Back to GetFilings.com

Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Thirteen Weeks Ended November 3, 2002

OR

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
Phoenix, Arizona 85027

(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, 139,180,118 Shares at December 10, 2002

Table of Contents

PETsMART, Inc.
INDEX

2

Table of Contents

INDEPENDENT ACCOUNTANTS’ REPORT

Board of Directors and Stockholders
PETsMART, Inc.
Phoenix, Arizona

We have reviewed the accompanying consolidated balance sheet of PETsMART, Inc. and subsidiaries as of November 3, 2002, and the related consolidated statements of operations for the 13 week and 39 week periods ended November 3, 2002 and October 28, 2001, and the related consolidated statements of cash flows for the 39 week periods ended November 3, 2002 and October 28, 2001. These financial statements are the responsibility of the Corporation’s management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of PETsMART, Inc. and subsidiaries as of February 3, 2002, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 12, 2002 (except for Note 19, as to which the date is June 24, 2002), we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of February 3, 2002 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Deloitte & Touche, LLP
Phoenix, Arizona
December 2, 2002

3

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(Unaudited)

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

4

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

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

5

Table of Contents

PETsMART, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

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

6

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 1 — GENERAL:

     PETsMART, Inc., including subsidiaries (the “Company” or “PETsMART”), is North America’s leading provider of food, supplies, accessories, live pets and professional services for the lifetime needs of pets. As of November 3, 2002, the Company operated 581 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 thirty-nine weeks ended November 3, 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 weeks ended October 28, 2001, the Company did not repurchase any of its Notes. For the thirty-nine weeks ended October 28, 2001, the Company repurchased Notes with a face value of $7,750,000, at a discounted price of $6,382,000. The Company wrote off and included in the determination of the gain on early extinguishment of debt, $178,000 of unamortized deferred financing costs related to the purchase of the Notes. The Company recorded a gain on early extinguishment of debt for the thirty-nine weeks ended October 28, 2001, of $1,190,000 as a reduction to general and administrative expenses. The Company also reclassified the related income tax expense for the thirty-nine weeks ended October 28, 2001, of $476,000 to income tax expense (benefit). See Note 11.

NOTE 3 — NOTES RECEIVABLE FROM OFFICERS:

     During fiscal 2000, the Company began providing full-recourse loans to certain officers that the officers could use solely for the purpose of purchasing shares of the Company’s common stock on the open market. These loans mature five years after they were issued and accrue interest at 7.75% per annum, with principal and interest due at maturity. The officers were required to hold the common stock for a minimum of 18 months. The loans were 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 or third quarters of fiscal 2002, and the Company will not make any new loans to its officers under this program in the future. The officers repaid approximately $5,046,000 of the outstanding loans and

7

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 3 — NOTES RECEIVABLE FROM OFFICERS (cont’d):

interest during the third quarter of fiscal 2002, and the remaining balance as of November 3, 2002, was approximately $157,000. The balance of the loans were repaid on November 12, 2002.

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 thirty-nine weeks ended November 3, 2002, the Company paid $156,000 and $1,410,000, respectively, of such severance. There is no remaining liability as of November 3, 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 $6,900,000, a write-down of inventory of approximately $2,100,000, and a charge of approximately $1,000,000 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 $6,900,000 associated with PETsMART Direct’s building, fixtures, equipment, and software, which the Company 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 $2,100,000 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

8

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 5 — MINORITY INTEREST IN PETsMART.com (cont’d):

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.

NOTE 6 — COMPREHENSIVE INCOME:

     The income tax expense related to the foreign currency translation adjustment was approximately $180,000 and $277,000 for the thirteen and thirty-nine weeks ended November 3, 2002, respectively. The income tax benefit related to the foreign currency translation adjustment was approximately ($503,000) and ($362,000) for the thirteen and thirty-nine weeks ended October 28, 2001, respectively.

NOTE 7 — COMMON STOCK OFFERING:

     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. Costs associated with the offering were approximately $763,000 and were accounted for as a reduction of the proceeds.

NOTE 8 — 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 thirty-nine weeks ended November 3, 2002, and October 28, 2001, is as follows (in thousands, except per share data):

9

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 8 — EARNINGS PER SHARE (cont’d):

     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 thirty-nine weeks ended November 3, 2002. These shares were not included in the calculation of diluted earnings per share for the thirteen and thirty-nine weeks ended October 28, 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.

NOTE 9 — GOODWILL AND INTANGIBLE ASSETS:

     In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” 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 November 3, 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 thirty-nine weeks ended November 3, 2002, was as follows (in thousands):

     Amortization expense for the intangible assets was $74,000 and $214,000 during the thirteen and thirty-nine weeks ended November 3, 2002, respectively. The Company estimates the amortization expense to be approximately $74,000 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 10 — SUPPLEMENTAL SCHEDULE OF CASH FLOWS:

     Supplemental cash flow information for the thirty nine weeks ended November 3, 2002 and October 28, 2001 was as follows (in thousands):

10

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 11 — RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:

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 in fiscal 2002, and the adoption did not have a significant impact on the Company’s 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 a gain of $1,190,000 on early extinguishment of debt for the thirty-nine weeks ended October 28, 2001 as a reduction to general and administrative expenses. The Company also reclassified the related income tax expense of $476,000 for the thirty-nine weeks ended October 28, 2001 to income tax expense (benefit).

     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 the date when a company commits 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.

NOTE 12 — 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 its business. The Company has accrued certain amounts for estimated litigation costs associated with its legal proceedings.

11

Table of Contents

PETsMART, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)

NOTE 13- 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 thirty-nine week periods ended November 3, 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.

12

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:

	•		If we are unable to successfully implement our strategy of reformatting existing stores and opening new stores our results of operations would be harmed;
	•		New stores may erode sales at existing stores and comparable store sales growth may decrease as stores grow older;
	•		Our operating margins at new stores may be lower than those of existing stores;
	•		A disruption or malfunction in the operation of our distribution centers would impact our ability to deliver merchandise to our stores, which could harm our sales and results of operations;
	•		If our management information systems fail to perform as designed, our business could be harmed;
	•		A decline in consumers’ discretionary spending could reduce our sales and harm our business;
	•		Our results may fluctuate as a result of seasonal changes associated with the pet food and pet supply retailing industry and the timing of new store openings;
	•		The pet food and pet supply retailing industry is highly competitive, and continued competitive forces may reduce our sales and profitability;
	•		The loss of any of our key vendors, a decision by our vendors to make their products available in supermarkets or through mass merchandisers, or the inability of our vendors to provide products in a timely or cost-effective manner could harm our business;
	•		We depend on key personnel and may not be able to retain or replace these employees or recruit additional qualified personnel, which could harm our business;
	•		Our international operations may result in additional market risks, which may harm our business;
	•		Our business may be harmed if the operation of veterinary hospitals at our stores is limited or fails to continue;
	•		Our business exposes us to claims which could result in adverse publicity and harm our brand;
	•		If we need to raise additional capital our business would be harmed if we were unable to do so on acceptable terms; and
	•		A determination that we are in violation of any government regulations could require us to restructure our operations to comply in a given government jurisdiction and could harm our business.

     For more information about these risks, see the discussion under the heading “Risk Factors” in our Form 10-Q for the thirteen weeks ended August 4, 2002, filed with the Securities and Exchange Commission on September 18, 2002, which is incorporated herein by reference.

Overview

     We are North America’s leading provider of food, supplies, accessories, live pets and professional services for the lifetime needs of pets. As of November 3, 2002, we operated 581 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 Hospital™, 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 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

13

Table of Contents

value method, at a risk-free interest rate, over the remaining life of the lease, net of expected sublease income. We use our judgment 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 November 3, 2002 and February 3, 2002, there was a balance of approximately $10.1 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 peak periods of 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 two-year historical shrink rate against the volume of merchandise sales since the last inventory. As of November 3, 2002 and February 3, 2002, there was a balance of approximately $6.9 million and $9.1 million, respectively, for inventory shrinkage reserves.

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 $1,200 million 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 $0.25 million 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 November 3, 2002 and February 3, 2002, there was a balance of approximately $21.8 million and $16.8 million, respectively, in reserves related to casualty and workers compensation insurance policies. These reserves were recorded in other accrued expenses on the consolidated balance sheet.

Income Taxes

     We establish deferred income tax assets and liabilities 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 and Third Quarters of 2001

     The following charges and transactions, which occurred during the second and third quarters of 2001, resulted in net charges, before taxes, of $18.9 million, of which we recorded approximately $2.1 million in cost of sales and approximately $16.8 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 and third quarters of 2001, we recorded charges of approximately $7.4 million and $1.5 million, respectively, totaling approximately $8.9 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.

14

Table of Contents

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 the PETsMART.com 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.

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: