UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 30, 2004 Commission File Number 000-50421
CONN'S, INC.
(Exact name of registrant as specified in its charter)
A Delaware Corporation 06-1672840
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
3295 College Street
Beaumont, Texas 77701
(409) 832-1696
(Address, including zip code, and telephone
number, including area code, of registrant's
principal executive offices)
NONE
(Former name, former address and former
fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES NO X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of June 10, 2004:
Class Outstanding
- -------------------------------------- -------------------
Common stock, $.01 par value per share 23,172,799
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Page No.
--------------------- --------
Item 1. Consolidated Financial Statements..............................................................1
- -------
Consolidated Balance Sheets as of January 31, 2004 and April 30, 2004..........................1
Consolidated Statements of Operations for the three months ended
April 30, 2003 and 2004....................................................................2
Consolidated Statements of Stockholders' Equity for the three months
ended April 30, 2004.......................................................................3
Consolidated Statements of Cash Flows for the three months ended
April 30, 2003 and 2004....................................................................4
Notes to Consolidated Financial Statements.....................................................5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................................................9
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................20
- -------
Item 4. Controls and Procedures.......................................................................20
- -------
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................................................21
- -------
Item 6. Exhibits and Reports on Form 8-K..............................................................21
- -------
SIGNATURES ..............................................................................................22
i
Conn's, Inc.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
January 31, April 30,
2004 2004
-------------------------
Assets (unaudited)
Current assets
Cash and cash equivalents $12,942 $9,661
Accounts receivable, net 16,802 17,703
Interest in securitized asset 77,138 82,476
Inventories 53,742 57,099
Deferred income taxes 4,148 4,316
Prepaid expenses and other assets 3,031 2,338
------------ ------------
Total current assets 167,803 173,593
Debt issuance and other costs 250 89
Non-current deferred tax asset 3,945 4,140
Property and equipment
Land 10,708 11,633
Buildings 13,108 13,497
Equipment And Fixtures 7,574 8,060
Transportation Equipment 2,845 2,891
Leasehold Improvements 48,504 51,904
------------ ------------
Subtotal 82,739 87,985
Less accumulated depreciation (27,914) (29,826)
------------ ------------
Total property and equipment, net 54,825 58,159
Goodwill, net 7,917 7,917
Other assets, net 20 81
------------ ------------
Total assets $234,760 $243,979
============ ============
Liabilities and Stockholders' Equity
Current Liabilities
Notes payable $- $630
Current portion of long-term debt 338 328
Accounts payable 26,412 27,012
Accrued expenses 12,800 9,847
Income taxes payable 3,528 5,476
Deferred income taxes 313 358
Deferred revenue 6,225 6,450
Fair value of derivatives 1,121 1,017
------------ ------------
Total current liabilities 50,737 51,118
Long-term debt 14,174 14,079
Non-current deferred tax liability 477 534
Deferred gain on sale of property 811 769
Fair value of derivatives 202 -
Minority interest 1,769 1,829
Stockholders' equity
Common stock ($0.01 par value, 40,000,000 shares authorized;
23,101,772 and 23,172,799 shares issued and outstanding
at January 31, 2004 and April 30, 3004, respectively) 231 232
Additional paid-in capital 82,656 83,243
Accumulated other comprehensive income 5,032 5,731
Retained earnings 78,671 86,444
------------ ------------
Total stockholders' equity 166,590 175,650
------------ ------------
Total liabilities and stockholders' equity $234,760 $243,979
============ ============
See notes to consolidated financial statements.
1
Conn's, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except earnings per share)
Three Months Ended
April 30,
----------------------
2003 2004
---------- ----------
Revenues
Product sales $96,224 $107,529
Service maintenance agreement commissions (net) 5,987 6,635
Service revenues 4,476 4,378
---------- ----------
Total net sales 106,687 118,542
Finance charges and other 14,104 16,336
---------- ----------
Total revenues 120,791 134,878
Cost and Expenses
Cost of goods sold, including warehousing and occupancy costs 77,189 84,774
Cost of parts sold, including warehousing and occupancy costs 1,046 1,104
Selling, general and administrative expense 31,755 34,862
Provision for bad debts 1,368 1,422
---------- ----------
Total cost and expenses 111,358 122,162
---------- ----------
Operating income 9,433 12,716
Interest expense 1,546 582
---------- ----------
Income before minority interest and income taxes 7,887 12,134
Minority interest in limited partnership - (115)
---------- ----------
Income before income taxes 7,887 12,019
Provision for income taxes
Current 2,884 4,683
Deferred (82) (437)
---------- ----------
Total provision for income taxes 2,802 4,246
---------- ----------
Net income 5,085 7,773
Less preferred dividends (586) -
---------- ----------
Net income available for common shareholders $4,499 $7,773
========== ==========
Earnings per share
Basic $0.27 $0.34
Diluted $0.27 $0.33
Average common shares outstanding
Basic 16,720 23,145
Diluted 16,720 23,749
See notes to consolidated financial statements.
2
Conn's, Inc.
CONSOLIDATED STATEMMENTS OF STOCKHOLDERS' EQUITY
(unaudited)
(in thousands except option exercise amounts)
Accum.
Other
Common Stock Compre-
------------------- hensive Paid in Retained
Shares Amount Income Capital Earnings Total
---------- -------- ------------ ----------- ------------ ------------
Balance Janaury 31, 2004 23,102 $231 $5,032 $82,656 $78,671 $166,590
Exercise of options to acquire -
71,000 shares of common
stock 71 1 - 590 - 591
Cost of issuing capital - - - (3) - (3)
Net income - - - - 7,773 7,773
Reclassification adjustments on
derivative instruments
(net of tax of $ 98) - - 180 - - 180
Adjustment of fair value of
securitized assets (net of tax of
$ 283), net of reclass-
ification adjustments of
$2,161 (net of tax of $1,189) - - 519 - - 519
------------
Total comprehensive income 8,472
---------- -------- ------------ ----------- ------------ ------------
Balance April 30, 2004 23,173 $232 $5,731 $83,243 $86,444 $175,650
========== ======== ============ =========== ============ ============
See notes to consolidated financial statements.
3
Conn's, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
Three Months Ended April 30,
-----------------------------
2003 2004
----------- -------------
Cash flows from operating activities
Net income $5,085 $7,773
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation 1,614 1,880
Amortization 58 123
Provision for bad debts 1,368 1,422
Accretion from interests in securitized assets (2,960) (3,521)
Provision for deferred income taxes (82) (437)
Gain from sale of property and equipment (7) (1)
Gains from derivatives (net) (209) (26)
Change in operating assets and liabilities:
Accounts receivable (626) (3,544)
Inventory (652) (3,357)
Prepaid expenses and other assets 612 693
Accounts payable (1,505) 551
Accrued expenses (1,850) (3,051)
Income taxes payable 3,343 1,947
Deferred service contract revenue (384) 89
Other current liabilities 34 -
----------- -------------
Net cash provided by operating activities 3,839 541
----------- -------------
Cash flows from investing activities
Purchase of property and equipment (1,709) (4,346)
Proceeds from sale of property 167 2
----------- -------------
Net cash used in investing activities (1,542) (4,344)
----------- -------------
Cash flows from financing activities
Net proceeds from exercise of stock options - 591
Net payments under line of credit (1,690) (20)
Increase in debt issuance costs (270) -
Payment of promissory notes (482) -
----------- -------------
Net cash provided by (used in) financing activities (2,442) 571
Impact on cash of consolidation of SRDS - (49)
----------- -------------
Net change in cash (145) (3,281)
Cash and cash equivalents
Beginning of the year 2,448 12,942
----------- -------------
End of the year $2,303 $9,661
=========== =============
See notes to consolidated financial statements.
4
CONN'S , INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
April 30, 2004
1. Significant Accounting Policies
Basis of Presentation. The accompanying unaudited, condensed, consolidated
financial statements have been prepared in accordance with accounting principles
generally accepted in the United States for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the United States for complete
financial statements. The accompanying financial statements reflect all
adjustments that are, in the opinion of management, necessary for a fair
statement of the results for the interim periods presented. All such adjustments
are of a normal recurring nature. Operating results for the three months ended
April 30, 2004 are not necessarily indicative of the results that may be
expected for the year ending January 31, 2005. The financial statements should
be read in conjunction with the Company's audited consolidated financial
statements and the notes thereto included in the Company's Annual Report on Form
10-K filed on April 16, 2004.
The Company's balance sheet at January 31, 2004 has been derived from the
audited financial statements at that date but does not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial presentation. Please see the
Company's Form 10-K for the fiscal year ended January 31, 2004 for a complete
presentation of the audited financial statements at that date, together with all
required footnotes, and for a complete presentation and explanation of the
components and presentations of the financial statements.
Principles of Consolidation. The consolidated financial statements include
the accounts of Conn's, Inc. and its subsidiaries, limited liability companies
and limited partnerships, all of which are wholly-owned (the "Company"). All
material intercompany transactions and balances have been eliminated in
consolidation. The consolidated financial statements additionally include the
financial statements of a single entity meeting one or more of the standards of
Financial Accounting Standards Board ("FASB") Interpretation No. 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("FIN 46"), as described below.
The Company enters into securitization transactions to sell its retail
installment and revolving customer receivables. These securitization
transactions are accounted for as sales in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities, because the
Company has relinquished control of the receivables. Additionally, the Company
has transferred such receivables to a qualifying special purpose entity
("QSPE"). Accordingly, neither the transferred receivables nor the QSPE are
included in the consolidated financial statements of the Company.
Implementation of FIN 46. In January 2003, the FASB issued FIN 46 that
requires the consolidation of entities in which a company absorbs a majority of
the entity's expected losses, receives a majority of the entity's expected
residual returns, or both, as a result of ownership, contractual or other
financial interests in the entity. Currently, a company generally consolidates
entities when it has a controlling financial interest through ownership of a
majority voting interest in the entity. Although the Company itself does not
have a controlling financial interest in Specialized Realty Development
Services, LP ("SRDS"), SRDS is owned by various members of management and
individual investors of the Stephens Group, Inc. SRDS owns five retail stores
that it leases to the Company at April 30, 2004. The Company evaluated the
effects of the issuance of FIN 46 on the accounting for its leases with SRDS
and, as a result, determined that it is appropriate to consolidate the balance
sheets of SRDS with the balance sheets of the Company as of January 31, 2004 and
April 30, 2004. Additionally, commencing February 1, 2004 (the beginning of the
Company's 2005 fiscal year), the Company has determined that it is appropriate
to consolidate the operations of SRDS with those of the Company. The effect of
the consolidation on the Company's balance sheet at January 31, 2004 and April
30, 2004 was to increase cash, net property, debt and minority interests by the
amounts listed in the following table (dollars in thousands):
January 31, April 30,
2004 2004
----------------------
Increase in cash $1,024 $975
Increase in property and equipment, net 15,166 16,034
Increase in debt 14,421 14,333
Increase in minority interests 1,769 1,829
The Company has no financial obligation to the lenders for the outstanding
debt of SRDS.
Use of Estimates. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Earnings Per Share. In accordance with SFAS No. 128, Earnings per Share,
the Company calculates basic earnings per share by dividing net income by the
weighted average number of common shares outstanding. Diluted earnings per share
include the dilutive effects of any stock options granted calculated under the
treasury method. Because there were no options outstanding in the prior year
interim periods that were valued in excess of the grant price, there were no
such shares included in the diluted outstanding share total.
Goodwill. Goodwill represents primarily the excess of purchase price over
the fair market value of net assets acquired. Effective February 1, 2002, the
Company adopted the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets, whereby goodwill is no longer amortized, but rather the Company assesses
the potential future impairment of goodwill on an annual basis, or at any other
time when impairment indicators exist. The Company concluded that at January 31,
2004 and April 30, 2004 no impairment of goodwill existed.
Stock-Based Compensation. As permitted by SFAS No. 123, Accounting for
Stock-Based Compensation, the Company follows the intrinsic value method of
accounting for stock-based compensation issued to employees, as prescribed by
Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued
to Employees, and related interpretations. Since all options outstanding at
April 30, 2004 were granted at or above fair value, no compensation expense has
been recognized under the Company's stock option plan for any of the financial
statements presented.
If compensation expense for the Company's stock option plan had been
recognized using the fair value method of accounting under SFAS No. 123, net
income available for common stockholders would have decreased by 2.4% and 2.9%,
respectively, and diluted earnings per share would have decreased by 3.7% and
3.0%, respectively, for the three months ended April 30, 2003 and 2004. For
post-IPO grants, the Company has used the Black-Scholes model to determine fair
value. Prior to the IPO, the fair value of the options issued was estimated
using the minimum valuation option-pricing model. The following table presents
the impact to earnings per share if the Company had adopted the fair value
recognition provisions of SFAS No. 123 (dollars in thousands except per share
data):
Three Months Ended
April 30,
---------------------
2003 2004
---------- ---------
Net income available for common stockholders $4,499 $7,773
Stock-based compensation, net of tax, that would have
been reported under SFAS 123 (110) (225)
---------- ---------
Pro forma net income $4,389 $7,548
========== =========
Earnings per share-as reported:
Basic $0.27 $0.34
Diluted $0.27 $0.33
Pro forma earnings per share:
Basic $0.26 $0.33
Diluted $0.26 $0.32
6
Application of APB 21 to Cash Option Programs that Exceed One Year in
Duration: In February 2004, the Company began offering deferred interest payment
plans on certain products that extend beyond one year. In accordance with APB
21, Interest on Receivables and Payables, such sales are discounted to their
fair value resulting in a reduction in sales and receivables and the
amortization of the discount amount over the term of the deferred interest
payment plan. The difference between the gross sale and the discounted amount is
reflected as a deduction of "Product sales" in the consolidated statements of
operations and the amount of the discount being amortized in the current period
is recorded in "Finance charges and other". For the three months ended April 30,
2004, "Product sales" were reduced by $213,000 and "Finance charges and other"
was increased by $29,000 to effect the adjustment to fair value and to reflect
the appropriate amortization of the discount.
2. Supplemental Disclosure of Revenue and Comprehensive Income
A summary of the classification of the amounts included as "Finance charges
and other" is as follows (in thousands):
Three Months Ended
Arpil 30,
------------------------
2003 2004
----------- ----------
Securitization income $10,431 $11,328
Interest income from receivables not sold 231 295
Insurance commissions 3,041 3,776
Other 401 937
----------- ----------
Finance charges and other $14,104 $16,336
=========== ==========
The components of total comprehensive income for the three months April 30,
2003 and 2004 are presented in the table below:
Total comprehensive income:
Three Months Ended
April 30,
------------------------
2003 2004
----------- ----------
Net income $5,085
Unrealized gain on derivative instruments, net 744
Taxes on unrealized gain on derivatives (264)
Adjustment of fair value of securitized assets 186
Taxes on adjustment of fair value of securitized assets (66)
----------- ----------
Total comprehensive income $5,685 $-
=========== ==========
3. Fair Value of Derivatives
The Company held interest rate swaps and collars with notional amounts
totaling $70.0 million and $20.0 million as of April 30, 2003 and 2004,
respectively, with terms extending to April, 2005, and were held for the purpose
of hedging against variable interest rate risk, primarily related to cash flows
from the Company's interest-only strip as well as variable rate debt.
In fiscal 2003, hedge accounting was discontinued for $50.0 million of
swaps previously designated as hedges and in fiscal 2004, hedge accounting was
discontinued for the remaining $20.0 million of swaps. In accordance with SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities, at the
time hedge accounting was discontinued, the Company began to recognize changes
in fair value of the swaps as interest expense and to amortize the amount of
accumulated other comprehensive loss related to those derivatives as interest
expense over the period that the forecasted transactions affected the
consolidated statements of operations. During the three months ended April 30,
2003 and 2004, the Company reclassified $343,000 and $278,000, respectively, of
losses previously recorded in accumulated other comprehensive income into the
consolidated statements of operations and recorded $(780,000) and
$(305,000),.respectively, of interest reductions in the consolidated statement
of operations because of the change in fair value of the swaps.
7
Prior to discontinuing hedge accounting, the Company recorded hedge
ineffectiveness in each period, which arose from differences between the
interest rate stated in the derivative instrument and the interest rate upon
which the underlying hedged transaction was based. Ineffectiveness totaled
$229,000 for the three months ended April 30, 2003 and is reflected in "Interest
expense" in the consolidated statements of operations.
4. Amendment to bank Credit Facility
During the quarter the revolving line of credit was reduced from $40
million to $30.0 million through an amendment executed April 21, 2004. The
amendment also relaxed certain financial covenants and reduced the pricing
options for both the stand-by fee and the interest rate on outstanding balances.
5. Letters of Credit
The Company had outstanding unsecured letters of credit aggregating $11.8
million and $11.3 million at January 31, 2004 and April 30, 2004, respectively,
which secure a portion of the QSPE's asset-backed securitization program and the
deductible under the Company's insurance program and to secure international
product purchases. The maximum potential amount of future payments under these
letters of credit is considered to be the aggregate face amount of each letter
of credit.
As part of the asset-backed securitization program, the Company arranged
for the issuance of a stand-by letter of credit in the amount of $10.0 million
to provide assurance to the trustee of the asset-backed securitization program
that monthly funds collected by the Company would be remitted as required under
the base indenture and other related documents. The letter of credit has a term
of one year and expires in August 2004, at which time the Company expects to
renew such obligation. The letter of credit is callable, at the option of the
trustee, if the Company does not honor its obligation to remit funds under the
basic indenture and other related documents. The Company also has an obligation
to maintain the current letters of credit and to provide additional letters of
credit under its insurance program in amounts considered sufficient by the
carrier to cover expected losses of claims that remain open after the expiration
of the initial policy coverage period. The letter of credit is callable, at the
option of the insurance company, if the Company does not honor its requirement
to fund deductible amounts as billed.
In addition to the above, the Company obtained a commitment in March 2003
for $1.2 million in standby letters of credit to secure product purchases under
an international arrangement. There were no amounts drawn under this commitment
at April 30, 2004.
6. Contingencies
In December 2002, Martin E. Smith, as named plaintiff, filed a lawsuit
against the Company in the state district court in Jefferson County, Texas, that
attempts to create a class action for breach of contract and violations of state
and federal consumer protection laws arising from the terms of the Company's
service maintenance agreements. The lawsuit alleges an inappropriate overlap in
the product warranty periods provided by the manufacturer and the periods
covered by the service maintenance agreements that the Company sells. The
lawsuit seeks unspecified actual damages as well as an injunction against the
Company's current practices and extension of affected service contracts. The
Company believes that the warranty periods covered in its service maintenance
agreements are consistent with industry practice. The Company also believes that
it is premature to predict whether class action status will be granted or, if
granted, the outcome of this litigation. There is not currently a basis on which
to estimate a range of potential loss in this matter.
8
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-Looking Statements
This report contains forward-looking statements. We sometimes use words
such as "believe," "may," "will," "estimate," "continue," "anticipate,"
"intend," "expect," "project" and similar expressions, as they relate to us, our
management and our industry, to identify forward-looking statements.
Forward-looking statements relate to our expectations, beliefs, plans,
strategies, prospects, future performance, anticipated trends and other future
events. We have based our forward-looking statements largely on our current
expectations and projections about future events and financial trends affecting
our business. Actual results may differ materially. Some of the risks,
uncertainties and assumptions about us that may cause actual results to differ
from these forward-looking statements include, but are not limited to:
o our growth strategy and plans regarding opening new stores and
entering adjacent and new markets, including our plans to continue
expanding into the Dallas/Fort Worth metroplex;
o our intention to update or expand existing stores;
o estimated capital expenditures and costs related to the opening of new
stores or the update or expansion of existing stores;
o our cash flows from operations, borrowings from our revolving line of
credit and proceeds from securitizations to fund our operations, debt
repayment and expansion;
o technological and market developments, growth trends and projected
sales in the home appliance and consumer electronics industry,
including with respect to digital products like DVD players, HDTV,
digital radio, home networking devices and other new products, and our
ability to capitalize on such growth;
o changes in laws and regulations and/or interest, premium and
commission rates allowed by regulators on the credit, credit insurance
and service maintenance agreements as allowed by those laws and
regulations;
o our relationships with key suppliers;
o the adequacy of our distribution and information systems and
management experience to support our expansion plans;
o our expectations regarding competition and our competitive advantages;
o the outcome of litigation affecting our business; and
o non-payment of dividends.
Additional important factors that could cause our actual results to differ
materially from our expectations are discussed under "Risk Factors" in our Form
10-K filed with the Securities Exchange Commission on April 16, 2004. In light
of these risks, uncertainties and assumptions, the forward-looking events and
circumstances discussed in this report might not happen.
The forward-looking statements in this report reflect our views and
assumptions only as of the date of this report. We undertake no obligation to
update publicly or revise any forward-looking statements, whether as a result of
new information, future events or otherwise, except as required by law.
All forward-looking statements attributable to us, or to persons acting on
our behalf, are expressly qualified in their entirety by these cautionary
statements.
9
General
The following discussion and analysis is intended to provide you with a
more insightful understanding of our financial condition and performance in the
indicated periods, including an analysis of those key factors that contributed
to our financial condition and performance and that are, or are expected to be,
the key "drivers" of our business.
We are a specialty retailer that sells major home appliances, including
refrigerators, freezers, washers, dryers and ranges, and a variety of consumer
electronics, including projection, plasma and LCD televisions, camcorders, VCRs,
DVD players and home theater products. We also sell home office equipment, lawn
and garden products and bedding, and we continue to introduce additional product
categories for the home to help increase same store sales and to respond to our
customers' product needs. We require all sales personnel to specialize in home
appliances, consumer electronics, or "track" products which include small
appliances, computers, camcorders, DVD players, cameras and telephones that are
sold within the interior of a large, colorful track that circles the interior
floor of our stores. We currently operate 47 retail locations in Texas and
Louisiana.
Unlike many of our competitors, we provide in-house credit options for our
customers. Historically, we have financed over 56% of our retail sales. We
finance substantially all of our customer receivables through an asset-backed
securitization facility, and we derive servicing fee income and interest income
from these assets. As part of our asset-backed securitization facility, we have
created a qualifying special purpose entity, which we refer to as the QSPE or
the issuer, to purchase customer receivables from us and to issue asset-backed
and variable funding notes to third parties. We transfer receivables, consisting
of retail installment contracts and revolving accounts extended to our
customers, to the issuer in exchange for cash and subordinated securities. To
finance its acquisition of these receivables, the issuer has issued notes to
third parties.
We also derive revenues from repair services on the products we sell and
from product delivery and installation services we provide to our customers.
Additionally, acting as an agent for unaffiliated companies, we sell credit
insurance and service maintenance agreements to protect our customers from
credit losses due to death, disability, involuntary unemployment and property
damage and product failure. We also derive revenues from the sale of extended
service maintenance agreements to protect the customers after the original
warranty agreement has expired.
Executive Overview
This narrative is intended to provide an executive level overview of
our operations for the quarter ended April 30, 2004. A detailed explanation of
the changes in our operations for the quarter ended April 30, 2004 as compared
to the prior year is included beginning on page 16. As explained in that
section, our pretax income for the quarter ended April 30, 2004 increased
approximately52.4%, as a result of higher revenues, higher gross margins and
lower selling, general and administrative expenses as a percentage of revenues.
In addition, the utilization of our initial public offering proceeds to pay off
debt reduced our interest expense substantially. Some of the more specific
issues that impacted our operations are presented as follows:
o Same store sales for the quarter grew 3.5% over the same period for
the prior year. We believe that we were able to achieve this favorable
increase through a specific focus on our track sales and by taking the
opportunity to promote bedding and lawn and garden products. It is our
strategy to continue this focus throughout the balance of fiscal 2005.
o Our entry into the Dallas/Fort Worth market provided both a positive
and negative impact on our operations. Approximately, $8.5 million of
our product sales increase resulted from the opening of five new
stores in this market. However, our gross product and operating
margins were negatively impacted as we initially discounted prices and
incurred substantial standby costs in personnel and advertising to
insure that our initial entry into the market was well received. Our
plans provide for the opening of two to three additional stores in
this market during the balance of fiscal 2005 and we expect that many
of the standby costs previously absorbed will be reduced to a more
normal level.
10
o Part of our increase in same store sales during the quarter resulted
from our introduction of deferred interest payment plans on certain
products that extend beyond one year. In accordance with APB No. 21,
such sales have been discounted to their fair value, resulting in a
reduction in both sales and receivables and the discount amount has
been amortized over the term of the deferred payment plan. For the
three months ended April 30, 2004, such extended deferred interest
payment plans generated $2.7 million in product sales. Of the $2.7
million in "Product sales," we reduced "Finance charges and other" by
$213,000 and increased "Finance charges and other" by $29,000 to
effect the adjustment to fair value and to reflect the appropriate
amortization of the discount amount. We expect to continue to offer
this type of extended term promotional credit in the future.
o Our gross margin increased from 35.2% to 36.3%, primarily as a result
of our ability to drive same store sales in the current quarter
without the need to deeply discount prices as we did in the prior
year. While we expect to maintain future margins in the 36.0% to 37.0%
range, we do not expect a favorable increase in gross margin in the
next three quarters since the prior year quarters already reflect
margins at normal pricing levels.
o A significant part of our improvement in operations in the current
quarter resulted from increased vendor participation in our
company-wide grand opening celebration that took place during the
month of February 2004. As a result of reduced net advertising expense
of approximately $600,000 during the current quarter, Selling, general
and administrative (SG&A) expenses as a percent of revenues decreased
from 26.3% in fiscal 2004 to 25.8% in fiscal 2005. Since this vendor
sponsored promotional activity will not occur in the next three
quarters of fiscal 2005, it is expected that our SG&A percentage will
increase to the 27.0% to 28.0% range that we believe is more
representative of our past operations.
o Our operating margin was also positively impacted in the current
quarter by approximately 0.1% as a result of the implementation of
FASB Interpretation No. 46, Consolidation of Variable Interest
Entities, An Interpretation of Accounting Research Bulletin No. 51
("FIN 46"). FIN 46 had the impact of reclassifying approximately
$214,000 of occupancy expense from SG&A expense to interest expense.
In addition, our operating margin was positively impacted by the
improved gross margin and the reduction in advertising expense.
o As a result of the completion of our initial public offering, we were
able to utilize the net proceeds of the offering to retire all of our
balance sheet debt (not including any debt of Specialized Realty
Development Services, LP, which is reflected in the consolidated
financial statements as a result of FIN 46) and thereby substantially
reduce our interest expense in the first quarter. This transaction had
a further impact on our interest expense as the change in fair value
of derivatives is now being recorded as an adjustment to operations
rather than through "Other comprehensive income (OCI)". As an offset
to this present benefit, we are amortizing the balance included in OCI
over the period in which the forecasted transaction impacts the
consolidated statements of operations.
o As a result of FIN 46, beginning February 1, 2004, we now eliminate
the pretax operating profit contributed from the consolidation of
Specialized Realty Development Services, LP through the minority
interest line item in our consolidated statement of operations.
Operational Changes and Resulting Outlook
Our continued growth in the Dallas/Fort Worth metroplex is dependent on
our ability to develop an adequate distribution center for that market. The
present cross-dock facility located in that market contains approximately 36,000
square feet and will accommodate a total of six to eight stores. We are
currently in the planning stages to develop a complete warehouse and
distribution center for this market that we expect to contain approximately
150,000 square feet. Additional annual cost to lease and operate such a facility
is projected at approximately $2.0 million. It is expected that we will be
required to have such a distribution center operational by the end of fiscal
2005 or early in fiscal 2006.
11
The consumer electronics industry depends on new products to drive same
store sales increases. Typically, these new products, such as digital
televisions and DVD players, are introduced at relatively high price points that
are then gradually reduced as the product becomes more mainstream. To maintain
positive same store sales growth, unit sales must increase at a rate greater
than the decline in product prices. The affordability of the product helps the
unit sales growth. However, as a result of relatively short product life cycles
in the consumer electronics industry, which limit the amount of time available
for sales volume to increase, combined with rapid price erosion in the industry,
retailers are challenged to maintain overall gross margin levels and positive
same store sales. This has historically been our experience, although we have
experienced positive increases in unit prices in the last two fiscal quarters.
Application of Critical Accounting Policies
In applying the accounting policies that we use to prepare our consolidated
financial statements, we necessarily make accounting estimates that affect our
reported amounts of assets, liabilities, revenues and expenses. Some of these
accounting estimates require us to make assumptions about matters that are
highly uncertain at the time we make the accounting estimates. We base these
assumptions and the resulting estimates on authoritative pronouncements,
historical information and other factors that we believe to be reasonable under
the circumstances, and we evaluate these assumptions and estimates on an ongoing
basis. We could reasonably use different accounting estimates, and changes in
our accounting estimates could occur from period to period, with the result in
each case being a material change in the financial statement presentation of our
financial condition or results of operations. We refer to accounting estimates
of this type as "critical accounting estimates." We believe that the critical
accounting estimates discussed below are among those most important to an
understanding of our consolidated financial statements as of April 30, 2004.
Transfers of Financial Assets. We transfer customer receivables to the QSPE
that issues asset-backed securities to third party lenders using these accounts
as collateral, and we continue to service these accounts after the transfer. We
recognize the sale of these accounts when we relinquish control of the
transferred financial asset in accordance with SFAS No. 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.
As we transfer the accounts, we record an asset representing the interest only
strip which is the difference between the interest earned on customer accounts
and the cost associated with financing and servicing the transferred accounts,
including a provision for bad debts associated with the transferred accounts
discounted to a market rate of interest. The gain or loss recognized on these
transactions is based on our best estimates of key assumptions, including
forecasted credit losses, payment rates, forward yield curves, costs of
servicing the accounts and appropriate discount rates. The use of different
estimates or assumptions could produce different financial results. For example,
if we had assumed a 10.0% reduction in net interest spread (which might be
caused by rising interest rates or reductions in rates charged on the accounts
transferred), our interest in securitized assets would have been reduced by $3.4
million as of April 30, 2004, which may have an adverse effect on earnings. We
recognize income from our interest in these transferred accounts as gains on the
transfer of the asset, interest income and servicing fees This income is
recorded as "Finance charges and other" in our consolidated statements of
operations. If the assumption used for developing the reserve for doubtful
accounts on the books of the QSPE were changed by 0.5% from 3.5% to 4.0%, the
impact to recorded "Finance charges and other" would have been a reduction in
revenues and pretax income of $1.8 million.
Deferred Tax Assets. We have significant net deferred tax assets
(approximately $7.6 million as of April 30, 2004), which are subject to periodic
recoverability assessments. Realization of our net deferred tax assets may be
dependent upon whether we achieve projected future taxable income. Our estimates
regarding future profitability may change due to future market conditions, our
ability to continue to execute at historical levels and our ability to continue
our growth plans. These changes, if any, may require material adjustments to
these deferred tax asset balances. For example, if we had assumed that the
future tax rate at which these deferred items would reverse was 34.5% rather
than 35.3%, we would have reduced the net deferred tax asset account and net
income by approximately $168,000.
Intangible Assets. We have significant intangible assets related primarily
to goodwill and the costs of obtaining various loans and funding sources. The
determination of related estimated useful lives and whether or not these assets
are impaired involves significant judgments. Effective August 1, 2002, we
adopted the provisions of SFAS No. 142, Goodwill and Other Intangible Assets.
Prior to adoption of SFAS No. 142, we amortized goodwill over an estimated life
of fifteen years on a straight-line basis. Effective with the implementation of
SFAS No. 142, we ceased amortizing goodwill and began testing potential
12
impairment of this asset annually based on judgments regarding ongoing
profitability and cash flow of the underlying assets. Our testing includes using
judgments to estimate the separate operations of our insurance agency and
secondary credit portfolio, including allocations for interest, overhead and
taxes. Once these separate operations have been determined, we apply a multiple
of earnings based on existing market conditions and estimate operating cash flow
and compare the resulting estimated entity values to the recorded goodwill.
Changes in strategy or market conditions could significantly impact these
judgments and require adjustments to recorded asset balances. For example, if we
had reason to believe that our recorded goodwill had become impaired due to
decreases in the fair market value of the underlying business, we would have to
take a charge to income for that portion of goodwill that we believe is
impaired. Our goodwill balance at April 30, 2004 was $7.9 million.
Property, Plant and Equipment. Our accounting policies regarding land,
buildings, and equipment include judgments regarding the estimated useful lives
of such assets, the estimated residual values to which the assets are
depreciated, and the determination as to what constitutes increasing the life of
existing assets. These judgments and estimates may produce materially different
amounts of depreciation and amortization expense that would be reported if
different assumptions were used. These judgments may also impact the need to
recognize an impairment charge on the carrying amount of these assets as the
cash flows associated with the assets are realized. In addition, the actual life
of the asset and residual value may be different from the estimates used to
prepare financial statements in prior periods.
Revenue Recognition. Revenues from the sale of retail products are
recognized at the time the product is delivered to the customer. Such revenues
are recognized net of any adjustments for sales incentive offers such as
discounts, coupons, rebates, or other free products or services. We sell service
maintenance agreements and credit insurance contracts on behalf of unrelated
third parties. For contracts where the third parties are the obligors on the
contract, commissions are recognized in revenues at the time of sale, and in the
case of retrospective commissions, at the time that they are earned. Where we
sell service maintenance agreements in which we are deemed to be the obligor on
the contract at the time of sale, revenue is recognized ratably, on a
straight-line basis, over the term of the service maintenance agreement. These
service maintenance agreements are renewal contracts that provide our customers
protection against product repair costs arising after the expiration of the
manufacturer's warranty and the third party obligor contracts. These agreements
typically range from 12 months to 36 months. These agreements are separate units
of accounting under Emerging Issues Task Force No. 00-21, Revenue Arrangements
with Multiple Deliverables. The amounts of service maintenance agreement revenue
deferred at April 30, 2004 and January 31, 2004 were $3.2 million and $3.1
million, respectively, and are included in "Deferred revenue" in the
accompanying balance sheets.
Vendor Allowances. We receive funds from vendors for price protection,
product rebates, marketing and training and promotion programs which are
recorded on the accrual basis as a reduction to the related product cost or
advertising expense according to the nature of the program. We accrue rebates
based on the satisfaction of terms of the program and sales of qualifying
products even though funds may not be received until the end of a quarter or
year. If the programs are related to product purchases, the allowances, credits
or payments are recorded as a reduction of product cost; if the programs are
related to promotion or marketing of the product, the allowances, credits, or
payments are recorded as a reduction of advertising expense in the period in
which the expense is incurred.
13
Results of Operations
The following table sets forth certain statement of operations information
as a percentage of total revenues for the periods indicated:
Three Months Ended
April 30,
-----------------------
2003 2004
----------- -----------
Revenues:
Product sales 79.7 % 79.8 %
Service maintenance agreement commissions (net) 5.0 4.9
Service revenues 3.7 3.2
----------- -----------
Total net sales 88.3 88.0
Finance charges and other 11.7 12.0
----------- -----------
Total revenues 100.0 100.0
Costs and expenses:
Cost of goods sold, including warehousing and occupancy cost 63.9 62.9
Cost of parts sold, including warehousing and occupancy cost 0.9 0.8
Selling, general and administrative expense 26.3 25.9
Provision for bad debts 1.1 1.1
----------- -----------
Total costs and expenses 92.2 90.7
----------- -----------
Operating income 7.8 9.4
Interest expense 1.3 0.4
----------- -----------
Earnings before income taxes and minority interest 6.5 9.0
Minority interest 0.0 0.1
----------- -----------
Earnings before income taxes 6.5 8.9
Provision for income taxes 2.3 3.1
----------- -----------
Net income 4.2 % 5.8 %
=========== ===========
The table above identifies several changes in our operations for the current
quarter, including decreases in revenue and expense categories expressed as a
percentage of revenues for "Service revenues," "Cost of goods and parts sold,"
Selling, general and administrative expense" and "Interest expense." These
changes are discussed in the Executive Overview section on page 12 and in more
detail in the discussion of operating results beginning on page 16 below.
Same store sales growth is calculated by comparing the reported sales by
store for all stores that were open throughout a period to reported sales by
store for all stores that were open through the prior period. Sales from closed
stores have been removed from each period. Sales from relocated stores have been
included in each period because each store was relocated within the same general
geographic market. Sales from expanded stores have been included in each period.
The presentation of gross margins may not be comparable to other retailers
since we include the cost of our in-home delivery service as part of selling,
general and administrative expense. Similarly, we include the cost of
merchandising our products, including amounts related to purchasing the product,
in selling, general and administrative expense. It is our understanding that
other retailers may include such costs as part of their cost of goods sold.
Three Months Ended April 30, 2004 Compared to Three Months Ended April 30, 2003
Revenues. Total revenues increased by $14.1 million, or 11.7%, from $120.8
million for the three months ended April 30, 2003 to $134.9 million for the
three months ended April 30, 2004. The increase was attributable to increases in
net sales of $11.9 million, or 11.1%, and $2.2 million, or 15.8%, in finance
charges and other revenue. Of the $11.9 million increase in net sales, $3.6
million resulted from a same store sales increase of 3.5%, $8.4 million was
generated by five retail locations that were not open for three consecutive
months in each period, and $(100,000) resulted from a net decrease in service
revenues. Of the $11.9 million increase in net sales, $11.3 million was
attributable to product sales which was due to increased unit volume of sales of
approximately $4.4 million and increases in unit price points of approximately
14
$6.9 million. While this is the second consecutive quarter that we have not
experienced significant price deterioration, we are not yet confident that the
previous negative trend has reversed itself. Increased sales in bedding, lawn
and garden, computers and other new product categories included in the track
accounted for much of the increase in same store sales.
The following table presents the makeup of net sales by product category in
each quarter, including service maintenance agreement commissions and service
revenues, expressed both in dollar amounts and as a percent of total net sales.
Three Months Ended April 30,
----------------------------------------------
2003 2004 Percent
---------------------- ----------------------- Increase
Category Amount Percent Amount Percent (Decrease)
----------- ---------- ----------- ----------- -----------
Major home appliances $39,832 37.3 % $42,382 35.8 % 6.4 %
Consumer electronics 41,371 38.8 45,425 38.3 9.8
Home office equipment 6,571 6.2 9,277 7.8 41.2 (1)
Delivery/installation 1,877 1.8 2,184 1.8 16.4 (2)
Lawn and garden 3,671 3.4 4,306 3.6 17.3 (3)
Bedding 1,501 1.4 2,345 2.0 56.2 (3)
Other 1,401 1.3 1,610 1.4 14.9 (1)
----------- ---------- ----------- ----------- -----------
Total product sales 96,224 90.2 107,529 90.7 11.7
Service maintenance agreement
commissions 5,987 5.6 6,635 5.6 10.8
Service revenues 4,476 4.2 4,378 3.7 (2.2)(4)
----------- ---------- ----------- ----------- -----------
Total net sales $106,687 100.0 % $118,542 100.0 % 11.1 %
=========== ========== =========== =========== ===========
- ----------------------------------
(1) The increases are primarily due to the new emphasis on track sales.
(2) The increase is primarily due to a price increase charged to the
customer for delivery service.
(3) The increase is primarily due to continuing maturity of this new
product category and the continued sales emphasis on this product
category.
(4) The decrease in service revenues is attributable to a more stringent
review of billings made to the insurance company for covered warranty
service. As a result of these billing reviews, service revenues for
the three months ended April 30, 2004 were somewhat softened; however,
retrospective warranty claim settlements were positively impacted by
approximately $826,000 during the period. Such settlements, which
offset the decrease in service revenues are reflected in the line item
"Finance charges and other".
Revenue from "Finance charges and other" increased by approximately $2.2
million, or 15.8%, from $14.1 million for the three months ended April 30, 2003
to $16.3 million for the three months ended April 30, 2004. This increase in
revenue resulted primarily from increases in insurance commissions and other
revenues of $1.3 million and increases in securitization income of $897,000.
Both of these increases are attributable to higher product sales and increases
in our retained interest in assets transferred to the QSPE.
Cost of Goods Sold. Cost of goods sold, including warehousing and occupancy
cost, increased by $7.6 million, or 9.8%, from $77.2 million for the three
months ended April 30, 2003 to $84.8 million for the three months ended April
30, 2004. This increase was generally consistent with the 11.7% increase in net
product sales, although cost of products sold decreased from 80.2% of net
product sales in the quarter ended April 30, 2003 to 78.8% for the quarter ended
April 30, 2004. We attribute this product margin increase to a less aggressive
promotion during our February 2004 grand opening celebration during which we
celebrated company-wide the new stores that we opened in the last fiscal year
through special product sales and vendor participation programs. Cost of parts
sold, including warehousing and occupancy cost, increased approximately $58,000,
or 5.5%, for the same period.
15
Selling, General and Administrative Expense. Selling, general and
administrative expense increased by $3.1 million, or 9.8%, from $31.7 million
for the three months ended April 30, 2003 to $34.9 million for the three months
ended April 30, 2004. The decrease in expense as a percentage of total revenues
for this period results primarily from increased vendor participation in our
advertising program during the February 2004 grand opening celebration.
Provision for Bad Debts. The provision for bad debts decreased by $54,000,
or 4.0%, due to improved delinquency rates and collections activities associated
with our insurance and service programs and the customer receivables not
transferred to the QSPE.
Interest Expense. Interest expense decreased by $964,000, or 62.3%, from
$1.5 million for the three months ended April 30, 2003 to $582,000 for the three
months ended April 30, 2004. The net decrease in interest expense was
attributable to the following decreases:
o expiration of $80.0 million in our interest rate hedges resulted in a
decrease of 53.1% or $821,000 from the prior period;
o reclassification of amounts previously recorded in other comprehensive
income decreased interest expense by approximately $26,000; and
o the decrease in our average outstanding debt from $ 49.3 million to $
80,377 (when ignoring the impact of FIN 46 consolidation of $14.6
million, see below) resulted in a decrease in interest expense of
approximately $634,000;
that were offset by the following increases:
o the increase in interest rates and commitment fees of $93,000;
o the cessation of derivative accounting increased interest expense by
$209,000; and
o the implementation of FIN 46 resulted in reclassification of $216,000
in expenses previously reflected as occupancy cost in "Selling,
general and administrative expense" to "Interest expense".
Minority Interest. As a result of FIN 46, beginning February 1, 2004, we
now eliminate the pretax operating profit contributed from the consolidation of
Specialized Realty Development Services, LP through the minority interest line
item in our consolidated statement of operations, which for the three months
ended April 30, 2004, was $115,000.
Provision for Income Taxes. The provision for income taxes increased by
$1.4 million, or 51.5%, from $2.8 million for the three months ended April 30,
2003 to $4.2 million for the three months ended April 30, 2004. This increase
was generally consistent with the increase in pretax income of 52.4%. Effective
tax rates were generally consistent at 35.5% in fiscal 2004 and 35.3% in fiscal
2005.
Net Income. As a result of the above factors, net income increased $2.7
million, or 52.9%, from $5.1 million for the three months ended April 30, 2003
to $7.8 million for the three months ended April 30, 2004.
Liquidity and Capital Resources
Current Activities
Historically we have financed our operations through a combination of cash
flow generated from operations, external borrowings, including primarily bank
debt and asset-backed securitization facilities, and, most recently, our initial
public offering. As of January 31, 2004, we had $40.0 million under the
revolving line of credit (based on qualifying assets) and $8.0 million under our
unsecured bank line of credit available to us for general corporate purposes. At
April 30, 2004, the revolving line of credit was reduced to $30.0 million as a
result of an amendment to our bank credit facility. In exchange for the reduced
line of credit, the amendment to our bank credit facility reduces interest
rates, standby rates and commitment fees among other concessions.
16
A summary of the significant financial covenants that govern our bank
credit facility compared to our actual compliance status at April 30, 2004, is
presented below:
Required
Minimum/
Actual Maximum
----------------------- ----------------------
Debt service coverage ratio must exceed required minimum 2.93 to 1.00 1.75 to 1.00
Total leverage ratio must be lower than required maximum 1.92 to 1.00 3.00 to 1.00
Consolidated net worth must exceed required minimum $160,647,000 $77,580,923
Charge-off ratio must be lower than required maximum 0.02 to 1.00 0.05 to 1.00
Extension ratio must be lower than required maximum 0.02 to 1.00 0.04 to 1.00
Delinquency ratio must be lower than required maximum 0.06 to 1.00 0.12 to 1.00
We will continue to finance our operations and future growth through a
combination of cash flow generated from operations and external borrowings,
including primarily bank debt and the QSPE's asset-backed securitization
facilities. Based on our current operating plans, we believe that cash generated
from operations, available borrowings under our bank credit facility and
unsecured credit line, and access to the unfunded portion of the variable
funding portion of the QSPE's asset-backed securitization program will be
sufficient to fund our operations, store expansion and updating activities and
capital programs through at least January 31, 2006. However, there are several
factors that could decrease cash provided by operating activities, including:
o reduced demand for our products;
o more stringent vendor terms on our inventory purchases;
o increases in product cost that we may not be able to pass on to our
customers;
o reductions in product pricing due to competitor promotional
activities;
o changes in inventory requirements based on longer delivery times of
the manufacturers or other requirements which would negatively impact
our delivery and distribution capabilities;
o increases in the retained portion of our receivables portfolio under
our current QSPE's asset-backed securitization program as a result of
changes in performance;
o inability to expand our capacity for financing our receivables
portfolio under new or replacement QSPE asset-backed securitization
programs or a requirement that we retain a higher percentage of the
credit portfolio under such new programs;
o increases in program costs (interest and administrative fees relative
to our receivables portfolio associated with the funding of our
receivables); and
o increases in personnel costs required for us to stay competitive in
our markets.
During the three months ended April 30, 2004, net cash provided by
operating activities decreased $3.3 million from $3.8 million provided in the
2003 period to $543,000 provided in the 2004 period. The net decrease in cash
provided from operations resulted primarily from an increase in net income of
$2.7 million that was offset by adjustments to reconcile net income to net cash
provided by operations of $342,000, and a net decrease in cash resulting from
changes in current working capital requirements of $5.6 million. The decrease in
cash resulting from changes in current working capital included approximately
$3.5 million required to fund additional receivables, $2.7 million required to
fund or carry additional inventories and $700,000 of net other working capital
required.
Much of this increase in cash used for working capital purposes resulted
from a larger retention of receivables that were funded totally by us as well as
an increase in the credit enhancement required as a result of the increase in
the receivables that we transferred to the QSPE. We believe that the available
balances under our bank credit facility are sufficient to fund the increase in
receivables or the increase in credit enhancement that we expect for the through
the end of fiscal 2006.
17
We offer promotional credit programs to certain customers that provide for
"same as cash" interest free periods of varying terms, generally three, six or
12 months. These promotional accounts are eligible for securitization up to the
limits provided for in our securitization agreements. This limit is currently
20.0% of eligible securitized receivables. The percentage of eligible
securitized receivables represented by promotional receivables was 12.9% and
14.9% as of April 30, 2003 and April 30, 2004, respectively. This increase was
the result of sales with the use of promotional credit versus lower prices at
retail. If we exceed this 20.0% limit, we would be required to use some of our
other capital resources to fund or carry the unpaid balances of the receivables
for the promotional period. The weighted average promotional period was 11.0
months and 10.8 months for promotional receivables outstanding as of April 30,
2003 and April 30, 2004, respectively. The weighted average remaining term on
those same promotional receivables was 6.3 months and 7.0 months, respectively.
While overall these promotional receivables have a much shorter weighted average
term than non-promotional receivables, we receive less income as a result of a
reduced net interest margin used in the calculation of the gain on the sale of
receivables. As a result, the existence of the interest free extended payment
terms negatively impacts the gains as compared to other receivables.
Net cash used by investing activities increased by $2.8 million from $1.5
million for the three months ended April 30, 2003 to $4.3 million for the three
months ended April 30, 2004. The increase in cash used in investing activities
resulted primarily from an increase in the purchase of property and equipment of
$2.6 million and a decrease in the proceeds from the sale of property of
$165,000. The increase in cash expended for property and equipment resulted from
the opening of two additional stores in the Dallas/Fort Worth market and
reformatting of our stores to focus on track operations. Based on current plans,
we expect to continue to increase expenditures for property and equipment in the
balance of fiscal 2005 as we open additional stores, complete our track
reformatting and improve our warehouse facility in the Dallas/Fort Worth market.
Since we used the proceeds of our initial public offering to pay down all
interest bearing debt (other than that of Specialized Realty Development
Services, LP), there were only insignificant debt repayment transactions in the
current quarter, down $2.4 million from the prior year period. The exercise of
stock options by various employees during the quarter represented the additional
positive change in cash in financing activities of $588,000.
Off-Balance Sheet Financing Arrangements
Since we extend credit in connection with a large portion of our retail,
service maintenance and credit insurance sales, we have created a qualified
special purpose entity, which we refer to as the QSPE or the issuer, to purchase
customer receivables from us and to issue asset-backed and variable funding
notes to third parties. We transfer receivables, consisting of retail
installment contracts and revolving accounts extended to our customers, to the
issuer in exchange for cash and unsecured promissory notes. To finance its
acquisition of these receivables, the issuer has issued the notes described
below to third parties. The unsecured promissory notes issued to us are
subordinate to these third party notes.
At April 30, 2004, the issuer has issued two series of notes: a Series A
variable funding note in the amount of $250 million purchased by Three Pillars
Funding Corporation and three classes of Series B notes in the aggregate amount
of $200 million. Private institutional investors, primarily insurance companies,
purchased the Series B notes at a weighted fixed rate of 5.1%.
We continue to service the transferred accounts for the QSPE, and we
receive a monthly servicing fee, so long as we act as servicer, in an amount
equal to .0025% multiplied by the average aggregate principal amount of
receivables serviced plus the amount of average aggregate defaulted receivables.
The issuer records revenues equal to the interest charged to the customer on the
receivables less losses, the cost of funds, the program administration fees paid
in connection with either Three Pillars Funding Corporation or the Series B note
holders, and the servicing fee.
The Series A variable funding note permits the issuer to borrow funds up to
$250 million to purchase receivables from us, thereby functioning as a "basket"
to accumulate receivables. When borrowings under the Series A variable funding
note approach $250 million, the issuer intends to refinance the receivables by
issuing a new series of notes and to use the proceeds to pay down the
outstanding balance of the Series A variable funding note, so that the basket
will once again become available to accumulate new receivables. As of April 30,
2004, borrowings under the Series A variable funding note were $77.3 million.
18
We are not directly liable to the lenders under the asset-backed
securitization facility. However, in the ordinary course of business, the issuer
transfers accounts to us to enable us to maintain the funds available under the
asset-backed securitization facility at its contemplated level. If the issuer is
unable to repay the Series A and Series B notes due to its inability to collect
the transferred customer accounts, the issuer could not pay the subordinated
notes it has issued to us in partial payment for transferred customer accounts,
and the Series B lenders could claim the balance in its restricted cash account.
We are also contingently liable under a $10.0 million letter of credit that
secures our performance of our obligations or services under the servicing
agreement as it relates to the transferred assets that are part of the
asset-backed securitization facility.
The issuer is subject to certain affirmative and negative covenants
contained in the transaction documents governing the Series A variable funding
note and the Series B notes, including covenants that restrict, subject to
specified exceptions: the incurrence of non-permitted indebtedness and other
obligations and the granting of additional liens; mergers, acquisitions,
investments and disposition of assets; and the use of proceeds of the program.
The issuer also makes representations and warranties relating to compliance with
certain laws, payment of taxes, maintenance of its separate legal entity,
preservation of its existence, protection of collateral and financial reporting.
In addition, the program requires the issuer to maintain a minimum net worth.
A summary of the significant financial covenants that govern the issuer's
asset-backed credit facility compared to actual compliance status at April 30,
2004, is presented below:
Required
Minimum/
Actual Maximum
-------------- --------------
Issurer interest must exceed required minimum $26.5 million $25.3 million
Gross loss rate must be lower than required maximum 3.6% 10.0%
Net portfolio yield must exceed required minimum 9.9% 2.0%
Payment rate must exceed required minimum 6.9% 3.0%
Events of default under the Series A variable funding note and the Series B
notes, subject to grace periods and notice provisions in some circumstances,
include, among others: failure of the issuer to pay principal, interest or fees;
violation by the issuer of any of its covenants or agreements; inaccuracy of any
representation or warranty made by the issuer; certain servicer defaults;
failure of the trustee to have a valid and perfected first priority security
interest in the collateral; default under or acceleration of certain other
indebtedness; bankruptcy and insolvency events; failure to maintain certain loss
ratios and portfolio yield; change of control provisions and certain events
pertaining to us. The issuer's obligations under the program are secured by the
receivables and proceeds.
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[SEE SUPPLEMENTARY PDF FOR SECURITIZATION FACILITIES CHART]
Both the bank credit facility and the asset-backed securitization program
are significant factors relative to our ongoing liquidity and our ability to
meet the cash needs associated with the growth of our business. Our inability to
use either of these programs because of a failure to comply with their covenants
would adversely affect our continued growth. Funding of current and future
receivables under the QSPE's asset-backed securitization program can be
adversely affected if we exceed certain predetermined levels of re-aged
receivables, size of the secondary portfolio, the amount of promotional
receivables, write-offs, bankruptcies or other ineligible receivable amounts. If
the funding under the QSPE's asset-backed securitization program were reduced or
terminated, we would have to draw down our bank credit facility more quickly
than we have estimated.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest rates under our bank credit facility are variable and are
determined, at our option, as the base rate, which is the greater of prime rate
or federal funds rate plus 0.50% plus the base rate margin, which ranges from
0.50% to 1.75%, or LIBOR plus the LIBOR margin, which ranges from 1.50% to
2.75%. Accordingly, changes in the prime rate, the federal funds rate or LIBOR,
which are affected by changes in interest rates generally, will affect the
interest rate on, and therefore our costs under, our bank credit facility. We
are also exposed to interest rate risk associated with our interest only strip
and the subordinated securities we receive from our sales of receivables to the
QSPE.
We held interest rate swaps and collars with notional amounts totaling
$20.0 million as of January 31, 2004 and April 30, 2004, with terms extending
through April, 2005, and were held for the purpose of hedging against variable
interest rate risk, primarily related to cash flows from our interest-only strip
as well as our variable rate debt.
In fiscal 2003, hedge accounting was discontinued for $80.0 million of
swaps previously designated as hedges, and in fiscal 2004, hedge accounting was
discontinued for the remaining $20.0 million of swaps. In accordance with SFAS
No. 133, at the time hedge accounting was discontinued, we began to recognize
changes in fair value of the swaps as interest expense and to amortize the
amount of accumulated other comprehensive loss related to those derivatives as
interest expense over the period that the forecasted transactions affected the
statement of operations.
Prior to discontinuing these hedges, we recorded hedge ineffectiveness in
each period, which arose from differences between the interest rate stated in
the derivative instrument and the interest rate upon which the underlying hedged
transaction was based. Ineffectiveness totaled $229,000 for the three months
ended April 30, 2003 and is reflected in "Interest expense" in the Consolidated
Statements of Operations.
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Item 4. Controls and Procedures
An evaluation was performed 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 that evaluation, our management, including our Chief
Executive Officer and our Chief Financial Officer, concluded that our disclosure
controls and procedures were effective. There have been no significant changes
in our internal controls or in other factors that have materially affected, or
are reasonably likely to materially affect, our internal controls.
PART II - Other Information
Item 1. Legal Proceedings
In December 2002, Martin E. Smith, as named plaintiff, filed a lawsuit
against us in the state district court in Jefferson County, Texas, that attempts
to create a class action for breach of contract and violations of state and
federal consumer protection laws arising from the terms of our service
maintenance agreements. The lawsuit alleges an inappropriate overlap in the
warranty periods provided by the manufacturers of our products and the periods
covered by the service maintenance agreements that we sell. The lawsuit seeks
unspecified actual damages as well as an injunction against our current
practices and extension of affected service contracts. We believe that the
warranty periods provided by our service maintenance agreements are consistent
with industry practice. We believe that it is premature to predict whether class
action status will be granted or, if it is granted, the outcome of this
litigation. There is not currently a basis on which to estimate a range of
potential loss in this matter.
We are involved in routine litigation incidental to our business from time
to time. We do not expect the outcome of any of this routine litigation to have
a material effect on our financial condition or results of operations.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
The exhibits required to be furnished pursuant to Item 6 of Form 10-Q are
listed in the Exhibit Index filed herewith, which Exhibit Index is incorporated
herein by reference.
(b) Reports on Form 8-K
During the quarter ended April 30, 2004, we filed the following current reports
on Form 8-K:
o On March 4, 2004, we filed a current report on Form 8-K announcing the
results of product sales for the quarter and year ending January 31, 2004.
o On April 12, 2004, we filed a current report on Form 8-K announcing our
earnings for the quarter and year ended January 31, 2004.
o On April 23, 2004, we filed a current report on Form 8-K announcing the
modification of our revolving bank agreement filed.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this Report to be signed on its behalf
by the undersigned duly authorized officer.
CONN'S, INC.
By: /s/ C. William Frank
-----------------------------
C. William Frank
Executive Vice President and
Chief Financial Officer
Date: June 7, 2004
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INDEX TO EXHIBITS
Exhibit
Number Description
------ -----------
2 Agreement and Plan of Merger dated January 15, 2003, by and among
Conn's, Inc., Conn Appliances, Inc. and Conn's Merger Sub, Inc.
(incorporated herein by reference to Exhibit 2 to Conn's, Inc.
registration statement on Form S-1 (file no. 333-109046)).
3.1 Certificate of Incorporation of Conn's, Inc. (incorporated herein by
reference to Exhibit 3.1 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
3.1.1 Certificate of Amendment to the Certificate of Incorporation of
Conn's, Inc. filed on June 3, 2004 (filed herewith).
3.2 Bylaws of Conn's, Inc. (incorporated herein by reference to Exhibit
3.2 to Conn's, Inc. registration statement on Form S-1 (file no.
333-109046)).
3.2.1 Amendment to the Bylaws of Conn's, Inc. (filed herewith).
4.1 Specimen of certificate for shares of Conn's, Inc.'s common stock
(incorporated herein by reference to Exhibit 4.1 to Conn's, Inc.
registration statement on Form S-1 (file no. 333-109046)).
10.1 Amended and Restated 2003 Incentive Stock Option Plan (incorporated
herein by reference to Exhibit 10.1 to Conn's, Inc. registration
statement on Form S-1 (file no. 333-109046)).
10.1.1 Amendment to the Conn's, Inc. Amended and Restated 2003 Incentive
Stock Option Plan (filed herewith).
10.2 2003 Non-Employee Director Stock Option Plan (incorporated herein by
reference to Exhibit 10.2 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.3 Employee Stock Purchase Plan (incorporated herein by reference to
Exhibit 10.3 to Conn's, Inc. registration statement on Form S-1 (file
no. 333-109046)).
10.4 Conn's 401(k) Retirement Savings Plan (incorporated herein by
reference to Exhibit 10.4 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.5 Shopping Center Lease Agreement dated May 3, 2000, by and between
Beaumont Development Group, L.P., f/k/a Fiesta Mart, Inc., as Lessor,
and CAI, L.P., as Lessee, for the property located at 3295 College
Street, Suite A, Beaumont, Texas (incorporated herein by reference to
Exhibit 10.5 to Conn's, Inc. registration statement on Form S-1 (file
no. 333-109046)).
10.5.1 First Amendment to Shopping Center Lease Agreement dated September
11, 2001, by and among Beaumont Development Group, L.P., f/k/a Fiesta
Mart, Inc., as Lessor, and CAI, L.P., as Lessee, for the property
located at 3295 College Street, Suite A, Beaumont, Texas (incorporated
herein by reference to Exhibit 10.5.1 to Conn's, Inc. registration
statement on Form S-1 (file no. 333-109046)).
10.6 Industrial Real Estate Lease dated June 16, 2000, by and between
American National Insurance Company, as Lessor, and CAI, L.P., as
Lessee, for the property located at 8550-A Market Street, Houston,
Texas (incorporated herein by reference to Exhibit 10.6 to Conn's,
Inc. registration statement on Form S-1 (file no. 333-109046)).
10.7 Lease Agreement dated December 5, 2000, by and between Prologis
Development Services, Inc., f/k/a The Northwestern Mutual Life
Insurance Company, as Lessor, and CAI, L.P., as Lessee, for the
property located at 4810 Eisenhauer Road, Suite 240, San Antonio,
Texas (incorporated herein by reference to Exhibit 10.7 to Conn's,
Inc. registration statement on Form S-1 (file no. 333-109046)).
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10.7.1 Lease Amendment No. 1 dated November 2, 2001, by and between
Prologis Development Services, Inc., f/k/a The Northwestern Mutual
Life Insurance Company, as Lessor, and CAI, L.P., as Lessee, for the
property located at 4810 Eisenhauer Road, Suite 240, San Antonio,
Texas (incorporated herein by reference to Exhibit 10.7.1 to Conn's,
Inc. registration statement on Form S-1 (file no. 333-109046)).
10.8 Lease Agreement dated August 18, 2003, by and between Robert K.
Thomas, as Lessor, and CAI, L.P., as Lessee, for the property located
at 4610-12 McEwen Road, Dallas, Texas (incorporated herein by
reference to Exhibit 10.8 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.9 Credit Agreement dated April 24, 2003, by and among Conn Appliances,
Inc. and the Borrowers thereunder, the Lenders party thereto, JPMorgan
Chase Bank, as Administrative Agent, Bank of America, N.A., as
Syndication Agent, and SunTrust Bank, as Documentation Agent
(incorporated herein by reference to Exhibit 10.9 to Conn's, Inc.
registration statement on Form S-1 (file no. 333-109046)).
10.9.1 Amendment to Credit Agreement, dated April 23, 2003, by and among
Conn Appliances, Inc. and the Borrowers thereunder, the Lenders party
thereto, JPMorgan Chase Bank, as Administrative Agent, Bank of
America, N.A., as Syndication Agent, and SunTrust Bank, as
Documentation Agent (incorporated herein by reference to Exhibit 99.1
to Conn's current report on Form 8-K filed on April 23, 2004).
10.10 Receivables Purchase Agreement dated September 1, 2002, by and among
Conn Funding II, L.P., as Purchaser, Conn Appliances, Inc. and CAI,
L.P., collectively as Originator and Seller, and Conn Funding I, L.P.,
as Initial Seller (incorporated herein by reference to Exhibit 10.10
to Conn's, Inc. registration statement on Form S-1 (file no.
333-109046)).
10.11 Base Indenture dated September 1, 2002, by and between Conn Funding
II, L.P., as Issuer, and Wells Fargo Bank Minnesota, National
Association, as Trustee (incorporated herein by reference to Exhibit
10.11 to Conn's, Inc. registration statement on Form S-1 (file no.
333-109046)).
10.12 Series 2002-A Supplement to Base Indenture dated September 1, 2002,
by and between Conn Funding II, L.P., as Issuer, and Wells Fargo Bank
Minnesota, National Association, as Trustee (incorporated herein by
reference to Exhibit 10.12 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.13 Series 2002-B Supplement to Base Indenture dated September 1, 2002,
by and between Conn Funding II, L.P., as Issuer, and Wells Fargo Bank
Minnesota, National Association, as Trustee (incorporated herein by
reference to Exhibit 10.13 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.14 Servicing Agreement dated September 1, 2002, by and among Conn
Funding II, L.P., as Issuer, CAI, L.P., as Servicer, and Wells Fargo
Bank Minnesota, National Association, as Trustee (incorporated herein
by reference to Exhibit 10.14 to Conn's, Inc. registration statement
on Form S-1 (file no. 333-109046)).
10.15 Form of Executive Employment Agreement (incorporated herein by
reference to Exhibit 10.15 to Conn's, Inc. registration statement on
Form S-1 (file no. 333-109046)).
10.16 Form of Indemnification Agreement (incorporated herein by reference
to Exhibit 10.16 to Conn's, Inc. registration statement on Form S-1
(file no. 333-109046)).
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21 Subsidiaries of Conn's, Inc. (incorporated herein by reference to
Exhibit 21 to Conn's, Inc. registration statement on Form S-1 (file
no. 333-109046)).
23.1 Consent of Ernst & Young LLP (filed herewith).
31.1 Rule 13a-14(a)/15d-14(a) Certification (Chief Executive Officer)
(filed herewith).
31.2 Rule 13a-14(a)/15d-14(a) Certification (Chief Financial Officer)
(filed herewith).
32.1 Section 1350 Certification (Chief Executive Officer and Chief
Financial Officer) (furnished herewith).
99.1 Subcertification of Chief Operating Officer in support of Rule
13a-14(a)/15d-14(a) Certification (Chief Executive Officer) (filed
herewith).
99.2 Subcertification of Secretary/Treasurer in support of Rule
13a-14(a)/15d-14(a) Certification (Chief Executive Officer) (filed
herewith).
99.3 Subcertification of Chief Operating Officer and Secretary/Treasurer in
support of Section 1350 Certifications (furnished herewith).
25