actions or proceedings
directly related thereto; excluding, however, (i) amounts paid by the Company
for consignment inventory held on behalf of the parties involved in the Capital
Factors litigation and (ii) amounts already accrued on the books of the Company
for the purchase of merchandise from the parties involved in the Capital Factors
litigation and (iii) the value of any consigned inventory returned to parties
involved in the Capital Factors actions.
At this time the Company does not expect the payment of Restitution to
exceed $15.0 million and, based on the Company's current financial plan, expects
to be in compliance with all financial covenants as set forth in the Credit
Agreement for the remainder of fiscal year 2004.
On February 12, 2004, a putative class action complaint captioned
Greater Pennsylvania Carpenters Pension Fund, et al. v. Whitehall Jewellers,
Inc. et al., Case No. 04 C1107, was filed in the U.S. District Court for the
Northern District of Illinois against the Company and certain of the Company's
current and former officers. The complaint makes reference to the litigation
filed by Capital Factors, Inc. above and to the Company's November 21, 2003
announcement that it had discovered violations of Company policy by the
Company's Executive Vice President, Merchandising, with respect to Company
documentation regarding the age of certain store inventory. The complaint
further makes reference to the Company's December 22, 2003 announcement that it
would restate results for certain prior periods. The complaint purports to
allege that the Company and its officers made false and misleading statements
and falsely accounted for revenue and inventory during the putative class period
of November 19, 2001 to December 10, 2003. The complaint purports to allege
violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934
("1934 Act") and Rule 10b-5 promulgated thereunder.
On February 18, 2004, a putative class action complaint captioned
Michael Radigan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C
1196, was filed in the U.S. District Court for the Northern District of Illinois
against the Company and certain of the Company's current and former officers,
charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue and inventory
during the putative class period of November 19, 2001 to December 10, 2003. The
factual allegations of this complaint are similar to those made in the Greater
Pennsylvania Carpenters Pension Fund complaint discussed above.
On February 20, 2004, a putative class action complaint captioned
Milton Pfeiffer, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C
1285, was filed in the U.S. District Court for the Northern District of Illinois
33
against the Company and certain of the Company's current and former officers,
charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue, accounts
payable, inventory, and vendor allowances during the putative class period of
November 19, 2001 to December 10, 2003. The factual allegations of this
complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On April 6, 2004, the District Court in the Greater Pennsylvania
Carpenters case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints
with the Greater Pennsylvania Carpenters action, and dismissed the Radigan and
Pfeiffer actions as separate actions. On April 14, 2004, the court granted the
plaintiffs up to 60 days to file an amended consolidated complaint. The Court
also designated the Greater Pennsylvania Carpenters Pension Fund as the lead
plaintiff in the action and designated Greater Pennsylvania's counsel as lead
counsel.
On June 10, 2004, a putative class action complaint captioned Joshua
Kaplan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 3971, was
filed in the U.S. District Court for the Northern District of Illinois against
the Company and certain of the Company's current and former officers, charging
violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5
promulgated thereunder, and alleging that the Company and its officers made
false and misleading statements and falsely accounted for revenue, accounts
payable, inventory, and vendor allowances during the putative class period of
November 19, 2001 to December 10, 2003. The factual allegations of this
complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On June 14, 2004, lead plaintiff Greater Pennsylvania Carpenters
Pension Fund in Case No. 04C 1107 filed a consolidated amended complaint. On
July 14, 2004, the District Court in the Greater Pennsylvania Carpenters action
consolidated the Kaplan complaint with the Greater Pennsylvania Carpenters
action, and dismissed the Kaplan action as a separate action. On August 2, 2004,
Whitehall filed a motion to dismiss the consolidated amended complaint, and
briefing on the motion is expected to be completed by early October 2004.
On June 15, 2004, a shareholder derivative action complaint captioned
Richard Cusack v. Hugh Patinkin, et al., Case No. 04 CH 09705, was filed in the
Circuit Court of Cook County, Illinois, for the alleged benefit of the Company
against certain of the Company's officers and directors. The complaint asserts
claims for breach of fiduciary duty, abuse of control, gross mismanagement,
waste of corporate assets, unjust enrichment, breach of fiduciary duties for
insider selling and misappropriation of information, and contribution and
indemnification. The factual allegations of the complaint are similar to those
made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed
above. The plaintiff has agreed to the filing of a joint motion to stay the
proceedings in this case pending the District Court's determination of the
Defendants' motions to dismiss in the federal securities class actions. On
September 8, 2004, the Court granted a stay motion without argument. The Court
also set a status hearing for January 26, 2005.
The Company intends to vigorously contest these putative class action
complaints and the shareholder derivative complaint and exercise all of its
available rights and remedies. Given that these cases are in their early stages,
and no substantive proceedings have occurred, it is not possible to evaluate the
likelihood of an unfavorable outcome in any of these matters, or to estimate any
amount or range of potential loss, if any. While there are many potential
outcomes, an adverse outcome in any of these actions could have a material
adverse effect on the Company's results of operations, financial
34
condition or liquidity. It cannot be determined at this stage whether these
claims will be resolved in the fiscal year ending January 31, 2005.
On January 16, 2004, the Company was named as a defendant in a
copyright infringement lawsuit filed in the United States District Court for the
District of Minnesota by Janel Russell Designs, Inc. ("Janel Russell Designs").
Janel Russell Designs asserted that the Company infringed its copyright in a
jewelry design by selling infringing merchandise. Two of the allegedly
infringing pieces are supplied to the Company by Samuel Aaron Inc. and one is
supplied by Princess Pride Creations. Each of the suppliers had also been sued
by Janel Russell Designs in separate lawsuits. Pursuant to language in certain
Vendor Trading Agreements the Company entered into with each supplier, the
Company tendered the defense of the cases to Samuel Aaron and Princess Pride and
demanded indemnification. Both vendors agreed to defend and indemnify the
Company. The Company filed its answer on March 3, 2004.
On or about August 2, 2004, the lawsuit filed by Janel Russell Designs
was settled and dismissed with prejudice. The Company was not required to make
any payments in connection with the settlement.
The Company is also involved from time to time in certain other legal
actions and regulatory investigations arising in the ordinary course of
business. Although there can be no certainty, it is the opinion of management
that none of these other actions or investigations will have a material adverse
effect on the Company's results of operations or financial condition.
Item 4. Submission of Matters to a Vote of Security Holders
(a) The Company held its annual meeting of stockholders on June 24, 2004.
(b) No answer required.
(c) Proposal 1 involved the election of one director to serve until
the 2007 annual meeting of stockholders. The director and the
voting results were as follows:
---------------------------------------------------------------
NOMINEE FOR AUTHORITY WITHHELD
---------------------------------------------------------------
Sanford Shkolnik 11,725,968 1,118,127
---------------------------------------------------------------
There were no votes cast against any nominee, and there were no broker
non-votes with respect to any nominee.
Proposal 2 involved the ratification of the selection of
PricewaterhouseCoopers LLP as the Company's independent auditors for
the fiscal year ending January 31, 2005:
---------------------------------------------------------------
FOR AGAINST ABSTAIN
---------------------------------------------------------------
12,721,972 74,824 47,299
---------------------------------------------------------------
(d) Not applicable.
35
Item 5. Forward Looking Statements
This report contains certain forward-looking statements (as such term
is defined in Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934) and information relating to the Company that
are based on the current beliefs of management of the Company as well as
assumptions made by and information currently available to management including
statements related to the markets for our products, general trends and trends in
our operations or financial results, plans, expectations, estimates and beliefs.
In addition, when used in this report, the words "anticipate," "believe,"
"estimate," "expect," "intend," "plan," "predict" and similar expressions and
their variants, as they relate to the Company or our management, may identify
forward-looking statements. Such statements reflect our judgment as of the date
of this report with respect to future events, the outcome of which is subject to
certain risks, including the factors described below, which may have a
significant impact on our business, operating results or financial condition.
Investors are cautioned that these forward-looking statements are inherently
uncertain. Should one or more of these risks or uncertainties materialize, or
should underlying assumptions prove incorrect, actual results or outcomes may
vary materially from those described herein. Whitehall Jewellers, Inc.
undertakes no obligation to update forward-looking statements. The following
factors, among others, may impact forward-looking statements contained in this
report: (1) a change in economic conditions or the financial markets which
negatively impacts the retail sales environment and reduces discretionary
spending on goods such as jewelry; (2) reduced levels of mall traffic caused by
economic or other factors; (3) our ability to execute our business strategy and
the related effects on comparable store sales and other results; (4) the extent
and results of our store expansion strategy and associated occupancy costs, and
access to funds for new store openings; (5) the high degree of fourth quarter
seasonality of our business; (6) the extent and success of our marketing and
promotional programs; (7) personnel costs and the extent to which we are able to
retain and attract key personnel; (8) the effects of competition; (9) the
availability and cost of consumer credit; (10) relationships with suppliers
including the timely delivery to the Company of appropriate merchandise on
payment terms consistent with past practice; (11) our ability to maintain
adequate information systems capacity and infrastructure; (12) our leverage,
liquidity, and cost of funds and changes in interest rates that may increase
such costs; (13) our ability to maintain adequate loss prevention measures; (14)
fluctuations in raw material prices, including diamond, gem and gold prices;
(15) the impact of current or future price reductions taken on certain
merchandise inventory identified from time to time as items which would not be
part of the Company's future merchandise presentation; (16) developments
relating to the consolidated Capital Factors actions and the related SEC and
U.S. Attorney's office investigations, and shareholder and other civil
litigation, including the impact of such developments on our results of
operations and financial condition and relationship with our lenders or with our
vendors; (17) regulation affecting the industry generally, including regulation
of marketing practices; and (18) the risk factors identified from time to time
in our filings with the SEC.
36
Item 6. - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit Number Description
-------------- -----------
31.1 Certification of the Chief Executive Officer pursuant
to Rule 13a-14(a) of the Securities Exchange Act of
1934
31.2 Certification of the Chief Financial Officer pursuant
to Rule 13a-14(a) of the Securities Exchange Act of
1934
32.1 Certification of Chief Executive Officer pursuant to
18 United States Code Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
32.2 Certification of Chief Financial Officer pursuant to
18 United States Code Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
(b) Reports on Form 8-K
On May 6, 2004, the Company filed a Current Report on Form 8-K
with the SEC, to furnish a press release announcing sales for the first
quarter ended April 30, 2004.
On May 27, 2004, the Company filed a Current Report on Form
8-K with the SEC, to furnish a press release regarding financial
results for the first quarter ended April 30, 2004.
On June 2, 2004, the Company filed a Current Report on Form
8-K with the SEC, to file a press release announcing that it has named
Debbie Nicodemus-Volker as Executive Vice President of Merchandise.
On June 24, 2004, the Company filed a Current Report on Form
8-K with the SEC, to furnish a slide presentation that was used at the
Company's annual stockholder's meeting.
On June 25, 2004, the Company filed a Current Report on Form
8-K with the SEC, to disclose that a purported shareholder derivative
lawsuit has been filed against the members of the Company's Board of
Directors and certain Executive Officers of the Company.
37
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.
WHITEHALL JEWELLERS, INC.
(Registrant)
Date: September 10, 2004 By: /s/John R. Desjardins
------------------------------------
John R. Desjardins
Executive Vice President -
Chief Financial Officer and Treasurer
(duly authorized officer and
principal financial officer)
38