ITEM 1. BUSINESS
99 Cents Only Stores (the "Company") is a leading deep-discount retailer of primarily name-brand and consumable general merchandise. The Company's stores offer a wide assortment of regularly available consumer goods as well as a broad variety of first-quality, close-out merchandise. In 2003, a majority of the Company's product offerings were comprised of recognizable name-brand merchandise and were regularly available for reorder. As of March 12, 2004, the Company operated 194 retail stores with 150 in California, 19 in Texas, 15 in Arizona and 10 in Nevada. These stores have an average size of approximately 21,500 square feet. The Company's 99 Cents Only Stores generated average net sales per estimated saleable square foot of $308, which the Company believes is among the highest in the deep-discount convenience store industry, and average net sales per store of $4.9 million for stores open the full year in 2003.
The Company opened its first 99 Cents Only Store in 1982 and believes that it operates the nation's oldest existing single price point general merchandise chain. The Company competes in the deep-discount industry, which it believes is one of the fastest growing retail sectors in the United States. In line with the Company's business strategy, the Company has significantly increased the rate of store expansion over the last eight fiscal years. The Company expanded its 99 Cents Only Stores from 36 stores and 332,100 estimated saleable square feet at December 31, 1995 to 189 stores and 3,190,528 estimated saleable square feet at December 31, 2003, representing a compound annual growth rate ("CAGR") of 23% and 33%, respectively. Historically, the Company's 99 Cents Only Stores have been profitable within their first year of operation. Through March 12, 2004, the Company had opened 6 new stores and closed one store. It also plans to open an additional 42 new stores during the remainder of the year. The Company plans to continue its store square footage expansion in 2004 at a targeted growth rate of 25% per year. The Company estimates that the California, Texas, Arizona and Nevada markets have the potential for over 425, 99 Cents Only Stores. The Company intends to continue to expand in California, Texas, Arizona and Nevada in 2004 and 2005. See "Growth Strategy" for further discussion of geographic expansion plans.
The Company also sells merchandise through its Bargain Wholesale division at prices generally below normal wholesale levels to retailers, distributors and exporters. Bargain Wholesale complements the Company's retail operations by allowing the Company to purchase in larger volumes at more favorable pricing, to be exposed to a broader selection of opportunistic buys and to generate additional sales with relatively small incremental increases in operating expenses, contributing to strong overall operating margins for the Company. Bargain Wholesale represented 5.3% of the Company's net sales in 2003.
INDUSTRY
The Company participates primarily in the deep-discount retail industry, with its 99 Cents Only Stores. Deep-discount retail is distinguished from other retail formats by the purchase of close-out and other special-situation merchandise at prices substantially below original wholesale cost, and the subsequent sale of this merchandise at prices significantly below regular retail. This results in a continually changing selection of specific brands of products. The Company believes that the deep-discount retail industry is one of the fastest growing retail sectors in the United States.
The sale of close-out or special-situation merchandise develops in response to the need of manufacturers, wholesalers and others to distribute merchandise outside their normal channels. Close-out or special-situation merchandise becomes available for a variety of reasons, including a manufacturer's over-production, discontinuance due to a change in style, color, size, formulation or packaging, the inability to move merchandise effectively through regular channels, reduction of excess seasonal inventory, discontinuation of test-marketed items and the financial needs of the manufacturer.
Many deep-discount retailers also sell merchandise that can be purchased from a manufacturer or wholesaler on a regular basis. Although this merchandise can usually be purchased at less than original wholesale and sold below normal retail, the discount, if any, is generally less than with close-out merchandise. Deep-discount retailers sell regularly available merchandise to ensure a degree of consistency in their product offerings and to establish themselves as a reliable source of basic goods.
BUSINESS STRATEGY
The Company's goal is to continue to provide significant value to its customers on a wide variety of consumable merchandise in an exciting store environment. The Company's strategies to achieve this goal include the following:
Focus on "Name-Brand" Consumables. The Company strives to exceed its customers' expectations of the range and quality of name-brand consumable merchandise that can be purchased for 99 cents. During 2003, the Company purchased merchandise from more than 999 suppliers, including Colgate-Palmolive, Eveready Battery, General Electric, General Mills, Gerber Products, Hershey Foods, Johnson & Johnson, Kellogg's, Kraft, Mattel, Mead, Nabisco, Nestle, Procter & Gamble, Revlon, SmithKline Beecham and Unilever.
Broad Selection of Regularly Available Merchandise. The Company's retail stores offer consumer items in each of the following staple product categories: food (including frozen and deli items), beverages, health and beauty aids, household products (including cleaning supplies, paper goods, etc.), housewares (including glassware, kitchen items, etc.), hardware, stationary and party goods, seasonal goods, baby products and toys, giftware, pet products and clothing. The Company supplements its name-brand merchandise with private-label items. By consistently offering a wide selection of basic household consumable items, the Company attempts to encourage customers to shop at the stores for their everyday household needs, which the Company believes leads to a high frequency of customer visits.
Attractively Merchandised and Well-Maintained Stores. The Company strives to provide its customers an exciting shopping experience in customer-service-oriented stores, which are attractively merchandised, brightly lit and well-maintained. The Company's stores are merchandised and laid out in a "supermarket" format with items in the same category grouped together. In addition, the shelves are restocked as needed during the day. By offering merchandise in an attractive, convenient and familiar environment, the Company believes its stores appeal to a wide demographic of customers.
Strong Long-Term Supplier Relationships. The Company believes that it has developed a reputation as a leading purchaser of name-brand, re-orderable and close-out merchandise at discount prices through its ability to make immediate buying decisions, experienced buying staff, willingness to take on large volume purchases and take possession of merchandise immediately, ability to pay cash or accept abbreviated credit terms, reputation for prompt payment, commitment to honor all issued purchase orders and willingness to purchase goods close to a target season or out of season. The Company's relationship with its suppliers is further enhanced by its ability to minimize channel conflict for the manufacturer by quickly selling name-brand merchandise without, if requested by the supplier, advertising or wholesaling the item. Additionally, the Company believes it has well-maintained, attractively merchandised stores that have contributed to a reputation among suppliers for protecting their brand image.
Complementary Bargain Wholesale Operation. Bargain Wholesale complements the Company's retail operations by allowing the Company to purchase in larger volumes at more favorable pricing, to be exposed to a broader selection of opportunistic buys and to generate additional sales with relatively small incremental increases in operating expenses, contributing to strong overall operating margins for the Company. Net sales in the Company's Bargain Wholesale division were $46.0 million in 2003. The growth strategy for Bargain Wholesale is to focus on large domestic and international accounts and expansion into new geographic markets. The Company maintains showrooms in New York City and Chicago to support its Bargain Wholesale operation, which is based in Los Angeles.
Adherence to Disciplined Cost Controls and Savvy Purchasing. The Company believes it is able to provide its customers with significant value while maintaining strong operating margins through an adherence to a disciplined cost control program. The Company purchases merchandise at substantially discounted prices as a result of its buyers' knowledge, experience and negotiating ability and its established reputation among its suppliers. The Company applies this same approach to its relationships with other vendors and strives to maintain a lean operating environment focused on increasing net income.
Focus on Larger Stores in Convenient Locations. The Company's 99 Cents Only Stores are conveniently located in freestanding buildings, neighborhood shopping centers (anchored by 99 Cents Only Stores or co-anchored with a supermarket and/or a drug store), regional shopping centers or downtown central business districts where the Company believes consumers are more likely to do their regular household shopping. The Company's 194 existing 99 Cents Only Stores, average approximately 21,450 gross square feet. From January 1, 1999 through December 31, 2003, the Company has opened 130 new stores with an average of approximately 23,500 gross square feet and currently targets new store locations between 18,000 and 28,000 gross square feet. The Company's larger 99 Cents Only Stores allow a more effective display of a wider assortment of merchandise, carry deeper stock positions and provide customers with a more inviting and convenient environment that the Company believes encourages customers to shop longer and buy more. The Company's decision to target larger stores is based in part on the higher average annual net sales per store and operating income typically achieved by these stores. In the past, as part of its strategy to expand retail operations, the Company has at times opened larger new stores in close proximity to existing stores where the Company determined that the trade area could support a larger store. In some of these situations, the Company retained its existing store so long as it continued to contribute store-level operating income. While this strategy was designed to increase revenues and store-level operating income, it has had a negative impact on comparable store net sales as some customers migrated from the existing store to the larger new store. The Company believes that this strategy has impacted its historical comparable sales growth.
Experienced Management Team and Depth of Employee Option Grants. 99 Cents Only Stores' management team has many years of retail experience and has demonstrated its skills through a proven track record of financial performance. The Company's management strongly believes that employee ownership of the Company's stock helps build employee pride in the stores, which significantly contributes to the success of the Company and its operations. Accordingly, all members of the Company's management (other than David Gold, the Company's Chief Executive Officer, Howard Gold, Senior Vice President of Distribution, Jeff Gold, Senior Vice President of Real Estate and Information Systems, Eric Schiffer, President and Karen Schiffer, Senior Buyer) and almost all employees with tenure of more than six months with the Company receive an annual
grant of stock options. As of December 31, 2003, the Company's employees held options to purchase an aggregate of 4,428,672 shares, or 6.1% of the shares of Common Stock on a fully diluted basis.
GROWTH STRATEGY
Management believes that future growth will primarily result from new store openings facilitated by the following:
Growth in Existing Territories. As of March 12, 2004 the Company has 194 99 Cents Only Stores. There are 150 stores located in California, 19 in Texas, and 15 in Arizona and 10 in Nevada. By continuing to develop store growth in its current markets, the Company believes it can leverage its brand awareness in these regions and take advantage of its existing warehouse and distribution facilities, regional advertising and other management and operating efficiencies. The Company plans to open 48 new 99 Cents Only Stores in 2004. Of the 48 planned new stores, approximately 15 new stores will be located in California, 26 in Texas, six in Arizona and one in Nevada. The Company had opened 6 new stores and closed one California store through March 12, 2004. Three stores were in California, 2 were in Texas and one was in Arizona. The Company plans to continue its store square footage expansion in 2004 at a targeted rate of 25% per year. The Company estimates that the markets in California, Texas, Arizona and Nevada have the potential for over 425 99 Cents Only Stores.
Continued Expansion into Texas. On February 4, 2003 the Company announced the purchase of a 741,000 square foot modern distribution center in the Houston area, to service its store expansion in Texas, started in mid 2003. The distribution facility was acquired for $23 million cash and came fully racked including an automated pick to belt conveyor system. It also contained refrigerated and frozen storage space. The Company installed the "High Jump" supply chain management system in this warehouse and opened the first stores in Houston Texas on June 19, 2003. As of March 12, 2004, the Company had opened 18 new stores in the Houston area and one in Dallas. The Texas stores average 21,400 sellable square feet, which is similar in size to new stores opened in Northern California. Since January 1999 new stores opened average 18,500 salable square feet. The Company believes Texas has the potential for over 150 stores. The Company plans to add approximately 26 new stores in Texas in 2004.
Portable Format Facilitates Geographic Expansion. The Company believes that its concept of consistently offering a broad selection of name-brand consumables, at value pricing, in a convenient store format is portable to most other densely populated areas of the country. In November 1999, the Company opened its first 99 Cents Only Stores outside the state of California in Las Vegas, Nevada and now has a total of 10 stores in Nevada, 15 in Arizona and 19 in Texas.
Acquisitions. The Company considers lease acquisition or purchase opportunities as they become known to the Company and may make acquisitions of a chain, or chains, of clustered retail sites in densely populated regions, primarily for the purpose of acquiring favorable locations.
RETAIL OPERATIONS
The Company's retail stores offer customers a wide assortment of regularly available consumer goods, as well as a broad variety of first-quality, close-out merchandise, generally at a significant discount from normal retail. All merchandise sold in the Company's 99 Cents Only Stores retail stores sells for 99 cents per item or 99 cents for two or more items.
The following table sets forth relevant information with respect to the growth of the Company's existing 99 Cents Only Stores operations (dollar amounts in thousands, except sales per square foot):
Merchandising. All of the Company's stores offer a broad variety of first-quality, name-brand and other close-out merchandise as well as a wide assortment of regularly available consumer goods. The Company also carries a line of private label consumer products made exclusively for the Company. The Company believes that the success of its 99 Cents Only Stores concept arises from the value inherent in selling primarily name-brand
consumables, most of which retail elsewhere from $1.19 to $9.99, for only 99 cents per item or group of items. Each store typically carries over six thousand different stock keeping units (SKU).
Although a majority of the merchandise purchased by the Company is available for reorder, the mix of specific brands of merchandise frequently changes, depending upon the availability of close-out and other special-situation merchandise at suitable prices. Since commencing its closeout purchasing strategy in 1976, the Company has not experienced difficulty in obtaining name brand closeouts as well as re-orderable merchandise at attractive prices. Management believes that continuously changing specific name-brands found in its stores from one week to the next encourages impulse and larger volume purchases, results in customers shopping more frequently and helps to create a sense of urgency, awareness and excitement. Unlike many discount retailers, the Company rarely imposes limitations on the quantity of specific items that may be purchased by a single consumer.
The Company targets value-conscious consumers from a wide range of socio-economic backgrounds with diverse demographic characteristics. Purchases are by cash, credit or debit card. The Company's stores do not accept checks or manufacturers' coupons. The Company's stores are open every day with opening hours designated to meet the needs of family consumers.
Store Size, Layout and Locations. As of March 12, 2004, the Company had 194, 99 Cents Only Stores averaging approximately 21,500 gross square feet. Since January 1, 1999, the Company has opened 130 new stores that average 23,500 gross square feet and currently targets new store locations between 18,000 and 28,000 gross square feet. The Company's larger 99 Cents Only Stores allow it to more effectively display a wider assortment of merchandise, carry deeper stock positions and provide customers with a more, what management believes, inviting and convenient environment that encourages customers to shop longer and buy more. The Company's decision to target larger stores is based in part on higher average annual store revenues typically achieved by these stores.
The Company's stores are conveniently located in freestanding buildings, neighborhood shopping centers (anchored by 99 Cents Only Stores, a supermarket and/or a drug store), regional shopping centers or downtown central business districts where the Company believes consumers are more likely to do their regular household shopping.
The Company strives to provide stores that are attractively merchandised, brightly lit, well-maintained, "destination" locations. The layout of each of the Company's stores is customized to the actual size and configuration of the individual location. The interior of each store is, however, designed to reflect a uniform format, featuring attractively displayed products in windows, consistent merchandise display techniques, bright lighting, lower shelving height that allows unobstructed visibility throughout the store, distinctive color scheme, interior and exterior signage and customized check-out counters, floors, price tags, shopping carts and shopping bags. The Company emphasizes a strong visual presentation in all key traffic areas of the store. Merchandising displays are maintained throughout the day, change frequently and often incorporate seasonal themes. The Company believes that due to the continuously changing brand-names, the lower shelving height and the absence of aisle description signs, the typical customer tends to shop the whole store.
As of December 31, 2003 the Company leased 159 of its 189, 99 Cents Only Stores retail locations and owned 30 store locations. The Company typically seeks leases with an initial five-year to ten-year term and with one or more five-year renewal options. See "Item 2
ITEM 2. PROPERTIES
As of March 12, 2004, the Company owned 30 and leased 164 of its 194 store locations. The Company also has escrow deposits on five additional locations for future openings. The Company currently leases 12 store locations and a parking lot associated with one of these stores from the Gold Family. Our annual rental expense for these facilities totaled approximately $1.9 million, $2.2 million and $2.1 million in 2001, 2002 and 2003, respectively. We believe that our lease terms are just as favorable to us as they would be for an unrelated party. Under our current policy, we enter into real estate transactions with our affiliates only for the renewal or modification of existing leases and on occasions where we determine that such transactions are in our best interests. Moreover, the independent members of our Board of Directors must unanimously approve all real estate transactions between us and our affiliates. They must also determine that such transactions are equivalent to a negotiated arm's-length transaction with a third party. We cannot guarantee that we will reach agreements with the Gold family on renewal terms for the properties we currently lease from them. Also, even if we agree to such terms, we cannot be certain that our independent directors will approve them. If we fail to renew one of these leases, we could be forced to relocate or close the leased store. Any relocations or closures we experience will be costly and could adversely affect our business. One of our outside directors, Ben Schwartz, is a trustee of a trust that owns a property on which a single 99 Cents Only Stores is located. Management believes that the Company's stable operating history, excellent credit history and ability to generate substantial customer traffic give the Company significant leverage when negotiating lease terms. Most of the Company's leases provide for fixed rents, subject to periodic adjustments. Certain of the Company's store leases contain provisions that grant the Company a right of first refusal to acquire the subject site.
The following table sets forth, as of December 31, 2003, information relating to the expiration dates of the Company's current stores leases:
EXPIRING EXPIRING EXPIRING EXPIRING 2004 2005-2007 2008-2010 2011 AND BEYOND ---- --------- --------- ---------------
15(a) 57 42 40
(a) Includes three stores leased on a month-to-month basis.
The Company purchased its main warehouse, distribution and executive office facility, located in the City of Commerce, California in 2000. The Company also leases an additional 180,000 square feet of warehouse storage space almost adjacent to its main distribution facility.
On January 28, 2003 the Company purchased a 741,000 square feet warehouse and distribution center in Houston, to service its planned store expansion in Texas in 2003 and beyond. See "Growth Strategy - Expansion in Texas."
On December 31, 2003, the Company purchased a 66,000 square feet deli and frozen warehouse and distribution center located in the City of Commerce, California.
Also, the Company is in escrow to purchase a 180,000 square foot warehouse facility that is currently being leased by the Company.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Melgoza vs. 99 Cents Only Stores (Los Angeles Superior Court; Case No. BC 295342)
On May 7, 2003, the plaintiff, a former Store Manager, filed a putative class action on behalf of himself and others similarly situated. The suit alleges that the Company improperly classified Store Managers in the Company's California stores as exempt from overtime requirements as well as meals and rest period requirements under California law. Each store typically had one Store Manager and two or three Assistant Store Managers. Pursuant to the California Labor Code, the suit seeks to recover unpaid overtime compensation, penalties for failure to provide meal and rest periods, waiting time penalties for former employees, interest, attorney fees, and costs. The suit also charges, pursuant to California's Business and Professions Code section 17200, that the Company engaged in unfair business practices by failing to make such payments, and seeks payment of all such wages (in the form of restitution) for the four-year period preceding the filing of the case through the present. Plaintiff is now seeking leave to file an amended complaint that would (1) expand the class to include not only all current and former Store Managers who worked for the Company from May 7, 1999 but also all current and former Assistant Managers who worked for the Company during the same period; and (2) claims for additional penalties on behalf of all purported class members under California's new Labor Code Private Attorney General Act of 2004. The Company is vigorously asserting defenses to the various claims.
In view of the inherent difficulty of predicting the outcome of legal matters, the Company cannot state with confidence what the eventual outcome of this matter will be. However, based on current knowledge, this matter is not presently expected to have a material adverse effect on the Company's financial condition or overall liquidity, although it could have a material adverse effect on the Company's results of operations for the accounting period in which it is resolved.
Others:
The Company is named as a defendant in various other legal matters arising in the normal course of business. In management's opinion, none of these other matters will have a material effect on the Company's financial position, results of operations or overall liquidity.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the New York Stock Exchange under the symbol "NDN." The following table sets forth, for the calendar periods indicated, the high and low closing prices per share of the Common Stock as reported by the New York Stock Exchange.
As of March 12, 2004, the Company had approximately 30,849 holders of the Common Stock and an additional 528 shareholders of record.
The Company has not paid any cash dividends with respect to the Common Stock. The Company presently intends to retain future earnings to finance its development and expansion and therefore does not anticipate the payment of any cash dividends in the foreseeable future. Payment of future dividends, if any, will depend upon future earnings and capital requirements of the Company and other factors, which the Board of Directors considers appropriate.
The Company has one stock option plan (the 1996 Stock Option Plan, as amended). The plan is a fixed plan, which provides for the granting of non-qualified and incentive options to purchase up to 17,000,000 shares of common stock of which 5,268,045 are available for future option grants. Options may be granted to officers, employees, directors and consultants. Grants may be at fair market value at the date of grant or at a price determined by the compensation committee consisting of four outside members of the board of directors (the "Committee"). Options vest over a three-year period, one-third one year from the date of grant and one third per year thereafter. Options expire ten years from the date of grant. The Company accounts for its stock option plan under APB Opinion No. 25 under which no compensation cost has been recognized in fiscal 2001, 2002 and 2003.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth, selected financial and operating data of the Company for the periods indicated. The Consolidated Financial Statements for years 1999 through 2001 were audited by Arthur Andersen LLP (Andersen) which has ceased operations. A copy of the report previously issued by Andersen on our financial statements as of December 31, 2000 and 2001 and for each of the three years in the period ended December 31, 2001 is included elsewhere in this Form 10-K. Such report has not been reissued by Andersen. The following information should be read in conjunction with "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following management's discussion and analysis should be read in connection with "Item 6. Selected Financial Data," and "Item 8. Financial Statements and Supplementary Data."
GENERAL
99 Cents Only Stores increased its net sales, operating income and income from continuing operations in each year from 1999 to 2002. In 2003, 99 Cents Only Stores had net sales of $862.5 million, operating income of $87.4 million and net income of $56.5 million. Sales increased 20.8% over 2002. Operating income and net income decreased 3.4% and 4.1% respectively from 2002. From 1999 through 2003, the Company had a compound annual growth rate in net sales, operating income and net income of 21.7%, 14.4% and 16.2%, respectively.
During the three years ending December 31, 2003, average annual net sales per estimated saleable square foot (computed for 99 Cents Only Stores open for the full year) declined from $318 per square foot to $308 per square foot. This trend reflects the Company's determination to target larger locations for new store development. Existing stores average approximately 21,500 gross square feet. From January 1, 2001 through December 31, 2003, the Company opened 92 new stores (including one relocation in 2001) that average approximately 24,700 gross square feet. The Company currently targets new store locations between 18,000 and 28,000 gross square feet. Although it is the Company's experience that larger stores generally have lower average net sales per square foot than smaller stores, larger stores generally achieve higher average annual store revenues and operating income. During the three years ending December 31, 2003, average annual net sales per store (computed for 99 Cents Only Stores open for the full year) increased from $4.5 million to $4.9 million.
The Company's management believes that future growth will primarily result from new store openings facilitated by growth in our existing territories and expansion into new territories. The Company has now expanded into Texas, and expects to continue to open new stores in Texas as well as in California, Nevada and Arizona. The Company believes that its concept of consistently offering a broad selection of name-brand consumables, at value pricing, in a convenient store format is portable to most other densely populated areas of the country. The Company considers lease acquisitions or purchase opportunities as they become known to the Company and may make acquisitions of a chain, or chains, of clustered retail sites in densely populated regions, primarily for the purpose of acquiring favorable store locations. See "Growth Strategy" and Risk Factor "We Depend on New Store Openings for Future Growth."
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements requires management to make estimates and assumptions that affect reported earnings. These estimates and assumptions are evaluated on an on-going basis and are based on historical experience and on other factors that management believes are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, inventories, self-insurance reserves, and commitments and contingencies.
The Company believes that the following represent the areas where more critical estimates and assumptions are used in the preparation of the financial statements:
Investments: The Company records its investments, which are comprised primarily of investment grade federal and municipal bonds and commercial paper, at fair value. Any premium or discount recognized in connection with the purchase of an investment is amortized over the term of the investment. The Company accounts for its investments in marketable securities in accordance with Financial Accounting Standards Board No. 115 as trading securities.
Long-lived asset impairment: The Company records impairments when the carrying amounts of long-lived assets are determined not to be recoverable. Impairment is assessed and measured by an estimate of future cash flows expected to result from the use of the asset and its eventual disposition. Changes in market conditions can impact estimated future cash flows from use of these assets and additional impairments may be required should such changes occur.
Self-insurance reserves: The Company is self-insured in relation to worker's compensation claims in California. The Company provides for losses of estimated known and incurred but not reported insurance claims. These estimates are based on reported claims and actuarial valuations. Should a greater amount of claims occur compared to the estimates, reserves recorded may not be sufficient and additional expenses, which may be significant, could be incurred. The Company does not discount for the time value of money its projected future cash outlays for its existing workers compensation claims.
Universal International (Discontinued Operations)
In December 1999, the Company determined it would be in its best interest, and that of its shareholders, to focus its efforts on increasing the growth rate of 99 Cents Only Stores. In conjunction with its revised growth strategy, the Company decided to sell its Universal International, Inc. and Odd's-n-End's, Inc. subsidiaries (together "Universal"). Universal operated a multi-price point variety chain, with 65 stores located in the Midwest, Texas and New York, under the trade names Only Deals and Odd's-N-End's. Among other factors at that time, the Company considered its successful opening of its first 99 Cents Only Stores outside of Southern California, in Las Vegas, Nevada. Given the success of the Las Vegas, Nevada stores, the Company believed that the 99 Cents Only Stores concept was portable to areas outside of Southern California. As a result, the Company has focused greater management resources to increasing its store growth rate and expanding aggressively into Nevada, Arizona and in 2003, Texas.
The Company adopted a definitive plan to sell Universal within one year, as set forth by guidelines for the accounting treatment of discontinued operations. The Company engaged an investment-banking firm to evaluate and identify potential buyers for the Universal business and expected to sell Universal within the one-year time frame from when the Company classified Universal as a discontinued operation. The investment banking firm's marketing process focused upon selling the business as a going concern. From June 2000 through August 2000, sales presentations were delivered to both strategic buyers and financial buyers. This process did not generate the expected interest level from potential buyers that had been anticipated. The highest offer for the Universal business was significantly less than the Company's expectations. As a result of the difficulties encountered in trying to sell Universal and the necessity to complete the process by December 31, 2000, it was decided by the Board of Directors to be in the Company's and the shareholders' best interest to sell Universal for the Company's carrying value as of the close of business on September 30, 2000 to Universal Deals, Inc. and Universal Odd's-n-End's, Inc., both of which are owned 100% by David and Sherry Gold, both significant shareholders of 99 Cents Only Stores. Mr. Gold is also Chairman and CEO of 99 Cents Only Stores. The sale was effective as of the close of business on September 30, 2000. The purchase price for Universal was paid in cash and was equal to the Company's carrying book value of the assets of Universal at September 30, 2000 or $33.9 million. The net assets at September 30, 2000 included $29.2 million in inventory, net fixed assets of $7.6 million and $0.6 million of other assets. These assets were offset by $3.5 million of accounts payable, accrued and other liabilities. In connection with this transaction, 99 Cents Only Stores provided certain ongoing administrative services to Universal in 2000 and 2001 pursuant to a service agreement for a management fee of 6% of Universal sales revenues. During fiscal year 2000, the Company recorded an additional net loss from discontinued operations of $1.1 million, net of tax benefit of $0.7 million, for operating losses incurred through the date of sale, in excess of the amounts originally provided in 1999. In the fourth quarter of 2000, the Company received $1.3 million in management fees under the service agreement with Universal. The Company also received $0.4 million in lease payments for rental of a distribution facility to Universal. During 2001, the Company received $3.7 million in fees under the service agreement, $1.4 million in lease payments and sold $4.7 million in merchandise at a 10% mark-up. In 2002 the Company received $1.5 million in management fees under the service agreement from Universal and $1.4 million in lease payments. It also purchased $0.4 million of closeout inventory from Universal. During 2003 the Company received $1.4 million in management fees under the service agreement from Universal and $1.4 million in lease payments. The service and lease agreements with Universal culminated as of December 15, 2003 and there are no remaining amounts due to or from Universal under these agreements.
The following table sets forth for the periods indicated, certain selected income statement data, including such data as a percentage of net sales:
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002
Net Sales. Total net sales increased $148.5 million, or 20.8%, from $713.9 million in 2002 to $862.5 million in 2003. 99 Cents Only Stores net sales increased $152.3 million, or 22.9%, from $664.0 million in 2002 to $816.3 million in 2003. Bargain Wholesale net sales decreased $3.8 million, or 7.7%, from $50.0 million in 2002 to $46.1 million in 2003. The net effect of 38 new stores opened in 2003 increased 99 Cents Only Stores net sales by $67.3 million and the full year effect of 28 net stores opened in 2002 increased sales by $56.0 million. Comparable stores net sales increased 4.8% in 2003. The decrease in Bargain Wholesale net sales was primarily attributed to the competitive pricing environment in the wholesale business, a decline in sales to export brokers and a greater focus on the growth of the Company's retail business.
Gross profit. Gross profit, which consists of total net sales, less cost of sales, increased $59.2 million, or 20.7%, from $286.6 million in 2002 to $345.8 million in 2003. The increase in gross profit dollars was primarily due to higher sales volume. As a percentage of net sales, gross profit was 40.1% in 2003 and 2002. The retail gross margin decreased to 41.2% of sales in 2003 versus 41.7% in 2002. This percentage variance was due to a 35.2% growth in the grocery product sales, which have a lower margin than other product categories. Margins on closeouts vary widely depending on circumstances giving rise to product availability. See Risk Factor "We depend on our relationships with our suppliers and the availability of close-out and special-situation merchandise." The wholesale margin was 19.8% in 2003 versus 20.1% in 2002. Wholesale margin is generally driven by local competitive pricing factors, which results in lower sales prices.
Operating Expenses. Operating expenses, increased $56.3 million, or 31.5%, from $178.4 million in 2002 to $234.6 million in 2003. The 38 new store additions in 2003 increased operating expenses by $33.2 million. Distribution costs increased $11.6 million. This includes transportation costs, which increased $3.5 million due to the addition of new stores in Northern California, Nevada, Arizona and Texas. The addition
of the new Texas distribution center increased distribution costs $2.0 million, warehouse cost increased $6.1 million due to overall increase in labor cost. Increases in administrative costs include an increase in California workers compensation expense of $11.6 million based on store and labor growth in California. Other administrative cost increases of $4.4 million, include $1.1 million of start up costs in Texas. Additional key administrative staff positions were filled in information systems, real estate, distribution, human resources, finance, strategic planning and buying. Operating costs were offset by $1.4 million in management fees from Universal (see Universal International above).
Depreciation and Amortization. Depreciation increased $6.1 million. The 38 new store additions increased depreciation by $4.1 million and the new Texas distribution center increased depreciation $0.5 million. Other increases result from amortization of information systems costs and depreciation costs of the Los Angeles distribution center.
Operating income. Operating income decreased $3.1 million, or 3.4%, from $90.5 million in 2002 to $87.4 million in 2003. Operating income as a percentage of net sales was 10.1% in 2003 and 12.7% in 2002 primarily due to the increase in the operating costs discussed above.
Other (income) expense. Other (income) expense relates primarily to the interest income on the Company's marketable securities, net of interest expense on the Company's capitalized leases. Interest expense was $0.1 million in 2002 and in 2003. The Company had no bank debt during 2002 or 2003. Interest income earned on the Company's marketable securities was $3.1 million in 2003 and $3.5 million in 2002. At December 31, 2003, the Company held $145.7 million in short-term investments and $52.8 million in long-term investments. The Company's short-term investments are comprised primarily of investment grade federal and municipal bonds and commercial paper, all with short-term maturities. The Company generally holds investments until maturity. Also included in both 2003 and 2002 is $1.4 million of income under a lease agreement with Universal for a distribution facility. This agreement ended on December 15, 2003.
Provision for income taxes. The provision for income taxes in 2003 was $35.3 million, or 4.1% of net sales, compared to $36.4 million, or 5.1% of net sales in 2002. The effective combined federal and state rates of the provision for income taxes were 38.4% and 38.2% in 2003 and 2002, respectively. The effective combined federal and state tax rates are less than the statutory rates in each period and were calculated to reflect estimated tax rates after giving effect for tax credits and the estimated versus the actual tax rate differential. See Note 7 of "Notes to Financial Statements."
Net Income. As a result of the items discussed above, net income decreased $2.4 million, or 4.1%, from $59.0 million in 2002 to $56.5 million in 2003. Net income as a percentage of net sales was 6.5% in 2003 and 8.3% in 2002.
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
Net Sales. Total net sales increased $135.7 million, or 23.5%, from $578.3 million in 2001 to $713.9 million in 2002. 99 Cents Only Stores net sales increased $142.0 million, or 27.2%, from $522.0 million in 2001 to $664.0 million in 2002. Bargain Wholesale net sales decreased $6.3 million, or 11.2%, from $56.3 million in 2001 to $50.0 million in 2002. 99 Cents Only Stores net sales increased $79.7 million from the 28 new stores opened in 2002. The full year effect of 25 net stores opened in 2001 was $49.2 million. Comparable stores net sales increased 3.6% from 2001 to 2002. The decrease in Bargain Wholesale net sales was primarily attributed to the absence of sales to Universal, which were $4.7 million in 2001.
Gross profit. Gross profit, which consists of total net sales, less cost of sales, increased $58.7 million, or 25.8%, from $227.8 million in 2001 to $286.6 million in 2002. The increase in gross profit dollars was primarily due to higher sales volume. As a percentage of net sales, gross profit was 40.1% in 2002 versus 39.4% in 2001. This 0.7% variation results from the change in the ratio of retail versus wholesale sales. The retail gross margin increased 10 basis points to 41.7% of sales in 2002 versus 41.6% in 2001, this was due sales growth in houseplant and counter items. Gross margins will vary from time to time because of the closeout nature of the business. Margins on closeouts vary widely depending on circumstances giving rise to product availability. See Risk Factor "We depend on our relationships with our suppliers and the availability of close-out and special-situation merchandise". The wholesale margin was 20.1% in 2002 versus 19.3% in 2001. The wholesale margin increased as a result of the loss of $4.7 million in sales to Universal in 2001, which carried a lower margin of 10%.
Operating Expenses. Operating expenses, increased $36.8 million, or 26.0%, from $141.5 million in 2001 to $178.4 million in 2002. The 28 new stores opened in 2002 increased operating expenses $25.3 million. Approximately $4.3 million in cost increases were attributable to utility cost increases associated with the retrofitting of older stores with expanded frozen and deli selling and storage space. Minimum wage cost increases were $5.1 million. Growth in corporate staff positions and field rep staff positions were $1.2 million and there were other cost increases of $1.0 million. Operating costs were offset by $1.5 million in management fees from Universal (see Universal International above).
Depreciation. Depreciation increased $5.4 million in 2002 over 2001. New store additions accounted for $4.2 of this increase, $1.0 was attributable to increases in depreciation of computer hardware and software and $0.2 million was an increase in depreciation of distribution equipment.
Operating income. Operating income increased $16.6 million, or 22.4%, from $74.0 million in 2001 to $90.5 million in 2002. Operating income as a percentage of net sales was 12.8% in 2001 and 12.7% in 2002 primarily due to the increase in the operating costs discussed above.
Other (income) expense. Other (income) expense relates primarily to the interest income on the Company's marketable securities, net of interest expense on the Company's capitalized leases. Interest expense was $0.1 million in 2001 and in 2002. The Company had no bank debt during 2002 or 2001. Interest income earned on the Company's marketable securities was $3.5 million in 2002 and $4.6 million in 2001. At December 31, 2002, the Company held $146.9 million in short-term investments and $37.2 million in long-term investments. The Company's short-term investments are comprised primarily of investment grade federal and municipal bonds and commercial paper, all with short-term maturities. The Company generally holds investments until maturity. Also included in both 2002 and 2001 is $1.4 million of income under a lease agreement with Universal for a distribution facility.
Provision for income taxes. The provision for income taxes in 2002 was $36.4 million, or 5.1% of net sales, compared to $31.4 million, or 5.4% of net sales in 2001. The effective combined federal and state rates of the provision for income taxes were 39.3% and 38.1% in 2001 and 2002, respectively. The effective combined federal and state tax rates are less than the statutory rates in each period and were calculated to reflect estimated tax rates after giving effect for tax credits and the estimated versus the actual tax rate differential. See Note 7 of "Notes to Financial Statements."
Net Income. As a result of the items discussed above, net income increased $10.5 million, or 21.7%, from $48.4 million in 2001 to $59.0 million in 2002. Net income as a percentage of net sales was 8.3% in 2002 and 8.4% in 2001.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has funded its operations principally from cash provided by operations, and has not generally relied upon external sources of financing. The Company's capital requirements result primarily from purchases of inventory, expenditures related to new store openings and working capital requirements for new and existing stores. The Company takes advantage of close-out and other special-situation opportunities, which frequently result in large volume purchases, and as a consequence, its cash requirements are not constant or predictable during the year and can be affected by the timing and size of its purchases.
Net cash provided by operations during 2002 and 2003 was $72.3 and $79.5 million, respectively, consisting primarily of $75.7 million and $87.3 million of net income adjusted for non-cash items. The Company provided $12.2 million and $10.5 million respectively, in working capital and other activities. Net cash used in working capital and other activities primarily reflects the increases in inventories in the amount of $16.6 million and $24.2 million in 2002 and 2003, respectively.
Net cash used in investing activities during 2002 and 2003 was $77.5 and $112.2 million. In 2002, the Company used $41.6 million for the purchase of property and equipment including $19.6 million used for the purchase of new store locations, $0.1 million in investments in two partnerships for the purpose of obtaining leases on two store locations and $36.0 million for the purchase of short-term investments. The Company did not repurchase any of its shares under its stock repurchase program in 2001, which expired during 2002. In 2003, the Company used $97.3 million for the purchase of property and equipment including $23.0 million for the purchase of a modern distribution center in Houston, Texas, $8.3 million for a frozen and refrigerated warehouse in Los Angeles, $39.7 million for new and existing stores, $12.1 million for construction in progress on future store openings $1.5 million for distribution and warehouse equipment and $0.6 million for information systems and other corporate needs. The company also invested $14.4 million for the purchase of short and long-term investments.
Net cash provided by financing activities during 2002 and 2003 was $12.9 and $25.7 million, which represents the proceeds from the exercise of non-qualified stock options. The Company does not maintain any credit facilities with any bank.
The Company plans to open 48 new 99 Cents Only Stores in 2004. The average investment per new store opened in 2003, including leasehold improvements, furniture, fixtures and equipment, inventory and pre-opening expenses, was approximately $1,100,000 and includes 6 stores that were purchased. The Company does not capitalize pre-opening expenses. The Company's cash needs for new store openings including acquired properties are expected to total approximately $54.0 million in 2004. The Company's total planned capital expenditures in 2004 for additions to fixtures and leasehold improvements of existing stores as well as for distribution and transportation equipment, information systems, expansion and replacement will be approximately $26.0 million. The Company believes that its total capital expenditure requirements (including new store openings) will approximate $80.0 million in 2004. The Company intends to fund its liquidity requirements in 2004 out of net cash provided by operations, short-term investments and cash on hand.
CONTRACTUAL OBLIGATIONS
The following table summarizes our consolidated contractual obligations (in thousands) as of December 31, 2003. These should be read in conjunction with "Note 8. Commitments and Contingencies"
LEASE COMMITMENTS
The Company leases various facilities under operating leases except for two, which were classified as capital leases and will expire at various dates through 2018. Some of the lease agreements contain renewal options and/or provide for scheduled increases or increases based on the Consumer Price Index. Total minimum lease payments under each of these lease agreements, including scheduled increases, are charged to operations on a straight-line basis over the life of each respective lease. Certain leases require the payment of property taxes, maintenance and insurance. Rental expense charged to operations in 2000, 2001 and 2002 was approximately $15.6 million, $19.4 million and $24.9 million, respectively. The Company typically seeks leases with an initial five-year to ten-year term and with one or more five-year renewal options. See "Item 2. Properties." Most leases have renewal options ranging from three to ten years.
SEASONALITY AND QUARTERLY FLUCTUATIONS
The Company has historically experienced and expects to continue to experience some seasonal fluctuations in its net sales, operating income and net income. The highest sales periods for the Company are the Christmas and Halloween seasons. A greater amount of the Company's net sales and operating and net income is generally realized during the fourth quarter. The Company's quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of certain holidays (e.g., Easter) and the timing of new store openings and the merchandise mix.
SUPPLEMENTARY FINANCIAL INFORMATION
The following table sets forth certain unaudited results of operations for each quarter during 2002 and 2003. The unaudited information has been prepared on the same basis as the audited financial statements appearing elsewhere in this report and includes all adjustments, which management considers necessary for a fair statement of the financial data shown. The operating results for any quarter are not necessarily indicative of the results to be attained for any future period.
NEW AUTHORITATIVE PRONOUNCEMENTS
In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to recognize a liability at the inception of a guarantee equal to the fair value of the obligation undertaken and elaborates on the disclosures to be made by the guarantor. The disclosure requirements of FIN 45 are required for the fiscal year ended December 31, 2002. The recognition and measurement provisions of FIN 45 are effective, on a prospective basis, for guarantees issued by the Company beginning in fiscal 2003. The adoption of FIN 45 is not expected to have a material impact on the Company's financial position or results of operations.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities." FIN 46 establishes a new and far-researching consolidation accounting model. Although FIN No 46 was initially focused on special purpose entities, the applicability of FIN No 46 goes beyond such entities and can have applicability to franchise arrangements, regardless of whether the Company has voting or ownership control of such franchisee. In response to a number of comment letters and implementation questions, in December 2003 the FASB issued FIN No. 46R, which delays the effective date of FIN No 46 for certain entities until March 31, 2004, as well as provides clarification regarding other implementation issues. The Company will adopt Fin No 46 in its quarter ending March 31, 2004. Adoption of Fin No. 46 is not expected to have a significant impact on the Company's financial position, results of operations or liquidity.
RISK FACTORS
INFLATION MAY AFFECT OUR ABILITY TO SELL MERCHANDISE AT THE 99 CENTS PRICE POINT
Our ability to provide quality merchandise at the 99 cents price point is subject to certain economic factors, which are beyond our control, including inflation. Inflation could have a material adverse effect on our business and results of operations, especially given the constraints on our ability to pass on any incremental costs due to price increases or other factors. We believe that we will be able to respond to ordinary price increases resulting from inflationary pressures by adjusting the number of items sold at the single price point (e.g., two items for 99 cents instead of three items for 99 cents) and by changing our selection of merchandise. Nevertheless, a sustained trend of significantly increased inflationary pressure could require us to abandon our single price point of 99 cents per item, which could have a material adverse effect on our business and results of operations. See also "We are vulnerable to uncertain economic factors, changes in the minimum wage and workers' compensation" for a discussion of additional risks attendant to inflationary conditions.
WE DEPEND MAINLY ON NEW STORE OPENINGS OUTSIDE OF OUR TRADITIONAL CORE MARKET OF SOUTHERN CALIFORNIA FOR FUTURE GROWTH
Our sales and operating income growth results depend largely on our ability to open and operate new stores outside of our traditional core market of Southern California successfully and to manage a larger business profitably. In 2002 and 2003, we opened 28 and 38 99 Cents Only Stores, respectively. We also plan to grow retail square footage at a rate of approximately 25% per year. Our strategy depends on many factors, including our ability to identify suitable markets and sites for our new stores, negotiate leases with acceptable terms, refurbish stores, successfully compete against local competition, upgrade our financial and management information systems and controls and manage our operating expenses. In addition, we must be able to continue to hire, train, motivate and retain competent managers and store personnel. Many of these factors are beyond our control. As a result, we cannot assure you that we will be able to achieve our expansion goals. Any failure by us to achieve our expansion goals on a timely basis, obtain acceptance in markets in which we currently have limited or no presence, attract and retain management and other qualified personnel, appropriately upgrade our financial and management information systems and controls or manage operating expenses could adversely affect our future operating results and our ability to execute our business strategy.
We also cannot assure you that we will improve our results of operations when we open new stores. A variety of factors, including store location, store size, rental terms, competition, the level of store sales and the level of initial advertising influence if and when a store becomes profitable. Assuming that our planned expansion occurs as anticipated, our store base will include a relatively high proportion of stores with relatively short operating histories. We cannot assure you that our new stores will achieve the sales per saleable square foot and store-level operating margins currently achieved at our existing stores. If our new stores on average fail to achieve these results, our planned expansion could produce a decrease in our overall sales per saleable square foot and store-level operating margins. Increases in the level of advertising and pre-opening expenses associated with the opening of new stores could also contribute to a decrease in our operating margins. Finally, the opening of new stores in existing markets has in the past and may in the future reduce retail sales of existing stores in those markets, negatively affecting comparable store sales.
OUR OPERATIONS ARE CONCENTRATED IN CALIFORNIA
Currently, all but 44 of our 194, 99 Cents Only Stores are located in California. We operate 10 stores in Las Vegas, Nevada, 15 stores in Arizona and 19 stores in Houston, Texas. We expect that we will continue to open additional stores in California, as well as in Nevada, Arizona and Texas. Accordingly, our results of operations and financial condition largely depend upon trends in the California economy. If retail spending declines due to an economic slow-down or recession in California, we cannot assure you that our operations will not be negatively impacted.
In addition, California historically has been vulnerable to certain natural disasters and other risks, such as earthquakes, fires, floods and civil disturbance. At times, these events have disrupted the local economy. These events could also pose physical risks to our properties.
WE COULD EXPERIENCE DISRUPTIONS IN RECEIVING AND DISTRIBUTION
Our success depends upon whether our receiving and shipment schedules are organized and well managed. As we continue to grow, we may face unexpected demands on our warehouse operations, as well as unexpected demands on our transportation network, which could cause delays in delivery of merchandise to or from our warehouses to our stores. A fire, earthquake or other disaster at our warehouses could hurt our business, financial condition and results of operations, particularly because much of our merchandise consists of closeouts and other irreplaceable products. Although we maintain standard property and business interruption insurance, we do not have earthquake insurance on our properties. Although we try to limit our risk of exposure to potential product liability claims, we do not know if the limitations in our agreements are enforceable. We maintain insurance covering damage from use of our products. If any product liability claim is successful and large enough, our business could suffer.
WE DEPEND UPON OUR RELATIONSHIPS WITH OUR SUPPLIERS AND THE AVAILABILITY OF CLOSE-OUT AND SPECIAL-SITUATION MERCHANDISE
Our success depends in large part on our ability to locate and purchase quality close-out and special-situation merchandise at attractive prices. This helps us maintain a mix of name-brand and other merchandise at the 99 Cents price point. We cannot be certain that such merchandise will continue to be available in the future at a price that will be consistent with historical costs. Further, we may not be able to find and purchase merchandise in quantities necessary to accommodate our growth. Additionally, our suppliers sometimes restrict the advertising, promotion and method of distribution of their merchandise. These restrictions in turn may make it more difficult for us to quickly sell these items from our inventory. Although we believe our relationships with our suppliers are good, we do not have long-term agreements with any supplier. As a result, we must continuously seek out buying opportunities from our existing suppliers and from new sources. We compete for these opportunities with other wholesalers and retailers, discount and deep-discount chains, mass merchandisers, food markets, drug chains, club stores and various privately-held companies and individuals. Although we do not depend on any single supplier or group of suppliers and believe we can successfully compete in seeking out new suppliers, a disruption in the availability of merchandise at attractive prices could impair our business.
WE PURCHASE IN LARGE VOLUMES AND OUR INVENTORY IS HIGHLY CONCENTRATED
To obtain inventory at attractive prices, we take advantage of large volume purchases, close-outs and other special situations. As a result, our inventory levels are generally higher than other discount retailers. At December 31, 2002 and 2003, we recorded net inventory value of $83.2 million and $105.6 million, respectively. We periodically review the net realizable value of our inventory and make adjustments to its carrying value when appropriate. The current carrying value of our inventory reflects our belief that we will realize the net values recorded on our balance sheet. However, we may not be able to do so. If we sell large portions of our inventory at amounts less than their carrying value or if we write down a significant part of our inventory, our cost of sales, gross profit, operating income and net income could suffer greatly during the period in which such event or events occur. Margins could also be negatively affected should the grocery category sales continue to expand in importance and become a larger percentage of total sales in the future.
WE FACE STRONG COMPETITION
We compete in both the acquisition of inventory and sale of merchandise with other wholesalers, discount and deep-discount stores, single price point merchandisers, mass merchandisers, food markets, drug chains, club stores and other retailers. In the future, new companies may also enter the deep-discount retail industry. Additionally, we currently face increasing competition for the purchase of quality close-out and other special-situation merchandise. Some of our competitors have substantially greater financial resources and buying power than us. Our capability to compete will depend on many factors including our ability to successfully purchase and resell merchandise at lower prices than our competitors. We cannot assure you that we will be able to compete successfully against our current and future competitors.
WE ARE VULNERABLE TO UNCERTAIN ECONOMIC FACTORS, CHANGES IN THE MINIMUM WAGE AND WORKERS' COMPENSATION AND HEALTHCARE COSTS
Our ability to provide quality merchandise at our 99 Cents price point could be hindered by certain economic factors beyond our control, including but not limited to:
- - increases in inflation; - - increases in operating costs; - - increases in employee healthcare costs; - - increases in workers' compensation benefits; - - increases in prevailing wage levels; - - increases in legal costs; - - increases in government regulatory cost and - - decreases in consumer confidence levels.
In January 2001, California enacted a minimum wage increase of $0.50 per hour with an additional $0.50 increase required in January 2002. In 2001 and 2002, annual payroll expenses as a percentage of sales increased less than 1.0%. Self-insured workers' compensation reserves are subject to actuarial reviews, which could increase the overall cost of workers' compensation benefits. Because we provide consumers with merchandise at a 99 cents fixed price point, we typically cannot pass on cost increases to our customers.
WE FACE RISKS ASSOCIATED WITH INTERNATIONAL SALES AND PURCHASES
Although international sales historically have not been important to our overall net sales, they have contributed to historical growth in Bargain Wholesale's net sales. In addition, some of the inventory we purchase is manufactured outside the United States. There are many risks associated with doing business internationally. Our international transactions may be subject to risks such as:
- - political instability; - - currency fluctuations; - - exchange rate controls; - - changes in import and export regulations; and - - changes in tariff and freight rates.
The United States and other countries have also proposed various forms of protectionist trade legislation. Any resulting changes in current tariff structures or other trade policies could lead to fewer purchases of our products and could adversely affect our international operations.
WE COULD ENCOUNTER RISKS RELATED TO TRANSACTIONS WITH OUR AFFILIATES
We currently lease 12 of our 99 Cents Only Stores and a parking lot for one of these stores from certain members of the Gold family and their affiliates. Our annual rental expense for these facilities totaled approximately $2.2 and $2.1 million in each of 2001 and 2002. In addition, one of our directors, Ben Schwartz, is a trustee of a trust that owns a property on which a single 99 Cents Only Store is located. We believe that our lease terms are just as favorable to us as they would be for an unrelated party. Under our current policy, we enter into real estate transactions with our affiliates only for the renewal or modification of existing leases and on occasions where we determine that such transactions are in our best interests. Moreover, the independent members of our Board of Directors must unanimously approve all real estate transactions between the Company and our affiliates. They must also determine that such transactions are equivalent to a negotiated arm's-length transaction with a third party. We cannot guarantee that we will reach agreements with the Gold family on renewal terms for the properties we currently lease from them. Also, even if we agree to such terms, we cannot be certain that our independent directors will approve them. If we fail to renew one of these leases, we could be forced to relocate or close the leased store. Any relocations or closures we experience will be costly and could adversely affect our business.
WE RELY HEAVILY ON OUR MANAGEMENT TEAM
Our success depends substantially on David Gold and Eric Schiffer, our Chief Executive Officer and President, respectively. We also rely on the continued service of our executive officers and other key management. We have not entered into employment agreements with any of our executive officers and we do not maintain key person life insurance on them. As we continue to grow, our success will depend on our ability to identify, attract, hire, train, retain and motivate other highly skilled management personnel. Competition for such personnel is intense, and we may not be able to successfully attract, assimilate or retain sufficiently qualified candidates.
OUR OPERATING RESULTS MAY FLUCTUATE AND MAY BE AFFECTED BY SEASONAL BUYING PATTERNS
Historically, our highest net sales and operating income have occurred during the fourth quarter, which includes the Christmas and Halloween selling seasons. During 2002 and 2003, we generated approximately 29.5% and 28.7%, respectively, of our net sales and approximately 32.7% and 26.6% respectively, of our operating income during the fourth quarter. If for any reason the Company's net sales were to fall below norms during the fourth quarter it could have an adverse impact on our profitability and impair our results of operations for the entire year. Adverse weather conditions or other disruptions during the peak holiday season could also affect our net sales and profitability for the year.
In addition to seasonality, many other factors may cause our results of operations to vary significantly from quarter to quarter. Some of these factors are beyond our control. These factors include:
- - the number of new stores and timing of new store openings; - - the level of advertising and pre-opening expenses associated with new stores; - - the integration of new stores into our operations; - - general economic health of the deep-discount retail industry; - - changes in the mix of products sold; - - unexpected increases in shipping costs; - - ability to successfully manage our inventory levels; - - changes in our personnel; - - fluctuations in the amount of consumer spending; - - the amount and timing of operating costs and capital expenditures relating to the growth of our business.
WE ARE SUBJECT TO ENVIRONMENTAL REGULATIONS
Under various federal, state and local environmental laws and regulations, current or previous owners or occupants of property may become liable for the costs of removing any hazardous substances found on the property. These laws and regulations often impose liability without regard to fault. As of December 31, 2003, we leased all but 30 of our stores and own three distribution facilities. However, in the future we may be required to incur substantial costs for preventive or remedial measures associated with the presence of hazardous materials. In addition, we operate one underground diesel storage tank and one above-ground propane storage tank at our Southern California warehouse. Although we have not been notified of, and are not aware of, any current environmental liability, claim or non-compliance, we could incur costs in the future related to our leased properties and our storage tanks. In the ordinary course of our business, we sometimes handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations. We have adopted policies regarding the handling and disposal of these products, and we train our employees on how to handle and dispose of them. We cannot assure you that our policies and training will successfully help us avoid potential violations of these environmental laws and regulations in the future.
ANTI-TAKEOVER EFFECT; CONCENTRATION OF OWNERSHIP BY OUR EXISTING OFFICERS AND PRINCIPAL STOCKHOLDERS
In addition to some governing provisions in our Articles of Incorporation and Bylaws, we are also subject to certain California laws and regulations which could delay, discourage or prevent others from initiating a potential merger, takeover or other change in our control, even if such actions would benefit our shareholders and us. Moreover David Gold, our Chairman and Chief Executive Officer, and members of his immediate family and certain of their affiliates beneficially own as of December 31, 2003, 22,736,242 or 31.9% of shares outstanding. As a result, they have the ability to influence all matters requiring the vote of our shareholders, including the election of our directors and most of our corporate actions. They can also control our policies and potentially prevent a change in our control. This could adversely affect the voting and other rights of our other shareholders and could depress the market price of our common stock.
OUR STOCK PRICE COULD FLUCTUATE WIDELY
The market price of our common stock has risen substantially since our initial public offering on May 23, 1996. Trading prices for our common stock could fluctuate significantly due to many factors, including:
- - the depth of the market for our common stock; - - changes in expectations of our future financial performance, including financial estimates by securities analysts and investors; - - variations in our operating results; - - conditions or trends in our industry or industries of any of our significant clients; - - the conditions of the market generally; - - additions or departures of key personnel; and - - future sales of our common stock.
RISKS COULD ARISE DUE TO OUR USE OF ARTHUR ANDERSEN LLP AS OUR INDEPENDENT AUDITORS
There may be no effective remedy against Arthur Andersen LLP, which audited our financial statements for the years ended December 31, 2000 and 2001, in connection with a material misstatement or omission in those financial statements, or in connection with any other claim arising from its provision of auditing and other services to us. On September 15, 2002, Arthur Andersen was convicted of obstructing justice in connection with investigations of their former client Enron Corp. Arthur Andersen ceased practicing before the SEC effective August 31, 2002. Our inability to include in future registration statements or reports financial statements for one or more years audited by Arthur Andersen LLP or to obtain Arthur Andersen LLP's consent to the inclusion of their report on our 2000 and 2001 financial statements may impede our access to the capital markets. Should we seek to access the public capital markets, SEC rules will require us to include or incorporate by reference in any prospectus three years of audited financial statements. Until our audited financial statements for the fiscal year ending December 31, 2004 become available, the SEC's current rules would require us to present audited financial statements for one or more fiscal years audited by Arthur Andersen LLP. Prior to that time the SEC may cease accepting financial statements audited by Arthur Andersen LLP, in which case we would be unable to access the public capital markets unless PricewaterhouseCoopers LLP, our current independent accounting firm, or another independent accounting firm, is able to audit the financial statements originally audited by Arthur Andersen LLP. In addition, as a result of the departure of our former engagement team leaders, Arthur Andersen LLP is no longer in a position to consent to the inclusion or incorporation by reference in any prospectus of their report on our audited financial statements for the year ended December 31, 2000 and December 31, 2001, and investors in any subsequent offerings for which we use their audit report will not be entitled to recovery against them under Section 11 of the Securities Act of 1933 for any material misstatements or omissions in those financial statements. Consequently, our financing costs may increase or we may miss attractive market opportunities if either our annual financial statements for 2000 and 2001 audited by Arthur Andersen LLP should cease to satisfy the SEC's requirements or those statements are used in a prospectus but investors are not entitled to recovery against our auditors for material misstatements or omissions in them.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to interest rate risk for its investments in marketable securities, but management believes the risk is not material. At December 31, 2003, the Company had $199.0 million in marketable securities with most of the securities maturing at various dates through November 2009 with one security with market value of $4.5 million maturing in June 2018 and one security with market value of $0.5 million maturing in October 2028. The Company's investments are comprised primarily of investment grade federal and municipal bonds and commercial paper. The Company generally holds investments until maturity, and therefore should not bear any interest risk due to early disposition. We do not enter into any derivative or interest rate hedging transactions. Any premium or discount recognized upon the purchase of an investment. At December 31, 2003, the fair value of investments approximated the carrying value.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
99 CENTS ONLY STORES
Reports of Independent Public Auditors. . . . . . . . . . . . . . . . . . 24-25
Balance Sheets as of December 31, 2002 and 2003 . . . . . . . . . . . . . 26-27
Statements of Income for the years ended December 31, 2001, 2002 and 2003. . . . . . . . . . . . . . . . . . . . . 28
Statements of Shareholders' Equity for the years ended December 31, 2001, 2002 and 2003. . . . . . . . . . . . . . . . . . . . . 29
Statements of Cash Flows for the years ended December 31, 2001, 2002 and 2003. . . . . . . . . . . . . . . . . . . . . 30
Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . . . 31-38
REPORT OF INDEPENDENT PUBLIC AUDITORS
To Board of Directors and Shareholders of 99 Cents Only Stores:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the consolidated financial position of 99 Cents Only Stores and its subsidiary at December 31, 2003 and 2002 and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The financial statements of 99 Cents Only Stores for the year ended December 31, 2001, were audited by other independent accountants who have ceased operations. Those independent accountants expressed an unqualified opinion on those financial statements in their report dated February 20, 2002.
PricewaterhouseCoopers LLP Los Angeles, California February 27, 2004
REPORT OF FORMER INDEPENDENT PUBLIC ACCOUNTANTS
THE FOLLOWING REPORT IS A COPY OF A REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP (ANDERSEN). THIS REPORT HAS NOT BEEN REISSUED BY ANDERSEN AND ANDERSEN DID NOT CONSENT TO THE INCORPORATION BY REFERENCE OF THIS REPORT (AS INCLUDED IN THIS FORM 10-K) INTO ANY OF THE COMPANY'S REGISTRATION STATEMENTS.
TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF 99 CENTS ONLY STORES:
We have audited the accompanying balance sheets of 99 Cents Only Stores (a California Corporation) as of December 31, 2000 and 2001 and the related statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 99 Cents Only Stores as of December 31, 2000 and 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Los Angeles, California February 20, 2002 (Except for the matters discussed in Note 13, as to which date is March 9, 2002)
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
99 CENTS ONLY STORES NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 2003
1. LINE OF BUSINESS
99 Cents Only Stores (the Company) is incorporated in the State of California. The Company retails various consumable products through its 151 and 189 stores at December 31, 2002 and 2003, respectively. The Company is also a wholesale distributor of various consumable products.
2. CONCENTRATION OF OPERATIONS IN CALIFORNIA
All but 41 of our 99 Cents Only Stores at December 31, 2003 were located in California. The Company operates 10 stores in Las Vegas, Nevada and 14 stores in Arizona. The Company also opened 17 stores in Texas in 2003. The Company expects that it will continue to open additional stores in California as well as in Nevada, Arizona, and Texas.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
The Statements of Cash Flows classify changes in cash and cash equivalents (short term, highly liquid investments readily convertible into cash with an original maturity at date of purchase of three months or less) according to operating, investing or financing activities. At times, cash balances held at financial institutions are in excess of federally insured limits. The Company places its temporary cash investments with high credit, quality financial institutions and limits the amount of credit exposure to any one financial institution. The Company believes no significant concentration of credit risk exists with respect to these cash investments.
USE OF ESTIMATES
The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include self-insured workers' compensation reserves and inventory reserves.
INVENTORIES
Inventories are priced at the lower of cost (first in, first out) or market. Valuation allowances are recorded to properly state inventory at the lower of cost or market.
DEPRECIATION AND AMORTIZATION
Property and equipment are amortized and depreciated on a straight-line basis over the following useful lives of the assets:
Building and improvements . . . 27.5 - 30 years Leasehold improvements. . . . . Lesser of 5 years or remaining lease term Fixtures and equipment. . . . . 5 years Transportation equipment. . . . 3 years
The Company follows the policy of capitalizing expenditures that materially increase asset lives and charging ordinary repairs and maintenance to operations as incurred.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or changes indicate that the carrying amount of an asset or group of assets may not be recoverable. In evaluating whether an asset has been impaired, the Company compares the anticipated undiscounted future cash flows to be generated by the asset to the asset's carrying value. If the sum of the undiscounted future cash flows is less than the carrying amount of the asset, an impairment loss is recognized. No losses were recorded during the three years ended December 31, 2003.
LEASE ACQUISITION COSTS
The Company follows the policy of capitalizing expenditures that relate to the acquisition and signing of its retail store leases. These costs are amortized on a straight line basis over the initial term of the lease, which ranges from 5 to 10 years.
EARNINGS PER SHARE
"Basic" earnings per share is computed by dividing net income by the weighted average number of shares outstanding for the year. "Diluted" earnings per share is computed by dividing net income by the total of the weighted average number of shares outstanding plus the dilutive effect of outstanding stock options (applying the treasury stock method).
A reconciliation of the basic weighted average number of shares outstanding and the diluted weighted average number of shares outstanding for each of the three years in the period ended December 31, 2003 follows:
1,989 thousand shares of common stock equivalents were excluded from this calculation as they were anti-dilutive.
The Company has elected to continue to measure compensation costs associated with its stock option plan under APB 25, "Accounting for Stock Issued to Employees" and accordingly, under SFAS No. 123 as amended by SFAS No. 148, had the Company applied the fair value based method of accounting, which is not required, to all grants of stock options, the Company would have recorded additional compensation expense and pro forma net income and earnings per share amounts as follows for the years ended December 31, 2001, 2002 and 2003 (amounts in thousands, except for per share data):
These pro forma amounts were determined by estimating the fair value of each option on its grant date using the Black-Scholes option-pricing model with the following assumptions:
DEFERRED RENT
Certain of the Company's operating leases for its retail locations include scheduled increases in monthly payments. The Company has accounted for these leases to provide straight-line charges to operations over the lives of the leases.
REVENUE RECOGNITION
Revenue is recognized at the point of sale for retail sales. Wholesale sales revenue is recognized on the date shipped. Wholesale sales are shipped free on board shipping point. A reserve is maintained for incidental claims or damages. There are no contingencies or wholesale rights of return.
PRE-OPENING COSTS
The Company expenses, as incurred, all pre-opening costs related to the opening of new retail stores.
ADVERTISING
The Company expenses advertising costs as incurred. Advertising expenses were $3.4 million, $3.1 million and $3.8 million for 2001, 2002 and 2003, respectively.
STATEMENTS OF CASH FLOWS
Cash payments for income taxes were $25,260,000, $29,852,000 and $35,200,000 in 2001, 2002 and 2003, respectively. Interest payments totaled approximately $92,000, $128,000 and $125,000 for the years December 31, 2001, 2002 and 2003, respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist of cash, short-term and long-term investments, short-term trade receivables and payables. The carrying value for all such instruments approximate fair value at December 31, 2002 and 2003.
RECLASSIFICATIONS
Certain reclassifications have been made to the prior year to confirm with current year presentation.
NEW AUTHORITATIVE PRONOUNCEMENTS
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to recognize a liability at the inception of a guarantee equal to the fair value of the obligation undertaken and elaborates on the disclosures to be made by the guarantor. The disclosure requirements of FIN 45 are required for the fiscal year ended December 31, 2002. The recognition and measurement provisions of FIN 45 are effective, on a prospective basis, for guarantees issued by the Company beginning in fiscal 2003. The adoption of FIN 45 did not have an impact on the Company's financial position or results of operations.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities." FIN 46 establishes a new and far-researching consolidation accounting model. Although FIN No 46 was initially focused on special purpose entities, the applicability of FIN No 46 goes beyond such entities and can have applicability to franchise arrangements, regardless of whether the Company has voting or ownership control of such franchisee. In response to a number of comment letters and implementation questions, in December 2003 the FASB issued FIN No. 46R, which delays the effective date of FIN No 46 for certain entities until March 31, 2004, as well as provides clarification regarding other implementation issues. The Company will adopt Fin No 46 in its quarter ending March 31, 2004. Adoption of FIN No. 46 is not expected to have a significant impact on the Company's financial position, results of operations or liquidity.
4. INVESTMENTS
Investments in debt and equity securities are recorded as required by SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" as trading securities. The Company's investments are comprised primarily of investment grade federal and municipal bonds and commercial paper. As of December 31, 2002 and 2003, the fair value of investments approximated the carrying values and were invested as follows:
5. LONG-TERM INVESTMENT IN PARTNERSHIPS
The Company formed long-term partnerships in two instances for the purpose of acquiring and managing particular store sites, which were to be leased to the Company. No such arrangements exist in any of the other store sites owned or leased by the Company, and the Company does not anticipate entering into partnerships such as these in the future unless the circumstances are compelling.
The Company currently accounts for these partnerships under the equity method and its total investment is approximately $3 million.
The Company plans to consolidate the partnerships pursuant to the requirements of FIN No. 46 in future periods. The assets of the partnerships consist of real estate with a carrying value of approximately $3 million and there is no mortgage debt or other significant liabilities associated with the entities, other than a note payable to the Company. The balance sheet effect of consolidating these entities will be a $3 million reclassification from investments to property, plant and equipment and no corresponding impact on the Company's recorded liabilities.
6. PURCHASE OF DISTRIBUTION FACILITIES
In 2003, the Company purchased two distributions centers. (i) On January 28, 2003 the Company completed the purchase of a 741,000 square foot distribution center in Houston, to service its planned store expansion in Texas in 2003 and beyond. The facility was acquired for $23.0 million in cash and contains built in refrigerated and frozen storage space. (ii) On December 30, 2003, the Company completed the purchase of a 66,000 square foot deli & frozen distribution center in the City of Commerce. The facility was acquired for $8.4 million in cash.
7. INCOME TAX PROVISION
The provisions for income taxes for the three years ended December 31, 2003 are as follows:
Differences between the provisions for income taxes and income taxes at the statutory federal income tax rate for the three years ended December 31, 2003 are as follows:
A detail of the Company's net deferred tax assets as of December 31, 2002 and 2003 is as follows:
In connection with the acquisition and subsequent sale of Universal and Odd's-N-End's, the Company has remaining federal net operating loss carry-forwards of approximately $20.9 million which it can use to offset future taxable income. Future use of these loss carry-forwards may be limited and expire at various dates through 2017. Due to the uncertainty of the future use of such loss carry-forwards, the Company has recorded a valuation allowance equal to the tax effect of the loss carry-forward that may not be realizable.
8. RELATED-PARTY TRANSACTIONS
The Company leases certain retail facilities from its principal shareholders. Rental expense for these facilities was approximately $1.9 million, $2.2 million, and $2.2 million in 2001, 2002 and 2003, respectively. In addition, one of the Company's outside directors is a trustee of a trust that owns a property on which a single 99 Cents Only Store is located. Rent expense on this store amounted to $0.3 million in each of 2001, 2002 and 2003.
Effective September 30, 2000, the Company sold its discontinued operation, Universal International, Inc. to a company owned 100% by Dave and Sherry Gold, both significant shareholders of 99 Cents Only Stores (see Note 13). The sale price consisted of $33.9 million in cash and was collected at closing. These proceeds were invested in the Company's investment accounts. Mr. Gold is also CEO and Chairman of 99 Cents Only Stores. In connection with this sale a management services and lease agreement was entered into between Universal and the Company. The service agreement provided for the Company to render certain administrative services to Universal, including information technology support, accounting, buying and human resource functions. The Company charged Universal management fees for these services. The lease agreement involved the property that served as Universal's primary warehouse and distribution facility. The lease was structured on a triple net basis and provided for rental payments of $120,000 per month. Resolution of Universal post closing business issues required the extension of the service agreement and lease arrangement with 99 Cents Only Stores to December 2003.
The following is a summary of the transactions between the Company and Universal for 2001, 2002 and 2003 and a reconciliation of amounts due to/from shareholder resulting from such transactions (amounts in thousands):
9. COMMITMENTS AND CONTINGENCIES
CREDIT FACILITY
The Company does not maintain any credit facilities with any bank.
LEASE COMMITMENTS
The Company leases various facilities under operating leases except for two, which were classified as capital leases, expiring at various dates through 2017. Some of the lease agreements contain renewal options and/or provide for scheduled increases or increases based on the Consumer Price Index. Total minimum lease payments under each of these lease agreements, including scheduled increases, are charged to operations on a straight-line basis over the life of each respective lease. Certain leases require the payment of property taxes, maintenance and insurance. Rental expense charged to operations in 2000, 2001 and 2002 was approximately $15.6 million, $19.4 million and $24.9 million, respectively. As of December 31, 2003, the minimum annual rentals payable under all non-cancelable operating leases were as follows: (Amounts in thousands):
WORKERS' COMPENSATION
Effective August 11, 1993, the Company became self-insured as to workers' compensation claims. The Company provides for losses of estimated known and incurred but not reported insurance claims. Known claims are estimated and accrued when reported. At December 31, 2002 and 2003, the Company had accrued approximately $7.7 million and $16.3 million, respectively, for estimated workers' compensation claims. The Company recorded an adjustment in the fourth quarter of 2003 in the amount of $7.9 million to adjust its accrued workers' compensation liability to the amount determined by its most recent actuarial study.
LEGAL MATTERS
GILLETTE COMPANY LAWSUIT:
A lawsuit is pending, filed by the Gillette Company against the Company, arising out of a dispute over the interpretation of a contract between the parties. Gillette, which is suing for breach of contract, alleges that the Company owes Gillette an additional principal sum of approximately $2.1 million (apart from the approximately $1 million already paid to Gillette), plus fees, costs and interest. Also pending is a cross-complaint by the Company against Gillette, alleging breach of contract, fraud and unfair business acts. Trial is anticipated to commence in late March, 2004 or early April, 2004.
MELGOZA LAWSUIT:
On May 7, 2003, the plaintiff, a former Store Manager, filed a putative class action on behalf of himself and others similarly situated. The suit alleges that the Company improperly classified Store Managers in the Company's California stores as exempt from overtime requirements as well as meals and rest period requirements under California law. Each store typically has one Store Manager and two or three Assistant Store Managers. Pursuant to the California Labor Code, the suit seeks to recover unpaid overtime compensation, penalties for failure to provide meal and rest periods, waiting time penalties for former employees, interest, attorney fees, and costs. The suit also charges, pursuant to California's Business and Professions Code section 17200, that the Company engaged in unfair business practices by failing to make such payments, and seeks payment of all such wages (in the form of restitution) for the four-year period preceding the filing of the case through the present. Plaintiff is now seeking leave to file an amended complaint that would (1) expand the class to include not only all current and former Store Managers who worked for the Company from May 7, 1999 but also all current and former Assistant Managers who worked for the Company during the same period; and (2) claims for additional penalties on behalf of all purported class members under California's new Labor Code Private Attorney General Act of 2004. The Company is vigorously asserting defenses to the various claims.
In view of the inherent difficulty of predicting the outcome of legal matters, the Company cannot state with confidence what the eventual outcome of this matter will be. However, based on current knowledge, this matter is not presently expected to have a material adverse effect on the Company's financial condition or overall liquidity, although it could have a material adverse effect on the Company's results of operations for the accounting period in which it is resolved.
OTHERS:
The Company is named as a defendant in various other legal matters arising in the normal course of business. In management's opinion, none of these other matters will have a material effect on the Company's financial position, results of operations or overall liquidity.
10. STOCK-BASED COMPENSATION PLANS
The Company has one stock option plan (the 1996 Stock Option Plan, as amended). The plan is a fixed plan, which provides for the granting of non-qualified and incentive options to purchase up to 17,000,000 shares of common stock of which 5,268,045 are available for future option grants. Options may be granted to officers, employees, directors and consultants. Grants may be at fair market value at the date of grant or at a price determined by the compensation committee consisting of four outside members of the board of directors (the "Committee"). Options vest over a three-year period, one-third one year from the date of grant and one third per year thereafter. Options expire ten years from the date of grant. The Company accounts for its stock option plan under Accounting Principles Bulletin Opinion No. 25 ("APB 25") "Accounting for Stock Issued to Employees" under which no compensation cost has been recognized in fiscal 2001, 2002 and 2003. The following table summarizes stock options available for grant:
A summary of the status of the Company's stock option plan at December 31, 2001, 2002 and 2003 and changes during the years then ended is presented in the table and narrative below:
The following table summarized information about stock options outstanding at December 31, 2003:
11. OPERATING SEGMENTS
The Company has two business segments, retail operations and wholesale distribution. The majority of the product offerings include recognized brand-name consumable merchandise, regularly available for reorder. Bargain Wholesale sells the same merchandise at prices generally below normal wholesale levels to local, regional and national distributors and exporters.
The accounting policies of the segments are the same as those described above in the summary of significant accounting policies. The Company evaluates segment performance based on the net sales and gross profit of each segment. Management does not track segment data or evaluate segment performance on additional financial information. As such, there are no separately identifiable segment assets or separately identifiable statements of income data (below gross profit) to be disclosed. The Company accounts for inter-segment transfers at cost through its inventory accounts.
The Company had no customers representing more than 10 percent of net sales. Substantially all of the Company's net sales were to customers located in the United States. Reportable segment information for the years ended December 31, 2001, 2002 and 2003 follows (amounts in thousands):
12. 401(K) PLAN
In 1998 the Company adopted a 401(k) Plan (the Plan). All full-time employees are eligible to participate in the plan after 3 months of service. The Company does not match employee contributions. The Company may elect to make a discretionary contribution to the Plan. For the years ended December 31, 2001, 2002 and 2003, no discretionary contributions were made.
13. DISCONTINUED OPERATIONS
On March 4, 2000, the Board of Directors approved the disposition of Universal International, Inc. and Odd's-n-End's, Inc., which comprises the retail operations of Odds-n-Ends, Inc. and Only Deals, Inc.
The Company engaged an investment-banking firm in April 2000 to evaluate and identify potential buyers for the Universal business and expected to sell Universal within the one-year time frame from when the Company classified Universal as a discontinued business. The investment banking firm's marketing process focused upon selling the business as a going concern. During the summer of 2000, sales presentations were delivered to both strategic buyers and financial buyers. This process did not generate the expected interest level from potential buyers that had been anticipated. The highest offer for the Universal business was significantly less than the Company's expectations. As a result of the difficulties encountered in trying to sell Universal and the necessity to complete the process by December 31, 2000 it was decided by the Board of Directors to be in the Company's and the shareholders' best interest to sell Universal for the Company's carrying value as of the close of business on September 30, 2000 to Universal Deals, Inc., a limited liability company owned 100% by David and Sherry Gold, both significant shareholders of 99 Cents Only Stores. Mr. Gold is also Chairman and CEO of 99 Cents Only Stores. The sales price for Universal was the Company's carrying value as of the close of business on September 30, 2000, which was $33.9 million. The net assets at September 30, 2000 included $29.2 million in inventory, net fixed assets of $7.6 million and $0.6 million of other assets. These assets were offset by $3.5 million of accounts payable, accrued and other liabilities. In connection with this transaction 99 Cents Only Stores has provided certain ongoing administrative and other services to Universal pursuant to a services agreement and other arrangements. See note 8 for a summary of transactions between the Company and Universal for the years ended December 31, 2001, 2002 and 2003.
14. STOCK SPLIT
On March 9, 2002, the Company's Board of Directors approved a four-for-three stock split distributed on April 3, 2002 to shareholders of record on March 25, 2002. Also on February 17, 2001, the Company's Board of Directors approved a three-for-two stock split distributed on March 20, 2001 to shareholders of record on May 14, 2001. All share and per share data has been restated to reflect these stock splits.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
As of June 13, 2002, upon the recommendation of the Audit Committee of the Company, the Board of Directors dismissed Arthur Andersen LLP ("Andersen") as the Company's independent auditors. Arthur Andersen had served as the Company's independent auditors since 1989.
Andersen's reports on the consolidated financial statements of the Company and its subsidiaries for the two most recent years ended December 31, 2001 did not contain any adverse opinion or disclaimer of opinion, nor were such reports qualified or modified as to uncertainty, audit scope or accounting principles. During the Company's two most recent fiscal years ended December 31, 2001 and the subsequent interim period through June 13, 2002, there were: (i) no disagreements between the Company and Andersen on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedure which, if not resolved to Andersen's satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with their reports on the Company's consolidated financial statements for such years; and (ii) no "reportable events" as defined in item 304 (a) (1) (v) of Regulation S-K. The Company provided Andersen with a copy of the foregoing disclosures, and Andersen delivered a letter to the SEC, dated June 13, 2002, stating its agreement with such statements.
On June 13, 2002, the Company engaged PricewaterhouseCoopers LLP ("PwC") as its independent auditors to audit its financial statements for the year ending December 31, 2002. The decision to engage PwC was recommended by the Company's Audit Committee and approved by its Board of Directors. During the Company's two most recent years ended December 31, 2001 and subsequent interim period through June 13, 2002, the Company did not consult with PwC with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company's consolidated financial statements or any other matters or reportable events as set forth in Items 304 (a) (2) (i) and (ii) of Regulation S-K.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), of the effectiveness of the design and operation of our disclosure controls and procedures ("Disclosure Controls") as of December 31, 2003 pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our CEO and our CFO concluded that, subject to the limitations noted below, our Disclosure Controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC filings.
CHANGES IN INTERNAL CONTROLS AND PROCEDURES
There were no changes in our internal control over financial reporting during our fourth quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
LIMITATIONS ON THE EFFECTIVENESS OF CONTROLS
Our management, including our CEO and CFO, does not expect that our disclosure controls and internal control over financial reporting will prevent all error and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system can be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgements in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding Directors and Executive Officers of the registrant required by Item 401 of Regulation S-K and information regarding Directors and Executive Officers of the registrant required by Item 405 of Regulation S-K is presented under the captions "Election of Directors," "Management," "Code of Ethics," "Nominations," and "Section 16(a) Beneficial Ownership Reporting Compliance" in the definitive Proxy Statement for the Company's 2004 Annual Meeting of Shareholders, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 402 of Regulation S-K is presented under the caption "Executive Compensation" in the definitive Proxy Statement for the Company's 2004 Annual Meeting of Shareholders, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 403 of Regulation S-K is presented under the captions "Principal Shareholders" and "Equity Compensation Plan Information" in the definitive Proxy Statement for the Company's 2004 Annual Meeting of Shareholders, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 404 of Regulation S-K is presented under the caption "Certain Relationships" in the definitive Proxy Statement for the Company's 2004 Annual Meeting of Shareholders, and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 9(a) of Schedule 14A is presented under the caption "Independent Public Accountants" in the definitive Proxy Statement for the Company's 2004 Annual Meeting of Shareholders, and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
1. Financial Statements. Reference is made to the Index to the Financial Statements set forth in item 8 on page 21 of this Form 10-K.
2. Financial Statement Schedules. All Schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are included herein.
3. The Exhibits listed on the accompanying Index to Exhibits are filed as part of, or incorporated by reference into, this report.
4 Reports on Form 8-K. The Company furnished two reports on form 8-K during the fourth quarter of 2003. One, reporting Item 12 information, was furnished on October 9, 2003 and the second, also reporting Item 12 information, was furnished on October 21, 2003. An amendment to the second 8-K was furnished on October 24, 2003.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this annual report Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 12, 2004 99 Cents Only Stores
/s/ Eric Schiffer ---------------------------- By: Eric Schiffer President
Pursuant to the requirements of the Securities Exchange Act of 1934 this Annual Report on Form 10K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS PART I. FINANCIAL STATEMENT SCHEDULE
To the Board of Directors Of 99 Cents Only Stores:
Our audits of the consolidated financial statements referred to in our report dated February 27, 2004 appearing in the 2003 Annual Report to Shareholders of 99 Cents Only Stores also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
PricewaterhouseCoopers LLP Los Angeles, CA February 27, 2004
Exhibit Index
Exhibit Description
3.1 Amended and Restated Articles of Incorporation of the Registrant.(2)
3.2 Amended and Restated Bylaws of the Registrant.(1)
4.1 Specimen certificate evidencing Common Stock of the Registrant.(1)
10.1 Form of Indemnification Agreement and Schedule of Indemnified Parties.(1)
10.2 [Reserved]
10.3 Form of Tax Indemnification Agreement, between and among the Registrant and the Existing Shareholders.(1)
10.4 1996 Stock Option Plan.(1)
10.5 Lease for 730 West Foothill Boulevard, Azusa, California, dated as of December 1, 1995, by and between the Registrant as Tenant and HKJ Gold, Inc. as Landlord, as amended(1).
10.6 Lease for 13023 Hawthorne Boulevard, Hawthorne, California, dated April 1 1994, by and between the Registrant as Tenant and HKJ Gold, Inc. as Landlord, as amended.(1)
10.7 Lease for 6161 Atlantic Boulevard, Maywood, California, dated November 11, 1985, by and between the Registrant as Lessee and David and Sherry Gold, among others, as Lessors.(1)
10.8 Lease for 14139 Paramount Boulevard, Paramount, California, dated as of March 1 1996, by and between the Registrant as Tenant and 14139 Paramount Properties as Landlord, as amended.(1)
10.9 Release Agreement, dated March 25, 1996, regarding 11382 Beach Boulevard, Stanton, California, by and between the Registrant and 11382 Beach Partnership.(1)
10.10 Lease for 6124 Pacific Boulevard, Huntington Park, California, dated January 31, 1991, by and between the Registrant as Tenant and David and Sherry Gold as the Landlord, as amended.(1)
10.11 Lease for 14901 Hawthorne Boulevard, Lawndale, California, dated November 1, 1991, by and between Howard Gold, Karen Schiffer and Jeff Gold, dba 14901 Hawthorne Boulevard Partnership as Landlord and the Registrant as Tenant, as amended.(1)
10.12 Lease for 5599 Atlantic Avenue, North Long Beach, California, dated August 13, 1992, by and between the Registrant as Tenant and HKJ Gold, Inc. as Landlord, as amended.(1)
10.13 Lease for 1514 North Main Street, Santa Ana, California, dated as of November 12, 1993, by and between the Registrant as Tenant and Howard Gold, Jeff Gold, Eric J. Schiffer and Karen R. Schiffer as Landlord, as amended.(1)
10.14 Lease for 6121 Wilshire Boulevard, Los Angeles, California, dated as of July 1, 1993, by and between the Registrant as Tenant and HKJ Gold, Inc. as Landlord, as amended; and lease for 6101 Wilshire Boulevard, Los Angeles, California, dated as of December 1, 1995, by and between the Registrant as Tenant and David and Sherry Gold as Landlord, as amended.(1)
10.15 Lease for 8625 Woodman Avenue, Arleta, California, dated as of July 8, 1993, by and between the Registrant as Tenant and David and Sherry Gold as Landlord, as amended.(1)
10.16 Lease for 2566 East Florence Avenue, Walnut Park, California, dated as of April 18, 1994, by and between HKJ Gold, Inc. as Landlord and the Registrant as Tenant, as amended.(1)
10.17 Lease for 3420 West Lincoln Avenue, Anaheim, California, dated as of March 1, 1996, by and between the Registrant as Tenant and HKJ Gold, Inc. as Landlord, as amended.(1)
10.18 Master Lease for 4000 East Union Pacific Avenue, City of Commerce, California ("Warehouse and Distribution Facility Lease"), dated as of December 20, 1993, by and between the Registrant as Lessee and TBC Realty II Corporation ("TBC") as Lessor, together with Lease Guaranty ("Lease Guaranty"), dated December 20, 1993, by and between Sherry and David Gold and TBC with respect thereto and Letter Agreement, dated December 15, 1993, among Registrant, The Mead Corporation, TBC and Citicorp Leasing, Inc. with respect to the Lease Guaranty.(1)
10.19 Hawaiian Gardens Indemnity Agreement, dated as of March 25, 1996, by and between the Registrant and HKJ Gold, Inc.(1)
10.20 North Broadway Indemnity Agreement, dated as of May 1, 1996, by and between HKJ Gold, Inc. and the Registrant.(1)
10.21 Lease for 2606 North Broadway, Los Angeles, California, dated as of May 1, 1996, by and between HKJ Gold, Inc. as Landlord and the Registrant as Tenant.(1)
10.22 Grant Deed concerning 8625 Woodman Avenue, Arleta, California, dated May 2, 1996, made by David Gold and Sherry Gold in favor of Au Zone Investments #2, L.P., a California limited partnership.(1)
10.23 Grant Deed concerning 6101 Wilshire Boulevard, Los Angeles, California, dated May 2, 1996, made by David Gold and Sherry Gold in favor of Au Zone Investments #2, L.P., a California limited partnership.(1)
10.24 Grant Deed concerning 6124 Pacific Boulevard, Huntington Park, California, dated May 2, 1996, made by David Gold and Sherry Gold in favor of Au Zone Investments #2, L.P., a California limited partnership.(1)
10.25 Grant Deed concerning 14901 Hawthorne Boulevard, Lawndale, California, dated May 2, 1996, made by Howard Gold, Karen Schiffer and Jeff Gold in favor of Au Zone Investments #2, L.P., a California limited partnership.(1)
10.26 Services Agreement, dated as of December 28, 2000, by and between Universal International, Inc. and the registrant.(3)
10.27 Lease for 955 West Sepulveda, Los Angeles, California, dated as of July 17, 1995, by and between Schwartz Investment Co., as successor to VAT Partners II, as Landlord and the Company as Tenant.(2)
23.1 Consent of PriceWaterhouseCoopers LLP.*
31(a) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
31(b) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
32(a) Certification of Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
32(b) Certification of Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
* Filed herewith
(1) Incorporated by reference from the Company's Registration Statement on Form S-1 as filed with the Securities and Exchange Commission on May 21, 1996.
(2) Incorporated by reference from the Company's 2002 Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 31, 2003.
(3) Incorporated by reference from the Company's Current Report on Form 8-K as filed with the Securities and Exchange Commission on January 12, 2001.