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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: October 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 November 30, 2004 was 13,944,820 and the number of
shares of the Registrant's Class B common stock, $1.00 par value per share,
outstanding as of November 30, 2004 was 142.
WHITEHALL JEWELLERS, INC.
INDEX TO FORM 10-Q
FOR THE QUARTER ENDED OCTOBER 31, 2004
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Statements of Operations for the three months and nine months ended
October 31, 2004 and 2003 (unaudited)
Balance Sheets - October 31, 2004, January 31, 2004 and October 31,
2003 (unaudited)
Statements of Cash Flows for the nine months ended October 31, 2004
and 2003(unaudited)
Notes to Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Item 5. Other Information
Item 6. Exhibits
2
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Whitehall Jewellers, Inc.
Statements of Operations
for the three months and nine months ended October 31, 2004 and 2003
(unaudited, in thousands, except for per share data)
Three months ended Nine months ended
October 31, October 31, October 31, October 31,
2004 2003 2004 2003
----------- ----------- ----------- -----------
Net sales $ 63,340 $ 66,179 $ 208,652 $ 208,060
Cost of sales (including buying
and occupancy expenses) 45,781 45,299 142,731 139,877
--------- --------- --------- ---------
Gross profit 17,559 20,880 65,921 68,183
Selling, general and
administrative expenses 26,724 29,143 80,754 81,787
Professional fees and other charges 1,428 1,398 5,725 2,747
--------- --------- --------- ---------
Loss from operations (10,593) (9,661) (20,558) (16,351)
Interest expense 1,240 869 3,240 3,341
--------- --------- --------- ---------
Loss before income taxes (11,833) (10,530) (23,798) (19,692)
Income tax benefit (3,525) (3,122) (8,610) (6,694)
--------- --------- --------- ---------
Net loss $ (8,308) $ (7,408) $ (15,188) $ (12,998)
========= ========= ========= =========
Basic earnings per share:
Net loss $ (0.60) $ (0.53) $ (1.09) $ (0.92)
========= ========= ========= =========
Weighted average common share and common share
equivalents 13,948 14,051 13,941 14,156
========= ========= ========= =========
Diluted earnings per share:
Net loss $ (0.60) $ (0.53) $ (1.09) $ (0.92)
========= ========= ========= =========
Weighted average common share and common share
equivalents 13,948 14,051 13,941 14,156
========= ========= ========= =========
The accompanying notes are an integral part of the financial statements.
3
Whitehall Jewellers, Inc.
Balance Sheets
as of October 31, 2004, January 31, 2004 and October 31, 2003
(unaudited, in thousands except for share data)
October 31, January 31, October 31,
2004 2004 2003
----------- ----------- -----------
ASSETS
Current Assets:
Cash $ 1,296 $ 1,901 $ 1,251
Accounts receivable, net 2,006 2,544 497
Merchandise inventories 201,558 206,146 229,393
Other current assets 1,311 875 1,558
Current income tax benefit 10,955 2,294 7,122
Deferred financing costs 301 261 261
Deferred income taxes, net 2,764 5,712 2,577
--------- --------- ---------
Total current assets 220,191 219,733 242,659
Property and equipment, net 55,355 60,948 62,002
Goodwill, net 5,662 5,662 5,662
Deferred financing costs 528 654 683
--------- --------- ---------
Total assets $ 281,736 $ 286,997 $ 311,006
========= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Revolver loan $ 101,928 $ 80,340 $ 107,104
Current portion of long-term debt --- 640 640
Accounts payable 57,341 60,538 71,169
Customer deposits 3,232 3,601 4,771
Accrued payroll 4,134 4,457 4,778
Other accrued expenses 18,063 24,479 14,236
--------- --------- ---------
Total current liabilities 184,698 174,055 202,698
Deferred income taxes, net 2,685 3,639 3,442
Other long-term liabilities 3,616 3,535 3,446
--------- --------- ---------
Total liabilities 190,999 181,229 209,586
--------- --------- ---------
Commitments and contingencies
Stockholders' equity:
Common stock 18 18 18
Class B common stock --- --- ---
Additional paid-in capital 106,207 106,091 106,041
Retained earnings 24,123 39,311 35,027
Treasury stock, at cost (4,114,112, 4,134,143 and 4,135,626
shares, respectively) (39,611) (39,652) (39,666)
--------- --------- ---------
Total stockholders' equity, net 90,737 105,768 101,420
--------- --------- ---------
Total liabilities and stockholders' equity $ 281,736 $ 286,997 $ 311,006
========= ========= =========
The accompanying notes are an integral part of the financial statements.
4
Whitehall Jewellers, Inc.
Statements of Cash Flows
for the nine months ended October 31, 2004 and 2003
(unaudited, in thousands)
Nine months ended
------------------------
October 31, October 31,
2004 2003
----------- -----------
Cash flows from operating activities:
Net loss $ (15,188) $ (12,998)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities:
Depreciation and amortization 9,267 8,981
Deferred compensation 104 ---
Loss on disposition of assets 314 549
Write-off of deferred loan cost --- 516
Changes in assets and liabilities:
Decrease in accounts receivable, net 538 1,124
Decrease (increase) in merchandise inventories 4,588 (32,699)
(Increase) in other current assets (436) (88)
(Increase) in current income tax benefit (8,661) (7,122)
Increase (decrease) in deferred income taxes 1,994 (115)
(Decrease) increase in customer deposits (369) 1,317
(Decrease) increase in accounts payable (2,824) 42,784
(Decrease) in income taxes payable --- (3,303)
(Decrease) increase in accrued payroll (323) 1,496
(Decrease) increase in accrued liabilities (6,416) 2,856
Increase in other long-term liabilities 81 308
--------- ---------
Net cash (used in) provided by operating activities (17,331) 3,606
Cash flows from investing activities:
Capital expenditures (3,770) (9,492)
--------- ---------
Net cash used in investing activities (3,770) (9,492)
Cash flows from financing activities:
Borrowing on revolver loan 769,521 689,317
Repayment of revolver loan (747,933) (676,703)
Repayment of term loan --- (4,500)
Repayment of subordinated debt (640) ---
Purchase of treasury stock --- (3,832)
Proceeds from exercise of stock options 12 259
Proceeds under employee stock purchase plan 41 63
Financing costs (132) (1,117)
(Decrease) increase in outstanding checks, net (373) 1,602
--------- ---------
Net cash provided by financing activities 20,496 5,089
--------- ---------
Net change in cash and cash equivalents (605) (797)
Cash and cash equivalents at beginning of period 1,901 2,048
--------- ---------
Cash and cash equivalents at end of period $ 1,296 $ 1,251
========= =========
The accompanying notes are an integral part of the financial statements.
5
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
October 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
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 ("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 inventory cost unless evidence
exists supporting an alternative classification. The Company has recorded such
merchandise vendor allowances as a reduction of inventory cost.
6
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
$1,473,000 and $1,814,000 of vendor allowances for advertising for the first
nine 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 $3.3 million at October 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 the Company'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 $4.7 million for both the first nine months of fiscal
years 2004 and 2003.
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 typically
generates all or a significant majority of its income in the fourth quarter. In
accordance with the guidance in FASB Interpretation No. 18 ("FIN 18"), the
Company's current estimate of the income tax benefit associated with the
cumulative year to date fiscal 2004 loss results in an effective income tax rate
of 36.2%. Based on the current facts and circumstances, the provisions of FIN 18
effectively limit the amount of income tax benefit that can be recorded in the
interim period. The effective tax rate of 29.8% for the three months ended
October 31, 2004 is the result of reducing the cumulative year to date effective
rate from 42.5% used in the first six months to 36.2% in the third quarter. To
the extent that income in the fourth quarter is significantly more or less than
expected, the Company's effective income tax
7
rate for the fourth quarter and the full year could vary significantly from that
of the first nine 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 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 nine months ended October 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 Nine months ended
October 31, October 31, October 31, October 31,
2004 2003 2004 2003
---------- ----------- ----------- -----------
(in thousands, except for per share amounts)
---------------------------------------------------
Net loss, as reported $ (8,308) $ (7,408) $ (15,188) $ (12,998)
Deduct: Total stock-based employee
compensation expense determined under fair
value based method, net of related tax 164 322 486 910
effects
---------- ---------- ---------- ----------
Pro forma net loss $ (8,472) $ (7,730) $ (15,674) $ (13,908)
========== ========== ========== ==========
Earnings per share:
Basic-as reported $ (0.60) $ (0.53) $ (1.09) $ (0.92)
========== ========== ========== ----------
Basic-pro forma $ (0.61) $ (0.55) $ (1.12) $ (0.98)
========== ========== ========== ==========
Diluted-as reported $ (0.60) $ (0.53) $ (1.09) $ (0.92)
========== ========== ========== ==========
Diluted-pro forma $ (0.61) $ (0.55) $ (1.12) $ (0.98)
========== ========== ========== ==========
8
For purposes of pro forma net income and earnings per share calculation in
accordance with SFAS 123, the fair value of each option granted during the three
months ended October 31, 2003 and nine months ended October 31, 2004 and 2003 is
estimated using the Black-Scholes option-pricing model. The Company did not
grant options during the three months ended October 31, 2004. The assumptions
used are as follows:
For the three
months ended For the nine months ended
October 31, October 31, October 31,
2003 2004 2003
------------- ----------- ------------
Risk-free interest rate 3.6% 3.3% 3.1%
Dividend yield 0 0 0
Option life 5.5 years 5.5 years 5.5 years
Volatility 59% 56% 60%
Accounting for Guarantees
In November 2002, the 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 financials
statements for the 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 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 October 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 October 31, 2004, January 31, 2004 and October 31, 2003, accounts
receivable consisted of (in thousands):
October 31, January 31, October 31,
2004 2004 2003
----------- ----------- -----------
Accounts receivable $ 2,311 $ 3,082 $ 1,006
Less: allowance for doubtful accounts
(305) (538) (509)
-------- -------- --------
Accounts receivable, net $ 2,006 $ 2,544 $ 497
======== ======== ========
9
4. MERCHANDISE INVENTORIES
As of October 31, 2004, January 31, 2004 and October 31, 2003, merchandise
inventories consisted of (in thousands):
October 31, January 31, October 31,
2004 2004 2003
----------- ----------- -----------
Raw materials $ 11,586 $ 9,827 $ 9,070
Finished goods 189,972 196,319 220,323
--------- --------- ---------
Merchandise inventories $ 201,558 $ 206,146 $ 229,393
========= ========= =========
Raw materials primarily consist of diamonds, precious gems, semi-precious
gems and gold. Included within finished goods inventory are allowances for
inventory shrink, scrap and miscellaneous costs of $4,292,000, $3,731,000, and
$3,457,000 as of October 31, 2004, January 31, 2004 and October 31, 2003,
respectively. Also included within finished goods inventory is $1,210,000 of
certain consigned inventory in the Company's possession for which a liability
has been recorded in the financial statements as part of the Capital Factors
settlement discussed in Note 8. As of October 31, 2004, January 31, 2004 and
October 31, 2003, consignment inventories held by the Company that were not
included in the balance sheets totaled $81,732,000, $91,635,000, and
$90,765,000, respectively.
Certain merchandise procurement, distribution and warehousing costs are
allocated to inventory. As of October 31, 2004, January 31, 2004 and October 31,
2003, the amounts included in inventory were $3,692,000, $3,500,000 and
$3,831,000, respectively.
5. ACCOUNTS PAYABLE
Accounts payable includes outstanding checks, which were $3,793,000,
$4,166,000 and $8,114,000 as of October 31, 2004, January 31, 2004 and October
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 October 31, 2004, the calculated revolver availability, pursuant to the
Credit Agreement, was $122.1 million. The Company had $101.9 million of
outstanding borrowings under the revolving loan facility as of October 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
10
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 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 to the financial
statements included in the Company's Quarterly Report on Form 10-Q for the
fiscal quarter ended July 31, 2004, had not resulted in a breach of the Credit
Agreement. In addition, the lenders agreed that none of these matters would give
rise to a default or event of default under the Credit Agreement so long as the
resolution of such matters met certain conditions.
On September 28, 2004, the Company announced that it entered into a
non-prosecution agreement with the United States Attorney's Office for the
Eastern District of New York and that it reached a settlement of the
consolidated Capital Factors actions. See Note 8 to the financial statements.
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 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 currently exist or may arise with respect to
the settlement of the consolidated Capital Factors actions, the non-prosecution
agreement entered into with the United States Attorney's Office, and the
investigation by the SEC. The Company intends to contest vigorously the putative
class action complaints and the shareholder derivative complaint described in
Note 8 to the financial statements 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, it is not possible to evaluate the
likelihood of an unfavorable outcome in any of these matters, or to estimate the
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.
The Company was in compliance with the financial covenants of the Credit
Agreement as of October 31, 2004. However, the Company's business is highly
seasonal, and historically, income generated in the fourth fiscal quarter ending
each January 31 represents all or a significant majority of the income generated
during the fiscal year. 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
11
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 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.
12
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
at October 31, 2004 and 2003.
Three months ended Nine Months Ended
October 31, October 31, October 31, October 31,
2004 2003 2004 2003
----------- ----------- ----------- ---------
(in thousands)
Net loss $ (8,308) $ (7,408) $(15,188) $(12,998)
Weighted average shares for basic EPS 13,948 14,051 13,941 14,156
Incremental shares upon conversions:
Stock options --- --- --- ---
Weighted average shares for diluted EPS 13,948 14,051 13,941 14,156
Stock options excluded from the calculation of
diluted earnings per share due to
their antidilutive effect on the calculations 2,739 2,951 2,745 2,960
8. COMMITMENTS AND CONTINGENCIES
The United States Attorney for the Eastern District of New York conducted
a criminal investigation regarding matters that include those alleged in the
consolidated Capital Factors actions as described in Note 8 to the financial
statements included in the Company's Quarterly Report on Form 10-Q for the
fiscal quarter ended July 31, 2004.
On September 28, 2004, the Company announced that it entered into a
non-prosecution agreement with the United States Attorney's Office for the
Eastern District of New York and that it reached a settlement of the
consolidated Capital Factors actions.
Under the non-prosecution agreement with the United States Attorney, the
Company committed to pay restitution to Capital Factors, Inc. ("Capital
Factors") in the amount of $10.8 million, and to pay $350,000 to the United
States. In addition, as it has in the past, the Company will continue to
cooperate with the United States Attorney's Office in connection with its
investigation as requested, and has committed to maintain the corporate
compliance program and other policy changes that the Company has implemented. So
long as the Company fulfills its obligations under the non-prosecution
agreement, the United States Attorney's Office has agreed not to prosecute the
Company for any matters relating to Cosmopolitan Gem Corp.'s and Colorcast's
scheme to defraud Capital Factors or any other party.
13
The settlement agreement with Capital Factors and the separate settlement
agreement with International Diamonds, L.L.C. ("International") and Astra
Diamonds Manufacturers, Ltd. ("Astra") together provide for, among other things,
full releases of the Company by Capital Factors, International and Astra for
matters arising out of the consolidated Capital Factors actions in consideration
of payments to Capital Factors of $10.8 million ($8.2 million of which was paid
upon entry into the settlement agreement with Capital Factors and the remaining
portion of which is payable by December 23, 2004) and to International and Astra
an aggregate amount of $1.93 million (all of which was paid upon entry into the
settlement agreement with International and Astra). Upon full payment of these
amounts, Capital Factors, International and Astra have each agreed to dismiss
all of their respective claims against the Company in the consolidated Capital
Factors actions. The claims asserted against the Company by International and
Astra have been dismissed with prejudice, as the $1.93 million due under the
settlement agreement has been paid in full. On December 1, 2004, the Company
prepaid the final amount due to Capital Factors under the settlement agreement.
As the Company has fully satisfied its payment obligations to Capital Factors
under the terms of the settlement, the parties have filed stipulations to
dismiss the claims asserted against the Company by Capital Factors with
prejudice.
In addition, as part of the settlements, Capital Factors and International
and Astra have each agreed that they will release the Company from any claims
related to certain consignment goods and proceeds, which were originally
supplied to the Company by Ultimo, Inc., once such goods and proceeds have been
paid into court or placed in escrow.
Also as previously disclosed in September 2003, the SEC initiated a formal
inquiry of the Company with respect to matters that were the subject of the
consolidated Capital Factors actions. The Company has fully cooperated 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. In earlier periods, the Company
recorded litigation accruals totaling $9.2 million relating to the consolidated
Capital Factors actions and the United States Attorney and SEC investigations.
In connection with the final settlement of the Capital Factors and United States
Attorney's Office matters, the Company has recorded an additional accrual of
$117,000 before income taxes for the quarter ended October 31, 2004. Including
previously recorded payables and accruals and the Company's acquisition of
certain consignment inventory as a part of the Capital Factors settlement, the
litigation accrual as of October 31, 2004 covers all payments to be made to
Capital Factors.
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 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
14
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,
Whitehall filed a motion to dismiss the consolidated amended complaint, and
briefing on the motion is complete. No ruling on the motion to dismiss has yet
been received.
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
15
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,
it is not possible to evaluate the likelihood of an unfavorable outcome in any
of these matters, or to estimate the 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.
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.
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
16
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 operated a program under which executive officers and
directors, and parties introduced to the Company by its executive officers and
directors, were permitted to purchase most Company merchandise at approximately
ten percent above the Company's cost. No such purchases were made under this
program during fiscal 2004 as compared to $150,000 of such purchases in the
first nine months of fiscal 2003. This program was discontinued during the third
quarter of fiscal year 2004. Executive officers and directors, and parties
introduced to the Company by its executive officers and directors are now
permitted to purchase Company merchandise at the same level of discount that is
offered to the Company's support office employees, field supervisors and store
managers, which is less favorable in comparison to the discount that was offered
under the discontinued program.
17
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 October 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 quarter 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 quarter of fiscal
year 2003. However, for the first nine months of fiscal year 2004, the sales
increase experienced in the first quarter of fiscal year 2004 was almost
entirely offset by a decline in sales during the second and third quarters of
fiscal year 2004 as compared to sales during the second and third quarters of
fiscal year 2003. The sales decrease experienced in the second and third
quarters of fiscal 2004 was primarily due to lower unit sales in comparison to
the prior year period. Overall, comparable store sales for the first nine months
of fiscal year 2004 decreased 0.3% in comparison to the prior year period.
The Company reported a net loss of $15.2 million for the first nine months
of fiscal 2004, as compared to a net loss of $13.0 million for first nine months
of fiscal 2003. The increase in the Company's net loss for the first nine 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. In earlier periods, the Company recorded litigation
accruals totaling $9.2 million relating to the consolidated Capital Factors
actions and the United States Attorney and SEC investigations. In connection
with the final settlement of the consolidated Capital Factors actions and the
United States Attorney investigation, the Company has recorded an additional
accrual of $117,000 before income taxes for the quarter ended October 31, 2004.
Including previously recorded payables and accruals and the Company's possession
of certain consignment inventory for which a liability has been recorded in the
financial statements as a part of the Capital Factors settlement, the litigation
accrual covers all payments being made to Capital Factors, International, Astra
and the United States.
On September 28, 2004, the Company announced that it entered into a
non-prosecution agreement with the United States Attorney's Office for the
Eastern District of New York and that it reached a settlement of the
consolidated Capital Factors actions.
18
Under the non-prosecution agreement with the United States Attorney, the
Company committed to pay restitution to Capital Factors, Inc. ("Capital
Factors") in the amount of $10.8 million, and to pay $350,000 to the United
States. In addition, as it has in the past, the Company will continue to
cooperate with the United States Attorney's Office investigation as requested,
and has committed to maintain the corporate compliance program and other policy
changes that the Company has implemented. So long as the Company fulfills its
obligations under the non-prosecution agreement, the United States Attorney's
Office has agreed not to prosecute the Company for any matters relating to
Cosmopolitan's and Colorcast's scheme to defraud Capital Factors or any other
party.
The settlement agreement with Capital Factors and the separate settlement
agreement with International Diamonds, L.L.C. ("International") and Astra
Diamonds Manufacturers, Ltd. ("Astra") together provide for, among other things,
full releases of the Company by Capital Factors, International, and Astra, for
matters arising out of the consolidated Capital Factors actions in consideration
of payments to Capital Factors of $10.8 million ($8.2 million of which was paid
upon entry into the settlement agreement with Capital Factors and the remaining
portion of which is payable by December 23, 2004) and to International and Astra
an aggregate amount of $1.93 million (all of which was paid upon entry into the
settlement agreement with International and Astra). Upon full payment of these
amounts, Capital Factors, International and Astra have each agreed to dismiss
all of their respective claims against the Company in the consolidated Capital
Factors actions. The claims asserted against the Company by International and
Astra have been dismissed with prejudice, as the $1.93 million due under the
settlement agreement has been paid in full. On December 1, 2004, the Company
prepaid the final amount due to Capital Factors under the settlement agreement.
As the Company has fully satisfied its payment obligations to Capital Factors
under the terms of the settlement, the parties have filed stipulations to
dismiss the claims asserted against the Company by Capital Factors with
prejudice.
In addition, as part of the settlements, Capital Factors and International
and Astra have each agreed that they will release the Company from any claims
related to certain consignment goods and proceeds, which were originally
supplied to the Company by Ultimo, Inc., once such goods and proceeds have been
paid into court or placed in escrow.
The Company's business is highly seasonal. Historically, income generated
in the fourth fiscal quarter ending each January 31 represents all 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 high degree of seasonality 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.
19
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 Nine months ended
---------------------------- ------------------------
October October October October
Percentage of net sales 31, 2004 31, 2003 31, 2004 31, 2003
- ----------------------- -------- -------- -------- --------
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales (including buying
and occupancy expenses) 72.3 68.4 68.4 67.2
----- ----- ----- -----
Gross profit 27.7 31.6 31.6 32.8
Selling, general and
administrative expenses 42.2 44.1 38.7 39.3
Professional fees and other
charges 2.2 2.1 2.8 1.4
----- ----- ----- -----
Loss from operations (16.7) (14.6) (9.9) (7.9)
Interest expense 2.0 1.3 1.5 1.6
----- ----- ----- -----
Loss before income taxes (18.7) (15.9) (11.4) (9.5)
Income tax benefit (5.6) (4.7) (4.1) (3.3)
----- ----- ----- -----
Net loss (13.1%) (11.2%) (7.3%) (6.2%)
----- ----- ----- -----
Results of Operations for the Three Months Ended October 31, 2004
NET SALES
Net sales for the third quarter of fiscal 2004 decreased $2.9 million, or
4.3%, to $63.3 million from $66.2 million in the third quarter of fiscal 2003.
Comparable store sales decreased $2.4 million, or 3.9%, in the third quarter of
fiscal 2004 from the third quarter of fiscal 2003. Additionally, there were
sales decreases of $1.1 million primarily related to closed stores and $0.1
million related to changes in sales returns and allowances. These decreases were
partially offset by sales from new stores of $0.8 million. The total number of
merchandise units sold decreased by approximately 10.5% in the third quarter of
fiscal 2004 from the third quarter of fiscal 2003 while the average price per
merchandise sale increased to $337 in the third quarter of fiscal 2004 from $319
in the third quarter of fiscal 2003. The increase in average price per
merchandise sale was primarily due to sales of certain merchandise on which
price reductions were taken which had an average price per merchandise sale of
$413 in the third quarter of fiscal 2004. Excluding such merchandise, the
average price per merchandise sale was $323 in the third quarter of fiscal 2004.
The comparable store sales decrease was primarily due to lower unit sales in
comparison to the prior year period. Credit sales as a percentage of net sales
increased to 47.5% in the third quarter of fiscal 2004 from 45.6% in the third
quarter of fiscal 2003. The Company operated 386 stores as of October 31, 2004,
compared to 384 as of October 31, 2003.
GROSS PROFIT
Gross profit for the third quarter of fiscal 2004 decreased $3.3 million,
or 15.9%, to $17.6 million from $20.9 million in the same period in fiscal 2003.
Gross profit as a percentage of net sales decreased to 27.7% in the third
quarter of fiscal 2004 from 31.6% in the third quarter of fiscal 2003.
Merchandise gross margins declined by approximately 290 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 the mix of watch and
diamond sales which carry a lower margin than certain other merchandise
categories. Store occupancy and buying expenses, which increased
20
while sales decreased, also contributed to the reduction in gross profit
percentage. Store occupancy costs increased primarily due to the operation of
two additional stores in comparison to the prior year and higher rates on leases
renewed since the year-ago period. The decline in gross profit percentage was
partially offset by somewhat lower in-store discounting, and price increases
which were implemented during March 2004 on certain items.
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 and third quarters 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, approximately $70.4 million
of its merchandise inventory at cost would not be part of its future merchandise
presentation. Price reductions were taken on these items which have and will
continue to result in lower than historical margins on such merchandise. Sales
of these items totaled approximately $13.2 million with an approximate
merchandise cost of $7.9 million during the third quarter of fiscal 2004. The
impact of these sales accounted for a margin decline of approximately 265 basis
points during the third quarter of fiscal year 2004. Based on currently
anticipated selling prices, the Company expects to achieve positive but lower
than historical merchandise margins on such merchandise, which may negatively
affect 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 in future periods, which will negatively impact
margins. The Company in future periods may possibly consider alternative methods
of disposition for this inventory. Such alternatives may potentially result in
additional valuation allowances.
EXPENSES
Selling, general and administrative expenses, excluding professional fees
and other charges, for the third quarter of fiscal 2004 decreased $2.4 million,
or 8.3%, to $26.7 million from $29.1 million in the third quarter of fiscal
2003. As a percentage of net sales, selling, general and administrative expenses
decreased to 42.2% in the third quarter of fiscal 2004 from 44.1% in the third
quarter of fiscal 2003. The decrease in selling, general and administrative
expenses was primarily related to lower other expense ($1.5 million), lower
personnel expense ($0.4 million), lower advertising expense ($0.4 million), and
lower credit expense ($0.1 million). The decrease in other expenses is primarily
due to lower accruals for insurance and lower accruals for state and local
taxes, based on revised estimates, than those recorded in the year earlier
period. The decrease in personnel expense is primarily attributable to lower
incentive compensation costs as compared to the year-ago period partially offset
by an increase in the number of support office positions, higher salary and wage
rates, and an increase in medical benefit costs.
Professional fees and other charges were approximately $1.4 million in
both the third quarter of fiscal years 2004 and 2003. As discussed in Note 8 to
the financial statements, in connection with the settlement of the Capital
Factors actions, the Company recorded an additional accrual of $117,000 for the
third quarter of fiscal 2004.
LOSS FROM OPERATIONS
As a result of the factors discussed above, loss from operations was $10.6
million in the third quarter of fiscal 2004 compared to a loss of $9.7 million
in the third quarter of fiscal 2003. As a percentage of net sales, loss from
operations was 16.7% in the third quarter of fiscal 2004 compared to 14.6% in
the third quarter of fiscal 2003.
21
INTEREST EXPENSE
Interest expense increased $0.3 million to $1.2 million in the third
quarter of fiscal 2004 from $0.9 million in the third quarter of fiscal 2003,
resulting primarily from higher average interest rates partially offset by
somewhat lower average borrowings.
INCOME TAX BENEFIT
Income tax benefit increased $0.4 million to $3.5 million in the third
quarter of 2004 from $3.1 million in the third quarter of 2003. In accordance
with the guidance in FASB Interpretation No. 18 ("FIN 18"), the Company's
current estimate of the income tax benefit associated with the cumulative year
to date fiscal 2004 loss results in an effective income tax rate of 36.2% for
fiscal 2004. Based on the current facts and circumstances, the provisions of FIN
18 effectively limit the amount of income tax benefit that can be recorded in
the interim period. The effective income tax rate of 29.8% for the three months
ended October 31, 2004 is the result of reducing the cumulative year to date
effective tax rate from 42.5% to 36.2% in the third quarter. To the extent that
income in the fourth quarter is significantly more or less than expected, the
Company's effective income tax rate for the fourth quarter of fiscal year 2004
could vary significantly from that of the first nine months of fiscal year 2004.
The Company's annual effective income tax rate was 35.8% for fiscal 2003.
Results of Operations for the Nine Months Ended October 31, 2004
NET SALES
Net sales for the nine months ended October 31, 2004 increased $0.6
million, or 0.3%, to $208.7 million from $208.1 million in the nine months ended
October 31, 2003. Comparable store sales decreased $0.6 million, or 0.3%, in the
first nine months of fiscal 2004 from the same period in fiscal 2003.
Additionally, there were sales decreases of $3.4 million primarily related to
closed stores. These decreases were offset by sales from new stores of $4.6
million. The total number of merchandise units sold decreased 4.0% in the first
nine months of fiscal 2004 from the first nine months of fiscal 2003 while the
average price per merchandise sale increased to $302 in fiscal 2004 from $292 in
fiscal 2003. The increase in average price per merchandise sale was primarily
due to sales of certain merchandise on which price reductions were taken which
had an average price per merchandise sale of $408 in the first nine months of
fiscal 2004. Excluding such merchandise, the average price per merchandise sales
was $294 in the first nine months of fiscal 2004. The comparable store sales
decrease was primarily due to lower unit sales in comparison to the first nine
months of fiscal year 2003. Credit sales as a percentage of net sales increased
slightly in the first nine months of fiscal 2004 compared to the first nine
months of fiscal 2003. The Company operated 386 stores as of October 31, 2004
compared to 384 stores as of October 31, 2003.
GROSS PROFIT
Gross profit for the first nine months of fiscal 2004 decreased $2.3
million, or 3.3%, to $65.9 million from $68.2 million compared to the same
period in fiscal 2003. Gross profit as a percentage of sales decreased to 31.6%
in the first nine months of fiscal year 2004 from 32.8% in the first nine months
of fiscal year 2003. Merchandise gross margins declined by approximately 60
basis points as a result of lower margins resulting from price reductions on
certain merchandise beginning mid-July 2004, an increase
22
in the mix of watch and diamond sales which carry a lower margin than certain
other merchandise categories, and an increase in the provision for certain
damaged inventory. These margin decreases were partially offset by somewhat
lower in-store discounting, and price increases which were implemented during
March 2004 on certain items.
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 and third quarters 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, $70.4 million of its
merchandise inventory at cost would not be part of its future merchandise
presentation. Price reductions were taken on these items which have and will
continue to result in lower than historical margins on such merchandise. Sales
of these items totaled approximately $18.4 million with an approximate
merchandise cost of $11.0 million since program inception in July 2004. The
impact of these sales accounted for a margin decline of approximately 110 basis
points during the first nine months of fiscal year 2004. Based on currently
anticipated selling prices, the Company expects to achieve positive, but lower
than historical merchandise margins on such merchandise, which may negatively
affect 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 in future periods, which will negatively impact
margins. The Company in future periods may possibly consider alternative methods
of disposition for this inventory. Such alternatives may potentially result in
additional valuation allowances.
EXPENSES
Selling, general and administrative expenses, excluding professional fees
and other charges, for the first nine months of fiscal 2004 decreased $1.0
million, or 1.3%, to $80.8 million from $81.8 million for the first nine months
of fiscal 2003. As a percentage of net sales, selling, general and
administrative expenses decreased to 38.7% in the first nine months of fiscal
2004 from 39.3% in the first nine months of fiscal 2003. The dollar decrease was
primarily related lower other expense ($1.5 million) and lower credit expense
($0.2 million), which were partially offset by higher personnel expense ($0.7
million). The decrease in other expenses is primarily due to lower accruals for
insurance and lower accruals for state and local taxes, based on revised
estimates, than those recorded in the year earlier period. The increase in
personnel expenses is primarily attributable to an increase in the number of
support office positions, 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 $5.7 million in the first nine months of fiscal 2004 from $2.7 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
$777,000 during the first nine months of fiscal 2004. The Company also 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 $20.6
million in the first nine months of fiscal 2004 compared to a loss of $16.4
million in the first nine months of fiscal 2003. As a percentage of net
23
sales, loss from operations was 9.9% in the first nine months of fiscal 2004 as
compared to 7.9% in the prior year period.
INTEREST EXPENSE
Interest expense decreased $0.1 million to $3.2 million in the first nine
months of fiscal 2004 from $3.3 million in the first nine months of fiscal 2003.
Lower average borrowings in the first nine months of fiscal 2004 were partially
offset by higher interest rates.
INCOME TAX BENEFIT
Income tax benefit increased $1.9 million to $8.6 million in the first
nine months of fiscal 2004 from $6.7 million in the first nine months of fiscal
2003. In accordance with the guidance in FASB FIN 18, the Company's current
estimate of the income tax benefit associated with the cumulative year to date
fiscal 2004 loss results in an effective tax rate of 36.2% for fiscal 2004.
Based on the current facts and circumstances, the provisions of FIN 18
effectively limit the amount of income tax benefit that can be recorded in the
interim period. To the extent that income in the fourth quarter is significantly
more or less than expected, the Company's effective income tax rate for the
fourth quarter of fiscal year 2004 could vary significantly from that of the
first nine months of fiscal 2004. The Company's annual effective income tax rate
was 35.8% for fiscal 2003.
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. As of October 31, 2004, the calculated
revolver availability, pursuant to the Credit Agreement, was $122.1 million. The
Company had $101.9 million of outstanding borrowings under the revolving loan
facility as of October 31, 2004.
The Company's inventory levels and working capital requirements have
historically been highest in advance of the Christmas season. Inventory levels
as of October 31, 2004 are lower than historical levels due in part to the sale
of certain merchandise that will no longer be part of the Company's future
merchandise presentation and timing of receipts for 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 October 31, 2004, the maximum availability, under the Credit Agreement, was
$122.1 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 by operating activities was $17.3 million in
the first nine months of 2004 compared to $3.6 million provided by operating
activities in the first nine months of fiscal 2003. For the first nine months of
fiscal year 2004, depreciation and amortization ($9.3 million) and decreases in
merchandise inventories ($4.6 million) and accounts receivable ($0.5 million)
and an increase in deferred income taxes ($2.0 million) were offset by a net
loss ($15.2 million) and decreases in accrued liabilities ($6.4 million),
accounts payable ($2.8 million) and an increase in the current income tax
benefit ($8.7 million). The decrease in merchandise inventories is due in part
to the sale of certain merchandise that will no longer be part of the Company's
future merchandise presentation partially
24
offset by timing of receipts for the Christmas season. The increase in the
current income tax benefit was primarily due to the tax benefit generated from
the Company's net loss for the nine months ended October 31, 2004. The decrease
in accrued expenses is due in part to the payments to Capital Factors and
International and Astra in connection with the settlement agreements discussed
in Note 8 to the financial statements.
The Company utilized cash in the first nine months of 2004 to fund capital
expenditures ($3.8 million) primarily related to the opening of 6 new stores as
well as store remodels in the first nine months of 2004, to repay the Company's
subordinated debt at maturity ($0.6 million), and to pay financing costs ($0.1
million) associated with the second amended and restated Credit Agreement. These
expenditures were primarily funded through increased revolver borrowings ($21.6
million) since January 31, 2004. Net cash used in investing activities for the
nine months ended October 31, 2004 decreased by $5.7 million as compared to the
nine months ended October 31, 2003 due to a decrease in the number of new store
openings and store remodels.
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 agreed that,
as of March 23, 2004, the consolidated Capital Factors actions, the SEC
investigation and the United States Attorney's investigation, each as described
in Note 8 to the financial statements included in the Company's Quarterly Report
on Form 10-Q for the fiscal quarter ended July 31, 2004, had not resulted in a
breach of the Credit Agreement. In addition, the lenders had agreed that none of
these matters would give rise to a default or event of default under the Credit
Agreement so long as the resolution of such matters met certain conditions.
On September 28, 2004, the Company announced that it entered into a
non-prosecution agreement with the United States Attorney's Office for the
Eastern District of New York and that it reached a settlement of the
consolidated Capital Factors actions. See Note 8 to the financial statements.
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 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 currently exist or may arise with respect to
the settlement of the consolidated Capital Factors actions, the non-prosecution
agreement entered into with the United States Attorney's Office, and the
investigation by 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.
25
Given that these class action cases and the shareholder derivative complaint are
in their early stages, it is not possible to evaluate the likelihood of an
unfavorable outcome in any of these matters or to estimate the 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.
The Company was in compliance with the financial covenants of the Credit
Agreement as of October 31, 2004. However, the Company's business is highly
seasonal, and historically, income generated in the fourth fiscal quarter ending
each January 31 represents all or a significant majority of the income generated
during the fiscal year. 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.
Contractual Obligations and Contingencies
The following summarizes the Company's contractual obligations at October
31, 2004:
PAYMENTS DUE BY PERIOD
----------------------
Less
than 1 - 3 4 - 5 More than
(in thousands) Total 1 year years years 5 years
- -------------- ----- ------ ----- ----- ---------
Revolver $101,928 $ --- $ 101,928 $ --- $ ---
Accrued interest 328 328 --- --- ---
Capital Factors
Settlement
obligation 2,660 2,660 --- --- ---
Operating leases 180,452 30,104 81,262 38,140 30,946
-------- --------- --------- ------- ---------
Total contractual
obligations $285,368 $ 33,092 $ 183,190 $38,140 $ 30,946
-------- --------- --------- ------- ---------
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, without penalty, at the option of the
Company. In addition, the Company is party to employment and severance
agreements, previously filed with the SEC, with certain executive officers.
Manny A. Brown, an Executive Vice President of the Company, tendered his
resignation effective December 17, 2004. Mr. Brown gave the Company notice that
he is terminating his employment for Good Reason as that term is defined in the
Employment and Severance Agreement dated as of March 17, 1997 (the "Employment
Agreement"). His notice states that Good Reason exists based upon his good faith
belief that (i) his reporting responsibilities have changed as a result of the
recently announced hiring by the Company of Lucinda M. Baier as its President
and Chief Operating Officer and (ii) that his duties have become materially
lower than those he carried out at the outset of his employment. Pursuant to the
terms of the Employment Agreement, in the case of a Good Faith termination the
Company would be required to make a payment of approximately $700,000 to Mr.
Brown within 30 days after the termination of his employment. In addition,
pursuant to the Employment Agreement, the Company is required to continue to
keep in force policies of medical, accident, and life insurance with respect to
Mr. Brown for a period of up to 18 months and to share the costs of such
continuation in the same proportion as such costs were previously shared for a
period of up to 18 months.
26
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 Company's Annual Report on Form 10-K
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 has historically
generated all or a significant majority of its income in the fourth quarter. The
Company's current estimate of the cumulative year to date fiscal 2004 effective
income tax rate is 36.2%. To the extent that income is significantly more or
less than expected in the fourth quarter of 2004, the Company's effective income
tax rate for the remainder of fiscal 2004 could vary significantly from that of
the first nine 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 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 made 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 vendor allowances to be
classified as a reduction to cost of sales unless evidence exists
27
supporting an alternative classification. 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
$1,473,000 and $1,814,000 of vendor allowances for advertising for the first
nine 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 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 operated a program under which executive officers and
directors, and parties introduced to the Company by its executive officers and
directors, were permitted to purchase most Company merchandise at approximately
ten percent above the Company's cost. No such purchases were
28
made under this program during fiscal 2004 as compared to $150,000 of such
purchases in the first nine months of fiscal 2003. This program was discontinued
during the third quarter of fiscal year 2004. Executive officers and directors,
and parties introduced to the Company by its executive officers and directors
are now permitted to purchase Company merchandise at the same level of discount
that is offered to the Company's support office employees, field supervisors and
store managers, which is less favorable in comparison to the discount that was
offered under the discontinued program.
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 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 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 October 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 discount rates
for its customer's credit program purchases. These discount rates are sensitive
to significant 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.
29
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 October 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 October 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 United States Attorney for the Eastern Division of New York conducted
a criminal investigation regarding the matters that include those alleged in the
consolidated Capital Factors actions as described in Note 8 to the financial
statements included in the Company's Quarterly Report on Form 10-Q for the
fiscal quarter ended July 31, 2004.
On September 28, 2004, the Company announced that it entered into a
non-prosecution agreement with the United States Attorney's Office for the
Eastern District of New York and that it reached a settlement of the
consolidated Capital Factors actions.
Under the non-prosecution agreement with the United States Attorney, the
Company committed to pay restitution to Capital Factors, Inc. ("Capital
Factors") in the amount of $10.8 million, and to pay $350,000 to the United
States. In addition, as it has in the past, the Company will continue to
cooperate with the United States Attorney's Office in connection with its
investigation as requested, and has committed to maintain the corporate
compliance program and other policy changes that the Company has implemented. So
long as the Company fulfills its obligations under the non-prosecution
agreement, the United States Attorney's Office has agreed not to prosecute the
Company for any matters relating to Cosmopolitan Gem Corp.'s and Colorcast's
scheme to defraud Capital Factors or any other party.
The settlement agreement with Capital Factors and the separate settlement
agreement with International Diamonds, L.L.C. ("International") and Astra
Diamonds Manufacturers, Ltd. ("Astra") together provide for, among other things,
full releases of the Company by Capital Factors, International, and Astra, for
matters arising out of the consolidated Capital Factors actions in consideration
of payments to Capital Factors of $10.8 million ($8.2 million of which was paid
upon entry into the settlement agreement with Capital Factors and the remaining
portion of which is payable by December 23, 2004) and to International and Astra
an aggregate amount of $1.93 million (all of which was paid upon entry into the
settlement agreement with International and Astra). Upon full payment of these
amounts, Capital Factors, International and Astra have each agreed to dismiss
all of their respective claims against the Company in the consolidated Capital
Factors actions. The claims asserted against the Company by International and
Astra have been dismissed with prejudice, as the $1.93 million due under the
settlement agreement has been paid in full. On December 1, 2004, the Company
prepaid the final amount due to Capital Factors under the settlement agreement.
As the Company has fully satisfied its payment obligations to Capital Factors
under the terms of the settlement, the parties have filed stipulations to
dismiss the claims against the Company by Capital Factors with prejudice.
In addition, as part of the settlements, Capital Factors and International
and Astra have each agreed that they will release the Company from any claims
related to certain consignment goods and proceeds, which were originally
supplied to the Company by Ultimo, Inc., once such goods and proceeds have been
paid into court or placed in escrow.
Also as previously disclosed in September 2003, the SEC initiated a formal
inquiry of the Company with respect to matters that were the subject of the
consolidated Capital Factors actions. The Company has cooperated 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
31
loss from a loss contingency should be accrued by assessing whether a loss is
deemed probable and can be reasonably estimated. In earlier periods, the Company
recorded litigation accruals totaling $9.2 million relating to consolidated
Capital Factors actions and the United States Attorney and SEC investigations.
In connection with the final settlement of the Capital Factors and United States
Attorney's Office matters, the Company has recorded an additional accrual of
$117,000 before income taxes for the quarter ended October 31, 2004. Including
previously recorded payables and accruals and the Company's possession of
certain consignment inventory which the Company took ownership on December 1,
2004 as a part of the Capital Factors settlement, the litigation accrual covers
all payments made or to be made to Capital Factors, International, Astra and the
United States.
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 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
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
32
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 complete. No ruling in the motion to dismiss has yet
been received.
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,
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.
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.
33
Item 5 - Other Information
Forward-Looking Statements
This release 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 release, 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 release 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 undertakes no
obligation to update forward-looking statements. The following factors, among
others, may impact forward-looking statements contained in this release: (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 and the impact on the Company's profitability and liquidity; (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 on margins and resultant valuation allowances taken on certain
merchandise inventory identified from time to time as items which would not be
part of the Company's future merchandise presentation as well as alternative
methods of disposition of this merchandise inventory and resultant valuations
taken; (16) developments relating to settlement of the consolidated Capital
Factors actions, the non-prosecution agreement entered into with the United
States Attorney's Office, the SEC investigation, 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.
34
Item 6 - Exhibits
Exhibit Number Description
- -------------- -----------
10.1 Non-Prosecution Agreement dated as of September 28, 2004.
Incorporated by reference to Exhibit 10.1 of the Company's
Current Report on Form 8-K filed in September 28, 2004.
10.2 Letter to the United States Attorney for the Eastern District
of New York dated September 28, 2004. Incorporated by reference
to Exhibit 10.2 of the Company's Current Report on Form 8-K
filed on September 28, 2004.
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
35
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: December 9, 2004 By: /s/ John R. Desjardins
----------------------
John R. Desjardins
Executive Vice President -
Chief Financial Officer and
Treasurer (duly authorized
officer and principal
financial officer)
36