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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 NOVEMBER 2, 2002,
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 1-12814
COLE NATIONAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 34-1453189
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
5915 LANDERBROOK DRIVE 44124
MAYFIELD HEIGHTS, OHIO (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(440) 449-4100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS 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
--- ---
AS OF MAY 12, 2003, 16,192,769 SHARES OF THE REGISTRANT'S COMMON STOCK WERE
OUTSTANDING.
EXPLANATORY NOTE
This Form 10-Q of Cole National Corporation (the "Company") includes
the effects of the restatement described in Note 8 to the accompanying
Consolidated Financial Statements. See Note 8 for a summary of the effects of
the restatement on previously issued financial statements for prior periods.
The Company makes its annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and any amendments to those reports
available, free of charge, through its website, http://www.colenational.com, as
soon as reasonably practicable after such material is electronically filed with,
or furnished to, the Securities and Exchange Commission.
COLE NATIONAL CORPORATION AND SUBSIDIARIES
FORM 10-Q
QUARTER ENDED NOVEMBER 2, 2002
INDEX
Page No.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of November 2, 2002 and February 2, 2002
(as restated)....................................................................................... 1
Consolidated Statements of Operations for the 13 and 39 week periods ended
November 2, 2002 and November 3, 2001 (as restated)................................................. 2
Consolidated Statements of Cash Flows for the 39 week periods ended
November 2, 2002 and November 3, 2001 (as restated)................................................. 3
Notes to Consolidated Financial Statements.......................................................... 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...............16
Item 3. Quantitative and Qualitative Disclosures about Market Risk..........................................27
Item 4. Controls and Procedures.............................................................................27
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................................. 29
Item 6. Exhibits and Reports on Form 8-K................................................................... 30
Signatures.................................................................................................. 31
Certifications.............................................................................................. 32
EXHIBIT INDEX............................................................................................... 34
PART I. - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
COLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Dollars in thousands)
November 2, February 2,
2002 2002
(As restated,
see Note 8)
----------- -----------
Assets
Current assets:
Cash and cash equivalents $ 21,327 $ 63,418
Accounts receivable, less allowances of
$2,559 and $3,228, respectively 48,707 41,365
Current portion of notes receivable 2,862 2,824
Inventories 135,651 119,203
Prepaid expenses and other 27,927 29,214
Deferred income taxes 27,623 27,252
--------- ---------
Total current assets 264,097 283,276
Property and equipment, at cost 321,363 305,419
Less - accumulated depreciation and amortization (198,271) (184,985)
--------- ---------
Total property and equipment, net 123,092 120,434
Notes receivable, excluding current portion, less allowances of
$3,784 and $5,209, respectively 25,958 20,193
Deferred income taxes 30,459 27,801
Other assets 54,375 52,201
Other intangibles, net 46,646 46,146
Goodwill, net 85,550 85,543
--------- ---------
Total assets $ 630,177 $ 635,594
========= =========
Liabilities and Stockholders' Equity
Current liabilities:
Current portion of long-term debt $ 227 $ 259
Accounts payable 66,412 65,124
Accrued interest 8,447 6,748
Accrued liabilities 86,247 92,577
Accrued income taxes 4,757 8,604
Deferred revenue 37,450 35,401
--------- ---------
Total current liabilities 203,540 208,713
Long-term debt, net of discount and current portion 286,254 284,574
Other long-term liabilities 24,224 22,942
Deferred revenue, long term 11,932 11,049
Stockholders' equity 104,227 108,316
--------- ---------
Total liabilities and stockholders' equity $ 630,177 $ 635,594
========= =========
The accompanying notes to consolidated financial statements are an integral
part of these consolidated financial statements.
1
COLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)
Thirteen Week Periods Ended Thirty-Nine Week Periods Ended
------------------------------- -------------------------------
November 3, November 3,
2001 2001
November 2, (As restated, November 2, (As restated,
2002 see Note 8) 2002 see Note 8)
------------- ------------- ------------- -------------
Net revenue $ 275,501 $ 263,349 $ 853,332 $ 810,457
Costs and expenses:
Cost of goods sold 91,948 87,394 278,697 262,600
Operating expenses 184,009 175,665 556,843 527,825
Goodwill and tradename amortization -- 1,252 -- 3,758
--------- --------- --------- ---------
Total costs and expenses 275,957 264,311 835,540 794,183
--------- --------- --------- ---------
Operating income (loss) (456) (962) 17,792 16,274
Interest and other (income) expense, net:
Interest expense 6,582 7,279 20,533 22,307
Interest and other (income), net (617) (1,218) (4,393) (3,556)
--------- --------- --------- ---------
Total interest and other (income) expense, net 5,965 6,061 16,140 18,751
--------- --------- --------- ---------
Income (loss) before income taxes (6,421) (7,023) 1,652 (2,477)
Income tax provision (benefit) (4,494) (13,178) 1,157 (4,648)
--------- --------- --------- ---------
Income (loss) before extraordinary loss (1,927) 6,155 495 2,171
Extraordinary loss on early extinguishment of debt,
net of $3.9 million tax benefit -- -- (7,242) --
--------- --------- --------- ---------
Net income (loss) (1,927) 6,155 (6,747) 2,171
========= ========= ========= =========
Basic earnings (loss) per common share:
Income (loss) before extraordinary loss $ (0.12) $ 0.38 $ 0.03 $ 0.14
Extraordinary loss -- -- (0.45) --
--------- --------- --------- ---------
Net income (loss) $ (0.12) $ 0.38 $ (0.42) $ 0.14
========= ========= ========= =========
Diluted earnings (loss) per common share:
Income (loss) before extraordinary loss $ (0.12) $ 0.38 $ 0.03 $ 0.13
Extraordinary loss -- -- (0.44) --
--------- --------- --------- ---------
Net income (loss) $ (0.12) $ 0.38 $ (0.41) $ 0.13
========= ========= ========= =========
Weighted average shares:
Basic 16,276 16,102 16,205 15,989
Diluted 16,276 16,402 16,512 16,089
The accompanying notes to consolidated financial statements are an integral
part of these consolidated financial statements.
2
COLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)
Thirty-Nine Week Periods Ended
-------------------------------
November 3,
2001
November 2, (As restated,
2002 see Note 8)
------------- -------------
Cash flows from operating activities:
Net income (loss) $ (6,747) $ 2,171
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 27,239 29,727
Extraordinary loss on early extinguishment of debt, net of tax 7,242 --
Noncash compensation 953 1,318
Noncash interest, foreign currency (gains) losses and other, net (2,409) 501
Gain on sale of building -- (683)
Increases (decreases) in cash resulting from changes in operating
assets and liabilities:
Accounts and notes receivable, prepaid expenses and other assets (5,483) 5,320
Inventories (16,385) (14,042)
Accounts payable, accrued liabilities and other liabilities 16,595 (12,608)
Accrued interest 1,699 869
Accrued and deferred income taxes (2,968) (5,093)
--------- ---------
Net cash provided by operating activities 19,736 7,480
--------- ---------
Cash flows from investing activities:
Purchases of property and equipment, net (33,273) (27,259)
Net proceeds from sale of fixed assets -- 4,712
Systems development costs (3,671) (5,826)
Investment and notes receivables in Pearle Europe, net -- (6,446)
Cash paid for note receivable from third party network provider (4,000) --
Acquisition of business, net of cash acquired (978) (100)
Other, net (336) (711)
--------- ---------
Net cash used for investing activities (42,258) (35,630)
--------- ---------
Cash flows from financing activities:
Repayment of long-term debt (158,262) (507)
Proceeds from issuance of long-term debt 150,000 --
Increase (decrease) overdraft balances (6,289) 12,579
Net proceeds from exercise of stock options and issuance of stock 1,191 1,187
Repayments (Issuance) of notes receivable - stock options and awards, net 46 (340)
Payment of deferred financing fees (6,208) --
Other, net (47) (94)
--------- ---------
Net cash (used for) provided by financing activities (19,569) 12,825
--------- ---------
Cash and cash equivalents:
Net decrease during the period (42,091) (15,325)
Balance, beginning of period 63,418 37,218
--------- ---------
Balance, end of period $ 21,327 $ 21,893
========= =========
The accompanying notes to consolidated financial statements are an integral
part of these consolidated financial statements.
3
COLE NATIONAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts of Cole
National Corporation ("the Parent"), its wholly owned subsidiary, Cole National
Group, Inc. and its wholly owned subsidiaries (collectively, referred to as "the
Company"). The Company's 21% investment in Pearle Europe B.V. is accounted for
using the cost method. All significant intercompany transactions have been
eliminated in consolidation.
The accompanying consolidated financial statements have been prepared
without audit and certain information and footnote disclosures normally included
in financial statements prepared in accordance with accounting principles
generally accepted in the United States have been condensed or omitted, although
management believes that the disclosures herein are adequate to make the
information not misleading. Results for interim periods are not necessarily
indicative of the results to be expected for the full year. When reading the
financial information in this quarterly report, reference should be made to the
consolidated financial statements and notes contained in the Company's most
recently filed Annual Report on Form 10-K filed concurrently with this quarterly
report.
Nature of Operations
The Company is a specialty service retailer operating in both host and
nonhost environments, whose primary lines of business are optical products and
services and personalized gifts. The Company sells its products through 2,509
company-owned retail locations and 447 franchised locations in 50 states, Canada
and the Caribbean. In connection with its optical business, the Company is a
managed vision care benefits provider and claims payment administrator whose
programs provide comprehensive eyecare benefits primarily marketed directly to
large employers, health maintenance organizations (HMO) and other organizations.
The Company has two reportable segments: Cole Vision and Things Remembered (see
Note 5).
Use of Estimates
The preparation of financial statements, in conformity with accounting
principles generally accepted in the United States, requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Significant estimates are required in determining the allowance for
uncollectible accounts, inventory reserves, depreciation, amortization and
recoverability of long-lived assets, deferred income taxes, remakes and returns
allowances, managed vision underwriting results, self-insurance reserves, and
retirement and post-employment benefits.
Reclassifications
Certain reclassifications have been made to prior year financial
statements and the notes to conform to the current year presentation.
Revenue Recognition and Deferred Revenue
Revenues include sales of goods and services, including delivery fees,
to retail customers at company-operated stores, sales of merchandise inventory
to franchisees and other outside customers, other revenues from franchisees such
as royalties based on sales and initial franchise fees, and capitation and other
fees associated with Cole Vision's managed vision care business.
4
Revenues from merchandise sales and services, net of estimated returns
and allowances, are recognized at the time of customer receipt or when the
related goods are shipped direct to the customer and all significant obligations
of the Company have been satisfied. The reserve for returns and allowances is
calculated as a percentage of sales based on historical return percentages.
Capitation revenues are accrued when due under related contracts at the agreed
upon per member, per month rates. Administrative service revenue is recognized
when services are provided over the contract period and the Company's customers
are obligated to pay. Additionally, the Company sells discount programs which
have twelve-month terms. Revenues from discount programs are deferred and
amortized over the twelve-month term.
Additionally, the Company sells separately priced extended warranty
contracts with terms of coverage of 12 and 24 months. Revenues from the sale of
these contracts are deferred and amortized over the lives of the contracts,
while the costs to service the warranty claims are expensed as incurred.
Incremental costs directly related to the sale of such contracts, such as sales
commissions and percentage rent, are deferred in prepaid expenses and charged to
expense in proportion to the revenue recognized.
Franchise revenues based on sales by franchisees are accrued as earned.
Initial franchise fees are recorded as revenue when all material services or
conditions relating to the sale of the franchises have been substantially
performed or satisfied by the Company and when the related store begins
operations.
Things Remembered sells memberships in its Rewards Club(TM) program,
which allows members to earn rebates based on their accumulated purchases. The
Company defers and amortizes the membership fee revenue over the life of the
membership. The rebates, which can only be used to offset the price of future
customer purchases, are recognized as a reduction of revenue based on the
rebates earned and the estimated future redemptions. The cumulative liability
for unredeemed rebates is adjusted over time based on actual experience and
trends with respect to redemption.
Managed Vision Underwriting Results
The Company sells capitated managed vision care plans which generally
have a duration of one year. Based upon its experience, the Company believes
that it can predict utilization and claims experience under these plans with a
high level of confidence. Underwriting results are recognized using an estimated
percentage of claims revenue. Each quarter, a portion of the resulting gain is
reserved for potential variances between predicted and actual results. These
reserves are reconciled following the end of each plan year.
Valuation of Inventories
Inventories are recorded at the lower of cost or market based on the
first-in, first-out (FIFO) method for the optical inventories and based on the
weighted average cost method for the gift inventories. The Company records a
valuation reserve for future inventory cost markdowns to be taken for inventory
not expected to be part of its ongoing merchandise offering. The reserve is
estimated based on historical information regarding sell through for similar
products. The Company records a reserve for estimated shrinkage based on various
factors including sales volume, historical shrink results and current trends.
Property and Equipment
Property and equipment are stated at cost. Repairs and maintenance
costs that extend the life of the asset are capitalized. Depreciation is
provided principally by using the straight-line method over the estimated useful
life of the related assets, generally 2 to 10 years for furniture, fixtures and
equipment, 2 to 25 years for leasehold improvements and 5 to 40 years for
buildings and improvements.
Derivatives and Hedging Activity
The interest rate swap agreements utilized by the Company are
designated as fair value hedges of the underlying fixed rate debt obligations
and are recorded at fair value as an increase in noncurrent assets or
liabilities and an increase or decrease in long-term debt. These interest rate
swaps qualify for the short-cut method for assessing hedge effectiveness under
the provisions of Statement of Financial Accounting Standard (SFAS) No.
5
133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133).
Changes in fair value of the interest rate swaps are offset by the changes in
fair value of the underlying debt.
Goodwill and Other Intangible Assets
Goodwill, noncompete agreements and tradename assets were amortized
over their estimated useful economic life using the straight-line method and are
carried at cost less accumulated amortization. Beginning with fiscal year 2002,
all goodwill and tradename amortization ceased in accordance with Statement of
Financial Accounting Standard (SFAS) No. 142, "Goodwill and Other Intangible
Assets" (SFAS 142), and both goodwill and tradename, are tested at least
annually for impairment. The Company adopted the first day of the fourth fiscal
quarter for the annual impairment review. Other intangible assets with finite
lives are amortized over their estimated useful lives based on management's
estimates of the period that the assets will generate revenue.
Cash Flows
Net cash flows from operating activities reflect cash payments for
income taxes and interest of $4,038,000 and $18,254,000, respectively, for the
39 week periods ended November 2, 2002 and $316,000 and $20,622,000,
respectively, for the 39 week periods ended November 3, 2001.
Earnings Per Common Share
Basic earnings per common share is computed by dividing net income
available to common shareholders by the weighted average number of common shares
outstanding for the periods presented. Diluted earnings per common share also
includes the dilutive effect of potential common shares (primarily dilutive
stock options) outstanding for the periods presented. The following represents a
reconciliation from basic earnings per common share to diluted earnings per
share:
Thirteen Week Periods Thirty-Nine Week Periods
------------------------- ------------------------
2002 2001 2002 2001
------ ------ ------ ------
(In thousands, except for per share data)
Determination of shares:
Average common shares outstanding 16,276 16,102 16,205 15,989
Assumed conversion of dilutive stock options and awards -- 300 307 100
------ ------ ------ ------
Diluted average common shares outstanding 16,276 16,402 16,512 16,089
====== ====== ====== ======
Basic earnings (loss) per common share
before extraordinary loss $(0.12) $ 0.38 $ 0.03 $ 0.14
Diluted earnings (loss) per common share
before extraordinary loss $(0.12) $ 0.38 $ 0.03 $ 0.13
Total Other Comprehensive Income (Loss)
Total other comprehensive income (loss) for the 13 and 39 week periods
ended November 2, 2002 and November 3, 2001 is as follows (000's omitted):
Thirteen Week Periods Thirty-Nine Week Periods
--------------------- ------------------------
2002 2001 2002 2001
---- ---- ---- ----
Net income (loss) $(1,927) $6,155 $(6,747) $2,171
Cumulative translation income (loss) 276 (254) 281 (424)
------- ------ ------- ------
Total other comprehensive income (loss) $(1,651) $5,901 $(6,466) $1,747
======= ====== ======= ======
6
(2) GOODWILL AND OTHER INTANGIBLE ASSETS
The Company adopted SFAS 142 in the first quarter of fiscal 2002. This
statement requires that goodwill and certain intangible assets deemed to have
indefinite lives will no longer be amortized, but instead, be subject to reviews
for impairment annually, or more frequently if certain indicators arise. With
the adoption of this statement, the Company ceased amortization of goodwill and
tradenames as of February 3, 2002.
The Company completed the transitional impairment testing of goodwill
and tradenames during the second quarter of fiscal 2002 as required by SFAS 142.
Based on the findings of its outside valuation advisor, the Company has
concluded that there was no impairment at the adoption date of the new
accounting standard, effective February 3, 2002. The Company has elected to
perform its annual tests for potential impairment as of the first day of the
Company's fourth fiscal quarter.
The following table provides the comparable effects of adopting SFAS
142 for the 13 and 39 week periods ended November 2, 2002 and November 3, 2001.
Thirteen Week Periods Thirty-Nine Week Periods
------------------------ ------------------------
2002 2001 2002 2001
--------- ------ ------- ------
(In thousands, except per share amounts)
Net income (loss):
Reported income (loss) $ (1,927) $6,155 $(6,747) $2,171
Goodwill amortization - Cole Vision -- 704 -- 2,118
Goodwill amortization - Things Remembered -- 238 -- 712
Tradename amortization - Cole Vision -- 310 -- 928
Related tax adjustment -- (170) -- (510)
--------- ------ ------- ------
Adjusted income (loss) $ (1,927) $7,237 $(6,747) $5,419
========= ====== ======= ======
Basic earnings (loss) per share:
Reported income (loss) $ (0.12) $ 0.38 $ (0.42) $ 0.14
Goodwill and tradename amortization,
net of tax -- 0.07 -- 0.20
--------- ------ ------- ------
Adjusted income (loss) $ (0.12) $ 0.45 $ (0.42) $ 0.34
========= ====== ======= ======
Diluted earnings per share:
Reported income $ (0.12) $ 0.38 $ (0.41) $ 0.13
Goodwill and tradename amortization,
net of tax -- 0.06 -- 0.21
--------- ------ ------- ------
Adjusted net income (loss) $ (0.12) $ 0.44 $ (0.41) $ 0.34
========= ====== ======= ======
Other intangible assets consist of (In thousands):
2002 2001
-------- --------
Tradename $ 49,460 $ 49,460
Noncompete agreements 840 840
Contracts 4,438 3,460
-------- --------
54,738 53,760
Accumulated amortization (8,092) (7,614)
-------- --------
Other intangibles, net $ 46,646 $ 46,146
======== ========
7
The net carrying amount of goodwill at November 2, 2002, by business
segment, was $64.2 million at Cole Vision and $21.4 million at Things
Remembered. The increases in the net carrying amount of $6,649 for goodwill was
due to foreign currency translation of goodwill at Cole Vision. The net carrying
amount of $46.6 million for other intangibles at November 2, 2002 was
attributable to the Cole Vision segment. Additional contingent payments related
to the 1999 acquisition of Met Life's managed vision care benefits business
increased the net carrying amount of other intangibles by $1.0 million, net of
related amortization of $0.5 million.
(3) LONG-TERM DEBT
On May 22, 2002, Cole National Group issued $150.0 million of 8-7/8%
Senior Subordinated Notes that mature on May 15, 2012. Interest on the notes is
payable semi-annually on each May 15 and November 15, commencing November 15,
2002.
Net proceeds from the 8-7/8% note offering, together with cash on hand,
were used to retire $150.0 million of 9-7/8% Senior Subordinated Notes due 2006
and pay premiums and other costs associated with retiring those notes. The
Company's results for fiscal 2002 included an extraordinary loss on early
extinguishment of debt of approximately $7.2 million, net of an income tax
benefit of approximately $3.9 million, representing the payment of premiums and
other costs of retiring the notes and the write-offs of unamortized discount and
deferred financing fees.
On August 22, 1997, Cole National Group issued $125.0 million
of 8-5/8% Senior Subordinated Notes that mature in 2007 with no earlier
scheduled redemption or sinking fund payments. Interest on the 8-5/8% notes is
payable semi-annually on February 15 and August 15.
The 8-5/8% notes and the 8-7/8% notes are general unsecured obligations
of Cole National Group, subordinated in right of payment to senior indebtedness
of Cole National Group and senior in right of payment to any current or future
subordinated indebtedness of Cole National Group.
The indentures pursuant to which the 8-5/8% notes and the 8-7/8% notes
were issued restrict dividend payments to the Company. The indentures also
contain certain optional and mandatory redemption features and other financial
covenants.
On April 23, 1999, the Company issued a $10.0 million promissory note
bearing interest at 5.0% per annum in recognition of a commitment to contribute
$10.0 million to a leading medical institution, supporting the development of a
premier eye care research and surgical facility. The note requires a $5.0
million principal payment to be made on April 23, 2004, and principal payments
in the amount of $1.0 million to be made on the anniversary date of the note
each successive year through 2009. Interest only is payable annually for the
first 5 years, and thereafter with each payment of principal.
The Company has no significant principal payment obligations under its
outstanding indebtedness until the $5.0 million principal payment due in 2004
under the 5.0% promissory note and until 2007, when the $125.0 million Senior
Subordinated debt is due.
During the third quarter of fiscal 2002, the Company entered into
interest rate swap agreements to take advantage of favorable market interest
rates. These agreements require the Company to pay an average floating interest
rate based on six-month LIBOR plus 4.5375% to a counter party while receiving a
fixed interest rate on a portion of the Company's $125.0 million 8-5/8% Senior
Subordinated Notes due 2007. The counter party is a major commercial bank. The
agreements mature August 15, 2007 and qualify as fair value hedges. The
aggregate notional amount of the interest rate swap agreements is $50.0 million.
At November 2, 2002, the floating rate of swaps was approximately 6.1% and the
fair value of the swap agreements was an unrealized gain of approximately $0.5
million. There was no impact to earnings in the first nine months due to hedge
ineffectiveness.
(4) CREDIT FACILITY
The operating subsidiaries of Cole National Group, Inc. have a working
capital commitment of $75.0 million that extends until May 31, 2006. Borrowings
under the credit facility presently bear interest based on
8
leverage ratios of Cole National Group at a rate equal to either (a) the
Eurodollar Rate plus 2.25% or (b) 1.25% plus the highest of (i) the CIBC prime
rate, (ii) the three-week moving average of the secondary market rates for
three-month certificates of deposit plus 1.0% or (iii) the federal funds rate
plus 0.5%. Cole National Group pays a commitment fee of between 0.50% and 0.75%
per annum on the total unused portion of the facility based on the percentage of
revolving credit commitments used. The Company and Cole National Group
guarantees this credit facility. The credit facility is secured by the assets of
the operating subsidiaries of Cole National Group, Inc.
The credit facility requires the principal operating subsidiaries of
Cole National Group to comply with various operating covenants that restrict
corporate activities, including covenants restricting the ability of the
subsidiaries to incur additional indebtedness, pay dividends, prepay
subordinated indebtedness, dispose of certain investments or make acquisitions.
The credit facility also requires the subsidiaries of Cole National Group to
comply with certain financial covenants, including covenants regarding interest
coverage and maximum leverage. On November 25, 2002 the Company received a
waiver, which expired on December 31, 2002 associated with the restatement of
the financial statements. On December 19, 2002 the credit agreement was amended
to accommodate the anticipated changes due to the restatement. The Company
received a waiver dated May 9, 2003 of the maximum leverage coverage test for
the fiscal year end 2002 and the first quarter of fiscal 2003. During the waiver
period the maximum leverage test was adjusted to accommodate the effect of the
restatement on the Company's financial statements. This waiver will expire on
the earlier of May 17, 2003 if the Lenders do not receive the Form 10-K and
10-Q's for the first through third fiscal quarters of 2002; on May 23, 2003 if
certain additional financial information is not received by the Lenders; or June
30, 2003. The Company is in compliance with the covenants in the credit
agreement and expects to meet the waiver conditions. The Company expects to
complete a permanent amendment to the credit agreement on or before June 30,
2003. However, there is no assurance that the Company will be successful in its
effort to complete such an amendment. The Company believes that even if it is
unsuccessful in its effort to complete such an amendment, it will have
sufficient liquidity from internal and other external sources.
The credit facility restricts dividend payments to Cole National Group
from its subsidiaries to amounts needed to pay interest on the 8-7/8% notes and
the 8-5/8% notes, and certain amounts related to taxes, along with up to 0.25%
of Cole National Group's consolidated net revenue annually for other direct
expenses of the Company or Cole National Group. The credit facility restricts
dividend payments to Cole National Group in an aggregate amount not to exceed
$50.0 million to allow for the repurchase of Senior Subordinated Notes.
No borrowings under the credit facility were outstanding as of November
2, 2002 and November 3, 2001. There were no borrowings during the third quarter
of fiscal 2002 and fiscal 2001.
(5) SEGMENT INFORMATION
Information on the Company's reportable segments is as follows (dollars
in thousands):
Thirteen Week Period Thirty-Nine Week Period
--------------------------- --------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Net revenue:
Cole Vision $ 221,778 $ 210,293 $ 672,827 $ 630,553
Things Remembered 53,723 53,056 180,505 179,904
--------- --------- --------- ---------
Consolidated net revenue $ 275,501 $ 263,349 $ 853,332 $ 810,457
========= ========= ========= =========
Operating income (loss):
Cole Vision $ 6,054 $ 2,346 $ 22,251 $ 15,319
Things Remembered (2,643) (811) 5,313 8,879
--------- --------- --------- ---------
Total segment operating income (loss) 3,411 1,535 27,564 24,198
Unallocated amount:
Corporate expenses 3,867 2,497 9,772 7,924
--------- --------- --------- ---------
Consolidated operating income (loss) (456) (962) 17,792 16,274
Interest and other (income) expense, net 5,965 6,061 16,140 18,751
--------- --------- --------- ---------
Income (loss) before income taxes $ (6,421) $ (7,023) $ 1,652 $ (2,477)
========= ========= ========= =========
9
(6) COMMITMENTS AND CONTINGENCIES
The Company leases a substantial portion of its computers, equipment
and facilities including laboratories, office and warehouse space, and retail
store locations. These leases generally have initial terms of up to 10 years and
often contain renewal or purchase options. Operating and capital lease
obligations are based upon contractual minimum rates and, in most leases
covering retail store locations, additional rents are payable based on store
sales. In addition, Cole Vision operates departments in various host stores
paying occupancy costs solely as a percentage of sales under agreements
containing short-term cancellation clauses. Generally, the Company is required
to pay taxes and normal expenses of operating the premises for laboratory,
office, warehouse and retail store leases; the host stores pay these expenses
for departments operated on a percentage-of-sales basis.
The Company guarantees future minimum lease payments for certain store
locations leased directly by franchisees. These guarantees totaled approximately
$13.7 million as of February 2, 2002 and November 2, 2002. Performance under a
guarantee by the Company is triggered by default of a franchisee in their base
commitment. Generally, these guarantees also extend to payments of taxes and
other normal expenses payable under these leases, the amounts of which are not
readily quantifiable.
Agreements between HAL, the Company and members of Pearle Europe
management require HAL and the Company to periodically offer to purchase Pearle
Europe shares held by the members of Pearle Europe Management. These offers are
required to be made (1) not later than September 3, 2003, (2) in May 2005, and
(3) biannually in May commencing in 2007. The obligations to fund the purchase
of any shares as to which the offer to purchase is accepted are pro rata to HAL
and to the Company based on their respective ownership interests on the date of
the offer. HAL and the Company have not yet agreed on the price to offer this
year or on the process to agree to the price or on the source of funding for
any purchases. Funds could be derived from payments by Pearle Europe, from the
separate resources of HAL and the Company, or from financings. In the event
that all of Pearle Europe's managers who are entitled to receive an offer to
purchase their shares were to accept that offer, the resulting obligation to
the Company could be material. The Company believes that it will have
sufficient liquidity to meet the obligation, if any, that may result from their
commitment in fiscal 2003.
(7) LEGAL PROCEEDINGS
The Company and its optical subsidiaries have been sued by the State of
California, which alleges claims for various statutory violations related to the
operation of 24 Pearle Vision Centers in California. The claims include untrue
or misleading advertising, illegal dilation fees, unlawful advertising of eye
exams, maintaining an optometrist on or near the premises of a registered
dispensing optician, unlawful advertising of an optometrist, unlicensed practice
of optometry, and illegal relationships between dispensing opticians, optical
retailers and optometrists. The action seeks unspecified damages, restitution
and injunctive relief. Although the State of California obtained a preliminary
injunction to enjoin certain advertising practices and from charging dilation
fees in July 2002, the terms of the injunction have not had and are not expected
to have any material effect on the Company's operations. In addition, both the
State and the Company have appealed the preliminary injunction. The injunction
is not expected to have a material effect on the Company's operations. Although
the Company believes it is in compliance with California law and intends to
continue to defend the issues raised in the case vigorously, it may be required
to further modify its activities or might be required to pay damages and or
restitution in currently undeterminable amount if it is not successful, the cost
of which, as well as continuing defense costs, might have a material adverse
effect on the Company's operating results and cash flow in one or more periods.
Things Remembered, Inc. is in the process of settling a class action
complaint in California alleging that the putative class (alleged to include 200
members) were improperly denied overtime compensation in violation of a
California law. The action sought unspecified damages, interest, restitution, as
well as declaratory and injunctive relief and attorneys' fees. On February 3,
2003, Things Remembered and the plaintiffs reached an agreement to resolve the
lawsuit for $562,500. The settlement is subject to court approval. A liability
of $562,500 was recorded in the fourth quarter of 2002.
Cole National Corporation is defending a purported class action lawsuit
alleging claims for various violations of federal securities laws related to the
Company's publicly reported revenues and earnings. The action, which proposes a
class period of March 23, 1999 through November 26, 2002 and names the Company
and certain present and former officers and directors as defendants, seeks
unspecified compensatory damages, punitive damages "where appropriate", costs,
expenses and attorneys fee. Following the Company's announcement in November
2002 of the restatement of the Company's financial statements (see Note 8 of
the Notes to Consolidated Financial Statements), the Securities and Exchange
Commission began an inquiry into the Company's previous accounting. The course
of this or further litigation or investigations arising out of the restatement
of the Company's financial statements cannot be predicted. In addition, under
certain circumstances the Company would be obliged to indemnify the individual
current and former directors and officers who are named as defendants in
litigation or who are or become involved in an investigation. The Company
believes it has insurance that should be available with respect to litigation
and any indemnification obligations. However, if the Company is unsuccessful in
defending against any such litigation, and if its insurance coverage is not
available or is insufficient to cover its expenses, indemnity obligations and
liability, if any, the litigation and/or investigation may have a material
adverse effect on the Company's financial condition, cash flow and results of
operations.
Cole National Group, Inc. has been named as a defendant along with
numerous other retailers, in patent infringement litigation challenging the
defendants' use of bar code technology. The Company believes it has available
defenses and does not expect any liability. However, if Cole National Group,
Inc. were to be found liable for an infringement, it might have a material
adverse effect on our operating results and cash flow in the period incurred.
In the ordinary course of business, the Company is involved in various
other legal proceedings. The Company is of the opinion that the ultimate
resolution of these matters will not have a material adverse effect on the
results of operations, liquidity or financial position of the Company.
10
In the ordinary course of business, the Company is involved in various
other legal proceedings. The Company is of the opinion that the ultimate
resolution of these matters will not have a material adverse effect on the
results of operations, liquidity or financial position of the Company.
(8) RESTATEMENT
Subsequent to the issuance of the Company's consolidated financial
statements for the second quarter of fiscal 2002, the Company determined it
needed to restate its previously issued financial statements for numerous items,
each of which was an "error" within the meaning of Accounting Principles Board
Opinion No. 20, "Accounting Changes". In addition to the restatement of its
annual financial statements, the Company has also restated its previously issued
quarterly financial statements for fiscal years 2002 and 2001.
Recognition of Revenues Earned on the Sale of Extended Warranty Contracts.
Customers purchasing eyeglasses from the Company's retail stores are offered the
option of buying a warranty for up to two years, paying in full for the warranty
at the time of sale. The Company historically recognized the revenue at the time
of the sale. The Company has made restatement adjustments to record the warranty
payment received at the time of the sale as deferred revenue and recognizes the
revenue on a straight-line basis over the warranty period.
Other Revenue Recognition Adjustments. Previously, the Company recognized
certain sales transactions as revenue when the customer placed the order and a
deposit was taken. Restatement adjustments were made to defer such revenue until
customer receipt or when the related goods were shipped direct to the customer
and all significant obligations of the Company were satisfied. In addition,
revenue adjustments have been made to establish adequate allowances for returns
and remakes. Historically, the Company had recorded returns and remakes based on
actual product returned during the period.
Valuation of Long-lived Assets. Historically, the Company did not consider
certain mature stores with negative cash flows in its asset impairment tests. In
addition, in testing for SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of", (SFAS 121) the
Company did not allocate goodwill to the respective stores. As part of the
restatement, the Company applied a methodology which includes all mature stores
in its asset impairment tests and includes an allocation of goodwill for years
prior to fiscal 2002. The restated financial statements also reflect the
recognition of losses on the disposal of fixed assets in the appropriate
periods. Additional adjustments were made to record depreciation expense for
certain depreciable fixed assets which were not previously being depreciated.
Also included is an adjustment to record capital lease assets and the
corresponding lease obligation for leases that had previously been accounted for
as operating leases.
Inventories and Cost of Goods Sold. The Company's restated financial statements
reflect adjustments relating to inventories and cost of goods sold primarily to
(i) recognize obsolescence reserves in appropriate periods and amounts, correct
calculation errors and recognize certain inventory costs in appropriate periods
and (ii) reflect certain vendor allowances previously recorded in operations but
not yet earned as a reduction in the inventory balances.
Accruals for Operating Expenses. Historically, the Company did not always record
changes in estimates in the period of change, and established accruals for
certain expenses that had not yet been incurred. The restated financial
statements reflect adjustments to recognize certain operating expenses in the
period in which they were incurred and to record the corresponding liability for
those items not paid at the end of the period. Such operating expenses primarily
consist of advertising, self-insurance, IBNR claims, retirement and post
employment benefits, vacation, allowance for uncollectible accounts and
miscellaneous operating expenses.
1998 Settlement from Former Owner of Pearle. The Company's 1998 financial
statements included the recognition of $6.0 million of income from a $13.0
million cash settlement with the former owner of Pearle. The terms of the
related agreement included the settlement of certain claims and indemnifications
associated with the purchase agreement. In addition, as part of the settlement,
the Company agreed to assume certain contingent liabilities from the former
owner. The restated financial statements reflect the treatment of this $6.0
million from the settlement as an adjustment to the purchase price of Pearle,
thereby reducing the goodwill that was established in connection with the Pearle
acquisition and associated amortization expense.
11
Investment in Pearle Europe. The Company owns a 21% equity interest in Pearle
Europe, B.V. ("Pearle Europe") which operates a retail optical business in
Europe. HAL Holding N.V. ("HAL"), a Dutch investment Company, owns 68% of Pearle
Europe and individual members of Pearle Europe's management own the remaining
11%. The Company has owned its interest in Pearle Europe and predecessor
companies since 1996. The Company has historically accounted for its investment
in Pearle Europe under the equity method, pursuant to which the Company's net
income has included its equity share in Pearle Europe's earnings. Under
Accounting Principles Board (APB) Opinion No. 18 "The Equity Method of
Accounting for Investments in Common Stock," use of the equity method is
appropriate when an investor has the ability to exercise significant influence
over the operating and financial policies of the investee. The Company has one
of five seats on Pearle Europe's Supervisory Board, and the Pearle Europe
management shareholders control one seat. HAL controls two seats, and appoints
the President of the Supervisory Board, with the consent of the Company. Between
1996 and June 2000, the contractual arrangements between the parties gave the
Company the ability to exercise significant influence over the operating and
financial policies of Pearle Europe. In Pearle Europe's early years, the Company
provided management advice and support. The contractual relationships between
the parties changed significantly in June 2000, so that the Company no longer
had the ability to exercise significant influence over the operating and
financial policies of Pearle Europe. The restated financial statements reflect a
change in the Company's method of accounting for its investment in Pearle Europe
from the equity method of accounting to the cost method of accounting beginning
with the third quarter of fiscal 2000. Under the cost method, the Company has
recorded its investment in the Pearle Europe shares at the carrying value as of
the end of second quarter fiscal 2000. Starting at the same time, the Company
included foreign currency gains and losses related to the Pearle Europe notes in
net income. The Company will recognize as income any dividends received from
Pearle Europe that are distributed from Pearle Europe's net accumulated
earnings.
Deferred Income Taxes and Income Tax Liabilities. The Company reviewed all of
its temporary differences and loss and tax credit carryforwards, and made
adjustments to its deferred tax assets and liabilities. Adjustments were made to
provide for state and local income tax deferred tax assets and liabilities,
which were previously not recorded. The Company evaluated the adequacy of the
tax liabilities established for the current and open tax years and adjusted the
amounts maintained in the tax liability accounts. Also included is the tax
effect of the restatement items.
Summary. This Form 10-Q for the quarterly period ended November 2, 2002 is being
filed at the completion of the restatement process, and at the same time as the
filing of the Company's Form 10-K for the fiscal year ended February 1, 2003.
The comparative financial information for the prior year set forth in the
financial statements of this Form 10-Q have been restated.
12
CONSOLIDATED BALANCE SHEET AS OF FEBRUARY 2, 2002
As
Previously
Reported Adjustments As Restated
---------- ----------- -----------
(Dollars in thousands)
ASSETS
Current assets:
Cash and cash equivalents $ 63,656 $ (238) $ 63,418
Accounts receivable, net of allowances 39,609 1,756 41,365
Current portion of notes receivable 2,926 (102) 2,824
Inventories 111,098 8,105 119,203
Refundable income taxes 502 (502) --
Prepaid expenses and other 22,757 6,457 29,214
Deferred income taxes 477 26,775 27,252
--------- --------- ---------
Total current assets 241,025 42,251 283,276
Property and equipment, at cost 297,649 7,770 305,419
Less - accumulated depreciation and amortization (174,300) (10,685) (184,985)
--------- --------- ---------
Total property and equipment, net 123,349 (2,915) 120,434
Notes receivable, excluding current portion, less allowances 19,056 1,137 20,193
Deferred income taxes 30,045 (2,244) 27,801
Other assets 44,175 8,026 52,201
Other intangibles, net 42,992 3,154 46,146
Goodwill, net 103,552 (18,009) 85,543
--------- --------- ---------
Total assets $ 604,194 $ 31,400 $ 635,594
========= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 85 $ 174 $ 259
Accounts payable 57,647 7,477 65,124
Accrued interest 6,539 209 6,748
Accrued liabilities and deferred revenues 79,722 12,855 92,577
Accrued income taxes 3,501 5,103 8,604
Deferred revenue -- 35,401 35,401
--------- --------- ---------
Total current liabilities 147,494 61,219 208,713
Long term debt, net of discount and current portion 284,318 256 284,574
Other long term liabilities 16,775 6,167 22,942
Deferred revenue, long-term -- 11,049 11,049
Stockholders' equity 155,607 (47,291) 108,316
--------- --------- ---------
Total liabilities and stockholders' equity $ 604,194 $ 31,400 $ 635,594
========= ========= =========
13
FOR THE QUARTER ENDED NOVEMBER 3, 2001
As Previously
Reported Adjustments As Restated
------------- ----------- ------------
(In thousands, except per share amounts)
Net revenue $ 261,488 $ 1,861 $ 263,349
Cost and expenses:
Cost of goods sold 86,906 488 87,394
Operating expenses 172,195 3,470 175,665
Goodwill and tradename amortization 1,435 (183) 1,252
--------- --------- ---------
Total costs and expenses 260,536 3,775 264,311
--------- --------- ---------
Operating income (loss) 952 (1,914) (962)
Interest and other (income) expense:
Interest expense 7,082 197 7,279
Interest and other (income) (1,113) (105) (1,218)
--------- --------- ---------
Total interest and other (income) expense, net 5,969 92 6,061
--------- --------- ---------
Income (loss) before income taxes (5,017) (2,006) (7,023)
Income tax provision (2,761) (10,417) (13,178)
--------- --------- ---------
Net income (loss) $ (2,256) $ 8,411 $ 6,155
========= ========= =========
Earnings (loss) per common share:
Basic $ (0.14) $ 0.52 $ 0.38
Diluted $ (0.14) $ 0.52 $ 0.38
14
FOR THE THIRTY-NINE WEEKS ENDED NOVEMBER 3, 2001
As Previously
Reported Adjustments As Restated
------------- ----------- ------------
(In thousands, except per share amounts)
Net revenue $ 805,127 $ 5,330 $ 810,457
Cost and expenses:
Cost of goods sold 264,706 (2,106) 262,600
Operating expenses 518,701 9,124 527,825
Goodwill and tradename amortization 4,333 (575) 3,758
--------- --------- ---------
Total costs and expenses 787,740 6,443 794,183
--------- --------- ---------
Operating income (loss) 17,387 (1,113) 16,274
Interest and other (income) expense:
Interest expense 21,150 1,157 22,307
Interest and other (income) (3,424) (132) (3,556)
--------- --------- ---------
Total interest and other (income) expense, net 17,726 1,025 18,751
--------- --------- ---------
Income (loss) before income taxes (339) (2,138) (2,477)
Income tax provision (187) (4,461) (4,648)
--------- --------- ---------
Net income (loss) $ (152) $ 2,323 $ 2,171
========= ========= =========
Earnings (loss) per common share:
Basic $ (0.01) $ 0.15 $ 0.14
Diluted $ (0.01) $ 0.14 $ 0.13
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
As discussed in Note 8 to the Consolidated Financial Statements, the
Company's financial statements have been restated. See Note 8 to the Notes to
Consolidated Financial Statements, for a summary of the significant effects of
the restatement. The following discussion of the Company's financial condition
and results of operations gives effect to the restatement and should be read in
conjunction with the Consolidated Financial Statements and related notes.
OVERVIEW
Cole National Corporation, primarily through the subsidiaries owned by
its direct subsidiary, Cole National Group, Inc., is a leading provider of
optical products and services and personalized gifts. The Company sells its
products and services through 2,509 company-owned retail locations and 447
franchised locations in 50 states, Canada and the Caribbean.
Fiscal years end on the Saturday closest to January 31 and are
identified according to the calendar year in which they begin. For example, the
fiscal year ended February 2, 2002 is referred to as "fiscal 2001." The current
fiscal year, which ends February 1, 2003, is referred to as "fiscal 2002."
Fiscal 2002 and fiscal 2001 each consisted of 52 weeks.
The Company has two reportable segments, Cole Vision and Things
Remembered. Most of Cole Vision's revenue represents sales of prescription
eyewear, accessories and services through its Cole Licensed Brands and Pearle
Vision retail locations. Cole Vision revenue also includes sales of merchandise
to franchisees, royalties based on franchise sales, initial franchise fees for
Pearle Vision and capitation revenue, administrative service fee revenue and
discount program service fees from its Cole Managed Vision business.
Things Remembered's revenue represents sales of engraveable gift
merchandise, personalization and other services primarily through retail in-line
stores and kiosks. Things Remembered revenue also includes direct sales through
its e-commerce site, http://www.ThingsRemembered.com, sales through Things
Remembered catalogs and through affiliate programs direct to businesses.
16
RESULTS OF OPERATIONS
The following schedule sets forth certain operating information for the
third quarter and first nine months of fiscal 2002 and fiscal 2001. This
schedule and subsequent discussions should be read in conjunction with the
consolidated financial statements included in this Form 10-Q.
Third Quarter First Nine Months
------------------------ ------------------------
2002 2001 Change 2002 2001 Change
---------- ----------- ------ ---------- ---------- ------
(Dollars in millions) (Dollars in millions)
Net revenue:
Cole Vision $ 221.8 $ 210.4 5.4 % $ 672.8 $ 630.6 6.7 %
Things Remembered 53.7 53.0 1.3 180.5 179.9 0.3
------- ------- ------- -------
Total net revenue $ 275.5 $ 263.4 4.6 % $ 853.3 $ 810.5 5.3 %
Gross margin:
Cole Vision $ 143.8 $ 136.8 5.1 % $ 442.4 $ 417.7 5.9 %
Things Remembered 39.7 39.2 1.3 132.2 130.2 1.5
------- ------- ------- -------
Total gross margin $ 183.5 $ 176.0 4.3 % $ 574.6 $ 547.9 4.9 %
Operating expenses:
Cole Vision $ 137.7 $ 133.4 3.2 % $ 420.1 $ 399.3 5.2 %
Things Remembered 42.4 39.8 6.5 126.9 120.6 5.2
Unallocated corporate 3.8 2.4 58.3 9.8 7.9 24.1
------- ------- ------- -------
Total operating expense $ 183.9 $ 175.6 4.7 % $ 556.8 $ 527.8 5.5 %
Goodwill and tradename amortization
Cole Vision $ - $ 1.1 (100.0)% $ - $ 3.1 (100.0)%
Things Remembered - 0.2 (100.0) - 0.7 (100.0)
------- ------- ------- -------
Total goodwill and tradename amortization $ - $ 1.3 (100.0)% $ - $ 3.8 (100.0)%
Operating income (loss):
Cole Vision $ 6.1 $ 2.3 165.2 % $ 22.3 $ 15.3 45.8 %
Things Remembered (2.7) (0.8) 237.5 5.3 8.9 (40.4)
Unallocated corporate expenses (3.8) (2.4) 58.3 (9.8) (7.9) 24.1
------- ------- ------- -------
Total operating income (loss) $ (0.4) $ (0.9) (55.6)% $ 17.8 $ 16.3 9.2 %
======= ======= ======= =======
Percentage of net revenue:
Gross margin 66.6 % 66.8 % (0.2) 67.3 % 67.6 % (0.3)
Operating expenses 66.8 66.7 0.1 65.3 65.1 0.1
Goodwill and tradename amortization - 0.5 (0.5) - 0.5 (0.5)
------- ------- ------- -------
Operating income (loss) (0.1)% (0.3)% 0.2 2.1 % 2.0 % 0.1
======= ======= ======= =======
Number of retail locations at the end
of the period
Cole Licensed Brands 1,313 1,279
Pearle company-owned 415 430
Pearle franchised 447 423
------- -------
Total Cole Vision 2,175 2,132
Things Remembered 781 790
------- -------
Total Cole National 2,956 2,922
======= =======
As used in Item 2 of Part I of this Form 10-Q, same-store sales growth
is a non-GAAP financial measure, which includes deferred warranty sales on a
cash basis and does not reflect provisions for returns and remakes and certain
other items. The Company's current systems do not gather data on these items on
an individual store basis. Adjustments to the cash basis sales information
accumulated at the store level are made for these items on an aggregate basis.
As a retailer, the Company believes that a measure of same-store sales
performance is important for understanding its operations. The Company
calculates same-store sales for stores opened for at least twelve
17
months. A reconciliation of same-store sales to revenue is presented below in
the section "Reconciliation of Same-Store Sales Growth". Same-store sales growth
follows:
2002
-------------------------------------------------
Third Quarter First Nine Months
------------------- ------------------
Cole Licensed Brands (U.S.) 6.5% 5.2%
Pearle company-owned (U.S.) 2.0% 4.8%
Total Cole Vision 4.7% 4.7%
Things Remembered (1.4)% (1.9)%
Total Cole National 3.4% 3.1%
Pearle franchise stores (U.S.) (1.8)% 1.6%
Same-store sales for Pearle U.S. franchise stores is a non-GAAP
financial measure that is provided for comparative purposes only. The Company
believes that its franchisees' method of reporting sales is consistent on a
year-to-year basis.
THIRD QUARTER FISCAL 2002 COMPARED TO THIRD QUARTER FISCAL 2001
CONSOLIDATED OPERATIONS
Total revenues were $275.5 million in the third quarter of fiscal 2002,
compared with $263.4 million in the same period of fiscal 2001. Total revenues
increased 4.6% in the third quarter, primarily attributable to a 3.4% increase
in same-store sales, an increase in the number of Target Optical stores open,
and an increase in revenues from managed vision care programs.
Gross margin was $183.5 million in the third quarter of fiscal 2002,
compared with $176.0 million in the same period of fiscal 2001, an increase of
4.3%. The gross margin dollar increase was primarily attributable to
improvements in net revenue at Cole Vision. The gross margin rate for the third
quarter was 66.6%, compared to 66.8% for the third quarter 2001. The decline was
attributable to lower gross margin percents at Cole Vision, partially offset by
a small gross margin rate improvement at Things Remembered.
Operating expenses were $183.9 million in the third quarter of fiscal
2002, compared with $175.6 million in the same period of fiscal 2001, an
increase of 4.7%. The increase in operating expenses was primarily due to costs
incurred to support the increase in net revenue and the number of Target Optical
stores opened in the past twelve months. As a percentage of net revenue,
operating expenses were 66.8% compared to 66.7% for the third quarter 2001. The
increase in operating expense percent was attributable to higher corporate
expenses and higher operating costs at Things Remembered. Executive severance
costs of $0.7 million and expenses totaling $0.3 million associated with the
closing of the corporate office and relocating it to the Company's facility in
Twinsburg, Ohio, were the primary reasons for the increase in corporate expense.
In addition, the Company reversed expense accruals related to benefits and legal
costs totaling $0.4 million in fiscal 2001 due to favorable experience. This
reversal of expense was not repeated in the third quarter of fiscal 2002.
Operating expenses at Things Remembered increased $2.6 million on a sales
increase of $0.7 million. Higher costs of rent and occupancy, resulting from
increases in insurance, taxes and other common area charges were the primary
reasons for the increase. These increases were offset by lower operating expense
percent at Cole Vision, primarily at Target Optical. Results at Target Optical
improved as the focus changed from an aggressive growth rate in store openings
to measured growth and improved operations. Operating expenses as a percent of
sales also improved at Cole Managed Vision, due to reductions in the cost per
claim processed.
The Company adopted SFAS 142 in the first quarter of fiscal 2002. SFAS
142 requires that goodwill and certain intangibles deemed to have indefinite
lives no longer be amortized, but instead, will be subject to annual reviews for
impairment. With the adoption of this statement, the Company ceased amortization
of goodwill and tradenames as of February 3, 2002. The Company recorded a $1.3
million goodwill and tradename amortization charge in the third quarter of
fiscal 2001.
18
Operating loss was $0.4 million in the third quarter of fiscal 2002,
compared to an operating loss of $0.9 million in the same period of fiscal 2001.
Improvements at Cole Vision and the cessation of goodwill and tradename
amortization were partially offset by a decline in operating income at Things
Remembered and the increase in corporate expenses mentioned above.
Interest and other (income) expense, net, decreased $0.1 million in the
third quarter of fiscal 2002 compared to the same period the prior year. The
Company recorded lower interest expense due to the May 2002 refinancing of its
$150.0 million Senior Subordinated Notes (See Note 3 for further information).
Lower interest expense was offset by lower transaction gains related to the
Company's investment in notes and interest receivable in Pearle Europe. The
Company recorded transaction gains of $0.1 million in the third quarter of
fiscal 2002 compared with $0.3 million in the third quarter of 2001. The Company
also recorded lower interest income from franchise receivables and from
temporary investments.
The effective income tax rate was 70.0% in fiscal 2002 compared with
187.8% in fiscal 2001. The lower effective tax rate in 2002 was primarily due to
the elimination of goodwill amortization pursuant to the new accounting standard
and reduction in the provision for valuation allowances related to deferred tax
assets for charitable contribution carryforwards.
COLE VISION SEGMENT
Cole Vision revenues were $221.8 million in the third quarter of fiscal
2002, compared with $210.4 million in the comparable period of fiscal 2001, an
increase of 5.4%. Same-store sales for the third quarter of fiscal 2002
increased 6.5% at Cole Licensed Brands and 2.0% at Pearle Vision company-owned
stores. Same-store sales reflected an increase in the average spectacle selling
price and an increase in transactions.
Gross margin as a percentage of net revenue decreased by 0.2 percentage
points at Cole Vision and was impacted by the continuation of a program to price
contact lenses more competitively in order to gain market share and an increase
in product sold to Pearle franchisees. Partially offsetting these factors were
the increase in average spectacle selling price and growth in managed vision
care claims and fee revenue. Product sales to franchisees carry a lower margin
but offer benefits for the Company, including helping franchise same-store sales
and producing a more uniform merchandise assortment and consistent brand look
across all stores.
Operating expenses were 3.2% higher at Cole Vision in the third quarter
of fiscal 2002. Revenue growth of $11.4 million was the primary reason for the
increase. Operating expenses as a percent of sales decreased 1.3% in the third
quarter, resulting primarily from operating improvements and the change from
fixed to percentage rent at Target Optical. Advertising expense percent was also
lower as a percent of revenues, primarily due to a $0.5 million negotiated
payment from U.S. Vision. U.S. Vision is a large provider in the Cole Managed
Vision Preferred Provider Network who operates Sears Optical locations and
benefits from the Company's marketing efforts.
Operating income at Cole Vision improved to $6.1 million in the third
quarter of fiscal 2002, compared with $2.3 million in the comparable period of
fiscal 2001. Increases in revenue and the operating efficiencies at Target
Optical were the primary reasons for the improvement. In addition, the cessation
of goodwill and tradename amortization in fiscal 2002 resulted in $1.1 million
of improved operating income.
THINGS REMEMBERED SEGMENT
Things Remembered sales were $53.7 million in the third quarter of
fiscal 2002, compared with $53.0 million in the comparable period of fiscal
2001, a 1.3% increase. Same-store sales declined 1.4% as fewer transactions
offset the increase in average selling price resulting from sales of new
merchandise at higher average unit prices, higher revenue from merchandise
personalization, and less merchandise sold at clearance prices.
Gross margin as a percent of net revenue increased 0.1% in the third
quarter of fiscal 2002 compared to the comparable period of fiscal 2001.
Operating expenses at Things Remembered increased $2.6 million on a
sales increase of $0.7 million. Higher costs of rent and occupancy, resulting
from increases in insurance, taxes and other common area charges
19
were the primary reason. These charges are generally variable and can increase
as mall ownership and or tenant occupancy rates change. Costs of marketing were
also higher due to efforts to increase sales in a difficult retail environment.
Costs of store payroll also grew at a slightly higher rate then the increase in
sales, due to higher wage rate and benefit costs.
Operating loss for the third quarter of fiscal 2002 was $2.7 million
compared to a loss of $0.8 million in the comparable period of fiscal 2001.
Higher costs of rent, occupancy, store payroll and marketing rising faster than
the increase in revenue, were the primary reasons for the increase in operating
loss.
FIRST NINE MONTHS FISCAL 2002 COMPARED TO FIRST NINE MONTHS FISCAL 2001
CONSOLIDATED OPERATIONS
Total revenue was $853.3 million for the first nine months of fiscal
2002, compared to $810.5 million for the comparable period of fiscal 2001. Total
revenue increased 5.3% during this period, primarily attributable to a 3.1%
increase in same-store sales, an increase in the number of Target Optical stores
open, and an increase in revenues from managed vision care programs.
Gross margin increased $26.7 million, or 4.9% in the first nine months
of fiscal 2002 compared to the same period a year ago. The gross margin dollar
increase was primarily attributable to improvements in net revenue at Cole
Vision. The gross margin rate decreased to 67.3% in fiscal 2002 from 67.6% in
fiscal 2001 due to a 0.5 percentage point decrease at Cole Vision offset by a
0.9 percentage point margin improvement at Things Remembered. The decline in
gross margin rate at Cole Vision was attributable to the same factors affecting
gross margin in the third quarter of fiscal 2002. The improvement in gross
margin rate at Things Remembered was due to a change in sales mix to higher-end
products.
Operating expenses increased $29.0 million, or 5.5% for the first nine
months of fiscal 2002 compared to the same period in fiscal 2001. The increase
in operating expenses was primarily due to costs incurred to support the
increase in net revenue and the number of Target Optical stores opened in the
past twelve months. For the first nine months, operating expenses as a
percentage of net revenue were higher than the comparable period last year.
Improvements at Cole Vision were offset by higher operating costs at Things
Remembered. For the first nine months of fiscal 2002, operating costs at Things
Remembered increased $6.3 million on a total revenue increase of $0.6 million.
Higher costs of rent and occupancy resulting from increases in insurance, taxes
and other common area charges, as well as increased costs of store payroll and
marketing were the primary reasons for the increase. Corporate expenses were
also higher in the first nine months of fiscal 2002, compared to the comparable
period of fiscal 2001. Executive severance costs of $0.7 million and expenses
totaling $0.3 million associated with the closing of the corporate office and
relocating it to the Company's facility in Twinsburg, Ohio were the primary
reasons for the increase in corporate expense.
The Company adopted SFAS 142 in the first quarter of fiscal 2002. SFAS
142 requires that goodwill and certain intangibles deemed to have indefinite
lives no longer be amortized, but instead, will be subject to annual reviews for
impairment. With the adoption of this statement, the Company ceased amortization
of goodwill and tradenames as of February 3, 2002. The Company recorded a $3.8
million goodwill and tradename amortization charge for the first nine months of
fiscal 2001.
Operating income for the first nine months of fiscal 2002 was $17.8
million, compared with $16.3 million for the comparable period of fiscal 2001, a
9.2% improvement. The $1.5 million improvement in operating income for the first
nine months reflected the elimination of goodwill and tradename amortization
from adopting SFAS 142 and improved operating earnings at Cole Vision. These
were partially offset by lower operating earnings at Things Remembered and the
increase in corporate expenses discussed above.
Interest and other (income) expense, net, decreased $2.6 million for
the first nine months of fiscal 2002 compared to the comparable period in fiscal
2001. The Company recorded a transaction gain of $2.1 million related to its
investment in notes and interest receivable from Pearle Europe in the first nine
months of fiscal 2002. This compared to a transaction loss of $0.4 million for
the comparable period of fiscal 2001. Interest expense was also lower than the
prior year, reflecting the refinancing of Cole National Group's Senior
Subordinated Notes. (See Note 3 of the Notes to Consolidated Financial
Statements for further information regarding this transaction.)
20
In addition, the Company recorded a $0.7 million gain from the sale of a
Dallas, Texas office facility in the first quarter of fiscal 2001.
The effective income tax rate was 70.0% in fiscal 2002 compared with
187.8% in fiscal 2001. The lower effective tax rate in 2002 was primarily due to
the elimination of goodwill amortization pursuant to the new accounting standard
and a reduction in the provision for valuation allowances related to deferred
tax assets for charitable contribution carryforwards.
The results for the first nine months of fiscal 2002 include an
extraordinary loss on early extinguishment of debt of $7.2 million, net of an
income tax benefit of $3.9 million. The extraordinary charge represents payment
of premiums and other costs of retiring Cole National Group's 9-7/8% Senior
Subordinated Notes due 2006 and the write-offs of unamortized discount and
deferred financing fees. See the section below entitled "Liquidity and Capital
Resources" and Note 3 of the Notes to Consolidated Financial Statements for more
information regarding the early extinguishment of debt.
COLE VISION SEGMENT
Cole Vision revenues were $672.8 million for the first nine months of
fiscal 2002, compared with $630.6 million for the comparable period of fiscal
2001. Same-store sales for the first nine months of fiscal 2002 increased in all
retail vision brands, despite the difficult retail environment. Cole Licensed
Brands and Pearle Vision company-owned locations increased same-store sales by
5.2% and 4.8%, respectively. Same-store sales reflected an increase in the
average spectacle selling price and strong transaction increases at Target
Optical. Same-store sales increases also reflected strong first quarter
transaction increases at Pearle Vision.
Gross margin rate decreased 0.5% for the first nine months of fiscal
2002, compared to the comparable period in fiscal 2001. The decrease in the nine
month gross margin rate at Cole Vision was attributable to the same factors
affecting third quarter gross margin discussed above.
Operating expenses were 5.2% higher at Cole Vision in the first nine
months of fiscal 2002 compared to the comparable period in fiscal 2001. Revenue
growth of $42.2 million was the primary reason for the increase. Operating
expenses as a percent of sales declined 0.9% in the first nine months, resulting
primarily from operating improvements at Cole Managed Vision and Pearle Vision.
Operating expenses at Cole Managed Vision declined as a percent of sales in the
first nine months of fiscal 2002 compared to the comparable period the prior
year due to the reduction of processing fees paid to Met Life as claims
processing was converted to the Company's internal systems at a lower cost per
claim. Improvements at Pearle Vision were due to lower costs of advertising, due
to lower national media spending.
Operating income at Cole Vision improved to $22.3 million for the first
nine months of fiscal 2002, compared to $15.3 million for the comparable period
of fiscal 2001. Improved operating earnings at Pearle Vision resulting from
higher revenues and lower advertising expenses, improvements in the processing
cost per claim at Cole Managed Vision, and the cessation of goodwill and
tradename amortization were the primary reasons for the increase. Goodwill and
tradename amortization at Cole Vision totaled $3.1 million during the first nine
months of fiscal 2001.
THINGS REMEMBERED SEGMENT
Things Remembered sales were $180.5 million for the first nine months
of fiscal 2002, compared with $179.9 million for the comparable period of fiscal
2001. Same-store sales declined 1.9% as fewer transactions offset the increase
in average selling price resulting from sales of new merchandise at higher
average unit prices, higher revenue from merchandise personalization, and less
merchandise sold at clearance prices.
The gross margin rate increased 0.9% at Things Remembered for the first
nine months of fiscal 2002 compared to the comparable period of fiscal 2001. The
increase in gross margin rate was primarily attributable to a change in sales
mix to higher end product.
Operating expenses were 5.2% higher at Things Remembered in the first
nine months of fiscal 2002 compared to the comparable period in fiscal 2001. The
21
increase in operating expenses, coupled with a 0.3% increase in sales, resulted
in higher operating expense percent of 3.3%. Higher costs of rent and occupancy,
resulting from increases in insurance, taxes, and other common area charges were
the primary reason for the increase. Costs of marketing were also higher due to
efforts to increase sales in a difficult retail environment. Costs of store
payroll also grew at a slightly higher rate then the increase in sales, due to
higher wage rate and benefit costs.
Operating income decreased to $5.3 million for the first nine months of
fiscal 2002, compared to $8.9 million in the comparable period of fiscal 2001.
Higher rent, occupancy, store payroll and marketing costs rising faster than the
revenues were the primary causes of the reduction in operating income.
RECONCILIATION OF SAME-STORE GROWTH
Same-store sales growth is a non-GAAP financial measure, which includes
deferred warranty sales on a cash basis and does not reflect provisions for
returns and remakes and certain other items. The Company's current systems do
not gather data on these items on an individual store basis. Adjustments to the
cash basis sales information accumulated at the store level are made for these
items on an aggregate basis. As a retailer, the Company believes that a measure
of same-store sales performance is important for understanding its operations.
The Company calculates same-store sales for stores opened for at least twelve
months. A reconciliation of same-store sales to revenue reported on a GAAP basis
follows:
2002
-------------------------------
Third Quarter Nine Months
------------- -----------
(Dollars in thousands)
Current year same-store sales $ 237,824 $ 736,790
Prior year same-store sales 230,108 714,585
Percent Change 3.4% 3.1%
Current year same-store sales $ 237,824 $ 736,790
Adjustment for:
Sales at new and closed stores 7,212 24,140
Extended warranties (781) (2,932)
Order vs. customer receipt 1,428 1,066
Returns, remakes and refunds (1,183) (1,489)
Other (107) (113)
--------- ---------
Store sales 244,393 757,462
Nonstore revenues 38,104 117,796
Intercompany eliminations (6,996) (21,926)
--------- ---------
GAAP Basis Net Revenue $ 275,501 $ 853,332
========= =========
LIQUIDITY AND CAPITAL RESOURCES
Cole National Corporation's primary source of liquidity is funds
provided from operations of its operating subsidiaries. In addition, its wholly
owned subsidiary, Cole National Group, Inc., and its operating subsidiaries have
a working capital line of credit. As of November 2, 2002, the total commitment
was $75.0 million and availability under the credit facility totaled $62.7
million after reduction for commitments under outstanding letters of credit.
There are no working capital borrowings outstanding at any time during the first
nine months of fiscal 2002 or fiscal 2001.
22
The credit facility, which is guaranteed by Cole National Corporation
and Cole National Group, requires Cole National Group and its principal
operating subsidiaries to comply with various operating covenants that restrict
corporate activities, including covenants restricting the ability of the
subsidiaries to incur additional indebtedness, pay dividends, prepay
subordinated indebtedness, dispose of certain investments or make acquisitions.
The credit facility also requires Cole National Group to comply with certain
financial covenants, including covenants regarding minimum interest coverage and
maximum leverage.
On May 22, 2002, the Company issued $150.0 million of 8-7/8% Senior
Subordinated Notes due 2012. The notes are unsecured and mature on May 15, 2012.
Net proceeds from the notes offering, together with cash on hand, were used to
retire $150.0 million of 9-7/8% Senior Subordinated Notes due 2006 and pay
premium and other costs associated with retiring those notes. An extraordinary
loss on early extinguishment of debt of $7.2 million, which is net of an income
tax benefit of $3.9 million, representing the payment of premiums and other
costs of retiring the notes and write-offs of unamortized discount and deferred
financing fees, was recorded in the second quarter of fiscal 2002.
The indentures pursuant to which the 8-5/8% notes and the 8-7/8% notes
were issued contain certain optional and mandatory redemption features and other
financial covenants, including restrictions on the ability of Cole National
Group to incur additional indebtedness, pay dividends or make other restricted
payments to Cole National Corporation. The indentures permit dividend payments
to Cole National Corporation for certain tax obligations and for administrative
expenses not to exceed 0.25% of net sales. See Note 3 of the Notes to
Consolidated Financial Statements. The Company may from time to time purchase
its outstanding notes in the open market or refinance them depending on capital
market conditions.
No significant principal payment obligations are due under the
Company's outstanding indebtedness until April 2004, when a $5.0 million
principal payment is due under a 5.0% promissory note and until 2007, when the
$125.0 million Senior Subordinated debt is due. The ability of Cole National
Corporation and its subsidiaries to satisfy their obligations will be primarily
dependent upon the future financial and operating performance of the
subsidiaries and upon the Company's ability to renew or refinance borrowings or
raise additional capital through equity financing or sales of assets.
Operations for the first nine months provided $19.7 million of cash in
fiscal 2002 compared with $7.5 million in fiscal 2001. Changes in working
capital resulted in a use of funds of $6.5 million in fiscal 2002, compared to a
use of funds of $25.6 million in fiscal 2001. Changes in accounts payable and
other liabilities resulted in a source of cash of $16.6 million in fiscal 2002
compared to a use of funds of $12.6 million in fiscal 2001. The benefit of the
increase in payables and other liabilities was due to timing of purchases and
payments and increases in deferred warranties. Changes in receivables and other
assets resulted in a use of funds of $8.5 million compared to a source of funds
of $5.3 million in fiscal 2001. The increase in receivables was due to increases
in sales and corresponding receivables at Cole Vision. Results of operations,
lower depreciation and amortization and non-cash interest charges provided lower
funds from operations. The Company recorded transaction gains of $2.1 million in
the first nine months of fiscal 2002 compared to a transaction loss of $0.4
million for the same period of fiscal 2001.
Net cash from investing activities resulted in a use of funds of $42.3
million for the first nine months of fiscal 2002 compared to a use of funds
totaling $35.6 million in the comparable period of fiscal 2001. Capital
expenditures, which accounted for most of the cash used for investing, were
$33.3 million and $27.3 million in fiscal 2002 and fiscal 2001, respectively.
The majority of capital expenditures were for store fixtures, equipment and
leasehold improvements for new stores, including the Target Optical expansion,
and remodeling of existing stores. Expenditures for systems development costs
totaled $3.7 million and $5.8 million for the first nine months of fiscal 2002
and fiscal 2001, respectively. In fiscal 2001, net proceeds of $4.7 million were
received from the sale of a Dallas office facility. In fiscal 2001, the Company
made a net investment in Pearle Europe of $6.4 million in connection with Pearle
Europe's acquisition of a leading optical retail chain in Portugal. Of this
amount, $4.7 million is accounted for as notes receivable and $1.7 million as
equity investment.
The Company provided a $4.0 million loan to U.S. Vision, Inc. as part
of the Company's management-led buyout. U.S. Vision is a large provider in Cole
Managed Vision Preferred Provider network. Interest on the note accrues at 8.75%
per annum (11.75% per annum in the event of default per the agreement) and is
due quarterly starting on December 31, 2002 and on the last day of each March,
June and September. The note matures December 1, 2003.
23
In connection with the Company's acquisition of Met Life's managed
vision care benefits business in October 1999, the Company is required to pay
additional amounts contingently due upon certain conditions being met over the
four-year period following the date of the purchase. These payments are based
upon various retention factors during the contingency period. The Company made a
contingent payment for approximately $0.7 million in relation to a factor noted
above. The Company expects that additional contingent payments will be made in
the fourth quarter of fiscal 2002 and the second quarter of fiscal 2003 relating
to this acquisition.
Net cash used for financing activities totaled $19.6 million for the
first nine months of fiscal 2002, compared to cash provided by financing of
$12.8 million for the comparable period of fiscal 2001. In May 2002, Cole
National Group, Inc., issued $150.0 million of 8-7/8% Senior Subordinated Notes
due May 2012. The net proceeds of this issuance and cash on hand were used to
retire all of Cole National Group's $150.0 million 9-7/8% Senior Subordinated
Notes due 2006. Finance fees and early repayment of the 9-7/8% notes resulted in
a net cash usage of $14.2 million. See Note 3 for further information regarding
this transaction. Changes in overdraft balances due to the timing of purchases
and payments resulted in a use of $6.3 million of cash in fiscal 2002 compared
to a source of $12.6 million in fiscal 2001.
The Company believes that funds provided from operations, including
cash on hand, along with funds available under the credit facility will provide
adequate sources of liquidity to allow its operating subsidiaries to continue to
expand the number of stores and to fund capital expenditures and system
development costs.
OFF BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL COMMITMENTS
The Company leases a substantial portion of its equipment and
facilities including laboratories, office and warehouse space, and retail
locations. In addition, Cole Vision operates departments in various host stores
and pays occupancy costs solely as a percentage of sales. A more complete
discussion of the Company's lease and license commitments is included in Note 6
of the Notes to Consolidated Financial Statements.
The Company guarantees future minimum lease payments for certain store
locations leased directly by Pearle franchisees. The term of these guarantees
range from one to ten years of which many are limited to periods that are less
than the full term of the leases involved. A more complete discussion of the
Company's guarantees is included in Note 6 of the Notes to Consolidated
Financial Statements.
In the second quarter of fiscal 2002, Cole National Group issued $150.0
million of Senior Subordinated Notes due 2012 and retired all of its $150.0
million Senior Subordinated Notes due 2006 as discussed above and in Note 3 of
the Notes to Consolidated Financial Statements. As a result, $150.0 million of
the Company's scheduled payments for contractual obligations as reported in its
latest annual report on Form 10-K have been shifted from due in the period "4-5
years" to due in the period "after 5 years".
The Company's primary source of liquidity, other than cash on hand, is
the working capital line of credit discussed above and in Note 4 of the Notes to
Consolidated Financial Statements. This facility has been extended until May 31,
2006 and supports $12.3 million of standby letters of credit that are renewable
annually.
RECENTLY ISSUED ACCOUNTING STANDARDS
The Company adopted SFAS 142 in the first quarter of fiscal 2002. This
statement requires that goodwill and certain intangible assets deemed to have
indefinite useful lives no longer be amortized, but instead be subject to at
least an annual review for impairment. With the adoption of this statement, the
Company ceased amortization of goodwill and tradenames as of February 3, 2002.
Amortization of goodwill and tradenames totaled $5.0 million in fiscal 2001.
During the second quarter of fiscal 2002, the Company completed the
transitional impairment testing of goodwill as required by SFAS 142. Based on
the findings of its outside valuation advisor, the Company has concluded that
there was no impairment of its goodwill or tradenames at the adoption date of
the new accounting standard, effective February 3, 2002. The Company has elected
to perform its annual tests for potential impairment as of the first day of the
Company's fourth quarter. Based on its annual tests performed in the fourth
quarter of fiscal 2002, the Company has concluded that there was no impairment
24
of its goodwill or tradenames. As part of the restatement, the Company and its
outside valuation advisor reviewed the previously completed impairment testing
and confirmed that there was no impairment of either goodwill or tradenames.
The Financial Accounting Standards Board (FASB) has issued SFAS No.
145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of SFAS
Statement No. 13, and Technical Corrections" (SFAS 145). SFAS 145 states that
the rescission of SFAS No. 4 shall be applied in fiscal years beginning after
May 15, 2002. Any gain or loss on extinguishment of debt that was classified as
an extraordinary item in prior periods presented that does not meet the criteria
in APB Opinion 30, "Reporting the Results of Operations - Reporting the Effects
of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions", for classification as an
extraordinary item shall be reclassified as an operating expense. The Company
will adopt SFAS 145 as of the beginning of fiscal 2003. As a result, the loss on
early extinguishment of debt reported as an extraordinary item for the year
ended February 1, 2003 will be reclassified at that time. The pretax loss from
the early extinguishment of debt will be presented as a separate line within
interest and other (income) expenses and the related income tax benefit will
reduce the reported income tax provision.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" (SFAS 146). This statement requires
that a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. The provisions of this statement were
effective for exit or disposal activities initiated after December 31, 2002. The
Company will adopt SFAS 146 on January 1, 2003. The adoption will have no effect
on the Company's financial position or operations.
The FASB has also issued SFAS No. 143, "Accounting for Asset Retirement
Obligations" (SFAS 143), and SFAS No. 144, "Accounting for Impairment or
Disposal of Long-Lived Assets" (SFAS 144). SFAS 143 provides guidance for legal
obligations arising from the retirement of long-lived assets. SFAS 144 addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets. SFAS 144 was adopted during fiscal 2002 and had no effect on the
Company's financial position or operations. SFAS 143 will be adopted during
fiscal 2003 and is not expected to have a material effect on the Company's
financial position or operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others" (FIN 45). This interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It
also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The Company will adopt the fair value recognition
provision of this interpretation for guarantees issued or modified after
December 31, 2002. The disclosure provisions of the interpretation will be
adopted for the year ended February 1, 2003.
CONTINGENCIES
A complaint was filed in the Superior Court of California, county of
San Diego against Cole National Corporation, its affiliates and certain of its
officers by the Attorney General of the State of California on February 14, 2002
and amended on February 22, 2002. The case, State of California v. Cole National
Corporation, et. al., alleges claims for various statutory violations related to
the operation of 24 Pearle Vision Centers in California. The claims include
untrue or misleading advertising, illegal dilation fees, unlawful advertising of
eye exams, maintaining an optometrist on or near the premises of a registered
dispensing optician, unlawful advertising of an optometrist, unlicensed practice
of optometry, and illegal relationships between dispensing opticians, optical
retailers and optometrists. The action seeks unspecified damages, restitution
and injunctive relief. Although the State of California obtained a preliminary
injunction to enjoin certain advertising practices and the charging of dilation
fees in July 2002, the terms of the injunction have not had and are not expected
to have a material effect on the Company operations. In addition, both the State
and the Company have appealed the preliminary injunction. Although we believe we
are in compliance with California law and intend to continue to defend the
issues raised in the case vigorously, the case is in its early stages and we
cannot predict with certainty its outcome or costs.
Cole National Corporation is defending a purported class action lawsuit
alleging claims for various violations of federal securities laws related to the
Company's publicly reported revenues and earnings. The action, which proposes a
class period of March 23, 1999 through November 26, 2002 and names the Company
and certain present and former officers and directors, seeks unspecified
compensatory damages, punitive damages "where appropriate", costs, expenses and
attorneys' fees. The company believes that it has insurance that should be
available with respect to litigation and any indemnification obligations.
However, if the Company is unsuccessful in defending against any such
litigation, and if its insurance coverage is not available or is insufficient to
cover its expenses, indemnity obligations and liability, if any, the litigation
and/or investigation may have a material adverse effect on the Company's
financial condition, cash flow and results of operations.
Cole National Group, Inc. has been named as a defendant along with
numerous other retailers, in patent infringement litigation challenging the
defendants' use of bar code technology. The Company believes it has available
defenses and does not expect any liability. However, if Cole National Group were
to be found liable for an infringement, it might have a material adverse effect
on the Company's operating results and cash flow in the period incurred.
25
FORWARD LOOKING STATEMENTS
The Company's expectations and beliefs concerning the future contained
in this document are forward looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. Actual results may differ
materially from those forecasted due to a variety of factors that can adversely
affect the Company's operating results, liquidity and financial condition such
as risks associated with potential adverse consequences of the restatement of
the Company's financial statements, including those resulting from litigation or
government investigations, restrictions or curtailment of the Company's credit
facility and other credit situations, costs and other effects associated with
the California litigation, the timing and achievement of improvements in the
operations of the optical business, the results of Things Remembered, which is
highly dependent on the fourth quarter holiday season, the nature and extent of
disruptions of the economy from terrorist activities or major health concerns
and from governmental and consumer responses to such situations, the actual
utilization of Cole Managed Vision funded eyewear programs, the success of new
store openings and the rate at which new stores achieve profitability, the
Company's ability to select, stock and price merchandise attractive to
customers, success of systems development and integration, competition in the
optical industry, integration of acquired businesses, economic and weather
factors affecting consumer spending, operating factors affecting customer
satisfaction, including manufacturing quality of optical and engraved goods, the
Company's relationships with host stores and franchisees, the mix of goods sold,
pricing and other competitive factors, and the seasonality of the Company's
business.
26
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's major market risk exposure is to changes in foreign
currency exchange rates in Canada and in Euros, which could impact its results
of operations and financial condition. Foreign exchange risk arises from the
Company's exposure to fluctuations in foreign currency exchange rates because
the Company's reporting currency is the United States dollar. Management seeks
to minimize the exposure to foreign currency fluctuations through natural
internal offsets to the fullest extent possible.
During the third quarter of fiscal 2002, the Company entered into an
interest rate swap agreement to take advantage of favorable market interest
rates. These agreements require the Company to pay an average floating interest
rate based on six month LIBOR plus 4.5375% to a counter party while receiving a
fixed rate on $50.0 million of the Company's $125.0 million 8-5/8% Senior
Subordinated Notes due 2007. The agreements mature August 15, 2007 and qualify
as fair value hedges. The LIBOR rate is reset in arrears. For the third quarter,
the market rate for six month LIBOR was 1.57438% which resulted in a rate of
6.1190% applied from the inception date of the swaps through November 2, 2003.
A change in six-month LIBOR would effect the interest cost associated
with the $50.0 million notional value of the swap. A 50% change (approximately
79 basis points) in the market rates of interest for six month LIBOR as compared
to the 6.1190% rate in effect for the third quarter of fiscal 2002 would
increase the Company's annual interest cost by $0.4 million.
In addition, the Company is exposed to changes in the fair value of our
debt portfolio, primarily resulting from the effects of changes in interest
rates. The Company utilizes interest rate swaps to manage its exposure.
Management believes that its use of these financial instruments is in the
Company's best interest. The Company does not enter into financial instruments
for trading purposes.
ITEM 4. CONTROLS AND PROCEDURES
(a) Immediately following the Signature section of this Quarterly Report
are certifications of the Company's Chief Executive Officer and Chief Financial
Officer required in accordance with Section 302 of the Sarbanes-Oxley Act of
2002 (the "Section 302 Certification"). This portion of our Quarterly Report on
Form 10-Q is our disclosure of the results of our control evaluation referred to
in paragraphs (4), (5) and (6) of the Section 302 Certification and should be
read in conjunction with the Section 302 Certification for a more complete
understanding of the topics presented.
In November 2002, the Company determined it needed to restate its
previously issued financial statements for the timing of the recognition of
revenues earned on the sale of extended warranty contracts. The Company issued a
press release on November 26, 2002 announcing the restatement of its historical
consolidated financial statements beginning with its 1998 fiscal year. The
Company subsequently determined that it needed to make changes in previously
issued financial statements in addition to the timing of the recognition of
warranty revenues. The adjustments have a significant negative impact on the
Company's previously reported revenue, net income, and earnings per share. See
Note 8 to the Notes to Consolidated Financial Statements for further discussion
of the restatement.
In March 2003, the Audit Committee engaged outside counsel to conduct
an inquiry into the issues surrounding the restatement. The results and
conclusions of that inquiry have been considered in the preparation of the
accompanying financial statements.
Within 90 days prior to the filing date of this Form 10-Q, the Company
carried out an evaluation, under the supervision and with the participation of
its Chief Executive Officer and Chief Financial Officer, pursuant to Rule 13a-15
promulgated under the Securities Exchange Act of 1934 (the "Exchange Act"), as
amended, of the effectiveness of the design and operation of its disclosure
controls and procedures. In making this evaluation, the Company has considered
matters relating to its restatement of previously issued financial statements,
including the substantial process that was undertaken to ensure that all
material adjustments necessary to restate the previously issued financial
statements were recorded. The Company believes that certain of the restatement
27
adjustments occurred because certain of the Company's control processes and
procedures related to the matters underlying such adjustments were not
effective.
In connection with the audit of the Company's financial statements for
the 2002 fiscal year and the restated financial statements for the 2001 and 2000
fiscal years, Deloitte & Touche reported to management and the Board of
Directors on April 30, 2003 that certain deficiencies existed during the audit
period in the design or operation of the Company's internal accounting controls
which constituted material weaknesses pursuant to standards established by the
American Institute of Certified Public Accountants. Such deficiencies related to
the application or selection of accounting principles, the use of management
judgment and estimates, and the adequacy of account details and reconciliations.
In order to improve the effectiveness of its control processes and
procedures, the Company has taken a number of actions within the past year. The
Company searched for and hired a new Chief Financial Officer from outside the
Company, and filled the position of Corporate Controller. The Audit Committee
approved a charter for the Internal Audit function; the Internal Audit staff was
strengthened and its role was expanded. The Company established an internal
representation requirement, whereby the operating executive and financial
officer of each business unit and major staff area are required to certify on a
quarterly basis the accuracy of the financial statements and the adequacy of the
control processes and procedures within that business unit or staff area. With
the approval of the Board of Directors, the Company amended its Business Code of
Conduct, and required that all management employees certify in writing that they
will comply with it. The Business Code of Conduct includes procedures for the
receipt, retention and treatment of complaints received from employees regarding
among other things, accounting and internal accounting control matters. The
Company is currently revising its Finance and Accounting Policies and Procedures
Manual.
Based in part upon these changes, the Company's Chief Executive Officer
and Chief Financial Officer concluded that as of the evaluation date, the
Company's disclosure controls and procedures were reasonably designed to ensure
that information required to be disclosed by the Company in the reports it files
or submits under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the rules and forms of the
Securities and Exchange Commission.
(b) Other than as described above, since the evaluation date by the
Company's management of its internal controls, there have not been any
significant changes in the internal controls or in other factors that could
significantly affect the internal controls.
28
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time during the ordinary course of business, the Company may
be threatened with, or may become a party to, a variety of legal actions and
other proceedings incidental to its business.
A complaint was filed in the Superior Court of California, county of San
Diego against Cole National Corporation, its affiliates and certain of its
officers by the Attorney General of the State of California on February 14, 2002
and amended on February 22, 2002. The case, State of California v. Cole National
Corporation, et al., alleges claims for various statutory violations related to
the operation of 24 Pearle Vision Centers in California. The claims include
untrue or misleading advertising, illegal dilation fees, unlawful advertising of
eye exams, maintaining an optometrist on or near the premises of a registered
dispensing optician, unlawful advertising of an optometrist, unlicensed practice
of optometry, and illegal relationships between dispensing opticians, optical
retailers and optometrists. The action seeks unspecified damages, restitution
and injunctive relief. Although the State of California obtained a preliminary
injunction to enjoin certain advertising practices and the charging of dilation
fees in July 2002, the terms of the injunction have not had and are not expected
to have a material effect on the Company's operations. In addition, both the
State and the Company have appealed the preliminary injunction. Although we
believe we are in compliance with California law and intend to continue to
defend the issues raised in the case vigorously, the case is in its early stages
and we cannot predict with certainty its outcome or costs.
Things Remembered, Inc. is in the process of settling a class action
complaint filed on August 14, 2002 in the Superior Court of San Francisco,
California, against Things Remembered by a purported class of approximately 200
employees of Things Remembered alleging that the members of the putative class
were improperly denied overtime compensation in violation of California law. The
action sought unspecified damages, interest, restitution, as well as declaratory
and injunctive relief and attorneys' fees. On February 3, 2003, Things
Remembered and the plaintiffs reached an agreement to resolve the lawsuit for
$562,500. The settlement is subject to court approval.
A class action complaint was filed on December 6, 2002 in the United
States District Court for the Northern District of Ohio against the Company and
certain present and former officers and directors by a purported class of
shareholders of the Company, alleging claims for various violations of federal
securities laws related to the Company's publicly reported revenues and
earnings. The action, which proposes a class period of March 23, 1999 through
November 26, 2002 and names the Company and certain present and former officers
and directors, seeks unspecified compensatory damages, punitive damages "where
appropriate", costs, expenses and attorneys fees. Following the announcement in
November 2002 of the restatement of the Company's financial statements, the
Securities and Exchange Commission began an inquiry into the Company's previous
accounting.
Cole National Group, Inc. has been named as a defendant, along with
numerous other retail companies, in patent infringement litigation in the United
States District Court for the District of Arizona, known as Lemelson Medical,
Education & Research Foundation, Limited Partnerships v. CompUSA, Inc. et. al.,
No. Civ. 00-0663, which challenges the defendants' use of bar code technology in
their retail operations. Cole National Group, Inc. is participating in a common
defense with a number of other defendants. A stay of the proceedings has been
sought and was granted, in deference to prior pending declaratory judgment suits
brought by the manufacturers and suppliers of the implicated technology seeking
to declare the patents in suit not infringed, invalid and unenforceable. Cole
National Group, Inc. likewise intends to oppose the allegations and claims
against it.
See Note 7 of Notes to Consolidated Financial Statements for further
discussion of these legal proceedings.
29
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits. The following Exhibits are filed herewith and made a part
hereof:
99.1 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
The Company filed a Form 8-K (Item 5) on December 6, 2002
announcing that Ron Eilers, President and Chief Operating Officer of
Deluxe Corporation (NYSE:DLX), had been appointed to its Board of
Directors.
The Company filed a Form 8-K (Item 5) on November 26, 2002,
which attached a press release announcing that the Company determined
to restate its previously issued financial statements for the timing of
the recognition of revenues earned on the sale of extended warranty
contracts.
The Company filed a Form 8-K (Item 5) on August 27, 2002,
which attached a press release announcing earnings for the second
quarter of fiscal 2002.
30
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.
COLE NATIONAL CORPORATION
By: /s/ Lawrence E. Hyatt
----------------------------------------------
Lawrence E. Hyatt
Executive Vice President and Chief
Financial Officer (Duly Authorized Officer)
By: /s/ Ann M. Holt
----------------------------------------------
Ann M. Holt
Senior Vice President and Corporate Controller
(Principal Accounting Officer)
Date: May 16, 2003
31
CERTIFICATION
I, Jeffrey A. Cole, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Cole National
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) All significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 16, 2003
/s/ Jeffrey A. Cole
-----------------------------------
Jeffrey A. Cole
Chairman and CEO
32
CERTIFICATION
I, Lawrence E. Hyatt, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Cole National
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) All significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 16, 2003
/s/ Lawrence E. Hyatt
-----------------------------------------------------
Lawrence E. Hyatt
Executive Vice President and Chief Financial Officer
33
COLE NATIONAL CORPORATION
FORM 10-Q
QUARTER ENDED NOVEMBER 2, 2002
EXHIBIT INDEX
Exhibit
Number Description
- ------- -----------
99.1+ Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
+ Filed herewith.
34