UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

Commission file number: 0-23574

 

PETCO ANIMAL SUPPLIES, INC.

(Exact name of registrant as specified in its charter)

 

 

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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). Yes o No ý

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

 

 

 

PETCO ANIMAL SUPPLIES, INC.

FORM 10-Q

For the Quarter Ended November 1, 2003

 

INDEX

 

Part I Financial Information
	Item 1.	Consolidated Financial Statements:
		Consolidated Balance Sheets as of February 1, 2003 and November 1, 2003
		Consolidated Statements of Operations for the thirteen and thirty-nine weeks ended November 2, 2002 and November 1, 2003
		Consolidated Statements of Cash Flows for the thirty-nine weeks ended November 2, 2002 and November 1, 2003
		Notes to Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
Part II Other Information
	Item 1.	Legal Proceedings
	Item 5.	Other Information
	Item 6.	Exhibits and Reports on Form 8-K
Signatures

 

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Part I. Financial Information

Item 1. Consolidated Financial Statements

 

PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

		February 1, 2003			November 1, 2003
					(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	108,937		$	68,562
Receivables		14,303			15,343
Inventories		138,410			154,448
Deferred tax assets		14,492			599
Other		7,459			9,506
Total current assets		283,601			248,458
Fixed assets, net		218,442			258,180
Debt issuance costs		5,724			4,698
Goodwill		40,644			40,289
Other assets		6,444			11,501
		$	554,855		$	563,126
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable		$	61,308		$	66,452
Accrued expenses		65,091			66,209
Accrued salaries and employee benefits		41,740			50,405
Current portion of long-term debt		2,000			1,420
Current portion of capital lease and other obligations		411			496
Total current liabilities		170,550			184,982
Long-term debt, excluding current portion		190,500			139,725
Senior subordinated notes payable		170,000			170,000
Capital lease and other obligations, excluding current portion		2,630			2,235
Deferred tax liability		13,268			13,474
Deferred rent and other liabilities		18,990			20,664
Total liabilities		565,938			531,080
Stockholders’ equity (deficit):
Common stock, $.001 par value, 250,000 shares authorized and 57,373 and 57,450 shares issued and outstanding at February 1, 2003 and November 1, 2003, respectively		57			57
Additional paid-in capital		65,179			65,965
Accumulated deficit		(76,319		)	(33,976		)
Total stockholders’ equity (deficit)		(11,083		)	32,046
		$	554,855		$	563,126

 

See accompanying notes to consolidated financial statements.

 

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PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share data)

 

		Thirteen weeks ended						Thirty-nine weeks ended
		November 2, 2002			November 1, 2003			November 2, 2002			November 1, 2003
Net sales		$	367,530		$	415,334		$	1,071,211		$	1,198,487
Cost of sales and occupancy costs		253,253			278,213			744,811			812,536
Gross profit		114,277			137,121			326,400			385,951
Selling, general and administrative expenses		86,460			104,785			252,340			298,694
Management fees and termination costs		—			—			12,760			—
Stock-based compensation and other costs		—			—			8,176			—
Operating income		27,817			32,336			53,124			87,257
Interest income		(239		)	(186		)	(548		)	(1,270		)
Interest expense		8,374			6,561			25,816			21,312
Debt retirement costs		—			—			3,336			1,572
Earnings before income taxes		19,682			25,961			24,520			65,643
Income taxes		7,676			6,752			11,811			21,877
Net earnings		12,006			19,209			12,709			43,766
Increase in carrying amount and premium on redemption of preferred stock		—			—			(20,487		)	—
Net earnings (loss) available to common stockholders		$	12,006		$	19,209		$	(7,778	)	$	43,766
Net earnings (loss) per common share:
Basic		$	0.21		$	0.33		$	(0.14	)	$	0.76
Diluted		$	0.21		$	0.33		$	(0.14	)	$	0.75

 

See accompanying notes to consolidated financial statements.

 

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PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)

 

		Thirty-nine weeks ended
		November 2, 2002			November 1 2003
Cash flows from operating activities:
Net earnings		$	12,709		$	43,766
Depreciation and amortization		38,247			43,755
Provision for deferred taxes		16,443			14,553
Stock-based compensation		8,439			—
Non-cash write-off of debt issuance costs		186			1,572
Changes in assets and liabilities:
Receivables		(2,964		)	(1,040		)
Inventories		(15,864		)	(16,038		)
Other assets		(2,328		)	(3,367		)
Accounts payable		(214		)	5,144
Accrued expenses		3,666			(3,484		)
Accrued interest		(5,709		)	4,702
Accrued salaries and employee benefits		3,251			8,666
Accrued store closing costs		819			(642		)
Deferred rent and other liabilities		(124		)	1,060
Net cash provided by operating activities		56,557			98,647
Cash flows from investing activities:
Additions to fixed assets		(44,362		)	(81,740		)
Acquisition of intangible assets		—			(3,037		)
Net repayments from employees		58			245
Net cash used in investing activities		(44,304		)	(84,532		)
Cash flows from financing activities:
Repayment of long-term debt agreements		(31,500		)	(51,355		)
Debt issuance costs		(1,465		)	(1,488		)
Repayment of capital lease and other obligations		(4,188		)	(310		)
Proceeds from the issuance of common stock		295,105			86
Costs from the issuance of common stock		(21,988		)	(1,423		)
Redemption of Series A senior redeemable preferred stock		(142,231		)	—
Redemption of Series B junior redeemable preferred stock		(97,538		)	—
Net cash used in financing activities		(3,805		)	(54,490		)
Net increase (decrease) in cash and cash equivalents		8,448			(40,375		)
Cash and cash equivalents at beginning of year		36,215			108,937
Cash and cash equivalents at end of period		$	44,663		$	68,562

 

See accompanying notes to consolidated financial statements.

 

5

 

PETCO ANIMAL SUPPLIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited, in thousands, except per share data)

 

Note 1—General

 

In the opinion of management of PETCO Animal Supplies, Inc. (the “Company” or “PETCO”), the unaudited consolidated financial statements presented herein contain all adjustments, consisting of normal recurring adjustments, necessary to fairly present the financial position, results of operations and cash flows of the Company as of November 1, 2003, and for the thirteen and thirty-nine week periods ended November 2, 2002 and November 1, 2003. Certain amounts have been reclassified to conform to the current period presentation. Because of the seasonal nature of the Company’s business, the results of operations for the thirteen and thirty-nine weeks ended November 2, 2002 and November 1, 2003 are not necessarily indicative of the results to be expected for the full year. The Company’s fiscal year ends on the Saturday closest to January 31, resulting in years of either 52 or 53 weeks. All references to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year. For example, references to fiscal 2003 refer to the fiscal year beginning on February 2, 2003 and ending on January 31, 2004. For further information, refer to the consolidated financial statements and related footnotes for fiscal 2002 included in the Company’s Annual Report on Form 10-K, as amended (File No. 0-23574), filed with the Securities and Exchange Commission on March 20, 2003.

 

Note 2—New Accounting Standards

 

In July 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets, which superseded Accounting Principles Board Opinion 17, Intangible Assets. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are tested at least annually for impairment. Separable intangible assets with defined lives will continue to be amortized over their useful lives. The provisions of SFAS No. 142 apply to goodwill and intangible assets acquired before and after the statement’s effective date. The Company recorded no asset impairment expense for the thirteen weeks ended November 2, 2002 and November 1, 2003, respectively, and $0.3 million and $0.4 million for the thirty-nine weeks ended November 2, 2002 and November 1, 2003, respectively, which is included in selling, general and administrative expenses in the accompanying consolidated statements of operations. Non-compete agreements, which comprise all of the Company’s intangible assets with defined lives, are included in other assets and had a carrying value of $0.2 million and $3.0 million and accumulated amortization of $1.8 million and $0.7 million at February 1, 2003 and November 1, 2003, respectively. Amortization of non-compete agreements was $0.1 million and $0.2 million for the thirteen weeks ended November 2, 2002 and November 1, 2003, respectively, and $0.2 million and $0.3 million for the thirty-nine weeks ended November 2, 2002 and November 1, 2003, respectively.

 

In April 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, which is effective for fiscal years beginning after May 14, 2002. SFAS No. 145 rescinds SFAS No. 4 which required that all gains and losses from debt extinguishment are to be classified as extraordinary only if they meet the criteria set forth in Accounting Principles Board Opinion, or APB, 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. During the thirty-nine weeks ended November 2, 2002, the Company repurchased $30.0 million in aggregate principal amount of its 10.75% senior subordinated notes, and in connection therewith recorded an extraordinary loss on the early extinguishment of debt totaling $2,004, consisting of a $3,150 prepayment premium and the write-off of $186 in unamortized debt discount, net of a tax benefit of $1,332. As a result of the adoption of SFAS No. 145, the Company has reclassified this amount from an extraordinary loss on early extinguishment of debt, to debt retirement costs, a component of recurring operations, for the thirty-nine weeks ended November 2, 2002. The related income tax benefit was reclassified to income taxes for the thirty-nine weeks ended November 2, 2002.

 

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that, subsequent to December 31, 2002, all costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. Management continually reviews the ability of stores to provide positive contributions to the Company’s results. Prior to December 31, 2002, the Company charged costs associated with store closures to operations upon commitment to close a store within 12 months of the date of commitment. Store closing costs consist of lease obligations, property taxes and common area maintenance costs, net of contractual sub-lease income and are recorded in cost of sales and occupancy costs in the accompanying statements of operations. For the thirteen and thirty-nine week periods ended November 2, 2002, there were $0.8 million and $2.0 million of store closing costs charged against operations, respectively. During the thirty-nine week period ended November 1, 2003, there were store closing cost reversals of $128 related to changes in estimates to previously recorded store closing accruals, resulting in a net impact of ($70) and ($105) for the thirteen and thirty-nine week periods ended November 1, 2003, respectively. The total accrued store closing costs were $2,702 and $2,060 as of February 1, 2003 and November 1, 2003, respectively, and are included in accrued expenses and deferred rent and other liabilities in the accompanying consolidated balance sheets.

 

6

 

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, SFAS No. 148 amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions are effective for financial statements issued for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. The Company adopted the interim disclosure provisions of SFAS No. 148 during the first quarter of fiscal 2003.

 

The Company accounts for stock option plans in accordance with the provisions of APB No. 25, Accounting for Stock Issued to Employees, and related interpretations which recognizes compensation expense on the grant date if the current market price of the stock exceeds the exercise price.

 

Had compensation costs for the Company’s stock option plans been determined based on the fair value at the grant date for awards under these plans, consistent with the methodology prescribed under SFAS No. 123, the Company’s net earnings (loss) would have been as reflected in the following table. The weighted average fair value per share of the options granted during the thirteen and thirty-nine week periods ended November 2, 2002 and November 1, 2003 were an estimated $9.15, $13.14, $8.71 and $7.35, respectively, on the date of grant using the Black-Scholes option pricing model with the following assumptions: no dividend yield, volatility of 44% and 43% for the thirteen and thirty-nine week periods ended November 2, 2002 and November 1, 2003, respectively; risk-free interest rates of 2.6% and 3.2% for the thirteen and thirty-nine week periods ended November 2, 2002 and November 1, 2003, respectively, and an expected life for all periods presented of five years.

 

		Thirteen Weeks Ended						Thirty-nine Weeks Ended
		November 2, 2002			November 1, 2003			November 2, 2002			November 1, 2003
Net earnings (loss) available to common stockholders		$	12,006		$	19,209		$	(7,778	)	$	43,766
Stock-based compensation recorded using the intrinsic value method, net of tax		—			—			5,148			—
Net earnings (loss) before stock-based compensation		12,006			19,209			(2,630		)	43,766
Stock-based compensation using the fair value method, net of tax		265			650			5,277			1,718
Pro forma net earnings (loss) available to common stockholders		11,741			18,559			(7,907		)	42,048
Pro forma basic earnings (loss) per common share		$	0.20		$	0.32		$	(0.14	)	$	0.73
Pro forma diluted earnings (loss) per common share		$	0.20		$	0.32		$	(0.14	)	$	0.72

 

In January 2003, the FASB’s Emerging Issues Task Force, or EITF, reached a consensus on Issue 02-16, Accounting by a Customer (including a Reseller) for Cash Consideration Received from a Vendor. EITF 02-16 provides guidance on how a customer should account for cash consideration received from a vendor. The transition provisions apply prospectively to arrangements with vendors entered into or modified subsequent to December 31, 2002, do not allow for prior period reclassification, and require all amounts received from vendors to be accounted for as a reduction of the cost of the products purchased unless certain criteria are met to allow presentation as a reduction of related selling, general and administrative expenses. The Company adopted the provisions of EITF 02-16 during the first quarter of fiscal 2003. Through the remainder of 2003, substantially all vendor support will initially be deferred as a reduction of the cost of inventory purchased from each supplier, and the support will be recognized into cost of sales as the related inventory is sold. For the thirteen and thirty-nine week periods ended November 1, 2003, the adoption of EITF 02-16 resulted in the reclassification of $6.7 million and $13.0 million of vendor consideration from an offset to selling, general and administrative expenses, to a $4.7 million and $8.7 million reduction of cost of sales, and a $2.0 million and $4.3 million deferral, reducing inventory, which will be recognized as a reduction of cost of sales in future periods.

 

In November 2003, the EITF reached a consensus on Issue 03-10, Application of EITF Issue No. 02-16, “Accounting by a Customer (including a Reseller) for Cash Consideration Received from a Vendor,” by Resellers to Sales Incentives Offered to Customers by Manufacturers. EITF 03-10 provides guidance on the accounting for consideration received by a reseller in the form of a reimbursement by the vendor for honoring the vendor’s sales incentives offered directly to consumers.  The transition provisions apply prospectively to arrangements with vendors entered into or modified in fiscal periods beginning in the Company’s first fiscal quarter ended May 1, 2004.  The Company is in the process of evaluating the impact of EITF 03-10 on its consolidated financial statements.

 

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Note 3—Net Earnings Per Share

 

Basic net earnings (loss) per common share are computed using the weighted average number of common shares outstanding during the period. Diluted net earnings (loss) per common share incorporates the dilutive incremental shares issuable upon the assumed exercise of potentially issuable common stock. Net earnings (loss) available to common stockholders and the weighted average number of common shares used to compute net earnings (loss) per common share, basic and diluted, are presented below:

 

		Thirteen Weeks Ended						Thirty-nine Weeks Ended
		November 2, 2002			November 1, 2003			November 2, 2002			November 1, 2003
Net earnings (loss) available to common stockholders		$	12,006		$	19,209		$	(7,778	)	$	43,766
Common shares, basic		57,334			57,448			55,667			57,411
Dilutive effect of stock options and warrants		614			1,017			—			812
Common shares, diluted		57,948			58,465			55,667			58,223

 

Options to purchase common shares that were outstanding for the thirteen and thirty-nine weeks ended November 2, 2002 and November 1, 2003, but were not included in the computation of diluted net earnings (loss) per common share because of their anti-dilutive impact on earnings (loss) per common share, were 80 and 5, and 1,303 and 80, respectively.

 

Note 4—Related Party Transactions

 

In October 2000, the Company entered into a management services agreement with two entities who were sponsors of the Company’s merger and recapitalization transaction. Under the terms of this agreement, the Company paid management fees in an aggregate amount of $0.3 million, and terminated the management services agreement and paid an aggregate amount of $12.5 million as a one-time termination fee, in the thirty-nine weeks ended November 2, 2002 to these two related parties.

 

In February 2002, the Company redeemed, for approximately $239.8 million, all of the then outstanding shares of series A and series B preferred stock, primarily from related parties.

 

Note 5—Long-Term Debt

 

The Company has a senior credit facility with a syndicate of banks that expires between October 2, 2006 and October 2, 2008. As of July 31, 2003, the senior credit facility consisted of a $75.0 million revolving credit facility and a $191.5 million term loan. On August 1, 2003, the Company made an early repayment of $50 million of the term loan from operating cash flows, incurring debt retirement costs of $1.6 million. In connection with the repayment, the Company entered into an amendment of the senior credit facility that resulted in an immediate interest rate reduction of 0.5% on the term loan and more favorable credit terms.

 

As of November 1, 2003, the senior credit facility now consists of a $75.0 million revolving credit facility and a $141.5 million term loan for a total commitment of $216.5 million. Borrowings under the senior credit facility are secured by substantially all of the Company’s assets and bear interest (1) in the case of the revolving facility, at the Company’s option, at the agent bank’s base rate plus a margin of up to 2.25%, or LIBOR plus a margin of up to 3.25%, based on the Company’s leverage ratio at the time, and (2) in the case of the term loan, at the Company’s option, at the agent bank’s base rate plus a fixed margin of 1.5%, or LIBOR plus a fixed margin of 2.5%. The effective interest rate of these borrowings at November 1, 2003 was 3.64%. The amended credit agreement contains certain affirmative and negative covenants related to, among other things, indebtedness, interest and fixed charges coverage and consolidated net worth. At November 1, 2003, the Company was in full compliance with all of these covenants, the outstanding balance of the term loan was $141.1 million and there were no borrowings on the revolving credit facility, which had $55 million of available credit.

 

Note 6—Senior Subordinated Notes

 

In October 2001, the Company issued $200 million in aggregate principal amount of its 10.75% senior subordinated notes maturing on November 1, 2011. Interest on the 10.75% senior subordinated notes accrues at a rate of 10.75% per annum and is payable semi-annually. The Company may redeem the 10.75% senior subordinated notes at its option at any time on or after November 1, 2006, in whole or in part, based upon an agreed upon schedule of redemption prices. At any time on or before November 1, 2004, the 10.75% senior subordinated notes may be redeemed from the proceeds of one or more qualifying public offerings of common stock of the Company at a redemption price of 110.75% of the principal amount of the 10.75% senior subordinated notes redeemed, plus accrued

 

8

 

interest, so long as there remains outstanding at least 65% of the original aggregate principal amount of the 10.75% senior subordinated notes after giving effect to each such redemption.

 

In March 2002, the Company repurchased $30.0 million in aggregate principal amount of its 10.75% senior subordinated notes and recorded an extraordinary loss on early extinguishment of debt totaling $2,004, consisting of a $3,150 prepayment premium and the write-off of $186 in unamortized debt discount, net of a tax benefit of $1,332. As a result of the adoption of SFAS No.145 as discussed above, the Company has reclassified this amount from an extraordinary loss on early extinguishment of debt, to debt retirement costs, a component of recurring operations, for the thirty-nine week period ended November 2, 2002.

 

Note 7—Initial Public Offering

 

On February 27, 2002, the Company completed an initial public offering of 14,500 shares of common stock for net proceeds of approximately $254.8 million, after deducting the underwriting discount and offering expenses. On March 14, 2002, the Company received additional net proceeds of approximately $17.7 million from the sale of 1,000 additional shares of common stock pursuant to the exercise of the underwriters’ over-allotment option. The Company used approximately $239.8 million of the net proceeds of its initial public offering to redeem in full all of the Company’s then outstanding shares of series A and series B preferred stock. In connection with the initial public offering, the Company also amended and restated its stockholders agreement and its securityholders agreement, terminated its management services agreement and used approximately $32.7 million of the net proceeds of the initial public offering, plus approximately $1.8 million in cash on-hand, to repurchase $30.0 million in aggregate principal amount of its 10.75% senior subordinated notes due 2011 at 110.5% of their face amount, plus accrued and unpaid interest through the repurchase date.

 

Concurrent with the initial public offering, warrants to purchase 2,132 shares of common stock were exercised, all outstanding options prior to the initial public offering became fully vested and the Company issued options to purchase 573 shares of common stock.

 

In connection with the initial public offering, the Company also effected a 2-for-1 stock split of its common stock. All references in the consolidated financial statements to the number of shares outstanding, price per share and per share amounts have been retroactively restated to reflect the stock split for all periods presented.

 

Note 8—Secondary Offering

 

On May 29, 2003, certain selling stockholders completed a public offering of 9,000 shares of the Company’s common stock, pursuant to an effective shelf registration statement previously filed by the Company with the SEC. An additional 1,350 shares of common stock were sold by certain selling stockholders to cover over-allotments on June 9, 2003. On June 23, 2003, certain selling stockholders completed a privately negotiated sale of 1,880 shares of the Company’s common stock pursuant to the shelf registration statement. All of the 12,230 shares were offered by selling stockholders and the Company did not receive any proceeds from the sale of the shares by the selling stockholders. Offering expenses of approximately $1.4 million were recorded by the Company as a direct charge to accumulated deficit during 2003. The Company terminated the shelf registration statement on June 30, 2003.

 

Note 9—Income Taxes

 

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date.   During the third quarter of 2003, the Company recorded a $3.4 million favorable resolution of an income tax accrual.

 

Note 10—Contingencies

 

In June 2002, allegations were made in a complaint filed in the San Francisco Superior Court by the San Francisco City Attorney’s office to the effect that certain associates have not properly cared for companion animals for sale in the Company’s two San Francisco stores. The complaint, which has been subsequently transferred to the Santa Clara Superior Court, seeks damages, penalties and an injunction against the sale of companion animals in the Company’s San Francisco stores. The complaint and related news reports have caused negative publicity and subsequently certain other California counties have indicated that they are reviewing the Company’s animal care policies. The Company takes seriously any allegations regarding the proper care of companion animals and has taken steps to reiterate to all its associates the importance of proper care for all companion animals in all of the Company’s stores. The Company is responding to the complaint and is defending it vigorously. The complaint and any similar actions, which could be filed in the future, could cause negative publicity, which could have a material adverse effect on the Company’s results of operations.

 

The District Attorneys of various California counties, through the San Diego District Attorney, have informed the Company that they are investigating certain alleged weights and measures violations. The investigation specifically concerns whether checkout price scanners used in the Company’s stores identified prices that in some instances didn’t match the posted prices for certain products, and whether the sale tags regarding those products were misleading. No legal action has been filed against the Company with respect to this investigation. Although the Company is working cooperatively with the District Attorneys to reach a satisfactory resolution of this matter, the Company cannot give any assurances that it will be able to resolve this matter on satisfactory terms or at all. The Company is unable at this time to determine whether any potential settlement of this matter, or the outcome of any litigation that might ensue if the Company is unable to settle this matter, will have a material impact on the Company’s results of operations or financial condition in any future period.

 

9

 

In April 2003, three alleged applicants for employment instituted an action against over 100 retailers, including the Company, in the Superior Court of California for the County of Los Angeles. The complaint in the action was filed individually and on behalf of a purported class. The complaint alleges that the individual plaintiffs and the purported class members sought employment with the other retailers, or the Company, and that the written employment application asked, in violation of the California Labor Code and Unfair Business Practices Act, about convictions for certain marijuana offenses and about convictions that resulted in the defendant being sent to a diversion program. The case in state court was stayed pending an initial status conference. One of the co-defendants has removed the action to the United States District Court for the Central District of California. The Company has not made an appearance in the case, and no pleadings or discovery have been initiated. The Company intends to vigorously defend the action, including contesting the certification of the action as a class action, and is unable at this time to determine whether the outcome of the litigation will have a material impact on the Company’s results of operations or financial condition in any future period.

 

In October 2003, the Company was served with a Civil Investigative Demand from the United States Federal Trade Commission, or FTC, seeking information and documents relating to the Company’s e-commerce website PETCO.com and more particularly the Company’s policies and practices regarding the protection of personal information furnished by customers to the website.  The request stems from an incident in late June 2003 in which a self-proclaimed hacker purportedly obtained unauthorized access to a portion of the Company’s website.  The Company has cooperated with the FTC’s inquiry by providing documents and information, and has taken and is taking additional steps to insure that its e-commerce customers’ privacy is maintained.  At the present time, the Company is unable to determine whether the FTC will initiate any enforcement action against the Company or the financial impact any such action might entail.

 

The Company is also involved in routine litigation arising in the ordinary course of its business. While the results of such litigation cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse effect on the Company’s consolidated financial position or results of operations.

 

Note 11—Supplemental Guarantor Condensed Consolidating Financial Statements

 

In October 2001, the Company issued $200 million in principal amount of its 10.75% senior subordinated notes due 2011 under which certain of its subsidiaries (the guarantor subsidiaries) serve as guarantors on a full and unconditional basis. Certain other subsidiaries (the non-guarantor subsidiaries) do not guarantee such debt. In March 2002, the Company repurchased $30.0 million in aggregate principal amount of these notes.

 

The Company has included the following tables which present the unaudited condensed consolidating balance sheets of PETCO Animal Supplies, Inc., as a parent company, its guarantor subsidiaries and its non-guarantor subsidiaries as of November 1, 2003 and February 1, 2003, and the related unaudited condensed consolidating statements of operations and cash flows for the thirty-nine weeks ended November 1, 2003 and November 2, 2002.

 

10

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY BALANCE SHEET

November 1, 2003

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
ASSETS
Current assets:
Cash and cash equivalents		$	68,031		$	531		$	—		$	—		$	68,562
Receivables		1,933			13,410			—			—			15,343
Inventories		143,582			10,866			—			—			154,448
Deferred tax assets		599			—			—			—			599
Other		6,314			3,192			—			—			9,506
Total current assets		220,459			27,999			—			—			248,458
Fixed assets, net		237,233			20,947			—			—			258,180
Debt issuance costs		4,698			—			—			—			4,698
Goodwill		—			40,289			—			—			40,289
Intercompany investments and advances		249,738			66,574			—			(316,312		)	—
Other assets		7,721			3,780			—			—			11,501
		$	719,849		$	159,589		$	—		$	(316,312	)	$	563,126
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable		$	(3,907	)	$	70,359		$	—		$	—		$	66,452
Intercompany payables		235,988			(235,988		)	—			—			—
Accrued expenses		58,796			7,413			—			—			66,209
Accrued salaries and employee benefits		49,454			951			—			—			50,405
Current portion of long-term debt		1,420			—			—			—			1,420
Current portion of capital lease and other obligations		496			—			—			—			496
Total current liabilities		342,247			(157,265		)	—			—			184,982
Long-term debt, excluding current portion		139,725			—			—			—			139,725
Senior subordinated notes payable		170,000			—			—			—			170,000
Capital lease and other obligations, excluding current portion		2,235			—			—			—			2,235
Deferred tax liability		13,474			—			—			—			13,474
Deferred rent and other liabilities		20,122			542			—			—			20,664
Total liabilities		687,803			(156,723		)	—			—			531,080
Stockholders’ equity (deficit)		32,046			316,312			—			(316,312		)	32,046
		$	719,849		$	159,589		$	—		$	(316,312	)	$	563,126

 

11

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY BALANCE SHEET

February 1, 2003

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
ASSETS
Current assets:
Cash and cash equivalents		$	108,174		$	763		$	—		$	—		$	108,937
Receivables		3,579			10,724			—			—			14,303
Inventories		128,837			9,573			—			—			138,410
Deferred tax assets		14,492			—			—			—			14,492
Other		7,413			46			—			—			7,459
Total current assets		262,495			21,106			—			—			283,601
Fixed assets, net		196,614			21,828			—			—			218,442
Debt issuance costs		5,724			—			—			—			5,724
Goodwill		—			40,644			—			—			40,644
Intercompany investments and advances		213,635			58,792			—			(272,427		)	—
Other assets		6,444			—			—			—			6,444
		$	684,912		$	142,370		$	—		$	(272,427	)	$	554,855
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable		$	(5,023	)	$	66,331		$	—		$	—		$	61,308
Intercompany payables		203,606			(203,606		)	—			—			—
Accrued expenses		58,839			6,252			—			—			65,091
Accrued salaries and employee benefits		41,325			415			—			—			41,740
Current portion of long-term debt		2,000			—			—			—			2,000
Current portion of capital lease and other obligations		411			—			—			—			411
Total current liabilities		301,158			(130,608		)	—			—			170,550
Long-term debt, excluding current portion		190,500			—			—			—			190,500
Senior subordinated notes payable		170,000			—			—			—			170,000
Capital lease and other obligations, excluding current portion		2,630			—			—			—			2,630
Deferred tax liability		13,268			—			—			—			13,268
Deferred rent and other liabilities		18,439			551			—			—			18,990
Total liabilities		695,995			(130,057		)	—			—			565,938
Stockholders’ equity (deficit)		(11,083		)	272,427			—			(272,427		)	(11,083		)
		$	684,912		$	142,370		$	—		$	(272,427	)	$	554,855

 

12

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF OPERATIONS

For the thirteen weeks ended November 1, 2003

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Net sales		$	385,373		$	289,791		$	—		$	(259,830	)	$	415,334
Cost of sales and occupancy costs		266,660			238,179			—			(226,626		)	278,213
Gross profit		118,713			51,612			—			(33,204		)	137,121
Selling, general and administrative expenses		97,515			40,474			—			(33,204		)	104,785
Operating income		21,198			11,138			—			—			32,336
Interest income		(186		)	—			—			—			(186		)
Interest expense		6,561			—			—			—			6,561
Debt retirement costs		—			—			—			—			—
Earnings before income taxes		14,823			11,138			—			—			25,961
Income taxes		6,752			—			—			—			6,752
Earnings before equity in earnings of subsidiaries		8,071			11,138			—			—			19,209
Equity in earnings of subsidiaries		11,138			—			—			(11,138		)	—
Net earnings		$	19,209		$	11,138		$	—		$	(11,138	)	$	19,209

 

13

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF OPERATIONS

For the thirty-nine weeks ended November 1, 2003

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Net sales		$	1,107,646		$	800,760		$	—		$	(709,919	)	$	1,198,487
Cost of sales and occupancy costs		771,936			661,337			—			(620,737		)	812,536
Gross profit		335,710			139,423			—			(89,182		)	385,951
Selling, general and administrative expenses		281,555			106,321			—			(89,182		)	298,694
Operating income		54,155			33,102			—			—			87,257
Interest income		(1,270		)	—			—			—			(1,270		)
Interest expense		21,312			—			—			—			21,312
Debt retirement costs		1,572			—			—			—			1,572
Earnings before income taxes		32,541			33,102			—			—			65,643
Income taxes		21,877			—			—			—			21,877
Earnings before equity in earnings of subsidiaries		10,664			33,102			—			—			43,766
Equity in earnings of subsidiaries		33,102			—			—			(33,102		)	—
Net earnings		$	43,766		$	33,102		$	—		$	(33,102	)	$	43,766

 

14

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF OPERATIONS

For the thirteen weeks ended November 2, 2002

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Net sales		$	338,943		$	251,023		$	—		$	(222,436	)	$	367,530
Cost of sales and occupancy costs		237,793			214,873			—			(199,413		)	253,253
Gross profit		101,150			36,150			—			(23,023		)	114,277
Selling, general and administrative expenses		83,739			25,744			—			(23,023		)	86,460
Operating income		17,411			10,406			—			—			27,817
Interest income		(239		)	—			—			—			(239		)
Interest expense		8,374			—			—			—			8,374
Earnings before income taxes		9,276			10,406			—			—			19,682
Income taxes		7,676			—			—			—			7,676
Earnings (loss) before equity in earnings of subsidiaries		1,600			10,406			—			—			12,006
Equity in earnings of subsidiaries		10,406			—			—			(10,406		)	—
Net earnings		$	12,006		$	10,406		$	—		$	(10,406	)	$	12,006

 

15

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF OPERATIONS

For the thirty-nine weeks ended November 2, 2002

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Net sales		$	984,615		$	711,057		$	—		$	(624,461	)	$	1,071,211
Cost of sales and occupancy costs		697,992			602,893			—			(556,074		)	744,811
Gross profit		286,623			108,164			—			(68,387		)	326,400
Selling, general and administrative expenses		249,437			71,290			—			(68,387		)	252,340
Management fees and termination costs		12,760			—			—			—			12,760
Stock-based compensation and other costs		8,176			—			—			—			8,176
Operating income (loss)		16,250			36,874			—			—			53,124
Interest income		(548		)	—			—			—			(548		)
Interest expense		25,816			—			—			—			25,816
Debt retirement costs		3,336			—			—			—			3,336
Earnings (loss) before income taxes and extraordinary item		(12,354		)	36,874			—			—			24,520
Income taxes		11,811			—			—			—			11,811
Earnings (loss) before equity in earnings of subsidiaries		(24,165		)	36,874			—			—			12,709
Equity in earnings of subsidiaries		36,874			—			—			(36,874		)	—
Net earnings		$	12,709		$	36,874		$	—		$	(36,874	)	$	12,079

 

16

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF CASH FLOWS

For the thirty-nine weeks ended November 1, 2003

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Cash flows from operating activities:
Net earnings		$	43,766		$	33,102		$	—		$	(33,102	)	$	43,766
Adjustments to reconcile net earnings to net cash provided by operating activities		49,968			(28,189		)	—			33,102			54,881
Net cash provided by operating activities		93,734			4,913			—			—			98,647
Cash flows from investing activities:
Additions to fixed assets		(79,632		)	(2,108		)	—			—			(81,740		)
Acquisition of intangible assets		—			(3,037		)	—			—			(3,037		)
Net (loans) repayments to employees		245			—			—			—			245
Net cash used in investing activities		(79,387)			(5,145		)	—			—			(84,532		)
Cash flows from financing activities:
Repayment of long term debt agreements		(51,355		)	—			—			—			(51,355		)
Debt issuance costs		(1,488		)	—			—			—			(1,488		)
Repayment of capital lease and other obligations		(310		)	—			—			—			(310		)
Proceeds from the issuance of common stock		86			—			—			—			86
Costs from the issuance of common stock		(1,423		)	—			—			—			(1,423		)
Net cash used in financing activities		(54,490		)	—			—			—			(54,490		)
Net decrease in cash and cash equivalents		(40,143		)	(232		)	—			—			(40,375		)
Cash and cash equivalents at the beginning of the period		108,174			763			—			—			108,937
Cash and cash equivalents at the  end of the period		$	68,031		$	531		$	—		$	—		$	68,562

 

17

 

PETCO ANIMAL SUPPLIES, INC.

CONDENSED CONSOLIDATING GUARANTOR, NON-GUARANTOR AND

PARENT COMPANY STATEMENT OF CASH FLOWS

For the thirty-nine weeks ended November 2, 2002

(unaudited, in thousands)

 

		PETCO Animal Supplies, Inc. Parent Company Guarantor			Guarantor Subsidiaries			Non-Guarantor Subsidiaries			Reclassifications and Eliminations			PETCO Animal Supplies, Inc. and Subsidiaries
Cash flows from operating activities:
Net earnings		$	12,709		$	36,873		$	—		$	(36,873	)	$	12,709
Adjustments to reconcile net earnings to net cash provided by operating activities		42,642			(35,667		)	—			36,873			43,848
Net cash provided by operating activities		55,351			1,206			—			—			56,557
Cash flows from investing activities:
Additions to fixed assets		(43,619		)	(743		)	—			—			(44,362		)
Net (loans) repayments to/from employees		58			—			—			—			58
Net cash used in investing activities		(43,561		)	(743		)	—			—			(44,304		)
Cash flows from financing activities:
Repayment of long term debt agreements		(31,500		)	—			—			—			(31,500		)
Debt issuance costs		(1,465		)	—			—			—			(1,465		)
Repayment of capital lease and other obligations		(4,188		)	—			—			—			(4,188		)
Proceeds from the issuance of common stock		295,105			—			—			—			295,105
Costs from the issuance of common stock		(21,988		)	—			—			—			(21,988		)
Redemption of Series A senior redeemable preferred stock		(142,231		)	—			—			—			(142,231		)
Redemption of Series B junior redeemable preferred stock		(97,538		)	—			—			—			(97,538		)
Net cash used in financing activities		(3,805		)	—			—			—			(3,805		)
Net increase in cash and cash equivalents		7,985			463			—			—			8,448
Cash and cash equivalents at the beginning of the period		36,000			215			—			—			36,215
Cash and cash equivalents at the end of the period		$	43,985		$	678		$	—		$	—		$	44,663

 

18

 

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

 

The following information should be read in conjunction with the financial statements and the related notes included in Item 1 of Part I of this Quarterly Report on Form 10-Q and with the financial statements and related notes for the year ended February 1, 2003 and the related “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in our Annual Report on Form 10-K, as amended, for the year ended February 1, 2003. We also urge you to review and consider our disclosures describing various risks that may affect our business, which are set forth under the heading “Certain Cautionary Statements” in Item 1 of our Annual Report on Form 10-K, as amended, for the year ended February 1, 2003.

 

General

 

PETCO is a leading specialty retailer of premium pet food, supplies and services. As of November 1, 2003, we operated 652 stores in 43 states and the District of Columbia. We plan to follow a strategy of opening new stores in new and existing markets, expanding, remodeling or relocating certain existing stores and closing under-performing stores. Since the middle of 2001, all new stores have been opened in our millennium format, and we have engaged in a remodel program to convert certain existing stores to this format. As a result of our store expansion strategy, operating results may reflect lower average store contribution and operating margins due to increased store pre-opening expenses and lower anticipated sales volumes of newer stores.  The timing of costs incurred for the remodel program may affect comparability from period to period.

 

On October 2, 2000, we completed a leveraged recapitalization with an entity controlled by Leonard Green & Partners, L.P. and its affiliates, and TPG Partners III, L.P. and its affiliates, the sponsors of the transaction. The transaction was financed by a combination of equity, senior subordinated debt and a senior credit facility. A group of equity investors led by the sponsors contributed a total of approximately $200 million of equity to PETCO in the transaction. The transaction was accounted for as a recapitalization, and as such, a step-up of assets to fair market value was not required.

 

On February 27, 2002, we completed an initial public offering of our common stock. We received net proceeds of approximately $272.5 million from the offering of 15,500,000 shares of our common stock, including 1,000,000 shares of our common stock pursuant to the exercise of the underwriters’ option to purchase additional shares. We used approximately $239.8 million of the net proceeds of our initial public offering to redeem in full all of our then outstanding shares of series A and series B preferred stock and used approximately $32.7 million of the net proceeds of our initial public offering, plus approximately $1.8 million in cash-on-hand, to repurchase $30.0 million in aggregate principal amount of our senior subordinated notes at 110.5% of their face amount plus accrued and unpaid interest through the repurchase date.

 

Results of Operations

 

Third Quarter 2003 Compared with Third Quarter 2002

 

Net sales increased 13.0% to $415.3 million for the thirteen weeks ended November 1, 2003 from $367.5 million for the thirteen weeks ended November 2, 2002. The increase in net sales resulted primarily from the comparable store net sales increase of 6.0% and the addition of 61 new stores since the prior year third quarter, partially offset by the closure of nine stores, of which six were relocated. The 52 net new stores added during the last twelve months brings our store base to 652 locations nationwide. The comparable store net sales increase was attributable to improvements in product mix and increased traffic. The increase in comparable store net sales accounted for approximately $22.1 million, or 46.2%, of the net sales increase, while the net increase in our store base accounted for approximately $25.7 million, or 53.8%, of the net sales increase.

 

Gross profit, defined as net sales less cost of sales including store occupancy costs, increased 20.0%, or $22.8 million, to $137.1 million from $114.3 million in the prior year quarter. Gross profit as a percentage of net sales, increased approximately 190 basis points. The increase was driven by the continuing change in mix from lower-margin pet food sales to higher-margin categories, such as pet accessories, supplies and services, which accounted for 80 basis points of the improvement. The remainder of the increase was a result of a net benefit of 110 basis points from the adoption of Emerging Issues Task Force, or EITF, Issue 02-16.

 

Selling, general and administrative expenses increased to $104.8 million in the third quarter of 2003 from $86.5 million in the prior year quarter. As a percentage of net sales, these expenses increased to 25.2% in the third quarter of 2003 from 23.5% in the prior year quarter. The increase was primarily attributable to the adoption of EITF 02-16 in 2003, which resulted in the reclassification of $6.7 million of vendor consideration from an offset to selling, general and administrative expenses to a $4.7 million reduction of cost of sales and a $2.0 million deferral, reducing inventory, which will be recognized as a reduction of cost of sales in future periods.

 

Operating income in the third quarter of 2003 increased to $32.3 million, or 7.8% of net sales, from $27.8 million, or 7.6% of net sales, in the prior year quarter.

 

19

 

Net interest expense was $6.4 million for the thirteen weeks ended November 1, 2003, compared with $8.1 million in the prior year quarter. Lower debt levels due to the repayment of long-term debt and lower interest rates specific to our credit facility contributed to the reduction in interest expense. The early repayment of $50 million and amendment of our senior credit facility, completed during the second quarter, resulted in an immediate interest rate reduction of 0.5%, which is expected to further positively impact interest expense in future periods.

 

Income taxes for the third quarter of 2003 were $6.8 million, compared with $7.7 million in the prior year quarter.  The decrease over the prior year was a result of a $3.4 million favorable resolution of an income tax accrual which resulted in a favorable impact of $0.06 per diluted share.  Excluding the favorable tax resolution, the Company had an effective tax rate of 39% for the current quarter.

 

Net earnings in the third quarter of 2003 increased to $19.2 million, or $0.33 per diluted share, compared to $12.0 million, or $0.21 per diluted share, for the prior year quarter.  Net earnings for the third quarter of 2003 included a $3.4 million favorable resolution of an income tax accrual.

 

Thirty-nine Weeks Ended November 1, 2003 Compared with Thirty-nine Weeks Ended November 2, 2002

 

Net sales increased 11.9% to $1.2 billion for the thirty-nine weeks ended November 1, 2003 from $1.1 billion for the thirty-nine weeks ended November 2, 2002. The increase in net sales resulted primarily from the comparable store net sales increase of 5.6% and the addition of 61 new stores since the prior year period, partially offset by the closure of nine stores, of which six were relocated. The 52 net new stores added during the last twelve months brings our store base to 652 locations nationwide. The comparable store net sales increase was attributable to improvements in product mix and increased traffic. The increase in comparable store net sales accounted for approximately $59.5 million, or 46.7%, of the net sales increase, while the net increase in our store base accounted for approximately $67.8 million, or 53.3%, of the net sales increase.

 

Gross profit increased 18.2%, or $59.6 million, to $386.0 million from $326.4 million in the prior year period. Gross profit for the thirty-nine weeks ended November 2, 2002 included a non-cash stock-based compensation expense of $1.4 million related to the deemed fair value of our common stock as a result of our initial public offering. Gross profit as a percentage of net sales, increased approximately 170 basis points compared to the prior year period. The increase was primarily driven by the continuing change in mix from lower-margin pet food sales to higher-margin categories, such as pet accessories, supplies and services.  The effect of the adoption of EITF 02-16 on gross profit for the thirty-nine weeks ended November 1, 2003 included a net benefit of 70 basis points.

 

Selling, general and administrative expenses increased to $298.7 million in the thirty-nine weeks ended November 1, 2003, compared to $252.3 million in the prior year period. As a percentage of net sales, these expenses increased to 24.9% from 23.6% in the prior year period. Contributing to the increase were store pre-opening costs, costs associated with our store remodel program, and increased insurance, medical, dental and legal costs. In addition, the adoption of EITF 02-16 in 2003 resulted in the reclassification of $13.0 million of vendor consideration from an offset to selling, general and administrative expenses to a $8.7 million reduction of cost of sales and a $4.3 million deferral, reducing inventory, which will be recognized as a reduction of cost of sales in future periods.

 

Management fees in the prior year period were $0.3 million in addition to the aggregate amount of $12.5 million we paid as a one-time termination fee in February 2002 to terminate the management services agreement that we entered into in conjunction with our leveraged recapitalization. Non-cash stock-based compensation and other costs in the prior year period were $8.2 million. Non-cash stock-based compensation expenses were based on the deemed fair value of our common stock as a result of our initial public offering.

 

Operating income for the thirty-nine weeks ended November 1, 2003 increased to $87.3 million, or 7.3% of net sales, from $53.1 million, or 5.0% of net sales, in the prior year period. Operating income in the prior year period includes management fees and termination costs of $12.8 million and stock-based compensation expense totaling $8.4 million.

 

Net interest expense was $20.0 million for the thirty-nine week period ended November 1, 2003, compared with $25.3 million in the prior year period. Lower debt levels due to the repayment of long-term debt and lower interest rates specific to our credit facility contributed to the reduction in interest expense. The early repayment of $50 million and amendment of our senior credit facility, completed during August 2003, resulted in an immediate interest rate reduction of 0.5%, which is expected to further positively impact interest expense in future periods.

 

 

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Income taxes for the thirty-nine weeks ended November 1, 2003 were $21.9 million, compared with $11.8 million in the prior year period.  The lower rate in the current year was a result of a $3.4 million favorable resolution of an income tax accrual in the third quarter of 2003 and certain non-deductible stock-based compensation costs in the prior year. Excluding the favorable tax resolution in the current year, the Company had an effective tax rate of 39% for the thirty-nine weeks ended November 1, 2003.

 

Prior to the redemption in the first quarter of 2002 of all of our previously outstanding preferred stock in connection with our initial public offering, the holders of our series A preferred stock and our series B preferred stock were entitled to receive dividends at a rate of 14% and 12%, respectively. We were not required to pay these dividends in cash, and the unpaid dividends compounded quarterly. The dividends earned were added to the principal balance of the preferred stock, with a corresponding reduction in net earnings available to common stockholders.

 

Net earnings available to common stockholders for the thirty-nine weeks ended November 1, 2003 increased to $43.8 million, or $0.75 per diluted share, compared with a net loss available to common stockholders of $7.8 million, or a $0.14 loss per diluted share, for the prior year period. The thirty-nine week period ended November 1, 2003 included a non-recurring $3.4 million favorable resolution of an income tax accrual, and $1.6 million of debt retirement costs resulting from an early repayment of a portion of our long-term senior credit facility.  The thirty-nine week period ended November 2, 2002 included the following items: $12.8 million in management fees and termination costs related to the termination of a management services agreement that was entered into in conjunction with our leveraged recapitalization; $8.4 million in stock-based compensation expense, and other primarily financing and legal costs of $1.2 million, related to our initial public offering; debt retirement costs of $3.3 million related to the early repurchase of senior subordinated notes with proceeds of the initial public offering; and an increase in the carrying amount and premium on redemption of previously outstanding preferred stock of $20.5 million.

 

Liquidity and Capital Resources

 

We have financed our operations and expansion program through internal cash flow, external borrowings and the sale of equity securities. At November 1, 2003 total assets were $563.1 million, $248.5 million of which were current assets. Net cash provided by operating activities was $98.6 million for the thirty-nine week period ended November 1, 2003 compared to net cash provided by operating activities of $56.6 million in the prior-year period. Our sales are substantially on a cash basis. Therefore, cash flow generated from operating stores provides a significant source of liquidity. We use operating cash principally to make interest payments on our debt and to purchase inventory. A portion of the inventory we purchase is financed through vendor credit terms. We significantly increased our leverage following our leveraged recapitalization in October 2000, and we use cash generated from operating activities to service the increased debt levels.

 

We use cash in investing activities to purchase fixed assets for new stores, to acquire stores, to remodel certain existing stores and, to a lesser extent, to purchase warehouse and office fixtures, equipment and computer hardware and software in support of our distribution and administrative functions. We estimate that our purchases of fixed assets for fiscal 2003 will be approximately $90 million to $95 million, which includes the cost of purchasing additional land and office buildings adjacent to our existing national support center offices, and the estimated cost of remodeling existing stores into our millennium format. Cash used in investing activities was $84.5 million, including $14.0 million for the purchase of the land and office buildings, and $44.3 million for the thirty-nine week periods ended November 1, 2003 and November 2, 2002, respectively.

 

We have historically financed some of our purchases of equipment and fixtures through capital lease and other obligations. No purchases of fixed assets were financed in this manner during the thirty-nine week periods ended November 1, 2003 and November 2, 2002.

 

On October 2, 2000, we completed our leveraged recapitalization. In the transaction, each issued and outstanding share of our common stock was cancelled and converted automatically into the right to receive $22.00 in cash, with the exception of 134,351 shares retained by members of our management. As a result of subsequent stock splits, these 134,351 shares now represent 5,911,444 shares of common stock. In the leveraged recapitalization, we issued an aggregate of $195.0 million in common stock and preferred stock and $120.0 million of senior subordinated debt, entered into a $350.0 million senior credit facility, retired debt under the then existing credit facility and repurchased substantially all of our outstanding common stock for an aggregate of $463.4 million. Net proceeds from the issuance of new shares of common stock in the leveraged recapitalization was $15.9 million. This transaction was accounted for as a recapitalization and as such, a step-up of assets to fair market value was not required.

 

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In October 2001, we issued $200 million of our 10.75% senior subordinated notes due November 2011 and amended and restated our senior credit facility. We used the proceeds from the issuance of our 10.75% senior subordinated notes to repay all of our then outstanding 13% senior subordinated notes due 2010 and retired approximately $71 million of the term loan facilities under our senior credit facility. We may from time to time seek to retire some or all of our senior subordinated notes in open market purchases, negotiated transactions or otherwise. The scope of such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. Such repurchases may have a material effect on our liquidity, financial condition and results of operations.

 

On February 27, 2002, we completed an initial public offering of our common stock. We received net proceeds of approximately $272.5 million from the offering of 15,500,000 shares of our common stock, including 1,000,000 shares of our common stock pursuant to the subsequent exercise of the underwriters’ option to purchase additional shares. We used approximately $239.8 million of the net proceeds of our initial public offering to redeem in full all of our then outstanding shares of series A and series B preferred stock, and used approximately $32.7 million of the net proceeds of our initial public offering plus approximately $1.8 million in cash-on-hand to repurchase $30.0 million in aggregate principal amount of our senior subordinated notes at 110.5% of their face value plus accrued interest.

 

On February 3, 2003, we entered into a limited waiver and third amendment to our senior credit facility. The waiver allowed us to purchase land and buildings adjacent to our national support center, and also allows us to redeem or repurchase, from time to time, up to $50 million of our 10.75% senior subordinated notes. Certain other provisions of the waiver were allowed to expire on May 31, 2003.

 

On May 29, 2003, certain selling stockholders completed a public offering of 9,000,000 shares of our common stock pursuant to an effective shelf registration statement we previously filed with the SEC. An additional 1,350,000 shares of common stock was sold by certain selling stockholders to cover over-allotments on June 9, 2003. On June 23, 2003, certain selling stockholders completed a privately negotiated sale of 1,880,000 shares of our common stock pursuant to the shelf registration statement. All of the 12,230,000 shares were offered by selling stockholders. We did not receive any proceeds from the sale of these shares by the selling stockholders. We recorded offering expenses of approximately $1.4 million as a direct charge to accumulated deficit during 2003. We terminated the shelf registration statement on June 30, 2003.

 

We have a senior credit facility with a syndicate of banks that expires between October 2, 2006 and October 2, 2008 that, as of July 31, 2003, consisted of a $75.0 million revolving credit facility and a $191.5 million term loan. On August 1, 2003, we made an early repayment of $50 million of the term loan from operating cash flows and incurred debt retirement costs of $1.6 million. In connection with the repayment, we entered into an amendment of the senior credit facility which resulted in an immediate interest rate reduction of 0.5% on the term loan and more favorable credit agreement terms.

 

As of November 1, 2003, the senior credit facility now consists of a $75.0 million revolving credit facility and a $141.5 million term loan for a total commitment of $216.5 million. Borrowings under the senior credit facility are secured by substantially all of our assets and bear interest (1) in the case of the revolving facility, at our option, at the agent bank’s base rate plus a margin of up to 2.25%, or LIBOR plus a margin of up to 3.25%, based on our leverage ratio at the time, and (2) in the case of the term loan, at our option, at the agent bank’s base rate plus a fixed margin of 1.5%, or LIBOR plus a fixed margin of 2.5%. The effective interest rate of these borrowings at November 1, 2003 was 3.64%. The amended credit agreement contains certain affirmative and negative covenants related to, among other things, indebtedness, interest and fixed charges coverage and consolidated net worth. At November 1, 2003, we were in full compliance with all of these covenants, the outstanding balance of our term loan was $141.1 million and there were no borrowings on our revolving credit facility, which had $55 million of available credit.

 

Our primary long-term capital requirement is funding for the opening or acquisition of stores as well as the remodeling of certain existing stores. Cash flows used in financing activities were $54.5 million for the thirty-nine week period ended November 1, 2003 compared with cash flows used in financing activities of $3.8 million for the thirty-nine week period ended November 2, 2002. During the thirty-nine week period ended November 2, 2002, net proceeds of $273.1 million were generated from sales of our common stock. In addition, for the thirty-nine week period ended November 2, 2002, we used $239.8 million to redeem our series A senior preferred stock and our series B junior preferred stock and approximately $32.7 million of the net proceeds of the initial public offering, plus approximately $1.8 million in cash-on-hand, to repurchase $30.0 million in aggregate principal amount of our senior subordinated notes at 110.5% of their face amount plus accrued interest, leaving $170.0 million in aggregate principal amount of our senior subordinated notes outstanding. Remaining cash flows used in financing activities were repayments of long-term debt agreements and other obligations.

 

As of February 1, 2003, we had available net operating loss carryforwards of $19.3 million for federal income tax purposes, which begin expiring in 2012, and $20.0 million for state income tax purposes, which begin expiring in 2010.

 

We anticipate that cash flows generated by operations and funds available under the credit facility will be sufficient to finance our continued operations and planned store openings at least through the next twelve months.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Market risks relating to our operations result primarily from changes in short-term London Interbank Offered Rates, or LIBOR, as our senior credit facility utilizes a portfolio of short-term LIBOR contracts. These LIBOR contracts are fixed rate instruments for a period of between one and six months, at our discretion. Our portfolio of LIBOR contracts vary in length and interest rate, such that adverse changes in short-term interest rates could affect our overall borrowing rate when contracts are renewed. We entered into a $75.0 million interest rate collar agreement, or hedge, in December 2000 to offset this interest rate risk. This hedge expired in December 2002 with no further liability. Changes in the intrinsic value of the hedge were recorded as accumulated other comprehensive income (loss). Amounts received or paid under the hedge were recorded as reductions of or additions to interest expense. We periodically evaluate alternative hedging strategies, although currently we have no hedges outstanding, and we do not enter into derivative financial instruments for trading or speculative purposes.

 

All of the debt under our senior credit facility as of November 1, 2003 was subject to variable interest rate fluctuations. Based on this debt level, a hypothetical 10% increase in variable rates from the applicable rates at November 1, 2003 would increase net interest expense by approximately $0.2 million on an annual basis, and would decrease both earnings and cash flows for that annual period by approximately $0.1 million. We cannot predict market fluctuations in interest rates and their impact on debt, nor can there be any assurance that long-term fixed-rate debt will be available at favorable rates, if at all. Consequently, future results may differ materially from estimated results due to adverse changes in interest rates or debt availability.

 

We did not have any material foreign exchange or other significant market risk at November 1, 2003.

 

Item 4. Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports we file pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

 

There have been no changes in our internal control over financial reporting during the period covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Part II. Other Information

 

Item 1.  Legal Proceedings

 

In June 2002, allegations were made in a complaint filed in the San Francisco Superior Court by the San Francisco City Attorney’s office to the effect that certain associates have not properly cared for companion animals for sale in our two San Francisco stores. The complaint, which has been subsequently transferred to the Santa Clara Superior Court, seeks damages, penalties and an injunction against the sale of companion animals in our San Francisco stores. The complaint and related news reports have caused negative publicity and subsequently certain other California counties have indicated that they are reviewing our animal care policies. We take seriously any allegations regarding the proper care of companion animals and have taken steps to reiterate to all our associates the importance of proper care for all companion animals in all of our stores. We are responding to the complaint and are defending it vigorously. The complaint and any similar actions, which could be filed in the future, could cause negative publicity, which could have a material adverse effect on our results of operations.

 

The District Attorneys of various California counties, through the San Diego District Attorney, have informed us that they are investigating certain alleged weights and measures violations. The investigation specifically concerns whether checkout price scanners used in our stores identified prices which sometimes did not match the posted prices for certain products, and whether the sale tags regarding those products were misleading. No legal action has been filed against us with respect to this investigation. Although we are working cooperatively with the District Attorneys to reach a satisfactory resolution of this matter, we cannot give any assurances that we

 

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will be able to resolve this matter on satisfactory terms or at all. We are unable at this time to determine whether any potential settlement of this matter, or the outcome of any litigation that might ensue if we are unable to settle this matter, will have a material impact on our results of operations or financial condition in any future period.

 

In April 2003, three alleged applicants for employment instituted an action against over 100 retailers, including us, in the Superior Court of California for the County of Los Angeles. The complaint in the action was filed individually and on behalf of a purported class. The complaint alleges that the individual plaintiffs and the purported class members sought employment with the other retailers, or us, and that the written employment application asked, in violation of the California Labor Code and Unfair Business Practices Act, about convictions for certain marijuana offenses and about convictions that resulted in the defendant being sent to a diversion program. The case in state court was stayed pending an initial status conference. One of the co-defendants has removed the action to the United States District Court for the Central District of California. We have not made an appearance in the case, and no pleadings or discovery have been initiated. We intend to vigorously defend the action, including contesting the certification of the action as a class action, and are unable at this time to determine whether the outcome of the litigation will have a material impact on our results of operations or financial condition in any future period.

 

In October 2003, we were served with a Civil Investigative Demand from the United States Federal Trade Commission, or FTC, seeking information and documents relating to our e-commerce website PETCO.com and more particularly our policies and practices regarding the protection of personal information furnished by customers to the website.  The request stems from an incident in late June 2003 in which a self-proclaimed hacker purportedly obtained unauthorized access to a portion of our website.  We have cooperated with the FTC’s inquiry by providing documents and information, and have taken and are taking additional steps to insure that our e-commerce customers’ privacy is maintained.  At the present time, we are unable to determine whether the FTC will initiate any enforcement action against us, or the financial impact any such action might entail.

 

We are also involved in routine litigation arising in the ordinary course of our business. While the results of such litigation cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our consolidated financial position or results of operations.

 

Item 5. Other Information

 

10b5-1 Trading Plans

 

Certain members of our executive management team established new Rule 10b5-1 trading plans in November 2003 following the expiration of their existing Rule 10b5-1 trading plans.  Rule 10b5-1 is a rule adopted by the Securities and Exchange Commission that recognizes the creation of formal programs under which executives and other “insiders” may sell the securities of publicly traded companies on a regular basis pursuant to written plans that are entered into at a time when the plan participants are not aware of material nonpublic information and that otherwise comply with the requirements of Rule 10b5-1.  In aggregate, the new trading plans call for the sale of approximately 1% of the executive management team’s initial PETCO holdings per month for twelve months, representing average monthly sales of approximately 70,500 shares of common stock.  The first month in which sales could occur under the new trading plans is December 2003.

 

The PETCO executives who entered into the new Rule 10b5-1 trading plans are Brian K. Devine, Chairman, President and Chief Executive Officer, Bruce C. Hall, Executive Vice President and Chief Operating Officer, James M. Myers, Executive Vice President and Chief Financial Officer, Robert E. Brann, Senior Vice President, Merchandising, Frederick W. Major, Senior Vice President, Information Systems, Keith G. Martin, Senior Vice President, Operations, Janet D. Mitchell, Senior Vice President, Human Resources and Administration, and William M. Woodard, Senior Vice President, Business Development.  Under the trading plans, the above mentioned executives may sell up to a maximum aggregate amount of 847,000 shares of common stock during the period beginning on December 1, 2003 and ending on November 30, 2004 without subsequent control over the timing of specific transactions by the plan participants.  The participants in the trading plans may amend or terminate the trading plans under certain circumstances and have the right to sell additional shares of common stock outside of the trading plans when they are not in possession of material nonpublic information.  The trading plans will expire on November 30, 2004 unless subsequently extended or terminated in accordance with the terms of such trading plans. Under each trading plan, an independent broker will execute the trades pursuant to selling parameters established by the plan participant when the trading plan was entered into without further direction from the participant.

 

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Certain Cautionary Statements

 

Some of the statements in this Quarterly Report on Form 10-Q, including, but not limited to, Part I, Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements are therefore entitled to the protection of the safe harbor provisions of these laws. We generally identify forward-looking statements in this Quarterly Report by using words like “believe,” “intend,” “target,” “expect,” “estimate,” “may,” “should,” “plan,” “project,” “contemplate,” “anticipate,” “predict” or similar expressions. You can also identify forward-looking statements by discussions of strategy, plans or intentions. These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These factors, such as performance of new stores, ability to execute expansion strategy and sustain growth, debt levels, reliance on vendors and exclusive distribution arrangements, competition, integration of operations as a result of acquisitions, compliance with various state and local regulations and dependence on senior management, are discussed from time to time in the reports we file with the Securities and Exchange Commission, including our Annual Report on Form 10-K, as amended, for the fiscal year ended February 1, 2003.

 

Item 6. Exhibits and Reports on Form 8-K

 

(a)		Exhibits
		31.1	Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
		32.1	Certifications 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
		None

 

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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.

 

		PETCO ANIMAL SUPPLIES, INC.
		By:	/s/ BRIAN K. DEVINE
			Brian K. Devine
			Chairman, President and
			Chief Executive Officer
			Date: December 3, 2003
		By:	/s/ JAMES M. MYERS
			James M. Myers
			Executive Vice President and
			Chief Financial Officer
			Date: December 3, 2003

 

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