Back to GetFilings.com

Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number: 0-21888

PETsMART, INC.

Delaware (State or other jurisdiction of incorporation or organization)				94-3024325 (I.R.S. Employer Identification No.)

19601 N. 27th Avenue

(623) 580-6100

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.

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date:

Common Stock, $.0001 Par Value, 137,840,617 Shares at September 9, 2002

Table of Contents

PETsMART, Inc.

2

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements.

3

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these consolidated financial statements.

4

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial statements.

5

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 1 — GENERAL:

         PETsMART, Inc., including subsidiaries (the “Company” or “PETsMART”), is the leading provider of food, supplies, accessories and professional services for the lifetime needs of pets in North America. As of August 4, 2002, the Company operated 570 retail stores. The Company offers a broad line of products for all the life stages of pets and is the nation’s largest provider of high-quality grooming and pet training services. Through its strategic relationship with Banfield, The Pet Hospital^TM, PETsMART makes full-service veterinary care available in approximately half of its stores. Through its direct marketing channels, PETsMART also is a leading mail order catalog and e-commerce retailer of pet and equine products and supplies.

         PETsMART’s accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments (which are of a normal recurring nature), necessary for a fair statement of the results of the interim periods presented. Certain reclassifications have been made to prior period financial statements to present them on a basis comparable with the current period’s presentation.

         Because of the seasonal nature of the Company’s business, the results of operations for the thirteen and twenty-six weeks ended August 4, 2002, are not necessarily indicative of the results to be expected for the full year. The Company’s fiscal year ends on the Sunday nearest January 31.

         For further information, refer to the financial statements and related footnotes for the fiscal year ended February 3, 2002, included in the Company’s Form 8-K (File No. 0-21888), filed with the Securities and Exchange Commission on June 25, 2002, as amended on July 18, 2002.

NOTE 2 – SUBORDINATED CONVERTIBLE NOTES:

         In November 1997, the Company sold 6 3/4% Subordinated Convertible Notes due 2004 (the “Notes”) with an aggregate principal amount of $200,000,000. The remaining principal outstanding as of February 3, 2002, was $173,500,000. The outstanding Notes were convertible to the Company’s common stock at any time prior to maturity at a conversion price of $8.75 per share, subject to adjustment under certain conditions. During February and March 2002, the remaining balance of the Notes was called for redemption, resulting in the repurchase of Notes for approximately $275,000 in cash and the conversion of the remainder into approximately 19,800,000 shares of common stock. As a result of the redemption, unamortized debt issue costs of $2,357,000 and accrued interest of $3,902,000 were reclassified to stockholders’ equity, resulting in a net increase of $1,545,000.

         During the thirteen and twenty-six weeks ended July 29, 2001, the Company purchased Notes with a face value of $5,250,000 and $7,750,000, at a discounted price of $4,638,000 and $6,382,000, respectively. The unamortized deferred financing costs related to the purchase of the Notes of $121,000 and $178,000, respectively, were written off and included in the determination of the gain on early extinguishment of debt. The Company recorded a gain on early extinguishment of debt for the thirteen and twenty-six weeks ended July 29, 2001 of $491,000 and $1,190,000, respectively, as a reduction to general and administrative expenses. The Company also reclassified the related income tax expense for the thirteen and twenty-six weeks ended July 29, 2001 of $196,000 and $476,000, respectively, to income tax expense (benefit). See Note 9.

NOTE 3 – NOTES RECEIVABLE FROM OFFICERS:

         During fiscal 2000, the Company began providing full-recourse loans to certain officers to be used solely for the purpose of purchasing shares of the Company’s common stock on the open market. These loans mature five years after they are issued and accrue interest at 7.75% per annum, with principal and interest due at maturity. The officers are required to hold the common stock for a minimum of 18 months. The loans are collateralized by the Company’s common stock purchased by the officers. The loans must be repaid in full, including accrued interest, upon the earlier of the scheduled maturity date or an event of default, which could include, among other things, the sale of the underlying common stock or the officers’ termination of employment. The Company recorded $495,000 of new officer loans under this program in the first quarter of fiscal 2002. There were no new loans provided in the second quarter of fiscal 2002, and the Company will not make any new loans to its officers under this program in the future.

6

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 4 – SPECIAL CHARGES:

         During the fourth quarter of fiscal 2001, the Company approved a plan to move administrative functions, during fiscal 2002, of PETsMART Direct, Inc., (“PETsMART Direct”) and PETsMART.com, Inc., (“PETsMART.com”) to the Company’s administrative office located in Phoenix, Arizona. As a result of the reorganization of these functions, the Company identified 90 positions for elimination, all of which had been eliminated as of August 4, 2002, and recorded severance charges of approximately $1,410,000 in the fourth quarter of fiscal 2001. Also as part of the plan, the Company closed five small neighborhood PetWise retail stores located in upstate New York, and recorded a reserve in the fourth quarter of fiscal 2001 of approximately $778,000 for the remaining offices and retail store lease obligations.

         The Company classified the accrued severance as a component of other accrued expenses. During the thirteen and twenty-six weeks ended August 4, 2002, the Company paid $621,000 and $1,254,000, respectively, of such severance, and the remaining liability as of August 4, 2002 was $156,000, which the Company expects to be paid by the end of fiscal 2002.

         Since 1996, the Company has incurred costs related to merger, integration, store closure, and other business restructuring costs in connection with certain acquisitions. The activity related to the 1996 closed store reserve, as well as the remaining lease obligations for the closed stores and administrative offices associated with the PETsMART Direct and PETsMART.com reorganization is as follows (in thousands):

         The reserves principally relate to store, office, and equipment lease payments due over lease terms, and costs to be incurred at the end of the lease.

         During the second quarter of 2001, the Company recorded an impairment charge of approximately $6.9 million, a write-down of inventory of approximately $2.1 million, and a charge of approximately $1.0 million for other asset write-downs and reserves. As a result of an analysis of the PETsMART Direct business model, the Company performed an impairment analysis in accordance with Statement of Financial Accounting Standards, (“SFAS”), No. 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of.” The analysis indicated an impairment of $6.9 million associated with PETsMART Direct’s building, fixtures, equipment, and software, which was recorded in general and administrative expenses. The fair value of such assets was determined based on market appraisals and analysis of expected future discounted cash flows. Also in the second quarter of 2001, the Company analyzed the inventory of PETsMART Direct and decided to discount or dispose of certain items, resulting in a $2.1 million charge to cost of sales to record the inventory at the net realizable value.

NOTE 5 – MINORITY INTEREST IN PETsMART.com:

         In June 2001, the Company purchased 1,020,789 shares of PETsMART.com’s convertible voting preferred stock from minority shareholders for approximately $741,000, which increased its voting ownership to a requisite percentage for income tax reporting purposes. This will allow the Company to utilize a portion of PETsMART.com’s net operating loss carryforwards. As a result, in the second quarter 2001, the Company recorded a deferred tax asset of $18,885,000, eliminated the net goodwill of $8,575,000 and recorded a tax benefit of $10,310,000. In January 2002, the Company acquired all the remaining shares held by PETsMART.com minority stockholders for approximately $9,500,000 through the merger of PETsMART.com with a PETsMART wholly owned subsidiary. As a result of the additional investment, the Company recorded goodwill of approximately $8,896,000, net of the minority interest balance of approximately $604,000, in the fourth quarter of fiscal 2001.

7

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 6 – COMPREHENSIVE INCOME:

         The income tax expense (benefit) related to the foreign currency translation adjustment was approximately ($15,000) and $97,000 for the thirteen and twenty-six weeks ended August 4, 2002, respectively. The income tax expense related to the foreign currency translation adjustment was approximately $148,000 and $141,000 for the thirteen and twenty-six weeks ended July 29, 2001, respectively.

NOTE 7 — EARNINGS PER SHARE:

         To calculate basic earnings per share, the Company divides net income by the number of weighted average common shares outstanding during each period. To calculate diluted earnings per share, the Company divides net income by the number of weighted average common shares outstanding during the period, after adjusting for dilutive stock options and dilutive common shares assumed to be issued on conversion of the Notes. Net income is adjusted for the interest expense, net of income tax benefit, when the Notes are included in the diluted earnings per share calculation.

         A reconciliation of the basic and diluted earnings per share computations for the thirteen and twenty-six weeks ended August 4, 2002, and July 29, 2001, is as follows (in thousands, except per share data):

         During February and March 2002, the remaining balance of Notes was called for redemption, resulting in the repurchase of Notes for approximately $275,000 in cash and the conversion of the remainder into approximately 19,800,000 shares of common stock. Prior to the conversion, and due to the dilutive effect these shares would have had on earnings per share, the Company includes these shares in the calculation of diluted earnings per share for the twenty-six weeks ended August 4, 2002. These shares were not included in the calculation of diluted earnings per share for the thirteen and twenty-six weeks ended July 29, 2001, due to the anti-dilutive effect they would have had on earnings per share. Dilutive securities for the periods presented also consist of stock options.

8

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 8 – GOODWILL AND INTANGIBLE ASSETS:

         In accordance with SFAS No. 142, the Company discontinued the amortization of goodwill, effective February 4, 2002. The Company has completed the transitional goodwill impairment test for its reporting units and recorded no impairment charge.

         A reconciliation of the previously reported net income and earnings per common share to the amounts adjusted for the exclusion of goodwill amortization, net of the related income tax effect, is as follows (in thousands, except per share amounts):

         As of the periods ended August 4, 2002, and February 3, 2002, the carrying amount of goodwill was $13,222,000.

         Intangible assets consisted solely of trademarks, and changes in the carrying amount for the twenty-six weeks ended August 4, 2002 was as follows (in thousands):

         Amortization expense for the intangible assets was $71,000 and $140,000 during the thirteen and twenty-six weeks ended August 4, 2002, respectively. The Company estimates the amortization expense to be approximately $142,000 for the remainder of the year. For fiscal years 2003 through 2007, the Company estimates the amortization expense to be approximately $282,000 each year.

NOTE 9 – RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:

         In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which replaces Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The new standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The statement is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company does not expect that the adoption will have a significant impact on its financial position or results of operations.

         In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of April 2002,” that, among other things, rescinded SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt.” With the rescission of SFAS No. 4, companies generally will no longer classify early extinguishment of debt as an extraordinary item. The provision is effective for fiscal years beginning after May 15, 2002, and early application is encouraged. The Company adopted the statement as of August 4, 2002, and as a result, the Company reclassified the gain on early extinguishment of debt for the thirteen and twenty-six weeks ended July 29, 2001 of $491,000 and $1,190,000, respectively, as a reduction to general and administrative expenses. The Company also reclassified the related income tax expense of $196,000 and $476,000 for the thirteen and twenty-six weeks ended July 29, 2001, respectively, to income tax expense (benefit).

9

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 9 – RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONT’D):

         In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” and amends Accounting Principles Board Opinion No. 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.” The new rules apply to the classification and impairment analyses conducted on long-lived assets other than certain intangible assets. The new rules also resolve conflicting treatment of the impairment of long-lived assets, and provide implementation guidance regarding impairment calculations. SFAS No. 144 also expands the definition of discontinued operations to include all distinguishable components of an entity that will be eliminated from ongoing operations in a disposal transaction. The Company adopted SFAS No. 144 beginning fiscal 2002, and the adoption did not have a significant impact on the Company’s financial position or results of operations.

NOTE 10 – CONTINGENCIES:

         On January 16, 2001, certain former stockholders of Pet City Holdings, a United Kingdom corporation, including Richard Northcott, who was a PETsMART board member from December 1996 to September 1997, filed two complaints, one in federal court and one in state court, seeking damages in excess of $100 million against PETsMART and certain of our former and current officers and directors. These plaintiffs subsequently dismissed the state court complaint, prior to the issuance of any rulings on the merits, and added the claims from the state complaint to a consolidated federal complaint. The consolidated complaint relates to the 1996 acquisition of Pet City by PETsMART and the proceedings are pending in the United States District Court for the Central District of California. Plaintiffs allege misrepresentations or omissions that misled the shareholders of Pet City concerning PETsMART’s business, financial status, and prospects. Plaintiffs also allege claims for breach of fiduciary duty and for relief under English common law. PETsMART previously filed a motion to dismiss the consolidated complaint. On September 6, 2001, the federal court granted PETsMART’s motion to dismiss without leave to amend as to plaintiffs’ claims for breach of fiduciary duty and claims for relief under English common law. The court granted in part and denied in part PETsMART’s motion to dismiss with leave to amend as to plaintiffs’ state and federal securities fraud claims. The court denied PETsMART’s motion to dismiss the state common law fraud claims. On October 19, 2001, plaintiffs filed a first amended consolidated complaint, and PETsMART moved to dismiss the amended complaint. On March 15, 2002, the federal court again granted in part and denied in part PETsMART’s motion to dismiss as to plaintiffs’ state and federal securities fraud claims. The court also denied PETsMART’s motion to dismiss the state common law fraud and breach of contract claims. On April 8, 2002, PETsMART filed an answer to the amended complaint denying the plaintiffs’ allegations and damage claims. As a result, the parties have commenced discovery in the action. PETsMART believes that the plaintiffs’ allegations are without merit and intend to vigorously defend the action. However, no assurance can be provided as to the outcome of the action and, at this time, management cannot estimate the range of possible loss, if any.

         The Company is involved in various other legal proceedings that it does not believe are material to our business. The Company has accrued certain amounts for estimated litigation costs associated with its legal proceedings.

NOTE 11 — FINANCIAL INFORMATION BY BUSINESS SEGMENT:

         As of February 3, 2002, the Company had three reportable segments; PETsMART North America, which included all retail stores, PETsMART Direct, which included the Company’s equine catalog and Internet operations, and PETsMART.com, which included the Company’s pet catalog and Internet operations. As a result of the reorganization of the PETsMART Direct and PETsMART.com operations and the results of operations of these operating segments during the thirteen and twenty-six week periods ended August 4, 2002, the Company has evaluated its segment reporting requirements under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and determined that the PETsMART Direct and PETsMART.com operating segments do not meet the quantitative thresholds for disclosure as reportable operating segments.

10

Table of Contents

PETsMART, Inc. and Subsidiaries

NOTE 12 – SUBSEQUENT EVENT:

         In July 2002, the Company filed a registration statement, on Form S-3, for a public offering of 14,500,000 shares of its common stock, plus an over-allotment option of 2,175,000 shares. Of these shares, 13,182,584 were offered by entities affiliated with Carrefour SA, and 1,317,416 shares, plus the shares in the over-allotment option, were offered by the Company.

         On August 5, 2002, the Company completed the sale of 1,317,416 shares of common stock for $13.40 per share, resulting in proceeds, net of underwriting fees, of approximately $16,859,000. On August 12, 2002, the underwriters exercised the over-allotment option and purchased 2,175,000 additional shares of common stock for $13.40 per share, resulting in proceeds, net of underwriting fees, of approximately $27,833,000. The Company expects to incur costs associated with the offering of approximately $900,000.

11

Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

         Except for the historical information contained in this document, the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, the section entitled “Risk Factors,” as well as in the sections entitled Distribution, Information Systems, Competition and Government Regulation included in our Form 10-K for the year ended February 3, 2002, filed with the Securities and Exchange Commission on April 15, 2002.

Overview

         We are the leading provider of food, supplies, accessories, and professional services for the lifetime needs of pets in North America. As of August 4, 2002, we operated 570 retail stores. We offer a broad line of products for all the life stages of pets, and we are the nation’s largest provider of high-quality pet grooming and training services. Through our strategic relationship with Banfield, The Pet HospitalTM, we make full-service veterinary care available in approximately half of our stores. Through our direct marketing channels, we also are a leading mail order catalog and e-commerce retailer of pet and equine products and supplies.

Critical Accounting Policies and Estimates

         The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. On an ongoing basis, we evaluate estimates related to reserves for store closures, inventory shrinkage, insurance liabilities and reserves and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Those estimates form the basis for judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Reserve for Closed Stores

         We continuously evaluate the performance of our retail stores and periodically close those that are underperforming. We establish reserves for future rental payments on closed stores and terminated subleases, and classify these costs in general and administrative expenses. The costs for future rental payments associated with closed stores are calculated using the net present value method, at a risk-free interest rate, over the remaining life of the lease, net of expected sublease income. Judgment is used to estimate the underlying real estate market related to the expected sublease income, and we can make no assurances that additional charges to the current stores will not be required based on the changing real estate environment. As of August 4, 2002 and February 3, 2002, we recorded approximately $10.6 million and $12.3 million, respectively, for closed store reserves.

Inventory Shrinkage Reserves

         Our stores perform physical inventories once a year and, in between physical inventories, stores periodically perform counts on certain inventory items. Therefore, as of the end of each reporting period, there will be stores with certain inventory items that have not been counted. Due to the holiday season, stores do not perform physical inventories during the last quarter of the fiscal year, but continue to perform counts on certain inventory items. All distribution centers perform counts throughout each quarter of all inventory items in the building once each quarter. As of the end of each reporting period, we estimate the inventory shrinkage reserve by applying a rolling three-year historical shrink rate against the volume of merchandise sales since the last inventory. As of August 4, 2002 and February 3, 2002, we recorded approximately $9.2 million and $9.1 million, respectively, for inventory shrinkage reserves.

12

Table of Contents

Insurance Liabilities and Reserves

         We maintain standard property and casualty insurance on all stores, product liability insurance covering the sale of live pets, and workers compensation insurance. Property insurance covers approximately $1.2 billion in buildings and contents, including furniture and fixtures, leasehold improvements and inventory. Under our casualty and workers compensation insurance policies, we retain the initial risk of loss of $250,000 per occurrence for each policy. We establish reserves for losses based on actuarial estimates, including losses for which claims have been incurred but not yet reported. Loss estimates rely on actuarial observations of ultimate loss experienced during similar historical events. As of August 4, 2002 and February 3, 2002, we recorded approximately $18.9 million and $16.8 million, respectively, in reserves related to casualty and workers compensation insurance policies. These reserves were recorded in other accrued expenses.

Income Taxes

         Deferred income tax assets and liabilities are established for temporary differences between the financial reporting bases and the income tax bases of our assets and liabilities at enacted tax rates expected to be in effect when such assets or liabilities are realized or settled. Deferred income tax assets are reduced by a valuation allowance if, in our judgment, it is more likely than not that such assets will not be realized. In the second quarter of 2001, we reversed the valuation allowances on deferred tax assets of approximately $18.9 million associated with our increase in ownership of PETsMART.com.

Certain Charges and Transactions in the Second Quarter of 2001

         The following charges and transactions, which occurred during the second quarter of 2001, resulted in net charges, before taxes, of $17.4 million, of which we recorded approximately $2.1 million in cost of sales and approximately $15.3 million in general and administrative expenses.

Impairment of Long-Lived Assets and Asset Write-Downs

         During the second quarter of 2001, we recorded an impairment charge of approximately $6.9 million, a write-down of inventory of approximately $2.1 million, and a charge of approximately $1.0 million for other asset write-downs and reserves. As a result of an analysis of the PETsMART Direct business model, we performed an impairment analysis in accordance with Statement of Financial Accounting Standards, or SFAS, No. 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of.” The analysis indicated an impairment of $6.9 million associated with PETsMART Direct’s building, fixtures, equipment, and software, which was recorded in general and administrative expenses. The fair value of such assets was determined based on market appraisals and analysis of expected future discounted cash flows. Also in the second quarter of 2001, we analyzed the inventory of PETsMART Direct and decided to discount or dispose of certain items, resulting in a $2.1 million charge to cost of sales to record the inventory at the net realizable value.

Store Closure Reserves

         During the second quarter of 2001, we recorded charges totaling approximately $7.4 million for future rental payments on closed stores and terminated subleases. The costs for future rental payments associated with closed stores were calculated using the net present value method, at a risk-free interest rate, over the remaining life of the lease, net of expected sublease income.

Income Tax Benefit

         In June 2001, we increased our voting ownership in PETsMART.com to a requisite percentage for income tax reporting purposes that will allow us to utilize a portion of PETsMART.com’s net operating loss carry forwards. As a result, we reversed previously established valuation allowances of approximately $18.9 million, eliminated the remaining goodwill of approximately $8.6 million, and recorded a tax benefit of approximately $10.3 million.

13

Table of Contents

Results of Operations

         The following table presents the percent of net sales of certain items included in our consolidated statements of operations, unless otherwise indicated:

         As a result of the reorganization of the PETsMART Direct and PETsMART.com operations and the results of operations of these operating segments during the twenty-six week period ended August 4, 2002, we have evaluated our segment reporting requirements under SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and determined that the PETsMART Direct and PETsMART.com operating segments do not meet the quantitative thresholds for disclosure as reportable operating segments.

Thirteen Weeks Ended August 4, 2002 Compared to Thirteen Weeks Ended July 29, 2001

Net Sales

         Net sales increased 11.9% to $651.5 million for the thirteen weeks ended August 4, 2002, from $582.4 million for the thirteen weeks ended July 29, 2001. Store sales increased by $70.0 million as a result of 17 additional net stores and an 11.4% increase in comparable store sales. Services sales increased by 31.1 %, or $9.4 million. The increases were partially offset by a decrease in direct marketing channels sales of $10.3 million. As of August 4, 2002, we operated 570 stores, compared with 553 stores as of July 29, 2001. Since July 29, 2001, we have opened 24 new stores, nine of which were opened in the second quarter of 2002, and we closed seven stores, two of which were closed in the second quarter of 2002. The increase in services revenue, which includes grooming, training and our three PETsHOTEL operations, was due primarily to higher volume. The decrease in revenue from direct marketing channels was from lower pet catalog sales, due to a decision to reduce circulation and advertising in 2002, and lower e-commerce sales. Also, in the fourth quarter of 2001, we sold an ancillary equine catalog to a third party and closed five small neighborhood PetWise retail stores located in upstate New York, which had been part of the direct marketing channels business in the second quarter of 2001.

Gross Profit

         Gross profit is net of cost of sales. Cost of sales includes cost of goods sold and related expenses, net of discounts earned and lost, warehouse and distribution costs, store and warehouse occupancy costs, transportation costs and services payroll, fringe, supplies and other operating costs.

         Gross profit increased as a percentage of net sales to 28.6% for second quarter of 2002, from 25.4% for the second quarter of 2001. The increase primarily reflected higher services revenue, which carries a higher margin than merchandise, lower product cost of goods sold due to sales of higher margin products, and lower distribution costs for our direct marketing channels during

14

Table of Contents

the second quarter of 2002, compared with the second quarter of 2001. The lower distribution costs for our direct marketing channels were primarily a result of the benefits obtained from their integration in the first half of 2002. In the second quarter of 2001, we recorded a charge to cost of sales of $2.1 million, as discussed in the section entitled “Certain Charges and Transactions in the Second Quarter of 2001.” Excluding this charge, gross profit would have been 25.8% of net sales for the second quarter of 2001.

Operating Expenses

         Operating expenses, which include store and direct marketing channel payroll and benefits, advertising and preopening costs, as well as other store level and direct marketing channel expenses, decreased as a percentage of net sales to 18.8% for the second quarter of 2002, from 19.8% for the second quarter of 2001. A reduction of operating expenses in our direct marketing channels drove the decrease due primarily to the benefits obtained from their integration in the first half of 2002. Also contributing to the decrease as a percentage of sales was a reduction in advertising expense and equipment rent expense for the second quarter of 2002, compared with the second quarter of 2001. These decreases were partially offset by increases in depreciation expense and store incentive bonus expenses for the second quarter of 2002, compared with the second quarter of 2001. In 2002, we have shifted our focus to using available cash to purchase new equipment and equipment expiring under lease agreements rather than entering into new equipment lease contracts.

General and Administrative Expenses

         General and administrative expenses decreased as a percentage of net sales to 3.7% for the second quarter of 2002, from 6.9% for the second quarter of 2001. In the second quarter of 2001, we recorded net charges of $15.3 million, as discussed in the section entitled “Certain Charges and Transactions in the Second Quarter of 2001.” Excluding these transactions, general and administrative expenses would have been 4.3% of net sales for the second quarter of 2001. The decrease was due to reduction of expenses in our direct marketing channels due primarily to the benefits obtained from their integration in the first half of 2002, as well as credits received through a resolution for vendor services, and overall leveraging of corporate expenses during the quarter. The decrease was partially offset by higher bonus accruals related to our performance for 2002.

Interest Expense

         Interest expense decreased to $5.5 million for the second quarter of 2002, from $7.1 million for the second quarter of 2001. The decrease was primarily due to the retirement and conversion of our 6 3/4% Subordinated Convertible Notes due 2004, or the Notes, in the first quarter of 2002. The decrease was partially offset by higher interest as a result of additional capital leases entered into since the second quarter of 2001.

Minority Interest

         Minority interest in subsidiary loss of $0.7 million represents the recognition of our minority interest in the pretax loss of PETsMART.com for the second quarter of 2001. In January 2002, we acquired all the remaining shares held by PETsMART.com minority stockholders for approximately $9.5 million through the merger of PETsMART.com with a PETsMART wholly owned subsidiary.

Income Tax Expense

         In the second quarter of 2002, the $13.5 million income tax expense represents an effective rate of 38.5%, which brings the effective rate to 38.75% for the twenty-six weeks ended August 4, 2002. For the second quarter of 2001, the $15.8 million income tax benefit included a $10.3 million tax benefit associated with the June 2001 increase in ownership of PETsMART.com, and a $5.5 million tax benefit related to the period loss, or an effective tax rate of 40.3%.

Twenty-Six Weeks Ended August 4, 2002 Compared to Twenty-Six Weeks Ended July 29, 2001

Net Sales

         Net sales increased 11.4% to $1,297.3 million for the twenty-six weeks ended August 4, 2002, from $1,164.6 million for the twenty-six weeks ended July 29, 2001. Store sales increased by $136.0 million as a result of 17 additional net stores and an 11.8% increase in comparable store sales. Services sales increased by 34.6%, or $19.7 million. The increases were partially offset by a decrease in direct marketing channel sales of $23.0 million. As of August 4, 2002, we operated 570 stores, compared with 553 stores as of July 29, 2001. Since July 29, 2001, we opened 24 new stores, 14 of which were opened in the twenty-six weeks ended August 4, 2002, and we closed seven stores, four of which were closed in the twenty-six weeks ended August 4, 2002. The increase in services revenue, which includes grooming, training and our three PETsHOTEL operations, was due primarily to higher volume. The decrease in revenue from direct marketing channels was from lower pet catalog sales, due to a decision to reduce circulation and advertising in 2002, and lower e-commerce sales. Also, in the fourth quarter of 2001, we sold

15

Table of Contents

an ancillary equine catalog to a third party and closed five small neighborhood PetWise retail stores located in upstate New York, which had been part of the direct marketing channels business in the twenty-six weeks ended July 29, 2001.

Gross Profit

         Gross profit increased as a percentage of net sales to 28.4% for twenty-six weeks ended August 4, 2002, from 25.6% for the twenty-six weeks ended July 29, 2001. The increase primarily reflected higher services revenue, which carries a higher margin than merchandise, lower product cost of goods sold due to sales of higher margin products, and lower distribution costs for our direct marketing channels during the twenty-six weeks ended August 4, 2002, compared with the twenty-six weeks ended July 29, 2001. The lower distribution costs for our direct marketing channels were primarily a result of the benefits obtained from their integration in the first half of 2002. In the second quarter of 2001, we recorded a charge to cost of sales of $2.1 million, as discussed in the section entitled “Certain Charges and Transactions in the Second Quarter of 2001.” Excluding this charge, gross profit would have been 25.7% of net sales for the twenty-six weeks ended July 29, 2001.

Operating Expenses

         Operating expenses decreased as a percentage of net sales to 18.4% for the twenty-six weeks ended August 4, 2002, from 20.0% for the twenty-six weeks ended July 29, 2001. As a percentage of sales, reductions in advertising expenses drove the decrease due primarily to reductions in store and direct marketing channels advertising, as well as reductions in catalog distribution during the twenty-six weeks ended August 4, 2002, compared with the twenty-six weeks ended July 29, 2001. In addition, reductions of operating expenses in the direct marketing channels contributed to the decrease due primarily to the benefits obtained from their integration in the first half of 2002. Equipment rent expense also decreased for the twenty-six weeks ended August 4, 2002, compared with the twenty-six weeks ended July 29, 2001. The decrease was partially offset by an increase in depreciation expense and store incentive bonus expenses for the twenty-six weeks ended August 4, 2002, compared with the twenty-six weeks ended July 29, 2001. In 2002, we have shifted our focus to using available cash to purchase new equipment and equipment expiring under lease agreements rather than entering into new equipment lease contracts.

General and Administrative Expenses

         General and administrative expenses decreased as a percentage of net sales to 3.7% for the twenty-six weeks ended August 4, 2002, from 5.7% in the twenty-six weeks ended July 29, 2001. In the second quarter of 2001, we recorded net charges of $15.3 million, as discussed in the section entitled “Certain Charges and Transactions in the Second Quarter of 2001.” Excluding these transactions, general and administrative expenses would have been 4.4% of net sales for the twenty-six weeks ended July 29, 2001. The decrease was due to reduction of expenses in our direct marketing channels due primarily to the benefits obtained from their integration in the first half of 2002, as well as credits received through a resolution for vendor services, and overall leveraging of corporate expenses during the twenty-six weeks ended August 4, 2002. The decrease was partially offset by higher bonus accruals related to our performance for 2002.

Interest Expense

         Interest expense decreased to $10.9 million for the twenty-six weeks ended August 4, 2002, from $13.1 million for the twenty-six weeks ended July 29, 2001. The decrease was primarily due to the retirement and conversion of Notes in the first quarter of 2002. For the twenty-six weeks ended July 29, 2001, interest expense also included higher bank fees due to the expensing of unamortized fees when we entered into a new credit agreement in April 2001. The decrease was partially offset by higher interest as a result of additional capital leases entered into since the second quarter of 2001.

Minority Interest

         Minority interest in subsidiary loss of $1.3 million represents the recognition of our minority interest in the pretax loss of PETsMART.com for the twenty-six weeks ended July 29, 2001. In January 2002, we acquired all the remaining shares held by PETsMART.com minority stockholders for approximately $9.5 million through the merger of PETsMART.com with a PETsMART wholly owned subsidiary.

Income Tax Expense

         For the twenty-six weeks ended August 4, 2002, the $27.6 million income tax expense represents an effective rate of 38.75%. For the twenty-six weeks ended July 29, 2001, the $15.4 million income tax benefit included a $10.3 million tax benefit associated with the June 2001 increase in ownership of PETsMART.com and a $5.1 million tax benefit related to the period loss, or an effective rate of 40.0%.

16