ITEM 1. BUSINESS
THE COMPANY
Finlay Enterprises, Inc., a Delaware corporation (the "Company"), conducts business through its wholly owned subsidiary, Finlay Fine Jewelry Corporation, a Delaware corporation, and its wholly owned subsidiaries ("Finlay Jewelry"). References to "Finlay" mean, collectively, the Company and Finlay Jewelry. All references herein to "Departments" refer to fine jewelry departments operated pursuant to license agreements or other arrangements with host department stores.
Finlay is one of the leading retailers of fine jewelry in the United States. The Company operates leased fine jewelry Departments in major department stores for retailers such as The May Department Stores Company ("May"), Federated Department Stores ("Federated"), Belk, the Carson Pirie Scott division of Saks Incorporated, Marshall Field's and Dillard's. Finlay sells a broad selection of moderately priced fine jewelry, including necklaces, earrings, bracelets, rings and watches, and markets these items principally as fashion accessories with an average sales price of approximately $186 per item. Average sales per Department were $923,000 in 2002 and the average size of a Department is approximately 700 square feet.
On a domestic basis, Finlay's sales have increased from $822.0 million in 1998 to $930.7 million in 2002, a compound annual growth rate of 3.2%. Income from operations before depreciation and amortization expense has increased from $77.1 million to $80.8 million in the same period. See footnote 7 to "Selected Consolidated Financial Data" for a reconciliation to the Company's Consolidated Financial Statements. Finlay has increased in size from 959 locations at the beginning of 1998 to 1,011 locations at the end of 2002.
As of February 1, 2003, Finlay operated its 1,011 locations in 20 host store groups, in 45 states and the District of Columbia. Finlay's largest host store relationship is with May, for which Finlay has operated Departments since 1948. Finlay operates in 440 of May's fine jewelry departments, representing substantially all of May's department stores. Finlay's second largest host store relationship is with Federated, for which Finlay has operated Departments since 1983. Finlay operates Departments in 160 of Federated's 463 department stores. Over the past three years, store groups owned by May and Federated accounted for an average of 47% and 23%, respectively, of Finlay's sales. Management believes that it maintains excellent relations with its host store groups, 18 of which have had leases with Finlay for more than five years (representing 94% of Finlay's sales in 2002) and 15 of which have had leases with Finlay for more than ten years (representing 80% of Finlay's sales in 2002).
On January 22, 2003, Finlay Jewelry's revolving credit agreement with General Electric Capital Corporation ("G.E. Capital") and certain other lenders was amended and restated (the "Revolving Credit Agreement"). The Revolving Credit Agreement, which matures in January 2008, provides Finlay Jewelry with a senior secured revolving line of credit up to $225.0 million (the "Revolving Credit Facility").
On April 3, 2000, Finlay completed the acquisition of certain assets of Jay B. Rudolph, Inc. ("J.B. Rudolph") for $20.6 million, consisting primarily of inventory and fixed assets. By acquiring J.B. Rudolph (the "J.B. Rudolph Acquisition"), Finlay added 57 Departments and also added new host store relationships with Bloomingdale's and Dayton's and Hudson's (both now operating as Marshall Field's).
On January 3, 2000, Societe Nouvelle d'Achat de Bijouterie - S.O.N.A.B. ("Sonab"), the Company's European leased jewelry department subsidiary, sold the majority of its assets for $9.9 million. After the sale, the buyer operated more than 80 locations previously included in Sonab's 130-location base in France. The remaining departments were closed in 1999. The Company recorded a pre-tax charge in 1999 of $28.6 million for the write-down of assets for disposition and related closure expenses. In 2002,
the Company revised its original estimate of closure expenses to reflect its remaining liability and, as a result, recorded a gain of $1.4 million, on a pre-tax basis.
Finlay's fiscal year ends on the Saturday closest to January 31. References to 2003, 2002, 2001, 2000, 1999 and 1998 relate to the fiscal years ending on January 31, 2004, February 1, 2003, February 2, 2002, February 3, 2001, January 29, 2000 and January 30, 1999, respectively. Each of the fiscal years includes 52 weeks except 2000, which includes 53 weeks.
Finlay Jewelry was initially incorporated on August 2, 1985 as SL Holdings Corporation ("SL Holdings"). The Company, a Delaware corporation incorporated on November 22, 1988, was organized by certain officers and directors of SL Holdings to acquire certain operations of SL Holdings. In connection with a reorganization transaction in 1988, which resulted in the merger of a wholly owned subsidiary of the Company into SL Holdings, SL Holdings changed its name to Finlay Fine Jewelry Corporation and became a wholly owned subsidiary of the Company. The Company is a holding company and has no operations of its own. The primary asset of the Company is the common stock of Finlay Jewelry, which conducts all of Finlay's operations. The principal executive offices of the Company are located at 529 Fifth Avenue, New York, New York 10017 and its telephone number at this address is (212) 808-2800.
GENERAL
OVERVIEW. Host stores benefit from outsourcing the operation of their fine jewelry departments. By engaging Finlay, host stores gain specialized managerial, merchandising, selling, marketing, inventory control and security expertise. Additionally, by avoiding the high working capital investment typically required of the jewelry business, host stores improve their return on investment and can potentially increase their profitability.
As a lessee, Finlay benefits from the host stores' reputation, customer traffic, advertising, credit services and established customer base. Finlay also avoids the substantial capital investment in fixed assets typical of stand-alone retail formats. These factors have generally enabled Finlay's new Departments to achieve profitability within their first 12 months of operation. Finlay further benefits because net sales proceeds are generally remitted to Finlay by each host store on a monthly basis with essentially all customer credit risk borne by the host store.
As a result of Finlay's strong relationships with its vendors, management believes that the Company's working capital requirements are lower than those of many other jewelry retailers. In recent years, on average, approximately 50% of Finlay's merchandise has been carried on consignment. The use of consignment merchandise also reduces Finlay's inventory exposure to changing fashion trends because, in general, unsold consigned merchandise can be returned to the vendor.
INDUSTRY. Management believes that current trends in jewelry retailing, particularly in the department store sector, provide a significant opportunity for Finlay's growth. Consumers spent approximately $53.2 billion on jewelry (including both fine and costume jewelry) in the United States in 2002, an increase of approximately $21.6 billion over 1992, according to the United States Department of Commerce. In the department store sector in which Finlay operates, consumers spent $4.1 billion on fine jewelry in 2002. Management believes that demographic factors such as the maturing of the U.S. population and an increase in the number of working women have resulted in greater disposable income, thus contributing to the growth of the fine jewelry retailing industry. Management also believes that jewelry consumers today increasingly perceive fine jewelry as a fashion accessory, resulting in purchases which augment the Company's gift and special occasion sales. Finlay's Departments are typically located in "high traffic" areas of leading department stores, enabling Finlay to capitalize on these consumer buying patterns.
GROWTH STRATEGY. Finlay intends to continue to pursue the following key initiatives to increase sales and earnings:
o INCREASE COMPARABLE DEPARTMENT SALES. Finlay's merchandising and marketing strategy includes emphasizing key merchandise items, increasing focus on holiday and event-driven promotions, participating in host store marketing programs and positioning its Departments as a "destination location" for fine jewelry. Finlay believes that comparable Department sales will continue to benefit from these strategies. As a result of a challenging retail environment, Finlay's comparable store sales have slowed in the past two years, although they have continued to outpace the comparable store sales of its host stores.
o ADD DEPARTMENTS WITHIN EXISTING HOST STORE GROUPS. Finlay's well established relationships with many of its host store groups have enabled the Company to add Departments in new locations opened by existing host stores. Finlay has operated Departments in May stores since 1948 and operates in 440 of May's fine jewelry departments, representing substantially all of May's department stores. Finlay has also operated Departments in Federated stores since 1983 and operates Departments in 160 of Federated's 463 department stores.
o ESTABLISH NEW HOST STORE RELATIONSHIPS. Finlay has an opportunity to grow primarily by establishing new relationships with department stores that presently operate their own fine jewelry departments or have an interest in opening jewelry departments. Finlay seeks to establish these new relationships by demonstrating to department store management the potential for improved financial performance. Through acquisitions, Finlay has added Marshall Field's, Parisian, Dillard's and Bloomingdale's to its host store relationships.
o IMPROVE OPERATING LEVERAGE. Finlay seeks to continue to leverage expenses both by increasing sales at a faster rate than expenses and by reducing its current level of certain operating expenses. For example, Finlay has demonstrated that by increasing the selling space (with host store approval) of certain high volume Departments, incremental sales can be achieved without having to incur proportionate increases in selling and administrative expenses. In addition, management believes the Company will benefit from further investments in technology and refinements of operating procedures designed to allow Finlay's sales associates more time for customer sales and service. In March 2002, the Company implemented a new merchandising and inventory control system and a point-of-sale system for its Departments. These systems will provide the foundation for future productivity and expense control initiatives. Further, Finlay's central distribution facility has enabled the Company to improve the flow of merchandise to Departments and to reduce payroll and freight costs.
MERCHANDISING STRATEGY. Finlay seeks to maximize sales and profitability through a unique merchandising strategy known as the "Finlay Triangle", which integrates store management (including host store management and Finlay's store group management), vendors and Finlay's central office. By coordinating efforts and sharing access to information, each Finlay Triangle participant plays a role which emphasizes its area of expertise in the merchandising process, thereby increasing productivity. Within guidelines set by the central office, Finlay's store group management contributes to the selection of the specific merchandise most appropriate to the demographics and customer tastes within their particular geographical area. Finlay's advertising initiatives and promotional planning are closely coordinated with both host store management and Finlay's store group management to ensure the effective use of Finlay's marketing programs. Vendors participate in the decision-making process with respect to merchandise assortment, including the testing of new products, marketing, advertising and stock levels. By utilizing the Finlay Triangle, opportunities are created for the vendor to assist in identifying fashion trends thereby improving inventory turnover and profitability, both for the vendor and Finlay. As a result, management believes it capitalizes on economies of scale by centralizing certain activities, such as vendor selection, advertising and planning, while allowing store management the flexibility to implement merchandising programs tailored to the host store environments and clientele.
THE FINLAY TRIANGLE
--------------- CENTRAL / / OFFICE \ \ / / --------------- \ \ / / \ \ ------------- --------------- VENDORS - - - - STORE - - - - MANAGEMENT ------------- ---------------
Finlay has structured its relationships with vendors to encourage sharing of responsibility for marketing and merchandise management. Finlay furnishes to vendors, through on-line access to Finlay's information systems, the same sales, stock and gross margin information that is available to Finlay's store group management and central office for each of the vendor's styles in Finlay's merchandise assortment. Using this information, vendors are able to participate in decisions to replenish inventory which has been sold and to return or exchange slower-moving merchandise. New items are tested in specially selected "predictor" Departments where sales experience can indicate an item's future performance in Finlay's other Departments. Management believes that the access and input which vendors have in the merchandising process results in a better assortment, timely replenishment, higher turnover and higher sales of inventory, differentiating Finlay from its competitors.
Since many of the host store groups in which Finlay operates differ in fashion image and customer demographics, Finlay's flexible approach to merchandising is designed to complement each host store's own merchandising philosophy. Finlay emphasizes a "fashion accessory" approach to fine jewelry and watches, and seeks to provide items that coordinate with the host store's fashion focus as well as to maintain stocks of traditional and gift merchandise.
STORE RELATIONSHIPS
HOST STORE RELATIONSHIPS. As of February 1, 2003, Finlay operated 1,011 locations in 20 host store groups, in 45 states and the District of Columbia. Management believes that it maintains excellent relations with its host store groups, 18 of which have had leases with Finlay for more than five years (representing 94% of Finlay's sales in 2002) and 15 of which have had leases with Finlay for more than ten years (representing 80% of Finlay's sales in 2002). As a consequence of the strong and, in many instances, long-term relationships, host store groups have routinely renewed Finlay's lease agreements at their renewal dates. Management believes that the majority of its lease agreements will continue to be renewed routinely.
The following table identifies the host store groups in which Finlay operated Departments at February 1, 2003, the year in which Finlay's relationship with each host store group commenced and the number of Departments operated by Finlay in each host store group.
- -------------------- (1) Effective February 2, 2003, Younkers was consolidated into the Carson Pirie Scott host store group. (2) Includes the former Dayton's and Hudson's Departments added in 2000 as a result of the J.B. Rudolph Acquisition.
TERMS OF LEASE AGREEMENTS. Finlay's lease agreements typically have an initial term of one to five years. Finlay has, where possible, entered into five-year lease agreements. Substantially all of Finlay's lease agreements contain renewal options or provisions for automatic renewal absent prior notice of termination by either party. Lease renewals are generally for one to five year periods. In exchange for the right to operate a Department within the host store, Finlay pays each host store group a lease fee, calculated as a percentage of sales (subject to a minimum annual fee in a limited number of cases).
Finlay's lease agreements require host stores to remit sales proceeds for each month (without regard to whether such sales were cash, store credit or national credit card) to Finlay approximately three weeks after the end of such month. However, Finlay cannot ensure the collection of sales proceeds from its host stores. Additionally, substantially all of Finlay's lease agreements provide for accelerated payments during the months of November and December, which require the host store groups to remit to Finlay 75% of the estimated months' sales prior to or shortly following the end of each such month. Each host store group withholds from the remittance of sales proceeds a lease fee and other expenditures, such as advertising costs, which the host store group may have incurred on Finlay's behalf.
Finlay is usually responsible for providing and maintaining any fixtures and other equipment necessary to operate its Departments, while the host store is typically required to provide clean space for installation of any necessary fixtures. The host store is generally responsible for paying utility costs (except certain telephone charges), maintenance and certain other expenses associated with the operation of the Departments. Finlay's lease agreements typically provide that Finlay is responsible for the hiring (subject to the suitability of such employees to the host store) and discharge of its sales and Department supervisory personnel, and substantially all lease agreements require Finlay to provide its employees with salaries and certain benefits comparable to those received by the host store's employees. Many of Finlay's lease agreements provide that Finlay may operate the Departments in any new stores opened by the host store group. In certain instances, Finlay is operating Departments without written agreements, although the arrangements in respect of such Departments are generally in accordance with the terms described herein.
In several cases, Finlay is subject to limitations under its lease agreements which prohibit Finlay from operating Departments for competing host store groups within a certain geographical radius of the host stores (typically five to ten miles). Such limitations restrict Finlay from further expansion within areas where it currently operates Departments, including expansion by possible acquisitions. Certain lease agreements, however, make an exception for adding Departments in stores established by groups with which Finlay has a preexisting lease arrangement. In addition, Finlay has from time to time obtained the consent of an existing host store group to operate in another host store group within a prohibited area. For example, May and Federated have granted consents of this type to Finlay with respect to one another's stores. Further, Finlay sought and received the consent of certain of its existing host store groups in connection with the 1997 acquisition of certain assets of the Diamond Park Fine Jewelers division of Zale Corporation and the J.B. Rudolph Acquisition.
CREDIT. Substantially all consumer credit risk is borne by the host store rather than by Finlay. Purchasers of Finlay's merchandise at a host store are entitled to the use of the host store's credit facilities on the same basis as all of the host store's customers. Payment of credit card or check transactions is generally guaranteed to Finlay by the host store, provided that the proper credit approvals have been obtained in accordance with the host store's policy. Accordingly, payment to Finlay in respect of its sales proceeds is generally not dependent on when, or if, payment is received by the host store.
DEPARTMENTS OPENED/CLOSED. During 2002, Department openings offset by closings resulted in a net increase of five Departments. The openings, which totaled 21 Departments, and the closings, which totaled 16 Departments, were all within existing store groups. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--2002 Compared with 2001".
The following table sets forth data regarding the number of domestic Departments which Finlay has operated from the beginning of 1998:
For the years presented in the table above, Department closings were primarily attributable to: ownership changes in host store groups; internal consolidation within host store groups; the closing or sale by host store groups of individual stores; host store group decisions to consolidate with one lessee; and Finlay's decision to close unprofitable Departments. To management's knowledge, none of the Department closings during the periods presented in the table above resulted from dissatisfaction of a host store group with Finlay's performance.
PRODUCTS AND PRICING
Each of Finlay's Departments offers a broad selection of necklaces, earrings, bracelets, rings and watches. Other than watches, substantially all of the fine jewelry items sold by Finlay are made from precious metals and many also contain diamonds or colored gemstones. Finlay also provides jewelry and watch repair services. Finlay does not carry costume or gold-filled jewelry. Specific brand identification is generally not important within the fine jewelry business, except for watches and designer jewelry. With respect to watches, Finlay emphasizes brand name vendors, including Citizen, Bulova, Movado and Seiko. Many of Finlay's lease agreements with host store groups restrict Finlay from selling certain types of merchandise or, in some cases, selling particular merchandise below certain price points.
The following table sets forth the sales and percentage of sales by category of merchandise for 2002, 2001 and 2000:
- ---------------------- (1) Includes special promotional items, remounts, estate jewelry, pearls, beads, cubic zirconia, sterling silver and men's jewelry, as well as repair services and accommodation sales to Finlay employees.
See "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Finlay sells its merchandise at prices generally ranging from $50 to $1,000. In 2002, the average price of items sold by Finlay was approximately $186 per item. An average Department has over 5,000 items in stock. Consistent with fine jewelry retailing in general, a substantial portion of Finlay's sales are made at prices discounted from listed retail prices. Finlay's advertising and promotional planning are closely coordinated with its pricing strategy. Publicized sales events are an important part of Finlay's marketing efforts. A substantial portion of Finlay's sales occur during such promotional events. The amount of time during which merchandise may be offered at discount prices is limited by applicable laws and regulations. See "Legal Proceedings".
PURCHASING AND INVENTORY
GENERAL. A key element of Finlay's strategy has been to lower the working capital investment required for operating its existing Departments and opening new Departments. In recent years, on average, approximately 50% of Finlay's merchandise has been obtained on consignment and certain additional inventory has been purchased with extended payment terms. In 2002, Finlay's net monthly investment in inventory (i.e., the total cost of inventory owned and paid for) averaged 33% of the total cost of its on-hand merchandise. Finlay is generally granted exchange privileges which permit Finlay to return or exchange unsold merchandise for new products at any time. In addition, Finlay structures its relationships with vendors to encourage their participation in and responsibility for merchandise management. By making the vendor a participant in Finlay's merchandising strategy, Finlay has created opportunities for the vendor to assist in identifying fashion trends, thereby improving inventory turnover and profitability. As a result, Finlay's direct capital investment in inventory has been reduced to levels which it believes are low for the retail jewelry industry. In addition, Finlay's inventory exposure to changing fashion trends is reduced because, in general, unsold consignment merchandise can be returned to the vendor.
Management believes the willingness of vendors to participate in the inventory management process is due, in part, to the large volume of merchandise which Finlay sells in its Departments and the desire of vendors to take advantage of Finlay's nationwide distribution network. By offering their merchandise through Finlay's Departments, vendors are able to reach a broad spectrum of the marketplace in coordination with national or regional advertising campaigns conducted by the vendors or their service organizations.
In 2002, merchandise obtained by Finlay from its 40 largest vendors (out of a total of approximately 500 vendors) generated approximately 79% of sales, and merchandise obtained from Finlay's largest vendor generated approximately 10% of sales. Finlay does not believe the loss of any one of its vendors would have a material adverse effect on its business.
GOLD CONSIGNMENT AGREEMENT. Finlay Jewelry is party to an amended and restated gold consignment agreement (as amended, the "Gold Consignment Agreement"), which enables Finlay Jewelry to receive consignment merchandise by providing gold, or otherwise making payment, to certain vendors. While the merchandise involved remains consigned, title to the gold content of the merchandise transfers from the vendors to the gold consignor. Effective September 30, 2002, Finlay Jewelry amended the Gold Consignment Agreement to extend the term to July 31, 2005, and to permit Finlay Jewelry to obtain up to the lesser of (i) 165,000 fine troy ounces or (ii) $50.0 million worth of gold, subject to a formula as prescribed by the Gold Consignment Agreement. At February 1, 2003, amounts outstanding under the Gold Consignment Agreement totaled 134,785 fine troy ounces, valued at approximately $49.5 million. The average amount outstanding under the Gold Consignment Agreement was $39.1 million for the fiscal year ended February 1, 2003. In the event this arrangement is terminated, Finlay Jewelry will be required to return or repurchase the outstanding gold at the prevailing gold rate in effect on that date.
Under the Gold Consignment Agreement, Finlay Jewelry is required to pay a daily consignment fee on the dollar equivalent of the fine gold value of the ounces of gold consigned thereunder. The daily consignment fee is based on a floating rate which, as of February 1, 2003, was 2.8% per annum. In conjunction with the Gold Consignment Agreement, Finlay granted to the gold consignor a first priority perfected lien on, and a security interest in, specified gold jewelry of participating vendors approved under the Gold Consignment Agreement and a lien on proceeds and products of such jewelry, subject to the terms of an intercreditor agreement between the gold consignor and the Revolving Credit Agreement lenders.
OPERATIONS
GENERAL. Most of Finlay's Departments have between 50 and 150 linear feet of display cases (with an average of approximately 72 linear feet) generally located in high traffic areas on the main floor of the host stores. Each Department is supervised by a manager whose primary duties include customer sales and service, scheduling and training of personnel, maintaining security controls and merchandise presentation. Most of the Departments utilize up to 260 staff hours per week on a permanent basis, depending on the Department's sales volume, and employ additional sales staff during the peak year-end holiday season. Each Department is open for business during the same hours as its host store. Subject to the terms of the applicable host store group lease agreement, Finlay is generally responsible for its own operating decisions within each of its Department operations, including the hiring and compensation of sales staff. See "--Store Relationships--Terms of Lease Agreements".
To parallel host store operations, Finlay establishes separate group service organizations responsible for managing Departments operated for each host store. Staffing for each group organization varies with the number of Departments in each group. Typically, Finlay services each host store group with a group manager, an assistant group manager, one or more group buyers, one or more regional supervisors who oversee the individual Department managers and a number of clerical employees. Each group manager reports to a regional vice president, who is responsible for the supervision of up to six host store groups. In its continued efforts to improve comparable Department sales through improved operating efficiency, Finlay has taken steps to minimize administrative tasks at the Department level, to improve customer service and, as a result, sales.
Finlay had average sales per linear foot of approximately $12,600 in 2002, $12,700 in 2001 and $13,600 in 2000. Finlay determines average sales per linear foot by dividing its sales by the aggregate estimated measurements of the outer perimeters of the display cases of Finlay's Departments. Finlay had average sales per Department of approximately $923,000, $925,000 and $981,000 in 2002, 2001 and 2000, respectively.
MANAGEMENT INFORMATION AND INVENTORY CONTROL SYSTEMS. Finlay and its vendors use the Company's management information systems to monitor sales, gross margin and inventory performance by location, merchandise category, style number and vendor. Using this information, Finlay is able to monitor merchandise trends and variances in performance and improve the efficiency of its inventory management. Finlay also measures the productivity of its sales force by maintaining current statistics for each employee such as sales per hour, transactions per hour and transaction size. In March 2002, the Company implemented a new merchandising and inventory control system and a point-of-sale system for its Departments. These systems will serve to support future growth of the Company as well as provide improved analysis and reporting capabilities to facilitate merchandising solutions. Additionally, these systems will provide the foundation for future productivity and expense control initiatives.
PERSONNEL AND TRAINING. Finlay considers its employees an important component of its operations and devotes substantial resources to training and improving the quality of sales and management personnel. Finlay seeks to motivate its employees by linking a substantial percentage of their compensation to performance standards. In most cases, individual sales personnel are compensated on an hourly basis and paid a commission on sales. Department managers are generally compensated on the
basis of a salary plus a percentage of their Department's sales. Group managers and regional vice presidents are eligible to earn bonuses of up to 50% of their base salaries upon the achievement of specified goals.
As of the end of 2002, Finlay employed approximately 6,100 persons of which approximately 95% were regional and local sales and supervisory personnel and the balance were employed in administrative or executive capacities. Of Finlay's 6,100 employees, approximately 3,000 were part-time employees, working less than 32 hours per week. Finlay's labor requirements fluctuate because of the seasonal nature of Finlay's business. See "--Seasonality". Management believes that its relations with its employees are good. Less than 1% of Finlay's employees are unionized.
ADVERTISING. Finlay promotes its products through four-color direct mail catalogs, using targeted mailing lists, and newspaper advertising of the host store groups. Finlay maintains an in-house advertising staff responsible for preparing a majority of Finlay's advertisements and for coordinating the finished advertisements with the promotional activities of the host stores. Finlay's gross advertising expenditures over the past five fiscal years have consistently been approximately 6% of sales, a level which is consistent with the jewelry industry's reliance on promotional efforts to generate sales. The majority of Finlay's lease agreements with host store groups require Finlay to expend certain specified minimum percentages of the respective Department's annual sales on advertising and promotional activities.
INVENTORY LOSS PREVENTION AND INSURANCE. Finlay undertakes substantial efforts to safeguard its merchandise from loss or theft, including the installation of safes at each location and the taking of a daily diamond inventory count. During 2002, inventory shrinkage amounted to approximately 0.7% of sales. Finlay maintains insurance covering the risk of loss of merchandise in transit or on Finlay's premises (whether owned or on consignment) in amounts that management believes are reasonable and adequate for the types and amounts of merchandise carried by Finlay.
GOLD HEDGING. The cost to Finlay of gold merchandise sold on consignment in some cases is not fixed until the sale is reported to the vendor or the gold consignor in the case of merchandise sold pursuant to the Gold Consignment Agreement. In such cases, the cost of merchandise varies with the price of gold and Finlay is exposed to the risk of fluctuations in the price of gold between the time Finlay establishes the advertised or other retail price of a particular item of merchandise and the date on which the sale of the item is reported to the vendor or the gold consignor. In order to hedge against this risk and to enable Finlay to determine the cost of such goods prior to their sale, Finlay may elect to fix the price of gold prior to the sale of such merchandise. Accordingly, Finlay, at times, enters into futures contracts, such as forwards, based upon the anticipated sales of gold product in order to hedge against the risk arising from its payment arrangements. The value of gold hedged under such contracts represented approximately 6.0% of the Company's cost of goods sold in 2002. Under such contracts, the Company obtains the right to purchase a fixed number of fine troy ounces of gold at a specified price per ounce for a specified period. Such contracts typically have durations ranging from one to nine months and are generally priced at the spot gold price plus an amount based on prevailing interest rates plus customary transactions costs. When sales of such merchandise are reported to the consignment vendors and the cost of such merchandise becomes fixed, Finlay sells its related hedge position. At February 1, 2003, the Company had two open positions in futures contracts for gold totaling 4,000 fine troy ounces, valued at $1.4 million, which expire during 2003. The fair market value of gold under such contracts was $1.5 million at February 1, 2003.
Finlay manages the purchase of futures contracts by estimating and monitoring the quantity of gold that it anticipates it will require in connection with its anticipated level of sales of the type described above. Finlay's gold hedging transactions are entered into by Finlay in the ordinary course of its business. Finlay's gold hedging strategies are determined and monitored on a regular basis by Finlay's senior management and its Board of Directors.
COMPETITION
Finlay faces competition for retail jewelry sales from national and regional jewelry chains, other department stores, local independently owned jewelry stores and chains, specialty stores, mass merchandisers, catalog showrooms, discounters, direct mail suppliers, televised home shopping and the internet. Management believes that competition in the retail jewelry industry is based primarily on the price, quality, fashion appeal and perceived value of the product offered and on the reputation, integrity and service of the retailer. See "--Store Relationships--Terms of Lease Agreements" with respect to certain limitations on Finlay's ability to compete.
SEASONALITY
The retail jewelry business is highly seasonal. See "Selected Consolidated Financial Data" and "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Seasonality".
WEBSITE ACCESS TO THE COMPANY'S REPORTS
Finlay's internet website address is www.finlayenterprises.com. The Company's annual reports on Form 10-K ("Form 10-K"), quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), are available free of charge through our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission (the "Commission"). The reference to the Company's website address does not constitute incorporation by reference of the information contained on the website, and the information contained on the website is not part of this document.
ITEM 2.
ITEM 2. PROPERTIES
The only real estate owned by Finlay is the central distribution facility, totaling 106,200 square feet at 205 Edison Avenue, Orange, Connecticut. Finlay leases approximately 18,400 square feet at 521 Fifth Avenue, New York, New York, and 49,100 square feet at 529 Fifth Avenue, New York, New York for its executive, accounting, advertising, the majority of its data processing operations and other administrative functions. The leases for such space expire September 30, 2008. Generally, as part of Finlay's lease arrangements, host stores provide office space to Finlay's host store group management personnel free of charge.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, Finlay is involved in litigation relating to claims arising out of its operations in the normal course of business. As of April 29, 2003, Finlay is not a party to any legal proceedings that, individually or in the aggregate, are reasonably expected to have a material adverse effect on Finlay's business, results of operations, financial condition or cash flows. However, the results of these matters cannot be predicted with certainty, and an unfavorable resolution of one or more of these matters could have a material adverse effect on Finlay's business, results of operations, financial condition or cash flows.
Commonly in the retail jewelry industry, a substantial amount of merchandise is sold at a discount to the "regular" or "original" price. Finlay's experience is consistent with this practice. See "Business-- Products and Pricing". A number of states in which Finlay operates have regulations which require retailers who offer merchandise at discounted prices to offer the merchandise at the "regular" or "original" prices for stated periods of time. Management believes it is in substantial compliance with all applicable legal requirements with respect to such practices.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2002.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The common stock, par value $.01 per share ("Common Stock"), of the Company is traded on the Nasdaq National Market under the symbol "FNLY". The high and low sales prices for the Common Stock during 2002 and 2001 were as follows:
The Company has never paid cash dividends on its Common Stock and has no present intention to pay any cash dividends in the foreseeable future. Certain restrictive covenants in the indenture relating to Finlay Jewelry's $150.0 million aggregate principal amount of 8 3/8% Senior Notes due May 1, 2008 (the "Senior Notes") (the "Senior Note Indenture") and the indenture relating to the Company's $75.0 million aggregate principal amount of 9% Senior Debentures due May 1, 2008 (the "Senior Debentures") (the "Senior Debenture Indenture", and collectively with the Senior Note Indenture, the "Senior Indentures"), the Revolving Credit Agreement and the Gold Consignment Agreement impose limitations on the payment of dividends by the Company (including Finlay Jewelry's ability to pay dividends to the Company). See "Management's Discussion and Analysis of Financial Condition and Results of Operations".
During 2002, cash dividends of $15.7 million were distributed by Finlay Jewelry to the Company. The distributions are generally utilized to pay interest on the Senior Debentures and certain expenses of the Company, such as legal, accounting and directors' fees and to purchase Common Stock under the stock repurchase program described below.
Information regarding the Company's equity compensation plans is set forth in Item 12 of Part III of this Form 10-K, which information is incorporated herein by reference.
On December 1, 2000, the Company announced that its Board of Directors had approved a stock repurchase program to acquire up to $20 million of Common Stock. The Company may, at the discretion of management, purchase its Common Stock, from time to time through September 29, 2003 under the stock repurchase program. The extent and timing of repurchases will depend upon general business and market conditions, stock prices, availability under the Revolving Credit Facility, compliance with certain restrictive covenants and its cash position and requirements going forward. As of February 1, 2003, the Company repurchased 1,332,942 shares for $13.8 million.
As of April 29, 2003, there were 9,204,408 shares of Common Stock outstanding and approximately 33 record holders of the Common Stock, including holders who are nominees for an undetermined number of beneficial owners, estimated to be in excess of 500. The last reported sale price for the Common Stock on the Nasdaq National Market on April 29, 2003 was $13.31.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial information below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto. See "Index to Consolidated Financial Statements". The income statement and balance sheet data for each of the years ended February 1, 2003, February 2, 2002, February 3, 2001, January 29, 2000 and January 30, 1999 have been derived from the Company's audited Consolidated Financial Statements.
--------------------- (1) Each of the fiscal years for which information is presented includes 52 weeks except 2000, which includes 53 weeks.
(2) Included in 1999 are charges associated with the sale and closure of Sonab totaling $28.6 million. Included in cost of sales is $7.8 million for the write-down of inventory with the balance of $20.8 million recorded as an operating expense. Included in 2002 is a $1.4 million credit which represents a revision of the Company's estimate of closure expenses to reflect its remaining liability associated with the closure of Sonab. Refer to Note 13 of Notes to Consolidated Financial Statements.
(3) Finlay utilizes the LIFO method of accounting for inventories. If Finlay had valued inventories using the first-in, first-out inventory valuation method, the gross margin would have increased (decreased) as follows: $2.3 million, $3.8 million, $1.8 million, $(1.1) million and $(1.0) million for 2002, 2001, 2000, 1999 and 1998, respectively.
(4) As a result of certain call requirements associated with the previously outstanding debentures and notes, Finlay had outstanding both the new debt and the old debt for a period of twenty-five days in 1998. The net effect of the above, offset by reduced interest expense on the borrowings under the Revolving Credit Agreement and interest income on excess cash balances, was $0.7 million.
(5) In accordance with the provisions of the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor" ("EITF 02-16"), the Company recorded a cumulative effect of accounting change as of February 3, 2002, the date of adoption, that decreased net income for 2002 by $17.2 million, net of tax, or $1.78 per share, on a diluted basis. The application of EITF 02-16 changes the Company's accounting treatment for the recognition of vendor allowances. In 2002, $20.0 million of vendor allowances has been reflected as a reduction to cost of sales. In prior years, these allowances were
(footnotes continue on following page)
recorded as a reduction to gross advertising expenses and thus decreased selling, general and administrative expenses ("SG&A"). Refer to Note 2 of Notes to Consolidated Financial Statements.
(6) The extraordinary charges of $12.2 million include $7.1 million for redemption premiums on the previously outstanding debentures and notes and $3.9 million to write off deferred financing costs and debt discount associated with the previously outstanding debentures and notes. The income tax benefit on the extraordinary charges totaled $4.8 million.
(7) The pro forma financial information reflects the Company's domestic operations only and excludes the operations of Sonab, as well as the impact of the sale and closure of Sonab. The pro forma financial information for 2002 excludes the Company's adoption of EITF 02-16, described in Note 5 above. Additionally, the pro forma financial information for 1998 excludes (i) the extraordinary charge of $12.2 million, on a pre-tax basis, described in Note 6 above, and (ii) the interest associated with refinancing, described in Note 4 above. The pro forma financial information was calculated as follows:
The Company believes that the pro forma domestic statement of operations data presents, on a comparable basis, the Company's domestic results of operations and provides additional information for analyzing the Company's operating performance. This presentation should not be construed as a substitute for income from operations, net income or cash flow from operating activities (all as determined in accordance with generally accepted accounting principles ("GAAP")) for the purpose of analyzing Finlay's operating performance, financial position and cash flows as this presentation is not defined by GAAP. Finlay has presented this information, because it is commonly used by certain investors to compare companies on the basis of consistent performance.
(8) EBITDA, a non-GAAP financial measure, represents income from operations before depreciation and amortization expenses and is calculated as follows:
For 1999 and 2002, consolidated EBITDA includes the charges totaling $28.6 million and the credit totaling $1.4 million, respectively, associated with the sale and closure of Sonab. The Company believes EBITDA provides additional information for determining its ability to meet future debt service requirements. EBITDA should not be construed as a substitute for income from operations, net income or cash flow from operating activities (all as determined in accordance with GAAP) for the purpose of analyzing Finlay's operating performance, financial position and cash flows as EBITDA is not defined by generally accepted accounting principles. Finlay has presented EBITDA, however, because it is commonly used by certain investors to analyze and compare companies on the basis of operating performance and to determine a company's ability to service and/or incur debt. Finlay's computation of EBITDA may not be comparable to similar titled measures of other companies.
(9) Includes Departments and stand-alone locations.
(10) Excluding sales for the 53rd week of 2000, the percentage increase in sales for 2000 was 8.8% and the percentage decrease in sales for 2001 was 4.1%.
(11) Comparable Department sales are calculated by comparing the sales from Departments open for the same months in the comparable periods.
(12) Average domestic sales per Department is determined by dividing domestic sales by the average of the number of domestic Departments open at the beginning and at the end of each period.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following should be read in conjunction with "Selected Consolidated Financial Information" and the Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.
Certain statements under this caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" constitute "forward-looking statements" under the Securities Act of 1933, as amended (the "Securities Act"), and the Exchange Act. See "Special Note Regarding Forward-Looking Statements".
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. These generally accepted accounting principles require management to make estimates and assumptions that affect certain financial statement accounts reported and disclosed at the date of the financial statements. Actual results may differ from those estimates.
Certain of the Company's significant accounting policies are described in Note 2 of Notes to the Consolidated Financial Statements. The Company believes that the following discussion addresses the critical accounting policies, which are those that are most important to the portrayal of the Company's financial condition and results of operations and require management's most difficult, subjective or complex judgments. The Company is not aware of any likely events or circumstances which would result in different amounts being reported that would materially affect its financial condition or results of operations.
MERCHANDISE INVENTORIES
The Company values its inventories at the lower of cost or market. The cost is determined by the last-in, first-out method utilizing selected producer price indices published for jewelry and watches by the Bureau of Labor Statistics. Factors related to inventories such as future consumer demand and the economy's impact on consumer discretionary spending, inventory aging, ability to return merchandise to vendors, merchandise condition and anticipated markdowns are analyzed to determine estimated net realizable values. An adjustment is recorded to reduce the LIFO cost of inventories, if required. Any significant unanticipated changes in the factors above could have a significant impact on the value of the inventories and the Company's reported operating results.
DERIVATIVE INSTRUMENTS
The Company is exposed to market risk related to changes in the price of gold and at times enters into futures contracts, such as forwards, to hedge against the risk of gold price fluctuations. In 2001, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities", which requires that all derivative instruments be recorded on the balance sheet as either an asset or a liability measured at its fair value. Accounting for derivative instruments under this pronouncement did not have a material impact on the Company's financial condition, results of operations and cash flows for 2002 and 2001.
VENDOR ALLOWANCES
The Company receives allowances from its vendors through a variety of programs and arrangements, including cooperative advertising. The allowances are generally intended to offset the Company's costs of promoting, advertising and selling the vendors' products in its Departments. Vendor allowances are recognized as a reduction of cost of sales or SG&A when the purpose for which the vendor funds were
intended to be used has been fulfilled. Accordingly, a reduction or increase in vendor allowances has an inverse impact on cost of sales and/or SG&A.
In March 2003, the EITF finalized Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor". EITF 02-16 addresses the accounting treatment for vendor allowances and provides that cash consideration received from a vendor should be presumed to be a reduction of the prices of the vendors' product and should therefore be shown as a reduction in the purchase price of the merchandise. Further, these allowances should be recognized as a reduction in cost of sales when the related product is sold. To the extent that the cash consideration represents a reimbursement of a specific, incremental and identifiable cost, then those vendor allowances should be used to offset such costs.
In accordance with EITF 02-16, the Company recorded a cumulative effect of accounting change as of February 3, 2002, the date of adoption, that decreased net income for 2002 by $17.2 million, net of tax, or $1.78 per share, on a diluted basis. As of February 3, 2002, deferred vendor allowances totaled (i) $17,129,000 for owned merchandise, and (ii) $12,306,000 for merchandise received on consignment. As of February 1, 2003, the Company's fiscal year end, deferred vendor allowances totaled (i) $18,452,000 for owned merchandise, which is included as an offset to merchandise inventories on the 2002 Consolidated Balance Sheet, and (ii) $10,493,000 for merchandise received on consignment, which is included as deferred income on the 2002 Consolidated Balance Sheet. In 2002, this change resulted in the reclassification of vendor allowances of $20.0 million, which had previously been accounted for as a reduction to SG&A, to now reduce cost of sales and consequently, increase gross margin. The Company's 2002 unaudited quarterly financial data has been revised to reflect this change in accounting method. See Note 10 of Notes to Consolidated Financial Statements of the Company. The adoption of EITF 02-16 is not expected to have a material impact on the financial position or results of operations of the Company in 2003.
During 2001 and 2000, the Company recorded its vendor allowances as an offset to gross advertising expenses, which is included in SG&A on the Consolidated Statements of Operations. For 2001 and 2000, the unaudited pro forma impact of the adoption of EITF 02-16, as if it had occurred prior to 2000, was to decrease cost of sales and increase SG&A by $20,374,000 and $23,665,000, respectively. For both years, net income and net income per share would not have been materially different.
REVENUE RECOGNITION
The Company recognizes revenue upon the sale of merchandise, either owned or consigned, to its customers, net of anticipated returns. The provision for sales returns is based on the Company's historical return rate.
COVENANT REQUIREMENTS
The Company's agreements covering the Revolving Credit Agreement, the Senior Debentures and the Senior Notes each require that Finlay comply with certain restrictive and financial covenants. In addition, Finlay Jewelry is party to the Gold Consignment Agreement, which also contains certain covenants. As of and for the year ended February 1, 2003, the Company was in compliance with all of its covenants. Management expects to be in compliance with all of its covenants through 2003. Because compliance is based, in part, on management estimates and actual results can differ from those estimates, there can be no assurance that the Company will be in compliance with the covenants in the future or that the lenders will waive or amend any of the covenants should the Company be in violation of any such covenants. The Company believes the assumptions used are appropriate.
The Revolving Credit Agreement contains customary covenants, including limitations on, or relating to capital expenditures, liens, indebtedness, investments, mergers, acquisitions, affiliate transactions, management compensation and the payment of dividends and other restricted payments. The Revolving
Credit Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations.
The Senior Indentures contain restrictions relating to, among other things, the payment of dividends, the making of certain investments or other restricted payments, the incurrence of additional indebtedness, the creation of certain liens, entering into transactions with affiliates, the disposition of certain assets and engaging in mergers and consolidations.
The Gold Consignment Agreement requires Finlay Jewelry to comply with certain covenants, including restrictions on the incurrence of certain indebtedness, the creation of liens, engaging in transactions with affiliates and limitations on the payment of dividends. In addition, the Gold Consignment Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations.
EFFECT OF NEW ACCOUNTING STANDARDS
On February 3, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives are no longer to be amortized but tested for impairment on an annual basis. The Company has determined that there was no impairment of goodwill as of February 3, 2002 since the carrying value of the Company's reporting unit did not exceed its fair value. In making this assessment, management relied on a number of factors including 2002's operating results, business plans, economic projections, anticipated future cash flows and marketplace data. A change in these underlying assumptions may cause a change in the results of the tests and, as such, could cause fair value to be less than the carrying value. In such event, Finlay would then be required to record a charge, which would impact earnings. Finlay will continue to review the carrying value of goodwill for impairment on an annual basis or more frequently if circumstances indicate impairment may have occurred. The Company's goodwill amortization in 2001 and 2000 totaled $3.7 million in each year.
In October 2001, the FASB issued SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement extends the reporting requirements to include reporting separately as discontinued operations components of an entity that have either been disposed of or classified as held-for-sale. The Company adopted the provisions of SFAS No. 144 in 2002 and the adoption did not have a material impact on the Company's financial position or results of operations.
ACCOUNTING STANDARDS NOT YET ADOPTED
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statement No. 4, 44, and 64, Amendment of FASB No. 13, and Technical Corrections", which amends certain existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Additionally, the statement provides that gains and losses from debt extinguishment are not automatically shown as an extraordinary item on a company's statement of operations. The provisions of SFAS No. 145 are effective for fiscal years beginning after May 15, 2002. The adoption of SFAS No. 145 is not expected to have a material impact on the financial position or results of operations of the Company.
RESULTS OF OPERATIONS
The following table sets forth operating results as a percentage of sales for the periods indicated:
- -------------------- (1) See Note 5 to "Selected Consolidated Financial Data".
2002 COMPARED WITH 2001
SALES. Sales decreased $22.1 million, or 2.3%, in 2002 compared to 2001. Comparable Department sales increased 0.1% in 2002, which management attributes to a continued challenging retail environment. Comparable Department sales includes sales from Departments open for the same month during comparable periods. Total sales were negatively impacted by approximately $31.0 million, or 3.3%, as a result of the 2001 closing of three host store groups, offset by the net effect of new Department openings and closings.
Finlay's merchandising and marketing strategy includes the following initiatives: (i) emphasizing its "Key Item" and "Best Value" merchandising programs, which provide a targeted assortment of items at competitive prices; (ii) increasing focus on holiday and event-driven promotions as well as host store marketing programs; and (iii) positioning the Company's Departments as a "destination location" for fine jewelry.
During 2002, Finlay opened 21 Departments within existing store groups, which included 11 Departments in May. During this period, Finlay closed 16 Departments including five in May and three in Federated.
GROSS MARGIN. Gross margin increased by $6.6 million in 2002 compared to 2001 and, as a percentage of sales, gross margin increased by 1.9%, primarily due to the Company's adoption of EITF 02-16. The application of EITF 02-16 changes the Company's accounting treatment for the recognition of vendor allowances. In 2002, $20.0 million of vendor allowances has been reflected as a reduction to cost of sales based on the sale of the related product. In prior years, these allowances were recorded as a reduction to gross advertising expenses and thus decreased SG&A.
Excluding the adoption of EITF 02-16, gross margin decreased by $14.0 million in 2002 compared to 2001 and, as a percentage of sales, gross margin decreased by 0.3%, primarily due to (i) management's continued efforts to increase market penetration and market share through its pricing strategy and (ii) the impact of higher gold prices. Offsetting these factors were favorable physical inventory shortage results and a lower LIFO charge of $2.3 million in 2002 versus $3.8 million in 2001.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. SG&A totaled $399.3 million, an increase of $5.1 million, or 1.3%, in 2002 compared to 2001, primarily due to the Company's adoption of EITF 02-16 which, as discussed above, resulted in a $20.0 million increase to SG&A. SG&A as a percentage of sales increased to 42.9% in 2002 from 41.4% in 2001.
Excluding the adoption of EITF 02-16, SG&A decreased by $14.9 million, or 3.8%, in 2002 compared to 2001 primarily due to payroll expense and lease fees associated with the decrease in the Company's sales and reduced gross advertising expenses. Additionally, the Company recorded a $1.8 million reduction in employee medical benefits expense associated with favorable claims experience subsequent to a change in medical insurance carriers. SG&A as a percentage of sales, excluding the adoption of EITF 02-16, decreased to 40.8% in 2002 from 41.4% in 2001.
CREDIT ASSOCIATED WITH THE SALE AND CLOSURE OF SONAB. In 2002, the Company revised its 1999 estimate of closure expenses to reflect its remaining liability associated with the closure of Sonab and, as a result, recorded a credit of $1.4 million.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization decreased by $2.5 million in 2002 compared to 2001, reflecting the discontinuance of goodwill amortization of $3.7 million and the effect of certain assets becoming fully depreciated, offset by additional depreciation and amortization as a result of capital expenditures and capitalized software costs for the most recent 12 months.
INTEREST EXPENSE, NET. Interest expense decreased by $2.1 million reflecting a lower weighted average interest rate (7.6% for 2002 compared to 7.8% for 2001) and a decrease in average borrowings ($286.2 million for 2002 compared to $305.8 million for 2001).
PROVISION FOR INCOME TAXES. The effective tax rate, before the cumulative effect of accounting change, decreased to 39.1% in 2002 from 42.6% in 2001, primarily as a result of the cessation in 2002 of the amortization of non-deductible goodwill.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF TAXES. The Company elected to adopt EITF 02-16 retroactive to the beginning of 2002 and recorded a cumulative effect after-tax reduction to earnings of $17.2 million. The charge relates to the deferral of a portion of the Company's previously collected vendor allowances relating to both owned merchandise and merchandise received on consignment.
NET INCOME. Net income of $7.0 million for 2002 represents a decrease of $11.5 million as compared to net income of $18.5 million in 2001 as a result of the factors discussed above.
2001 COMPARED WITH 2000
SALES. Sales decreased $47.3 million, or 4.7%, in 2001 compared to 2000. Excluding sales for the 53rd week of 2000, sales decreased 4.1%. Comparable Department sales decreased 3.0%. Management attributes this decrease in comparable Department sales primarily to a challenging retail environment and the extraordinary events of September 11, 2001 and its impact on the economy, which resulted in reduced consumer discretionary spending. Total sales were negatively impacted by $17.3 million as a result of the 2001 closing of two host store groups, offset by the benefit of a full year of sales from the former J.B. Rudolph departments and the net effect of new Department openings and closings.
During 2001, Finlay opened 33 Departments within existing store groups, which included 22 Departments in May. During this period Finlay closed 80 Departments which were comprised of the following:
GROSS MARGIN. Gross margin decreased by $30.3 million in 2001 compared to 2000 and, as a percentage of sales, gross margin decreased by 0.7%, primarily due to (i) management's continued efforts to increase market penetration and market share through its pricing strategy, (ii) a charge of $3.8 million in the LIFO provision compared to the prior year's provision of $1.8 million and (iii) a charge of $1.5 million for the markdown of aged inventory.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. SG&A totaled $394.2 million, a decrease of $15.8 million, or 3.8%, in 2001 compared to 2000 due primarily to payroll expense and lease fees associated with the decrease in the Company's sales. SG&A as a percentage of sales increased to 41.4% in 2001 from 41.0% in 2000 as a result of the negative impact of payroll and other expenses as a percentage of sales due to the lower sales volume.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased by $2.5 million in 2001 compared to 2000, reflecting $13.9 million in capital expenditures and an increase in capitalized software costs for the most recent 12 months. Additionally, during 2001, the Company began amortizing the capitalized software for its new merchandising and point-of-sale systems. These costs were offset by the effect of certain assets becoming fully depreciated.
INTEREST EXPENSE, NET. Interest expense decreased by $3.1 million reflecting a lower weighted average interest rate (7.8% for 2001 compared to 8.6% for 2000) and a decrease in average borrowings ($305.8 million for 2001 compared to $321.6 million for 2000).
PROVISION FOR INCOME TAXES. The effective income tax rate for 2001 and 2000 was 42.6%.
NET INCOME. Net income of $18.5 million for 2001 represents a decrease of $8.0 million as compared to net income of $26.5 million in 2000 as a result of the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Finlay's primary capital requirements are for funding working capital for new Departments and for working capital growth of existing Departments and, to a lesser extent, capital expenditures for opening new Departments, renovating existing Departments and information technology investments. For 2002 and 2001, capital expenditures totaled $12.5 million and $13.9 million, respectively. Total capital expenditures for 2003 are estimated to be approximately $12.0 to $13.0 million. Although capital expenditures are limited by the terms of the Revolving Credit Agreement, to date this limitation has not precluded the Company from satisfying its capital expenditure requirements.
Finlay's operations substantially preclude customer receivables as Finlay's lease agreements require host stores to remit sales proceeds for each month (without regard to whether such sales were cash, store credit or national credit card) to Finlay approximately three weeks after the end of such month. However, Finlay cannot ensure the collection of sales proceeds from its host stores. Additionally, on average,
approximately 50% of Finlay's merchandise has been carried on consignment. The Company's working capital balance was $209.0 million at February 1, 2003, an increase of $6.5 million from February 2, 2002. The increase resulted primarily from the impact of 2002's net income (exclusive of depreciation and amortization) partially offset by the adoption of EITF 02-16, capital expenditures, additions to deferred charges and the purchase of treasury stock.
The seasonality of Finlay's business causes working capital requirements, and therefore borrowings under the Revolving Credit Agreement, to reach their highest level in the months of October, November and December in anticipation of the year-end holiday season. Accordingly, Finlay experiences seasonal cash needs as inventory levels peak. Additionally, substantially all of Finlay's lease agreements provide for accelerated payments during the months of November and December, which require the host store groups to remit to Finlay 75% of the estimated months' sales prior to or shortly following the end of each such month. These proceeds result in a significant increase in the Company's cash, which is used to reduce the Company's borrowings under the Revolving Credit Agreement. During 2002, by closely monitoring sales and the continued challenging retail environment, the Company reduced its inventory levels as compared to 2001. During 2002, the reduced inventory levels favorably impacted the Company's outstanding borrowings under the Revolving Credit Agreement.
In January 2003, Finlay entered into the Revolving Credit Agreement, which expires in January 2008. The Revolving Credit Agreement provides Finlay Jewelry with a line of credit of up to $225.0 million to finance working capital needs. Amounts outstanding under the Revolving Credit Agreement bear interest at a rate equal to, at Finlay's option, (i) the prime rate plus a margin ranging from zero to 1.0% or (ii) adjusted Eurodollar rate plus a margin ranging from 1.0% to 2.0%, in each case depending on the financial performance of the Company.
In each year, Finlay is required to reduce the outstanding revolving credit balance and letter of credit balance under the Revolving Credit Agreement to $50.0 million or less and $20.0 million or less, respectively, for a 30 consecutive day period (the "Balance Reduction Requirement"). Borrowings under the Revolving Credit Agreement at February 1, 2003 and February 2, 2002 were zero. The average amounts outstanding under the Revolving Credit Agreement for 2002 and 2001 were $61.2 million and $80.8 million, respectively. The maximum amount outstanding for 2002 was $111.4 million, at which point the unused excess availability was $106.4 million. At February 1, 2003, the Company was in compliance with all of its covenants under the Revolving Credit Agreement.
Finlay's long-term needs for external financing will depend on its rate of growth, the level of internally generated funds and the ability to continue obtaining substantial amounts of merchandise on advantageous terms, including consignment arrangements with its vendors. At both February 1, 2003 and February 2, 2002, $359.7 million of consignment merchandise from approximately 300 vendors was on hand. For 2002, Finlay had an average balance of consignment merchandise of $360.5 million as compared to an average balance of $377.4 million in 2001. See "Business--Store Relationships" and "Business--Purchasing and Inventory".
A significant amount of Finlay's operating cash flow has been used or will be required to pay interest, directly or indirectly, with respect to the Senior Debentures, the Senior Notes and amounts due under the Revolving Credit Agreement, including the payments required pursuant to the Balance Reduction Requirement. As of February 1, 2003, Finlay's outstanding borrowings were $225.0 million, which included a $75.0 million balance under the Senior Debentures and a $150.0 million balance under the Senior Notes. At February 1, 2003, the Company was in compliance with all of its covenants under the Senior Indentures.
The Company may, at the discretion of management, purchase Senior Debentures and/or Senior Notes from time to time in the open market. Additionally, beginning on May 1, 2003, the Senior Debentures and Senior Notes will be redeemable, in whole or in part, at the option of Finlay, at specified redemption prices plus accrued and unpaid interest, if any, to the date of the redemption. The extent and timing of any
bond repurchases will depend upon general business and market conditions, bond prices, availability under the Revolving Credit Facility, compliance with certain restrictive covenants and Finlay's cash position and requirements going forward.
Effective September 30, 2002, Finlay Jewelry amended the Gold Consignment Agreement to extend the term to July 31, 2005 and to permit Finlay to obtain up to the lesser of (i) 165,000 fine troy ounces or (ii) $50.0 million worth of gold, subject to a formula as prescribed by the Gold Consignment Agreement. At February 1, 2003, amounts outstanding under the Gold Consignment Agreement totaled 134,785 fine troy ounces, valued at approximately $49.5 million. The average amount outstanding under the Gold Consignment Agreement was $39.1 million in 2002. In the event this agreement is terminated, Finlay Jewelry will be required to return or repurchase the outstanding gold at the prevailing gold rate in effect on that date. For financial statement purposes, the consigned gold is not included in merchandise inventories on the Company's Consolidated Balance Sheets and, therefore, no related liability has been recorded. At February 1, 2003, Finlay Jewelry was in compliance with all of its covenants under the Gold Consignment Agreement.
The following tables summarize the Company's contractual and commercial obligations which may have an impact on future liquidity and the availability of capital resources, as of February 1, 2003 (dollars in thousands):
- ------------------ (1) Represents future minimum payments under noncancellable operating leases.
- ------------------- (1) There were no borrowings under the Revolving Credit Agreement at February 1, 2003. The average amount outstanding during 2002 was $61.2 million and the outstanding balance as of April 29, 2003 was $25.9 million. (2) Represents amount outstanding at February 1, 2003.
Finlay believes that, based upon current operations, anticipated growth, and continued availability under the Revolving Credit Agreement, Finlay Jewelry will, for the foreseeable future, be able to meet its debt service and anticipated working capital obligations, and to make distributions to the Company sufficient to permit the Company to meet its debt service obligations and to pay certain other expenses as they come due. No assurances, however, can be given that Finlay Jewelry's current level of operating results will continue or improve or that Finlay Jewelry's income from operations will continue to be sufficient to permit Finlay Jewelry and the Company to meet their debt service and other obligations. Currently, Finlay Jewelry's principal financing arrangements restrict annual distributions from Finlay
Jewelry to the Company to 0.25% of Finlay Jewelry's net sales for the preceding fiscal year and also allow distributions to the Company to enable it to make interest payments on the Senior Debentures. Other dividends and distributions, including those required to fund stock or bond repurchases, are subject to Finlay's satisfaction of certain restrictive covenants. The amounts required to satisfy the aggregate of Finlay Jewelry's interest expense totaled $16.8 million and $19.0 million for 2002 and 2001, respectively.
The Company has an employment agreement with one senior executive which provides for a minimum salary level as well as incentive compensation based on meeting specific financial goals. Such agreement has a remaining term of two years and has a remaining aggregate minimum value of $1,975,000 as of February 1, 2003.
In December 2000, the Company announced that its Board of Directors had approved a stock repurchase program to acquire up to $20 million of outstanding Common Stock. The Company may, at the discretion of management, purchase its Common Stock, from time to time through September 29, 2003 under the stock repurchase program. The extent and timing of repurchases will depend upon general business and market conditions, stock prices, availability under the Revolving Credit Facility, compliance with certain restrictive covenants and its cash position and requirements going forward. As of February 1, 2003, the Company repurchased 1,332,942 shares for $13.8 million.
In March 2002, the Company implemented a new merchandising and inventory control system and a point-of-sale system for its Departments. These systems will serve to support future growth of the Company as well as provide improved analysis and reporting capabilities and more timely sales and inventory information to facilitate merchandising solutions. Additionally, these systems will provide the foundation for future productivity and expense control initiatives. At February 1, 2003, a total of $22.1 million has been expended for software and implementation costs and is included in Deferred charges and other assets.
From time to time, Finlay enters into futures contracts, such as forwards, based upon the anticipated sales of gold product in order to hedge against the risk arising from its payment arrangements. At February 1, 2003, the Company had two open positions in futures contracts for gold, which expire during 2003, totaling 4,000 fine troy ounces, valued at $1.4 million. There can be no assurance that these hedging techniques will be successful or that hedging transactions will not adversely affect the Company's results of operations or financial position.
In February 2001, Federated announced its plans to close its Stern's division in which Finlay operated 23 departments. Finlay closed the majority of the Stern's departments during the second quarter of 2001. Subsequently, Federated converted the majority of the Departments to a host store in which Finlay does not operate. Finlay recorded a charge of approximately $1.0 million related to the write-off of fixed assets and employee severance. During 2001, Federated acquired the Liberty House department store chain and converted those Departments to a host store in which Finlay does not operate. Finlay operated in all twelve of the Liberty House department stores through mid-November 2001. Finlay recorded a charge of approximately $0.2 million related to the write-off of fixed assets and employee severance. During 2002, sales were reduced by approximately $31.0 million compared to the prior year as a result of the closings of Stern's, Liberty House and another smaller host store group.
During 1998, Sonab, the Company's European leased jewelry department subsidiary, began to experience lower sales trends due to the transition from a promotional pricing strategy to an everyday low price strategy. This change was made as a result of Sonab reassessing its pricing policy following certain local French court decisions. The adverse impact of such change continued through 1999. As a result of the foregoing, on January 3, 2000, Sonab sold the majority of its assets for approximately $9.9 million. After the sale, the buyer operated more than 80 locations previously included in Sonab's 130-location base in France. The remaining Departments were closed. All of Sonab's employees, excluding those that were hired by the buyer, were involuntary terminated, including sales associates, supervisors and corporate personnel. The Company recorded a pre-tax charge in the fourth quarter of 1999 of $28.6
million, or $1.62 per share on a diluted basis after-tax. The charge included the write down of inventory and fixed assets, employee payroll and severance costs, realization of foreign exchange losses and other close-down costs. As of February 1, 2003, the Company's exit plan has been completed with the exception of certain employee litigation and other legal matters. During the fourth quarter of 2002, the Company revised its original estimate of closure expenses to reflect its remaining liability, and as a result recorded a credit of $1.4 million. To date, the Company has charged a total of $26.4 million against its revised estimate of $27.2 million. The Company does not believe future operating results or liquidity will be materially impacted by any remaining payments.
SEASONALITY
Finlay's business is highly seasonal, with a significant portion of its sales and income from operations generated during the fourth quarter of each year, which includes the year-end holiday season. The fourth quarter accounted for an average of approximately 41% of Finlay's sales and approximately 79% of its income from operations for 2002, 2001 and 2000. Finlay has typically experienced net losses in the first three quarters of its fiscal year. During these periods, working capital requirements have been funded by borrowings under the Revolving Credit Agreement. Accordingly, the results for any of the first three quarters of any given fiscal year, taken individually or in the aggregate, are not indicative of annual results. See Note 10 of Notes to Consolidated Financial Statements of the Company.
The Company's Sales and Income from operations for each quarter of 2002, 2001 and 2000 were as follows. For 2002, the quarterly financial data has been revised to reflect the Company's retroactive adoption of EITF 02-16 to the beginning of 2002.
INFLATION
The effect of inflation on Finlay's results of operations has not been material in the periods discussed.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Form 10-K includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements other than statements of historical information provided herein are forward-looking statements and may contain information about financial results, economic conditions, trends and known uncertainties. The forward-looking statements contained herein are subject to certain risks and uncertainties that could cause actual results, performances or achievements to differ materially from those reflected in, or implied by, the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as trends in the general economy in the United States, low or negative growth in the economy or in the
financial markets which reduce discretionary spending on goods perceived to be luxury items, attacks or threats of attacks by terrorists or war which may negatively impact the economy and/or the financial markets and reduce discretionary spending on such goods, competition in the retail jewelry business, the seasonality of the retail jewelry business, the Company's ability to increase comparable department sales and to open new departments, the Company's dependence on or loss of certain host store relationships, particularly with respect to May and Federated, due to the concentration of sales generated by such host stores, the impact of any host store bankruptcy, the impact of declining mall traffic levels, the availability to the Company of alternate sources of merchandise supply in the case of an abrupt loss of any significant supplier, the Company's ability to continue to obtain substantial amounts of merchandise on consignment, the impact of fluctuations in gold and diamond prices, Finlay Jewelry's continuation of its Gold Consignment Agreement, the Company's compliance with applicable contractual covenants, the impact of future claims and legal actions arising in the ordinary course of business, the impact of recent accounting developments, the Company's dependence on key officers, the Company's ability to integrate future acquisitions into its existing business, the Company's high degree of leverage and the availability to the Company of financing and credit on favorable terms and changes in regulatory requirements which are applicable to the Company's business. Other such factors include the ability of the Company to complete the repurchases contemplated under its stock repurchase program, the adequacy of Finlay's working capital to complete the repurchases, the availability and liquidity of the Company's Common Stock, and overall market conditions for the Company's Common Stock.
Readers are cautioned not to rely on these forward-looking statements, which reflect management's analysis, judgment, belief or expectation only as of the date hereof. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof or to reflect the occurrence of unanticipated events. In addition to the disclosure contained herein, readers should carefully review any disclosure of risks and uncertainties contained in other documents the Company files or has filed from time to time with the Commission pursuant to the Exchange Act.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to market risk through the interest rate on its borrowings under the Revolving Credit Agreement, which has a variable interest rate. Based on the average amounts outstanding under the Revolving Credit Agreement for 2002, a 100 basis point change in interest rates would have resulted in an increase in interest expense of approximately $600,000 in 2002. In seeking to minimize the risks from interest rate fluctuations, the Company manages exposures through its regular operating and financing activities. In addition, the majority of the Company's borrowings are under fixed rate arrangements, as described in Note 4 of Notes to Consolidated Financial Statements.
The jewelry industry in general is affected by fluctuations in the prices of precious metals and precious and semi-precious stones. The availability and prices of gold, diamonds and other precious metals and precious and semi-precious stones may be influenced by cartels, political instability in exporting countries and inflation. Shortages of these materials or sharp changes in their prices could have a material adverse effect on the Company's results of operations or financial condition. The Company enters into forward contracts for the purchase of gold to hedge the risk of gold price fluctuations for future sales of gold consignment merchandise. The Company does not enter into forward contracts or other financial instruments for speculation or trading purposes. The fair value of gold under the forward contracts was $1.5 million at February 1, 2003.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
For information regarding the Company's change in independent auditors from Arthur Andersen LLP to Deloitte & Touche LLP, please refer to our Current Report on Form 8-K filed with the Commission on June 21, 2002.
We have had no disagreements with our independent auditors regarding accounting or financial disclosure matters.
PART III
Certain information incorporated herein by reference to the Company's Proxy Statement described below is also contained in the Finlay Jewelry Form 10-K for the fiscal year ended February 1, 2003.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below is certain information with respect to each of the current executive officers and directors of the Company and Finlay Jewelry. Each of the persons listed as a director is a member of the Board of Directors of both the Company and Finlay Jewelry.
See information under the caption "Certain Relationships and Related Transactions--Stockholders Agreement" to be included in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A ("Proxy Statement").
On March 26, 2003, Thomas H. Lee and Warren C. Smith, Jr. resigned from the Board of Directors of the Company and its subsidiaries, including Finlay Jewelry. On March 27, 2003, Mr. Lee and Mr. Smith, along with Thomas H. Lee Equity Partners, L.P. ("Equity Partners") and other affiliates, sold their Common Stock in the Company to Palisade Concentrated Equity Partnership (see footnote 4 of Item 12). Prior thereto, on July 12, 2002, the Company had repurchased an aggregate of 50,000 shares of Common Stock for $712,500 from Messrs. Lee and Smith, Equity Partners and other affiliates.
Under the Company's Restated Certificate of Incorporation, the Company's Board of Directors is classified into three classes. The members of each class will serve staggered three-year terms. Messrs. Desai, Goldstein and Murnane are Class I directors; Messrs. Cornstein, Kaplan, Kerin and Reiner are Class II directors; and Mr. Matthews and Ms. Merriman are Class III directors. The terms of the Class II, Class III and Class I directors expire at the annual meeting of stockholders to be held in 2003, 2004 and 2005, respectively. Officers serve at the discretion of the Board of Directors.
The business experience, principal occupations and employment of each of the executive officers and directors of the Company and Finlay Jewelry, together with their periods of service as directors and executive officers of the Company and Finlay Jewelry, are set forth below.
ARTHUR E. REINER became Chairman of the Company effective February 1, 1999 and, from January 1995 to such date, served as Vice Chairman of the Company. Mr. Reiner has also served as President and Chief Executive Officer of the Company since January 30, 1996 and as Chairman of the Board and Chief Executive Officer of Finlay Jewelry since January 3, 1995. Prior to joining Finlay, Mr. Reiner had spent over 30 years with the Macy's organization. From February 1992 to October 1994, Mr. Reiner was Chairman and Chief Executive Officer of Macy's East, a subsidiary of Macy's. From 1988 to 1992, Mr. Reiner was Chairman and Chief Executive Officer of Macy's Northeast, which was combined with Macy's Atlanta division to form Macy's East in 1992.
JOSEPH M. MELVIN was appointed as Executive Vice President and Chief Operating Officer of the Company and President and Chief Operating Officer of Finlay Jewelry on May 1, 1997. From September 1975 to March 1997, Mr. Melvin served in various positions with May, including, from 1990 to March 1997, as Chairman of the Board and Chief Operating Officer of Filene's (a division of May).
LESLIE A. PHILIP has been Executive Vice President and Chief Merchandising Officer of the Company and Finlay Jewelry since May 1997. From May 1995 to May 1997, Ms. Philip was Executive Vice President-Merchandising and Sales Promotion of Finlay Jewelry. From 1993 to May 1995, Ms. Philip was Senior Vice President--Advertising and Sales Promotion of Macy's, and from 1988 to 1993, Ms. Philip was Senior Vice President--Merchandise--Fine Jewelry at Macy's. Ms. Philip held various other positions at Macy's from 1970 to 1988.
EDWARD STEIN has been Senior Vice President and Director of Stores of Finlay Jewelry since July 1995. From December 1988 to June 1995, Mr. Stein was Vice President - Regional Supervisor of Finlay Jewelry, and occupied similar positions with Finlay's predecessors from 1983 to December 1988. Mr. Stein held various other positions at Finlay from 1965 to 1983.
BRUCE E. ZURLNICK has been Senior Vice President, Treasurer and Chief Financial Officer of the Company and Finlay Jewelry since January 2000. From June 1990 to December 1999, he was Treasurer of the Company and Vice President and Treasurer of Finlay Jewelry. From December 1978 through May 1990, Mr. Zurlnick held various finance and accounting positions with Finlay's predecessors.
DAVID B. CORNSTEIN has been Chairman Emeritus of the Company since his retirement from day-to-day involvement with the Company effective January 31, 1999. He served as Chairman of the Company from May 1993 until his retirement, and has been a director of the Company and Finlay Jewelry since their inception in December 1988. Mr. Cornstein is a Principal of Pinnacle Advisors Limited. From December 1988 to January 1996, Mr. Cornstein was President and Chief Executive Officer of the Company. From December 1985 to December 1988, Mr. Cornstein was President, Chief Executive Officer and a director of a predecessor of the Company. Mr. Cornstein is a director of TeleHubLink Corporation and Opticare Health Systems, Inc.
ROHIT M. DESAI has been a director of the Company and Finlay Jewelry since May 1993. Mr. Desai is the founder of and, since its formation in 1984, has been Chairman and President of Desai Capital Management Incorporated, a specialized equity investment management firm in New York which manages the assets of various institutional clients through Equity-Linked Investors-II, Private Equity Investors III, L.P. and Private Equity Investors IV, L.P. Mr. Desai is also the managing general partner of the general partner of Equity-Linked Investors-II and the managing member of the general partners of Private Equity Investors III, L.P. and Private Equity Investors IV, L.P. Mr. Desai serves as a director of The Rouse Company, SITEL Corporation, Triton PCS and Independence Community Bank Corp.
MICHAEL GOLDSTEIN has been a director of the Company and Finlay Jewelry since May 1999. Mr. Goldstein has been Chairman of the Toys "R" Us Children's Fund, Inc. since June 2001. Mr. Goldstein was Chairman of the Board of Toys "R" Us, Inc. from February 1998 to June 2001. From February 1994 to February 1998, Mr. Goldstein was Vice Chairman of the Board and Chief Executive Officer of Toys
"R" Us, Inc., and served as acting Chief Executive Officer from August 1999 to January 14, 2000. Mr. Goldstein is also a director of Toys "R" Us, Inc., United Retail Group Inc. and 4Kids Entertainment, Inc.
JAMES MARTIN KAPLAN has been a director of the Company, Finlay Jewelry and their predecessors since 1985. Mr. Kaplan is a partner of the law firm of Blank Rome LLP, counsel to Finlay, the successor to Tenzer Greenblatt LLP, which he joined in 1998. From 1977 to 1998, Mr. Kaplan was a partner with the law firm of Zimet, Haines, Friedman & Kaplan, former counsel to Finlay.
JOHN D. KERIN has been a director since December 1999. Since January 2000, Mr. Kerin has been a consultant to The McGraw Hill Companies, Inc. From July 1979 to January 2000, Mr. Kerin served in various positions with The McGraw-Hill Companies, Inc., including, from May 1994 to January 2000, as Senior Vice President, Information Management and Chief Information Officer.
NORMAN S. MATTHEWS has been a director of the Company and Finlay Jewelry since July 1993. Mr. Matthews has been a retail consultant based in New York for more than the past five years. Mr. Matthews served as Vice Chairman and then President of Federated Department Stores from 1983 to 1988. He is also a director of Toys "R" Us, Inc., The Progressive Corporation, Henry Schein, Inc., Eye Care Centers of America, Inc. and Sunoco, Inc.
HANNE M. MERRIMAN was elected a director of the Company and Finlay Jewelry in December 1997. Ms. Merriman is the Principal in Hanne Merriman Associates, a retail business consulting firm. She is also a director of Ameren Corp., State Farm Mutual Automobile Insurance Company, The Rouse Company, Ann Taylor Stores Corporation and T. Rowe Price Mutual Funds. She is a member of the National Women's Forum.
THOMAS M. MURNANE has served as a director since December 2002. Mr. Murnane is a recently retired partner of PricewaterhouseCoopers, LLP, who served in various capacities during his tenure with that firm since 1980, including Director of the firm's Retail Strategy Consulting Practice, Director of Overall Strategy Consulting for the East Region of the United States, and most recently Global Director of Marketing and Brand Management for PwC Consulting. Mr. Murnane is also a director of The Pantry, Inc. and Pacific Sunwear of California, Inc.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information to be included in the section captioned "Executive Compensation" in the Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth certain information with respect to beneficial ownership of the Common Stock as of April 29, 2003 by (i) each person who, to the knowledge of the Company, was the beneficial owner of more than 5% of the outstanding Common Stock of the Company, (ii) each of the Company's directors, the Company's Chief Executive Officer and each of the four other most highly compensated executive officers of the Company or Finlay Jewelry, and by all current directors and executive officers as a group.
- -------------- *Less than one percent.
(1) Based on 9,204,408 shares outstanding on April 29, 2003. A person is deemed to be the beneficial owner of securities that can be acquired by such person within 60 days from April 29, 2003 upon the exercise of options. Each beneficial owner's percentage ownership is determined by assuming that options that are held by such person and which are exercisable within 60 days of April 29, 2003 have been exercised. Except as noted below, each beneficial owner has sole voting power and sole investment power, subject (in the case of the Company's directors and executive officers) to the terms of the Stockholders' Agreement. The address for the beneficial owners named in the table, unless specified otherwise in a subsequent footnote, is c/o the Company, 529 Fifth Avenue, New York, New York 10017.
(2) These shares represent shares reported as beneficially owned by FMR Corp. in a joint filing on Amendment No. 3 dated June 11, 2001 to a Schedule 13G dated February 1, 1999, as amended, filed with the Commission by FMR Corp., Edward C. Johnson 3d, Abigail P. Johnson, Fidelity Management & Research Company ("Fidelity") and Fidelity Low Priced Stock Fund (the "Fund"). According to said Schedule 13G Amendment, members of the Edward C. Johnson 3d family are the predominant owners of Class B shares of common stock of FMR Corp., representing approximately 49% of the voting power of FMR Corp. Mr. Johnson 3d owns 12.0% and Abigail Johnson owns 24.5% of the aggregate outstanding voting stock of FMR Corp. Mr. Johnson 3d is Chairman of FMR Corp. and Abigail P. Johnson is a Director of FMR Corp. The Johnson family group and all other Class B shareholders have entered into a shareholders' voting agreement under which all Class B shares will be voted in accordance with the majority vote of Class B shares. Accordingly, through their ownership of voting common stock and the execution of the shareholders' voting agreement, members of the Johnson family may be deemed, under the Investment Company Act of 1940, to form a controlling group with respect to FMR Corp. The Schedule 13G Amendment further states that Fidelity, a wholly-owned subsidiary of FMR Corp. and a registered investment adviser, is the beneficial owner of the 1,042,700 shares which are the
subject of the Schedule 13G Amendment as a result of its acting as investment adviser to the Fund, an investment company which owns all of such 1,042,700 shares. Edward C. Johnson 3d, FMR Corp., through its control of Fidelity, and the Fund each has sole power to dispose of the 1,042,700 shares owned by the Fund. Neither FMR Corp. nor Edward C. Johnson 3d, Chairman of FMR Corp., has the sole power to vote or direct the voting of the shares owned directly by the Fund, which power resides with the Fund's Board of Trustees. Fidelity carries out the voting of the shares under written guidelines established by the Fund's Board of Trustees. The address for FMR Corp., Fidelity and the Fund is 82 Devonshire Street, Boston, Massachusetts 02109.
(3) According to Amendment No. 6 dated January 15, 2003 to a Schedule 13G dated February 4, 1999, as amended, filed with the Commission by Mellon Financial Corporation ("Mellon Financial"), (i) Mellon Financial has sole power to vote 596,448 shares and sole power to dispose of 883,657 shares, and shares power to vote 97,800 shares and shares power to dispose of none of such shares, (ii) Boston Safe Deposit and Trust Company has sole power to vote 452,700 shares and sole power to dispose of 739,109 shares, and shares power to vote 97,800 shares and shares power to dispose of none of such shares, and (iii) The Boston Company, Inc. Asset Management, LLC has sole power to vote 422,100 shares and sole power to dispose of 540,200 shares, and shares power to vote 97,800 shares and shares power to dispose of none of such shares. All of the shares reported in the Schedule 13G Amendment are beneficially owned by Mellon Financial Corporation and direct or indirect subsidiaries in their various fiduciary capacities. The address for Mellon Financial Corporation is One Mellon Center, Pittsburgh, Pennsylvania 15258.
(4) These shares represent shares reported as beneficially owned by Palisade Capital Management, LLC, an investment adviser ("Palisade"), and Palisade Concentrated Equity Partnership ("PCEP"), in a Schedule 13D filed with the Commission on April 7, 2003. According to said Schedule 13D, each of Palisade and PCEP has sole power to vote, and sole power to dispose of, all of such shares, and each of Palisade and PCEP shares power to vote, and power to dispose of, none of such shares. PCEP is an investment fund which is managed by Palisade. The address for Palisade and PCEP is One Bridge Plaza, Fort Lee, New Jersey 07024.
(5) Includes options to acquire 66,667 shares of Common Stock having an exercise price of $14.00 per share.
(6) Includes options to acquire 414,632 shares of Common Stock having exercise prices ranging from $7.05 to $14.00 per share. Also includes 100,000 shares of restricted stock.
(7) According to a Schedule 13G, dated February 6, 2003, filed with the Commission by Investment Counselors of Maryland, LLC ("Investment Counselors"), Investment Counselors has sole power to vote 389,925 shares and sole power to dispose of all the indicated shares, and shares power to vote 177,100 shares and shares power to dispose of none of such shares. All of the indicated shares are owned by various investment advisory clients of Investment Counselors, which is deemed to be a beneficial owner of the shares due to its discretionary power to make investment decisions over such shares for its clients and its ability to vote such shares. In all cases, persons other than Investment Counselors have the right to receive, or the power to direct the receipt of, dividends from, or the proceeds from the sale of the shares. According to the Schedule 13G, no individual client of Investment Counselors holds more than five percent of the class. The address for Investment Counselors of Maryland, LLC is 803 Cathedral Street, Baltimore, Maryland 21201-5297.
(8) According to Amendment No. 4 dated February 12, 2003 to a Schedule 13G dated February 10, 1999, as amended, filed with the Commission by Neuberger Berman, LLC and Neuberger Berman, Inc. (collectively, "Neuberger Berman"), Neuberger Berman, LLC is deemed to be a beneficial owner of the indicated number of shares since it has shared power to make decisions whether to retain or dispose of, and in some cases the sole power to vote, such shares, which are held by many unrelated clients. Neuberger Berman, LLC does not, however, have any economic interest in the securities of those clients. The clients are the actual owners of the securities and have the sole right to receive and the power to direct the receipt of dividends from or proceeds from the sale of such securities. Neuberger Berman has sole power to vote or direct the voting of 401,200 shares, shared power to vote or direct the voting of none of such
shares, sole power to dispose of or direct the disposition of none of such shares, and shared power to dispose of or direct the disposition of 498,200 shares. Employee(s) of Neuberger Berman, LLC and Neuberger Berman Management, Inc. own 235,000 shares in their own personal securities accounts. Neuberger Berman, LLC disclaims beneficial ownership of these shares since these shares were purchased with each employee(s)' personal funds and each employee has exclusive dispositive and voting power over the shares held in their respective accounts. According to the Schedule 13G Amendment, Neuberger Berman, Inc. owns 100% of both Neuberger Berman, LLC and Neuberger Berman Management, Inc. and does not own over 1% of the Company's shares. The address of Neuberger Berman, LLC and Neuberger Berman, Inc. is 605 Third Avenue, New York, New York 10158-3698.
(9) Includes options to acquire an aggregate of 138,000 shares of Common Stock having exercise prices ranging from $7.05 to $23.1875 per share.
(10) Includes options to acquire an aggregate of 112,000 shares of Common Stock having exercise prices ranging from $8.50 to $16.50 per share. Mr. Matthews' address is 650 Madison Avenue, New York, New York 10022.
(11) Includes options to acquire an aggregate of 101,000 shares of Common Stock having exercise prices ranging from $7.05 to $24.3125 per share.
(12) Includes options to acquire an aggregate of 52,000 shares of Common Stock having exercise prices ranging from $7.05 to $13.4219 per share.
(13) Includes options to acquire an aggregate of 20,000 shares of Common Stock having exercise prices ranging from $9.85 to $13.4375 per share. The address of Mr. Goldstein is c/o Toys "R" Us, Inc., 461 From Road, Paramus, New Jersey 07652.
(14) Includes options to acquire an aggregate of 23,333 shares of Common Stock having exercise prices ranging from $7.05 to $13.5625 per share.
(15) Includes options to acquire an aggregate of 25,000 shares of Common Stock having exercise prices ranging from $8.50 to $21.3125 per share. Ms. Merriman's address is c/o Hanne Merriman Associates, 3201 New Mexico Avenue, N.W., Washington, DC 20016.
(16) Includes options to acquire an aggregate of 15,000 shares of Common Stock having exercise prices ranging from $9.85 to $14.5938 per share.
(17) In April 2002, as part of the Company's stock repurchase program, the Company repurchased 526,562 shares of Common Stock for $5,792,000 from Equity-Linked Investors-II, a partnership the managing partner of the general partner of which is Rohit M. Desai, a director of Finlay. The address of Mr. Desai and ELI-II is c/o Desai Capital Management Incorporated, 410 Park Avenue, New York, New York 10022. Includes options to acquire an aggregate of 5,000 shares of Common Stock having an exercise price of $15.877 per share.
(18) Includes options to acquire an aggregate of 972,632 shares of Common Stock having exercise prices ranging from $7.05 to $24.3125 per share.
Options to purchase Common Stock have been granted to employees and non-employee directors under various stock-based compensation plans. See Note 5 of Notes to Consolidated Financial Statements. The following table summarizes the number of stock options issued, the weighted-average exercise price and the number of securities remaining to be issued under all outstanding equity compensation plans as of February 1, 2003.
- ------------------ (1) Grants are permitted under the plans in the form of (i) stock options; (ii) stock appreciation rights in tandem with stock options; (iii) limited stock appreciation rights in tandem with stock options; (iv) restricted or nonrestricted stock awards subject to such terms and conditions as the Compensation Committee shall determine; (v) performance units which are based upon attainment of performance goals during a period of not less than two nor more than five years and which may be settled in cash or in Common Stock in the discretion of the Company's Compensation Committee; or (vi) any combination of the foregoing.
On April 16, 2003, the Board of Directors adopted the Executive Deferred Compensation and Stock Purchase Plan and the Director Deferred Compensation and Stock Purchase Plan, subject in each case to the approval of the Company's stockholders at the 2003 annual meeting (the "New Plans"). Under the New Plans, key executives of Finlay and the Company's non-employee directors as directed by the Company's Compensation Committee, will be eligible to acquire restricted stock units ("RSUs"). An RSU is a unit of measurement equivalent to one share of common stock, but with none of the attendant rights of a stockholder of a share of common stock. Two types of RSUs will be awarded under the New Plans: (i) participant RSUs, where a plan participant may elect to defer, in the case of an executive employee, a portion of his or her actual or target bonus, and in the case of a non-employee director, his or her retainer fees and Committee chairmanship fees, and receive RSUs in lieu thereof and (ii) matching RSUs, where the Company will credit a participant's plan account with one matching RSU for each participant RSU that a participant elects to purchase. While participant RSUs are fully vested at all times, matching RSUs will be subject to vesting and forfeiture as set forth in the New Plans. At the time of distribution under the New Plans, RSUs will be converted into actual shares of Common Stock of the Company. Purchases and awards of RSUs under the New Plans will not further dilute any stockholder's ownership percentage beyond the dilution already permitted under the existing long term incentive plans because the shares of Common Stock to be issued or used under the New Plans will be funded solely from shares of Common Stock already available for issuance under the existing long term incentive plans.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information to be included in the section captioned "Certain Relationships and Related Transactions" in the Proxy Statement is incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within the 90-day period prior to the filing of this report, an evaluation was carried out under the supervision and with the participation of the Company's management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), of the effectiveness of the Company's disclosure controls and procedures. Based on that evaluation, the CEO and CFO have concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Commission rules and forms. Subsequent to the date of their evaluation, there were no significant changes in the Company's internal controls, or in other factors that could significantly affect the internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
(1) Financial Statements.
See Financial Statements Index included in Item 8 of Part II of this Form 10-K.
(2) Financial Statement Schedules. None.
(3) Exhibits.
(Exhibit Number referenced to Item 601 of Regulation S-K).
(b) Reports on Form 8-K
On April 1, 2003, the Company filed a Current Report on Form 8-K under Item 5 to announce that on March 26, 2003, Thomas H. Lee and Warren C. Smith, Jr. resigned from the Company's Board of Directors and on March 27, 2003, Mr. Lee and Mr. Smith, along with Thomas H. Lee Equity Partners, L.P. and other affiliates, sold their Common Stock in the Company to a private investor.
On April 18, 2003, the Company filed a Current Report on Form 8-K under Item 12 to announce that the Company had adopted new accounting guidance for vendor allowances (EITF 02-16) retroactive to the beginning of fiscal 2002 and had changed its method of accounting for such allowances going forward. As a result, the Company has adjusted its reported earnings for the 2002 fiscal year to include a one-time, non-cash, after-tax charge of $17.2 million, which is classified as a "cumulative effect of a change in accounting principle."
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
Finlay Enterprises, Inc.
Date: May 1, 2003 By: /s/ ARTHUR E. REINER -------------------- Arthur E. Reiner Chairman of the Board
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED:
CERTIFICATIONS
I, Arthur E. Reiner, certify that:
1. I have reviewed this annual report on Form 10-K of Finlay Enterprises, Inc.:
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: May 1, 2003 /s/ Arthur E. Reiner -------------------- Arthur E. Reiner Chairman, President and Chief Executive Officer
I, Bruce E. Zurlnick, certify that:
1. I have reviewed this annual report on Form 10-K of Finlay Enterprises, Inc.:
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: May 1, 2003 /s/ Bruce E. Zurlnick --------------------- Bruce E. Zurlnick Senior Vice President, Treasurer and Chief Financial Officer
FINLAY ENTERPRISES, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Stockholders and Board of Directors of Finlay Enterprises, Inc.:
We have audited the accompanying consolidated balance sheet of Finlay Enterprises, Inc. (a Delaware corporation) and subsidiaries as of February 1, 2003, and the related consolidated statements of operations, changes in stockholders' equity and comprehensive income and cash flows for the fiscal year then ended. 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 audit. The Company's financial statements for the fiscal years ended February 2, 2002 and February 3, 2001, before the inclusion of the transitional disclosures discussed in Note 5 with respect to Statement of Financial Acccounting Standards ("SFAS") No. 148, Accounting for Stock Based Compensation - Transition and Disclosure and in Note 2 with respect to SFAS No. 142, Goodwill and Other Intangible Assets, were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated March 20, 2002.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Finlay Enterprises, Inc. and subsidiaries as of February 1, 2003, and the results of their operations and their cash flows for the fiscal year then ended in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002 to conform to SFAS No. 142.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for vendor allowances in 2002 to conform to Emerging Issues Task Force Issue No. 02-16.
As discussed above, the Company's fiscal 2001 and 2000 consolidated financial statements were audited by other auditors who have ceased operations. These financial statements have been revised to include the transitional disclosures required by SFAS No. 148 and SFAS No. 142. Our audit procedures with respect to the transitional disclosures included in Notes 5 and 2 with respect to 2001 and 2000 included (1) comparing the amount of stock-based compensation expense to the Company's underlying analysis obtained from management, (2) comparing the previously reported net income to the previously issued financial statements and the adjustments to reported net income representing stock based compensation and amortization expense related to goodwill, (including any related tax effects) recognized in those periods, to the Company's underlying analysis obtained from management, and (3) testing the mathematical accuracy of the reconciliation of adjusted or pro forma net income, as applicable, to reported net income and the related net income per share amounts. In our opinion, the disclosures for 2001 and 2000 in Notes 5 and 2 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the 2001 and 2000 consolidated financial statements of the Company other than with respect to such disclosures and reclassifications and, accordingly, we do not express an opinion or any other form of assurance on the 2001 and 2000 consolidated financial statements taken as a whole.
DELOITTE & TOUCHE LLP New York, New York April 14, 2003
The following report is a copy of a previously issued Report of Independent Public Accountants. This report relates to prior years' financial statements. This report has not been reissued by Arthur Andersen LLP. Arthur Andersen reported on the 2001 and 2000 consolidated financial statements prior to the transitional disclosures discussed in Notes 2 and 5.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of Finlay Enterprises, Inc.:
We have audited the accompanying consolidated balance sheets of Finlay Enterprises, Inc. (a Delaware corporation) and subsidiaries as of February 3, 2001 and February 2, 2002, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002. 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 Finlay Enterprises, Inc. and subsidiaries as of February 3, 2001 and February 2, 2002, and the results of their operations and their cash flows for the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002, in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP New York, New York March 20, 2002
FINLAY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
FINLAY ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
FINLAY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
FINLAY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--ORGANIZATION OF THE COMPANY AND SIGNIFICANT TRANSACTIONS
Finlay Enterprises, Inc. (the "Company"), a Delaware corporation, conducts business through its wholly owned subsidiary, Finlay Fine Jewelry Corporation and its wholly owned subsidiaries ("Finlay Jewelry"). References to "Finlay" mean collectively, the Company and Finlay Jewelry. Finlay is a retailer of fine jewelry products and operates leased fine jewelry departments in department stores throughout the United States. All references herein to leased departments refer to departments operated pursuant to license agreements or other arrangements with host department stores.
On January 22, 2003, Finlay Jewelry's revolving credit agreement with General Electric Capital Corporation ("G.E. Capital") and certain other lenders was amended and restated (the "Revolving Credit Agreement"). The Revolving Credit Agreement, which matures in January 2008, provides Finlay Jewelry with a senior secured revolving line of credit up to $225.0 million (the "Revolving Credit Facility").
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION: The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Finlay Jewelry. Intercompany accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES: The preparation of 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 may differ from those estimates.
FISCAL YEAR: The Company's fiscal year ends on the Saturday closest to January 31. References to 2003, 2002, 2001 and 2000 relate to the fiscal years ended on January 31, 2004, February 1, 2003, February 2, 2002 and February 3, 2001. Each of the fiscal years includes 52 weeks except 2000, which includes 53 weeks.
MERCHANDISE INVENTORIES: Consolidated inventories are stated at the lower of cost or market determined by the last-in, first-out ("LIFO") method. Inventory is reduced for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.
The cost to Finlay of gold merchandise sold on consignment, which typically varies with the price of gold, is not fixed until the merchandise is sold. Finlay, at times, enters into futures contracts, such as forwards, based upon the anticipated sales of gold product in order to hedge against the risk of gold price fluctuations. Such contracts typically have durations ranging from one to nine months. Changes in the market value of futures contracts are accounted for as an addition to, or reduction from, the inventory cost. For the years ended February 1, 2003, February 2, 2002 and February 3, 2001, the gain/loss on open futures contracts was not material. At both February 1, 2003 and February 2, 2002, the Company had several open positions in futures contracts for gold totaling 4,000 fine troy ounces and 17,500 fine troy ounces, respectively, valued at $1.4 million and $4.8 million, respectively. The fair value of gold under such contracts was $1.5 million and $4.9 million at February 1, 2003 and February 2, 2002, respectively.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
HEDGING: Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Under SFAS No. 133, all derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. SFAS No. 133 defines requirements for designation and documentation of hedging relationships, as well as ongoing effectiveness assessments, which must be met in order to qualify for hedge accounting. For a derivative that does not qualify as a hedge, changes in fair value would be recorded in earnings immediately. The Company has designated its existing derivative instruments, consisting of gold forward contracts, as cash flow hedges. For derivative instruments designated as cash flow hedges, the effective portion of the change in the fair value of the derivative is recorded in accumulated other comprehensive income, a separate component of stockholders' equity, and is reclassified into cost of sales when the offsetting effects of the hedged transaction affects earnings. Changes in the fair value of the derivative attributable to hedge ineffectiveness are recorded in earnings immediately. The Company adopted SFAS No. 133 on February 4, 2001 and recorded $24,000 as a cumulative transition adjustment (increasing other comprehensive income). At February 1, 2003, the fair value of the gold forward contracts resulted in the recognition of an asset of $93,600. The amount recorded in accumulated other comprehensive income of $55,000, net of tax, is expected to be reclassified into earnings during 2003.
The Company has documented all relationships between hedging instruments and hedged items, as well as its risk management objectives and strategy for undertaking various hedge transactions. The Company also assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items. The Company believes that the designated hedges will be highly effective and that the related hedge accounting will not have a material impact on the Company's results of operations.
DEPRECIATION AND AMORTIZATION: Depreciation and amortization are computed by the straight-line method over the estimated useful lives of the fixed assets ranging from three to thirty-nine years.
SOFTWARE DEVELOPMENT COSTS: Software development costs have been accounted for in accordance with Statement of Position (the "SOP") No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". The SOP states that software development costs that are incurred in the preliminary project stage are expensed as incurred. Once the specified criteria of the SOP have been met, internal and external direct costs incurred in developing or obtaining computer software as well as related interest costs are capitalized. Training and data conversion costs are expensed as incurred. In addition, costs incurred for the routine operation and maintenance of management information systems and software are expensed as incurred. Amortization is computed by the straight-line method over the estimated useful lives of the software ranging from three to seven years.
Included in Deferred charges and other assets in the accompanying Consolidated Balance Sheets at February 1, 2003 and February 2, 2002, are gross capitalized software costs of $27,526,000 and $24,254,000, respectively, and accumulated amortization of $10,300,000 and $6,564,000, respectively.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
GOODWILL: On February 3, 2002, the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". This Statement requires that goodwill no longer be amortized over its estimated useful life but tested for impairment on an annual basis. During the first quarter of 2002, a transitional goodwill impairment test was performed and the Company determined that there was no impairment of goodwill. Further, as required by SFAS No. 142, an annual impairment test was completed at the end of fiscal 2002 and the Company determined that there was no impairment. The following is a reconciliation of reported Net income and Net income per share adjusted to reflect the impact of the discontinuance of goodwill amortization for 2001 and 2000. The Company's actual 2002 Net income and Net income per share are shown for comparative purposes.
NET INCOME PER SHARE: Net income per share has been computed in accordance with SFAS No. 128, "Earnings per Share". Basic and diluted net income per share were calculated using the weighted average number of shares outstanding during each period, with options to purchase common stock, par value $0.01 per share ("Common Stock"), included in diluted net income per share, using the treasury stock method, to the extent that such options were dilutive. Due to the antidilutive impact on net income per share, 474,634, 1,159,569 and 884,400 options were not included in the weighted average shares outstanding for 2002, 2001 and 2000, respectively. The following is an analysis of the differences between basic and diluted net income per share:
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
DEBT ISSUANCE COSTS: Debt issuance costs are amortized over the term of the related debt agreements using the straight line method, which approximates that of the effective interest method. Net deferred debt issuance costs totaled $4,532,000 at February 1, 2003 and $4,072,000 at February 2, 2002. The debt issuance costs are reflected as a component of Deferred charges and other assets, net, in the accompanying Consolidated Balance Sheets. Amortization of debt issuance costs for 2002, 2001 and 2000 totaled $1,229,000, $1,231,000 and $1,221,000, respectively, and have been recorded as a component of Interest expense, net, in the accompanying Consolidated Statements of Operations.
REVENUE RECOGNITION: The Company recognizes revenue upon the sale of merchandise, either owned or consigned, to its customers, net of anticipated returns. The provision for sales returns is based on the Company's historical return rate.
COST OF SALES: Cost of sales includes the cost of merchandise sold, repair expense, shipping, shrinkage and inventory losses. Buying and occupancy costs such as lease fees are not included in Cost of sales and are reflected in Selling, general and administrative expenses ("SG&A") in the accompanying Consolidated Statements of Operations.
ADVERTISING COSTS: All costs associated with advertising are expensed in the month that the advertising takes place. For 2002, 2001 and 2000, gross advertising expenses were $48,975,000, $53,029,000 and $59,434,000, respectively, and are included in SG&A in the accompanying Consolidated Statements of Operations.
VENDOR ALLOWANCES: The Company receives allowances from its vendors through a variety of programs and arrangements, including cooperative advertising. The allowances are generally intended to offset the Company's costs of promoting, advertising and selling the vendors' products in its departments. Vendor allowances are recognized as a reduction of cost of sales or SG&A when the purpose for which the vendor funds were intended to be used has been fulfilled. Accordingly, a reduction or increase in vendor allowances has an inverse impact on cost of sales and/or SG&A.
In March 2003, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") finalized Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor" ("EITF 02-16"). EITF 02-16 addresses the accounting treatment for vendor allowances and provides that cash consideration received from a vendor should be presumed to be a reduction of the prices of the vendors' product and should therefore be shown as a reduction in the purchase price of the merchandise. Further, these allowances should be recognized as a reduction in cost of sales when the related product is sold. To the extent that the cash consideration represents a reimbursement of a specific, incremental and identifiable cost, then those vendor allowances should be used to offset such costs.
In accordance with EITF 02-16, the Company recorded a cumulative effect of accounting change as of February 3, 2002, the date of adoption, that decreased net income for 2002 by $17.2 million, net of tax, or $1.78 per share, on a diluted basis. As of February 3, 2002, deferred vendor allowances totaled (i) $17,129,000 for owned merchandise, and (ii) $12,306,000 for merchandise received on consignment. As of February 1, 2003, the Company's fiscal year end, deferred vendor allowances totaled (i) $18,452,000 for owned merchandise, which is included as an offset to Merchandise inventories on the 2002 Consolidated Balance Sheet, and (ii) $10,493,000 for merchandise received on consignment, which is included as Deferred income on the 2002 Consolidated Balance Sheet. In 2002, this change resulted in the reclassification of vendor
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
allowances of $20.0 million, which had previously been accounted for as a reduction to SG&A, to now reduce cost of sales and consequently, increase gross margin. The Company's 2002 unaudited quarterly financial data has been revised to reflect this change in accounting method (refer to Note 10). The adoption of EITF 02-16 is not expected to have a material impact on the financial position or results of operations of the Company in 2003.
During 2001 and 2000, the Company recorded its vendor allowances as an offset to gross advertising expenses, which is included in SG&A on the Consolidated Statements of Operations. For 2001 and 2000, the unaudited pro forma impact of the adoption of EITF 02-16, as if it had occurred prior to 2000, was to decrease cost of sales and increase SG&A by $20,374,000 and $23,665,000, respectively. For both years, Net income and Net income per share would not have been materially different (unaudited).
CASH EQUIVALENTS: The Company considers cash on hand, deposits in banks and deposits in money market funds as cash and cash equivalents.
FAIR VALUE OF FINANCIAL INSTRUMENTS: Cash, accounts receivable, short-term borrowings, accounts payable and accrued liabilities are reflected in the consolidated financial statements at fair value due to the short-term maturity of these instruments. Marketable securities are recorded in the consolidated financial statements at current market value, which approximates cost. The fair value of the Company's debt and off-balance sheet financial instruments are disclosed in Note 4 and in Merchandise inventories above.
STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" which became effective in 2002. This Statement amends SFAS No. 123 "Accounting for Stock-Based Compensation", to provide alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock-based compensation. The Company has elected to continue to recognize stock-based compensation using the intrinsic value method and has incorporated the additional disclosure requirements of SFAS No. 148. Pro forma net income as well as basic and diluted earnings per share are disclosed in Note 5. Deferred stock-based compensation is amortized using the straight-line method over the vesting period.
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS: SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which became effective for the Company in 2002, addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This Statement extends the reporting requirements to include reporting separately as discontinued operations, components of an entity that have either been disposed of or classified as held-for-sale. The adoption of SFAS No. 144 did not have a material impact on the financial position or results of operations of the Company.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES: In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS No. 146 requires that liabilities for costs associated with exit or disposal activities be recognized when the liabilities are incurred. This Statement also establishes fair value as the objective for initial measurement of the liabilities. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the financial position or results of operations of the Company.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ACCOUNTING STANDARD TO BE ADOPTED IN 2003: In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statement No. 4, 44, and 64, Amendment of FASB No. 13, and Technical Corrections", which amends certain existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Additionally, the Statement provides that gains and losses from debt extinguishment are not automatically shown as an extraordinary item on a company's statement of operations. The provisions of SFAS No. 145 are effective for fiscal years beginning after May 15, 2002. The adoption of SFAS No. 145 is not expected to have a material impact on the financial position or results of operations of the Company.
SEASONALITY: A significant portion of Finlay's revenues are generated in the fourth quarter due to the seasonality of the retail industry. As such, results for interim periods are not indicative of annual results. Refer to Note 10 for unaudited quarterly financial data.
NOTE 3--MERCHANDISE INVENTORIES
Merchandise inventories consisted of the following:
In accordance with EITF 02-16, Merchandise inventories has been reduced by $18.5 million as of February 1, 2003 to reflect the vendor allowances as a reduction in the cost of the merchandise. The LIFO method had the effect of decreasing income before income taxes in 2002, 2001 and 2000 by $2,342,000 (excluding a cumulative LIFO benefit of $512,000 relating to the adoption of EITF 02-16), $3,783,000 and $1,801,000, respectively. Finlay determines its LIFO inventory value by utilizing selected producer price indices published for jewelry and watches by the Bureau of Labor Statistics.
Approximately $359,676,000 and $359,729,000 at February 1, 2003 and February 2, 2002, respectively, of merchandise received on consignment is not included in Merchandise inventories and Accounts payable-trade in the accompanying Consolidated Balance Sheets.
Finlay Jewelry is party to an amended and restated gold consignment agreement (as amended, the "Gold Consignment Agreement"), which enables Finlay Jewelry to receive consignment merchandise by providing gold, or otherwise making payment, to certain vendors. While the merchandise involved remains consigned, title to the gold content of the merchandise transfers from the vendors to the gold consignor.
Effective September 30, 2002, Finlay Jewelry amended the Gold Consignment Agreement to extend the term to July 31, 2005, and to permit Finlay Jewelry to obtain up to the lesser of (i) 165,000 fine troy ounces or (ii) $50.0 million worth of gold, subject to a formula as prescribed by the Gold Consignment Agreement. At February 1, 2003 and February 2, 2002, amounts outstanding under the Gold Consignment Agreement totaled 134,785 and 127,519 fine troy ounces, respectively, valued at approximately $49.5
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3--MERCHANDISE INVENTORIES (CONTINUED)
million and $36.0 million, respectively. In the event this agreement is terminated, Finlay Jewelry will be required to return or repurchase the outstanding gold at the prevailing gold rate in effect on that date. For financial statement purposes, the consigned gold is not included in Merchandise inventories on the Company's Consolidated Balance Sheets and, therefore, no related liability has been recorded.
Under the Gold Consignment Agreement, Finlay Jewelry is required to pay a daily consignment fee on the dollar equivalent of the fine gold value of the ounces of gold consigned thereunder. The daily consignment fee is based on a floating rate which, as of February 1, 2003 and February 2, 2002, was approximately 2.8% and 3.0%, respectively, per annum. In addition, Finlay is required to pay a fee of 0.5% if the amount of gold consigned has a value equal to or less than $12.0 million. Included in interest expense for the years ended February 1, 2003, February 2, 2002 and February 3, 2001 are consignment fees of $1,153,000, $1,228,000 and $979,000, respectively.
In conjunction with the Gold Consignment Agreement, Finlay Jewelry granted the gold consignor a first priority perfected lien on, and a security interest in, specified gold jewelry of participating vendors approved under the Gold Consignment Agreement and a lien on proceeds and products of such jewelry subject to the terms of an intercreditor agreement between the gold consignor and G.E. Capital.
The Gold Consignment Agreement requires Finlay Jewelry to comply with certain covenants, including restrictions on the incurrence of certain indebtedness, the creation of liens, engaging in transactions with affiliates and limitations on the payment of dividends. In addition, the Gold Consignment Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations. Finlay Jewelry was in compliance with all of its covenants as of and for the year ended February 1, 2003.
NOTE 4--SHORT AND LONG-TERM DEBT
The Company and Finlay Jewelry are parties to the Revolving Credit Agreement with G.E. Capital and the other lenders thereto which provides Finlay Jewelry with a Revolving Credit Facility of up to $225.0 million. The Revolving Credit Facility matures in January 2008, and allows borrowings based on an advance rate of (i) up to 85% of eligible accounts receivable and (ii) up to 60% of eligible owned inventory after taking into account such reserves or offsets as G.E. Capital may deem appropriate (the "Borrowing Base"). Eligibility criteria are established by G.E. Capital, which retains the right to adjust the Borrowing Base in its reasonable judgement by revising standards of eligibility, establishing reserves and/or increasing or decreasing from time to time the advance rates (except that any increase in the borrowing base rate percentage shall require the consent of other lenders). Finlay Jewelry is permitted to use up to $30 million of the Revolving Credit Facility for the issuance of letters of credit issued for the account of Finlay Jewelry. The outstanding revolving credit balance and letter of credit balance under the Revolving Credit Agreement are required to be reduced each year to $50 million or less and $20 million or less, respectively, for a 30 consecutive day period (the "Balance Reduction Requirement"). Funds available under the Revolving Credit Agreement are utilized to finance working capital needs.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT (CONTINUED)
Amounts outstanding under the Revolving Credit Agreement bear interest at a rate equal to, at Finlay's option, (i) the Index Rate (as defined) plus a margin ranging from zero to 1.0% or (ii) adjusted Eurodollar rate plus a margin ranging from 1.0% to 2.0%, in each case depending on the financial performance of the Company. "Index Rate" is defined as the higher of (i) the prime rate and (ii) the Federal Funds Rate plus 50 basis points per annum. A letter of credit fee which could range from 1.0% to 2.0%, per annum, depending on the financial performance of the Company, of the face amount of letters of credit guaranteed under the Revolving Credit Agreement is payable monthly in arrears. An unused facility fee on the average unused daily balance of the Revolving Credit Facility is payable monthly in arrears equal to 0.375% per annum. Upon the occurrence (and during the continuance) of an event of default under the Revolving Credit Agreement, interest would accrue at a rate which is 2% in excess of the rate otherwise applicable, and would be payable upon demand.
The Revolving Credit Agreement is secured by a first priority perfected security interest in all of Finlay Jewelry's (and any subsidiary's) present and future tangible and intangible assets. The Revolving Credit Agreement contains customary covenants, including limitations on or relating to capital expenditures, liens, indebtedness, investments, mergers, acquisitions, affiliate transactions, management compensation and the payment of dividends and other restricted payments. The Revolving Credit Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations. Finlay was in compliance with all of its covenants as of and for the year ended February 1, 2003.
There were no amounts outstanding at February 1, 2003 or February 2, 2002 under the Revolving Credit Agreement. The maximum amounts outstanding under the Revolving Credit Agreement during 2002, 2001 and 2000 were $111,356,000, $125,231,000 and $155,559,000, respectively. The average amounts outstanding for the same periods were $61,151,000, $80,753,000 and $96,612,000, respectively. The weighted average interest rates were 3.9%, 5.5% and 8.6% for 2002, 2001 and 2000, respectively.
At February 1, 2003 and February 2, 2002, Finlay had letters of credit outstanding totaling $7.3 million and $4.3 million, respectively, which guarantee various trade activities. The contract amounts of the letters of credit approximate their fair value.
Long-term debt consisted of the following:
FEBRUARY 1, FEBRUARY 2, 2003 2002 ------------- -------------- (IN THOUSANDS) Senior Notes (a)............... $ 150,000 $ 150,000 Senior Debentures (b).......... 75,000 75,000 ------------- -------------- $ 225,000 $ 225,000 ============= ==============
- --------------------- (a) On April 24, 1998, Finlay Jewelry issued 8 3/8% Senior Notes due May 1, 2008 (the "Senior Notes") with an aggregate principal amount of $150,000,000. Interest on the Senior Notes is payable semi-annually on May 1 and November 1 of each year, and commenced on November 1, 1998. Except in the case of certain equity offerings, the Senior Notes are not redeemable prior to May 1, 2003. Thereafter, the Senior Notes will be redeemable, in whole or in part, at the option of Finlay, at specified redemption prices plus accrued and unpaid interest, if any, to the date of the redemption. In the event of a Change of Control (as defined in the indenture relating to the Senior Notes (as amended, the "Senior Note Indenture")), each holder of the Senior Notes will have the right to
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT (CONTINUED)
require Finlay Jewelry to repurchase its Senior Notes at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest thereon to the repurchase date. The Senior Notes rank senior in right of payment to all subordinated indebtedness of Finlay Jewelry and pari passu in right of payment with all unsubordinated indebtedness of Finlay Jewelry. However, because the Revolving Credit Agreement is secured by a pledge of substantially all the assets of Finlay Jewelry, the Senior Notes are effectively subordinated to the borrowings under the Revolving Credit Agreement. The Senior Note Indenture contains restrictions relating to, among other things, the payment of dividends, the making of certain investments or other restricted payments, the incurrence of additional indebtedness, the creation of certain liens, entering into transactions with affiliates, the disposition of certain assets and engaging in mergers and consolidations.
The fair value of the Senior Notes at February 1, 2003, determined based on market quotes, was approximately $140,438,000.
(b) On April 24, 1998, the Company issued 9% Senior Debentures due May 1, 2008 (the "Senior Debentures") with an aggregate principal amount of $75,000,000. Interest on the Senior Debentures is payable semi-annually on May 1 and November 1 of each year, and commenced on November 1, 1998. Except in the case of certain equity offerings, the Senior Debentures are not redeemable prior to May 1, 2003. Thereafter, the Senior Debentures will be redeemable, in whole or in part, at the option of Finlay, at specified redemption prices plus accrued and unpaid interest, if any, to the date of the redemption. In the event of a Change of Control (as defined in the indenture relating to the Senior Debentures (as amended, the "Senior Debenture Indenture" and collectively, with the Senior Note Indenture, the "Senior Indentures")), each holder of the Senior Debentures will have the right to require the Company to repurchase its Senior Debentures at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest thereon to the repurchase date. The Senior Debentures rank pari passu in right of payment with all unsubordinated indebtedness of the Company and senior in right of payment to all subordinated indebtedness of the Company. The Senior Debentures are secured by a first priority lien on and security interest in all of the issued and outstanding stock of Finlay Jewelry. However, the operations of the Company are conducted through Finlay Jewelry and, therefore, the Company is dependent upon the cash flow of Finlay Jewelry to meet its obligations, including its obligations under the Senior Debentures. As a result, the Senior Debentures are effectively subordinated to all indebtedness and all other obligations of Finlay Jewelry. The Senior Debenture Indenture contains restrictions relating to, among other things, the payment of dividends, the making of certain investments or other restricted payments, the incurrence of additional indebtedness, the creation of certain liens, entering into transactions with affiliates, the disposition of certain assets and engaging in mergers and consolidations.
The fair value of the Senior Debentures, determined based on market quotes, was approximately $67,500,000 at February 1, 2003.
Finlay was in compliance with all of the provisions of the Senior Indentures as of and for the year ended February 1, 2003.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT (CONTINUED)
The aggregate amounts of long-term debt payable in each of the five years in the period ending February 1, 2008 and thereafter are as follows:
(IN THOUSANDS) --------------- 2003............................. $ - 2004............................. - 2005............................. - 2006............................. - 2007............................. - Thereafter....................... 225,000 --------------- $ 225,000 ===============
Interest expense for 2002, 2001 and 2000 was $24,968,000, $27,045,000 and $30,185,000, respectively. Interest income for the same periods was $92,000, $108,000 and $128,000, respectively.
NOTE 5--STOCKHOLDERS' EQUITY
The Company's Long Term Incentive Plan (the "1993 Plan") permits the Company to grant to key employees of the Company and its subsidiaries, consultants and certain other persons, and directors of the Company (other than members of the Compensation Committee of the Company's Board of Directors), the following: (i) stock options; (ii) stock appreciation rights in tandem with stock options; (iii) limited stock appreciation rights in tandem with stock options; (iv) restricted or nonrestricted stock awards subject to such terms and conditions as the Compensation Committee shall determine; (v) performance units which are based upon attainment of performance goals during a period of not less than two nor more than five years and which may be settled in cash or in Common Stock at the discretion of the Compensation Committee; or (vi) any combination of the foregoing. Under the 1993 Plan, the Company may grant stock options which are either incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), or non-incentive stock options. As of February 1, 2003, an aggregate of 732,596 shares of the Company's Common Stock has been reserved for issuance pursuant to the 1993 Plan, of which a total of 455,320 shares are subject to options granted to certain senior management, key employees and a director. The exercise prices of such options range from $7.23 per share to $16.50 per share.
On March 6, 1997, the Board of Directors of the Company adopted the 1997 Long Term Incentive Plan (the "1997 Plan"), which was approved by the Company's stockholders in June 1997. The 1997 Plan, which is similar to the 1993 Plan, is intended as a successor to the 1993 Plan and provides for the grant of the same types of awards as are currently available under the 1993 Plan. Of the 1,850,000 shares of the Company's Common Stock that have been reserved for issuance pursuant to the 1997 Plan, a total of 1,135,015 shares, as of February 1, 2003, are subject to options granted to certain senior management, key employees and directors. The exercise prices of such options range from $7.05 per share to $24.31 per share.
The Company has adopted the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". As permitted by SFAS No. 123, the Company elected to continue to account for stock-based compensation using the intrinsic value method. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had the fair value method of accounting been
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)
applied to the Company's stock option plans, which requires recognition of compensation cost ratably over the vesting period of the stock options, Net income and Net income per share would be as follows:
The fair value of options granted in 2002, 2001 and 2000 was estimated using the Black-Scholes option-pricing model based on the weighted average market price at the grant date of $12.01 in 2002, $7.48 in 2001 and $12.75 in 2000 and the following weighted average assumptions: risk free interest rate of 4.73%, 4.62% and 6.80% for 2002, 2001 and 2000, respectively, expected life of seven years for each of 2002, 2001 and 2000 and volatility of 56.56% for 2002, 51.13% for 2001 and 49.48% for 2000. The weighted average fair value of options granted in 2002, 2001 and 2000 was $4.33, $2.57 and $5.22, respectively.
The following summarizes the transactions pursuant to the Company's 1993 Plan and 1997 Plan for 2002, 2001 and 2000:
The options outstanding at February 1, 2003 have exercise prices between $7.05 and $24.31, with a weighted average exercise price of $11.46 and a weighted average remaining contractual life of 5.22 years. Options generally vest in five years and expire in ten years from their dates of grant.
On December 1, 2000, the Company announced that its Board of Directors had approved a stock repurchase program to acquire up to $20 million of outstanding Common Stock. The Company may, at the discretion of management, purchase its Common Stock, from time to time, through September 29, 2003.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5--STOCKHOLDERS' EQUITY (CONTINUED)
The extent and timing of repurchases will depend upon general business and market conditions, stock prices, availability under the Revolving Credit Facility, compliance with certain restrictive covenants and its cash position and requirements going forward. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. During 2002, the Company repurchased 733,612 shares for $8,426,000 including (i) the repurchase of 526,562 shares for $5,792,000 from a partnership, the managing partner of the general partner of which is also a director of Finlay and (ii) the repurchase of an aggregate 50,000 shares for $712,500 from a partnership and a trust affiliated with a former director of Finlay and certain other persons affiliated therewith. During 2001 and 2000, the Company repurchased a total of 599,330 shares for $5,367,000.
On February 4, 2001, an executive officer of the Company was issued 100,000 shares of Common Stock, subject to restrictions ("Restricted Stock"), pursuant to a restricted stock agreement. The Restricted Stock becomes fully vested after four years of continuous employment by the Company and is accounted for as a component of stockholders' equity. Compensation expense of approximately $1.2 million is being amortized over four years and totaled approximately $300,000 in each of 2002 and 2001.
NOTE 6--LEASE AGREEMENTS
Finlay conducts all of its operations as leased departments in department stores. All of these leases, as well as rentals for office space and equipment, are accounted for as operating leases. A substantial number of such operating leases expire on various dates through 2008.
Substantially all of the department store leases provide that the title to certain fixed assets of Finlay transfers upon termination of the leases, and that Finlay will receive the undepreciated value of such fixed assets from the host store in the event such transfers occur. The values of such fixed assets are recorded at the inception of the lease arrangement and are reflected in the accompanying Consolidated Balance Sheets.
In several cases, Finlay is subject to limitations under its lease agreements with host department stores which prohibit Finlay from operating departments for other store groups within a certain geographical radius of the host store
The store leases provide for the payment of fees based on sales, plus, in some instances, installment payments for fixed assets. Only minimum fees, as represented in the table below, are guaranteed by the lease agreements with host department stores. Lease expense, included in Selling, general and administrative expenses, is as follows (in thousands):
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6--LEASE AGREEMENTS (CONTINUED)
Future minimum payments under noncancellable operating leases having initial or remaining noncancellable lease terms in excess of one year are as follows as of February 1, 2003: (IN THOUSANDS) -------------- 2003..................................... $ 1,974 2004..................................... 1,995 2005..................................... 1,930 2006..................................... 1,917 2007..................................... 1,917 Thereafter............................... 1,278 -------------- Total minimum payments required..... $ 11,011 ==============
NOTE 7--PROFIT SHARING PLAN
Finlay maintains a defined contribution profit-sharing plan to provide retirement benefits for all personnel. This plan provides for company matching contributions of $0.25 for each $1.00 of employee contribution, up to 5% of the employee's salary, as limited by the Code, which begin to vest upon the completion of two years of employment and accrues at the rate of 20% per year. Additionally, Finlay contributes 2% of the employees' earnings annually, as limited by the Code, which begin to vest upon the completion of three years of employment and accrues at the rate of 20% per year. Company contributions totaled $2,011,000, $1,856,000 and $1,989,000 for 2002, 2001 and 2000, respectively.
NOTE 8--INCOME TAXES
For income tax reporting purposes, the Company has an October 31 year end. The Company files a consolidated Federal income tax return with its wholly owned subsidiary, Finlay Jewelry and its wholly owned subsidiaries.
Deferred income taxes at year end reflect the impact of temporary differences between amounts of assets and liabilities for financial and tax reporting purposes.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8--INCOME TAXES (CONTINUED)
Deferred tax assets and liabilities at year end are as follows:
The components of income tax expense, before the cumulative effect of accounting change, are as follows (in thousands):
A reconciliation of the income tax provision computed by applying the federal statutory rate to Income before income taxes to the Provision for income taxes on the accompanying Consolidated Statements of Operations is as follows (in thousands):
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8--INCOME TAXES (CONTINUED)
In 2002, the Company recorded an income tax benefit of $11,713,000 in connection with the cumulative effect of accounting change.
At October 31, 2002, the Company had a net operating loss ("NOL") carryforward for tax purposes of approximately $1,600,000 which expires in 2005. At October 31, 2002, the Company also had Alternative Minimum Tax Credit carryovers of $566,000 which may be used indefinitely to reduce federal income taxes. SFAS No. 109 "Accounting for Income Taxes," requires that the tax benefit of such NOLs and tax credits be recorded as an asset to the extent that management assesses the utilization to be "more likely than not". As the accompanying Consolidated Financial Statements include profits earned after the tax year end at October 31 (the profit of the year-end holiday season), for financial reporting purposes only, the NOL carryforward has been absorbed in full and no NOL carryfoward exists as of February 1, 2003. Management determined at February 1, 2003 that, based upon the Company's history of operating results and its expectations for the future, no additional valuation allowance is warranted.
NOTE 9--COMMITMENTS AND CONTINGENCIES
The Company, from time to time, is involved in litigation concerning its business affairs. Management believes that the resolution of all pending litigation will not have a material adverse effect on the consolidated financial statements.
The Company has an employment agreement with one senior executive which provides for a minimum salary level as well as incentive compensation based on meeting specific financial goals. Such agreement has a remaining term of two years and has a remaining aggregate minimum value of $1,975,000 as of February 1, 2003.
The Revolving Credit Agreement, the Gold Consignment Agreement and the Senior Note Indenture currently restrict annual distributions from Finlay Jewelry to the Company to 0.25% of Finlay Jewelry's net sales for the preceding fiscal year and also allow distributions to the Company to enable it to make interest payments on the Senior Debentures. Other dividends and distributions, including those required to fund stock or bond repurchases, are subject to Finlay's satisfaction of certain restrictive covenants.
The Company's concentration of credit risk consists principally of accounts receivable. Over the past three years, approximately 70% of Finlay's sales were from operations in the May Department Stores Company ("May") and departments operated in store groups owned by Federated Department Stores ("Federated"), of which approximately 47% and 23% represented Finlay's sales in May and Federated, respectively. The Company believes that the risk associated with these receivables, other than those from department store groups indicated above, would not have a material adverse effect on the Company's financial position or results of operations.
The Company has not provided any third-party financial guarantees as of February 1, 2003.
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10--QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table summarizes the quarterly financial data for 2002 and 2001 (dollars in thousands, except per share data). In accordance with SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements", the 2002 quarterly financial data has been revised to reflect the Company's retroactive adoption of EITF 02-16 to the beginning of 2002
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10--QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
(a) Net income (loss) per share for each quarter is computed as if each quarter were a discrete period. As such, the total of the four quarters net income (loss) per share does not necessarily equal the net income (loss) per share for the year.
(b) Net income and net income per share in the fourth quarter includes a credit for the Company's revision of its original estimate for closure expenses associated with the sale and closure of Sonab in the amount of $852,000, net of tax. Refer to Note 13.
NOTE 11--JAY B. RUDOLPH, INC. ACQUISITION
On April 3, 2000, Finlay completed the acquisition of certain assets of Jay B. Rudolph, Inc. ("J.B. Rudolph") for $20.6 million, consisting primarily of inventory of approximately $16.3 million and fixed assets of approximately $4.0 million. By acquiring J.B. Rudolph (the "J.B. Rudolph Acquisition"), Finlay added 57 departments and also added new host store relationships with Bloomingdale's and Dayton's and Hudson's (both now operating as Marshall Field's). Finlay financed the acquisition of J.B. Rudolph with borrowings under the Revolving Credit Agreement. The J.B. Rudolph Acquisition was accounted for as a purchase, and, accordingly, the operating results of the former J.B. Rudolph departments have been included in the Company's consolidated financial statements since the date of acquisition. The Company recorded goodwill of $1.7 million.
The following summarized, unaudited pro forma combined results of operations for the year ended February 3, 2001 has been prepared assuming the J.B. Rudolph Acquisition occurred at the beginning of 2000. The pro forma information is provided for informational purposes only. It is based on historical information, as well as certain assumptions and estimates, and does not necessarily reflect the actual results that would have occurred nor is it necessarily indicative of future results of operations of the combined company (dollars in thousands, except per share data):
(UNAUDITED) FISCAL YEAR ENDED FEBRUARY 3, 2001 ------------------- Sales............................................. $ 1,010,911 Net income........................................ 27,009 Net income per share: Basic net income per share.................... $ 2.59 Diluted net income per share.................. $ 2.57
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12--STORE GROUP CLOSINGS
On February 8, 2001, Federated announced its plans to close its Stern's division in which Finlay operated 23 departments. Finlay closed the majority of the Stern's departments during the second quarter of 2001 and, as a result, recorded a charge of approximately $1.0 million related to the write-off of fixed assets and employee severance. During 2001, Federated acquired the Liberty House department store chain. In 2001, Finlay recorded a charge of approximately $150,000 related to the write-off of fixed assets and employee severance. During 2002, sales were reduced by approximately $31.0 million compared to the prior year as a result of the closing of Stern's, Liberty House and another smaller host store group.
NOTE 13--SALE AND CLOSURE OF SONAB
During 1998, Societe Nouvelle d' Achat de Bijouterie - S.O.N.A.B. ("Sonab"), the Company's European leased jewelry department subsidiary, began to experience lower sales trends due to the transition from a promotional pricing strategy to an everyday low price strategy. This change was made as a result of Sonab reassessing its pricing policy following certain local French court decisions. The adverse impact of such change continued through 1999. As a result of the foregoing, on January 3, 2000, Sonab sold the majority of its assets for approximately $9.9 million. After the sale, the buyer operated more than 80 locations previously included in Sonab's 130-location base in France. The remaining departments were closed.
The Company recorded a pre-tax charge in the fourth quarter of 1999 of $28.6 million, or $1.62 per share on a diluted basis after-tax, for the write-down of assets for disposition and related closure expenses. The pre-tax components of the charge, the related income tax effects and the net cash portion of the charge are as follows (dollars in millions):
- -------------
(a) Including transfer of inventory, furniture removal, main office costs during close-down period, lease termination costs, litigation and professional fees.
All of Sonab's employees, excluding those that were hired by the buyer, were involuntarily terminated, including sales associates, supervisors and corporate personnel. As of February 1, 2003, the Company's exit plan has been completed with the exception of certain employee litigation and other legal matters. During the fourth quarter of 2002, the Company revised its original estimate of closure expenses to reflect its remaining liability and, as a result, recorded a credit of $1.4 million. To date, the Company
FINLAY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13--SALE AND CLOSURE OF SONAB (CONTINUED)
has charged a total of $26.4 million against its revised estimate of $27.2 million. The Company does not believe future operating results will be materially impacted by any remaining payments.
NOTE 14--UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following table presents pro forma financial information for 2002, which reflects (i) the Company's domestic operations only and excludes the revised estimate of expenses associated with the closure of Sonab, and (ii) excludes the cumulative effect of accounting change resulting from the adoption of EITF 02-16. Refer to Notes 2 and 13 for additional information. In addition, the Company's actual results for 2001 and 2000 are shown for comparative purposes.
IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS (UNAUDITED)
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of Finlay Fine Jewelry Corporation
We have audited the accompanying consolidated balance sheet of Finlay Fine Jewelry Corporation (a Delaware corporation) and subsidiaries as of February 1, 2003, and the related consolidated statements of operations, changes in stockholder's equity and comprehensive income and cash flows for the fiscal year then ended. 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 audit. The Company's financial statements for the fiscal years ended February 2, 2002 and February 3, 2001, before the inclusion of the transitional disclosures discussed in Note 5 with respect to Statement of Financial Accounting Standards ("SFAS") No. 148, Accounting for Stock Based Compensation - Transition and Disclosure and in Note 2 with respect to SFAS No. 142, Goodwill and Other Intangible Assets, were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated March 20, 2002.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. 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 audit provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Finlay Fine Jewelry Corporation and subsidiaries as of February 1, 2003, and the results of their operations and their cash flows for the fiscal year then ended in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002 to conform to SFAS No. 142.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for vendor allowances in 2002 to conform to Emerging Issues Task Force Issue No. 02-16.
As discussed above, the Company's fiscal 2001 and 2000 consolidated financial statements were audited by other auditors who have ceased operations. These financial statements have been revised to include the transitional disclosures required by SFAS No. 148 and SFAS No. 142. Our audit procedures with respect to the transitional disclosures included in Notes 5 and 2 with respect to 2001 and 2000 included (1) comparing the amount of stock-based compensation expense to the Company's underlying analysis obtained from management, (2) comparing the previously reported net income to the previously issued financial statements and the adjustments to reported net income representing stock based compensation and amortization expense related to goodwill, (including any related tax effects) recognized in those periods, to the Company's underlying analysis obtained from management, and (3) testing the mathematical accuracy of the reconciliation of adjusted or pro forma net income, as applicable, to reported net income. In our opinion, the disclosures for 2001 and 2000 in Notes 5 and 2 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the 2001 and 2000 consolidated financial statements of the Company other than with respect to such disclosures and reclassifications and, accordingly, we do not express an opinion or any other form of assurance on the 2001 and 2000 consolidated financial statements taken as a whole.
DELOITTE & TOUCHE LLP New York, New York April 14, 2003
The following report is a copy of a previously issued Report of Independent Public Accountants. This report relates to prior years' financial statements. This report has not been reissued by Arthur Andersen LLP. Arthur Andersen reported on the 2001 and 2000 consolidated financial statements prior to the transitional disclosures discussed in Notes 2 and 5.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Finlay Fine Jewelry Corporation:
We have audited the accompanying consolidated balance sheets of Finlay Fine Jewelry Corporation (a Delaware corporation) and subsidiaries as of February 3, 2001 and February 2, 2002, and the related consolidated statements of operations, changes in stockholder's equity and cash flows for the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002. 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 Finlay Fine Jewelry Corporation and subsidiaries as of February 3, 2001 and February 2, 2002, and the results of their operations and their cash flows for the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002, in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP New York, New York March 20, 2002
FINLAY FINE JEWELRY CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
FINLAY FINE JEWELRY CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
FINLAY FINE JEWELRY CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
FINLAY FINE JEWELRY CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--ORGANIZATION OF THE COMPANY AND SIGNIFICANT TRANSACTIONS
Finlay Fine Jewelry Corporation, a Delaware corporation (together with its wholly owned subsidiaries "Finlay Jewelry"), is a wholly owned subsidiary of Finlay Enterprises, Inc. (the "Holding Company"). References to "Finlay" mean collectively, the Holding Company and Finlay Jewelry. Finlay is a retailer of fine jewelry products and operates leased fine jewelry departments in department stores throughout the United States. All references herein to leased departments refer to departments operated pursuant to license agreements or other arrangements with host department stores.
On January 22, 2003, Finlay Jewelry's revolving credit agreement with General Electric Capital Corporation ("G.E. Capital") and certain other lenders was amended and restated (the "Revolving Credit Agreement"). The Revolving Credit Agreement, which matures in January 2008, provides Finlay Jewelry with a senior secured revolving line of credit up to $225.0 million (the "Revolving Credit Facility").
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION: The accompanying consolidated financial statements include the accounts of Finlay Jewelry and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES: The preparation of 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 may differ from those estimates.
FISCAL YEAR: Finlay Jewelry's fiscal year ends on the Saturday closest to January 31. References to 2003, 2002, 2001 and 2000 relate to the fiscal years ended on January 31, 2004, February 1, 2003, February 2, 2002 and February 3, 2001. Each of the fiscal years includes 52 weeks except 2000, which includes 53 weeks.
MERCHANDISE INVENTORIES: Consolidated inventories are stated at the lower of cost or market determined by the last-in, first-out ("LIFO") method. Inventory is reduced for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.
The cost to Finlay of gold merchandise sold on consignment, which typically varies with the price of gold, is not fixed until the merchandise is sold. Finlay, at times, enters into futures contracts, such as forwards, based upon the anticipated sales of gold product in order to hedge against the risk of gold price fluctuations. Such contracts typically have durations ranging from one to nine months. Changes in the market value of futures contracts are accounted for as an addition to, or reduction from, the inventory cost. For the years ended February 1, 2003, February 2, 2002 and February 3, 2001, the gain/loss on open futures contracts was not material. At both February 1, 2003 and February 2, 2002, Finlay Jewelry had several open positions in futures contracts for gold totaling 4,000 fine troy ounces and 17,500 fine troy ounces, respectively, valued at $1.4 million and $4.8 million, respectively. The fair value of gold under such contracts was $1.5 million and $4.9 million at February 1, 2003 and February 2, 2002, respectively.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
HEDGING: Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. Under SFAS No. 133, all derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. SFAS No. 133 defines requirements for designation and documentation of hedging relationships, as well as ongoing effectiveness assessments, which must be met in order to qualify for hedge accounting. For a derivative that does not qualify as a hedge, changes in fair value would be recorded in earnings immediately. Finlay Jewelry has designated its existing derivative instruments, consisting of gold forward contracts, as cash flow hedges. For derivative instruments designated as cash flow hedges, the effective portion of the change in the fair value of the derivative is recorded in accumulated other comprehensive income, a separate component of stockholder's equity, and is reclassified into cost of sales when the offsetting effects of the hedged transaction affects earnings. Changes in the fair value of the derivative attributable to hedge ineffectiveness are recorded in earnings immediately. Finlay Jewelry adopted SFAS No. 133 on February 4, 2001 and recorded $24,000 as a cumulative transition adjustment (increasing other comprehensive income). At February 1, 2003, the fair value of the gold forward contracts resulted in the recognition of an asset of $93,600. The amount recorded in accumulated other comprehensive income of $55,000, net of tax, is expected to be reclassified into earnings during 2003.
Finlay Jewelry has documented all relationships between hedging instruments and hedged items, as well as its risk management objectives and strategy for undertaking various hedge transactions. Finlay Jewelry also assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items. Finlay Jewelry believes that the designated hedges will be highly effective and that the related hedge accounting will not have a material impact on Finlay Jewelry's results of operations.
DEPRECIATION AND AMORTIZATION: Depreciation and amortization are computed by the straight-line method over the estimated useful lives of the fixed assets ranging from three to thirty-nine years.
SOFTWARE DEVELOPMENT COSTS: Software development costs have been accounted for in accordance with Statement of Position (the "SOP") No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". The SOP states that software development costs that are incurred in the preliminary project stage are expensed as incurred. Once the specified criteria of the SOP have been met, internal and external direct costs incurred in developing or obtaining computer software as well as related interest costs are capitalized. Training and data conversion costs are expensed as incurred. In addition, costs incurred for the routine operation and maintenance of management information systems and software are expensed as incurred. Amortization is computed by the straight-line method over the estimated useful lives of the software ranging from three to seven years.
Included in Deferred charges and other assets in the accompanying Consolidated Balance Sheets at February 1, 2003 and February 2, 2002, are gross capitalized software costs of $27,526,000 and $24,254,000, respectively, and accumulated amortization of $10,300,000 and $6,564,000, respectively.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
GOODWILL: On February 3, 2002, Finlay Jewelry adopted SFAS No. 142, "Goodwill and Other Intangible Assets". This Statement requires that goodwill no longer be amortized over its estimated useful life but tested for impairment on an annual basis. During the first quarter of 2002, a transitional goodwill impairment test was performed and Finlay Jewelry determined that there was no impairment of goodwill. Further, as required by SFAS No. 142, an annual impairment test was completed at the end of fiscal 2002 and Finlay Jewelry determined that there was no impairment. The following is a reconciliation of reported Net income adjusted to reflect the impact of the discontinuance of goodwill amortization for 2001 and 2000. Finlay Jewelry's actual 2002 Net income is shown for comparative purposes.
DEBT ISSUANCE COSTS: Debt issuance costs are amortized over the term of the related debt agreements using the straight line method, which approximates that of the effective interest method. Net deferred debt issuance costs totaled $3,453,000 at February 1, 2003 and $2,788,000 at February 2, 2002. The debt issuance costs are reflected as a component of Deferred charges and other assets, net, in the accompanying Consolidated Balance Sheets. Amortization of debt issuance costs for 2002, 2001 and 2000 totaled $1,022,000, $1,025,000 and $1,013,000, respectively, and have been recorded as a component of Interest expense, net, in the accompanying Consolidated Statements of Operations.
REVENUE RECOGNITION: Finlay Jewelry recognizes revenue upon the sale of merchandise, either owned or consigned, to its customers, net of anticipated returns. The provision for sales returns is based on Finlay Jewelry's historical return rate.
COST OF SALES: Cost of sales includes the cost of merchandise sold, repair expense, shipping, shrinkage and inventory losses. Buying and occupancy costs such as lease fees are not included in Cost of sales and are reflected in Selling, general and administrative expenses ("SG&A") in the accompanying Consolidated Statements of Operations.
ADVERTISING COSTS: All costs associated with advertising are expensed in the month that the advertising takes place. For 2002, 2001 and 2000, gross advertising expenses were $48,975,000, $53,029,000 and $59,434,000, respectively, and are included in SG&A in the accompanying Consolidated Statements of Operations.
VENDOR ALLOWANCES: Finlay Jewelry receives allowances from its vendors through a variety of programs and arrangements, including cooperative advertising. The allowances are generally intended to offset Finlay Jewelry's costs of promoting, advertising and selling the vendors' products in its departments. Vendor allowances are recognized as a reduction of cost of sales or SG&A when the purpose for which the vendor funds were intended to be used has been fulfilled. Accordingly, a reduction or increase in vendor allowances has an inverse impact on cost of sales and/or SG&A.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
In March 2003, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") finalized Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor"("EITF 02-16"). EITF 02-16 addresses the accounting treatment for vendor allowances and provides that cash consideration received from a vendor should be presumed to be a reduction of the prices of the vendors' product and should therefore be shown as a reduction in the purchase price of the merchandise. Further, these allowances should be recognized as a reduction in cost of sales when the related product is sold. To the extent that the cash consideration represents a reimbursement of a specific, incremental and identifiable cost, then those vendor allowances should be used to offset such costs.
In accordance with EITF 02-16, Finlay Jewelry recorded a cumulative effect of accounting change as of February 3, 2002, the date of adoption, that decreased net income for 2002 by $17.2 million, net of tax. As of February 3, 2002, deferred vendor allowances totaled (i) $17,129,000 for owned merchandise, and (ii) $12,306,000 for merchandise received on consignment. As of February 1, 2003, Finlay Jewelry's fiscal year end, deferred vendor allowances totaled (i) $18,452,000 for owned merchandise, which is included as an offset to Merchandise inventories on the 2002 Consolidated Balance Sheet, and (ii) $10,493,000 for merchandise received on consignment, which is included as Deferred income on the 2002 Consolidated Balance Sheet. In 2002, this change resulted in the reclassification of vendor allowances of $20.0 million, which had previously been accounted for as a reduction to SG&A, to now reduce cost of sales and consequently, increase gross margin. Finlay Jewelry's 2002 unaudited quarterly financial data has been revised to reflect this change in accounting method (refer to Note 10). The adoption of EITF 02-16 is not expected to have a material impact on the financial position or results of operations of Finlay Jewelry in 2003.
During 2001 and 2000, Finlay Jewelry recorded its vendor allowances as an offset to gross advertising expenses, which is included in SG&A on the Consolidated Statements of Operations. For 2001 and 2000, the unaudited pro forma impact of the adoption of EITF 02-16, as if it had occurred prior to 2000, was to decrease cost of sales and increase SG&A by $20,374,000 and $23,665,000, respectively. For both years, Net income would not have been materially different (unaudited).
CASH EQUIVALENTS: Finlay Jewelry considers cash on hand, deposits in banks and deposits in money market funds as cash and cash equivalents.
FAIR VALUE OF FINANCIAL INSTRUMENTS: Cash, accounts receivable, short-term borrowings, accounts payable and accrued liabilities are reflected in the consolidated financial statements at fair value due to the short-term maturity of these instruments. Marketable securities are recorded in the consolidated financial statements at current market value, which approximates cost. The fair value of Finlay Jewelry's debt and off-balance sheet financial instruments are disclosed in Note 4 and in Merchandise inventories above.
STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" which became effective in 2002. This Statement amends SFAS No. 123 "Accounting for Stock-Based Compensation", to provide alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock-based compensation. Finlay has elected to continue to recognize stock-based compensation using the intrinsic value method and has incorporated the additional disclosure requirements of SFAS No. 148. Pro forma net income is disclosed in Note 5. Deferred stock-based compensation is amortized using the straight-line method over the vesting period.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS: SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which became effective for Finlay Jewelry in 2002, addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This Statement extends the reporting requirements to include reporting separately as discontinued operations, components of an entity that have either been disposed of or classified as held-for-sale. The adoption of SFAS No. 144 did not have a material impact on the financial position or results of operations of Finlay Jewelry.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES: In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses financial accounting and reporting for costs associated with exit or disposal activities. SFAS No. 146 requires that liabilities for costs associated with exit or disposal activities be recognized when the liabilities are incurred. This Statement also establishes fair value as the objective for initial measurement of the liabilities. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the financial position or results of operations of Finlay Jewelry.
ACCOUNTING STANDARD TO BE ADOPTED IN 2003: In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statement No. 4, 44, and 64, Amendment of FASB No. 13, and Technical Corrections", which amends certain existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Additionally, the Statement provides that gains and losses from debt extinguishment are not automatically shown as an extraordinary item on a company's statement of operations. The provisions of SFAS No. 145 are effective for fiscal years beginning after May 15, 2002. The adoption of SFAS No. 145 is not expected to have a material impact on the financial position or results of operations of Finlay Jewelry.
SEASONALITY: A significant portion of Finlay's revenues are generated in the fourth quarter due to the seasonality of the retail industry. As such, results for interim periods are not indicative of annual results. Refer to Note 10 for unaudited quarterly financial data.
NOTE 3--MERCHANDISE INVENTORIES
Merchandise inventories consisted of the following:
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3--MERCHANDISE INVENTORIES (CONTINUED)
In accordance with EITF 02-16, Merchandise inventories has been reduced by $18.5 million as of February 1, 2003 to reflect the vendor allowances as a reduction in the cost of the merchandise. The LIFO method had the effect of decreasing income before income taxes in 2002, 2001 and 2000 by $2,342,000 (excluding a cumulative LIFO benefit of $512,000 relating to the adoption of EITF 02-16), $3,783,000 and $1,801,000, respectively. Finlay determines its LIFO inventory value by utilizing selected producer price indices published for jewelry and watches by the Bureau of Labor Statistics.
Approximately $359,676,000 and $359,729,000 at February 1, 2003 and February 2, 2002, respectively, of merchandise received on consignment is not included in Merchandise inventories and Accounts payable-trade in the accompanying Consolidated Balance Sheets.
Finlay Jewelry is party to an amended and restated gold consignment agreement (as amended, the "Gold Consignment Agreement"), which enables Finlay Jewelry to receive consignment merchandise by providing gold, or otherwise making payment, to certain vendors. While the merchandise involved remains consigned, title to the gold content of the merchandise transfers from the vendors to the gold consignor.
Effective September 30, 2002, Finlay Jewelry amended the Gold Consignment Agreement to extend the term to July 31, 2005, and to permit Finlay Jewelry to obtain up to the lesser of (i) 165,000 fine troy ounces or (ii) $50.0 million worth of gold, subject to a formula as prescribed by the Gold Consignment Agreement. At February 1, 2003 and February 2, 2002, amounts outstanding under the Gold Consignment Agreement totaled 134,785 and 127,519 fine troy ounces, respectively, valued at approximately $49.5 million and $36.0 million, respectively. In the event this agreement is terminated, Finlay Jewelry will be required to return or repurchase the outstanding gold at the prevailing gold rate in effect on that date. For financial statement purposes, the consigned gold is not included in Merchandise inventories on Finlay Jewelry's Consolidated Balance Sheets and, therefore, no related liability has been recorded.
Under the Gold Consignment Agreement, Finlay Jewelry is required to pay a daily consignment fee on the dollar equivalent of the fine gold value of the ounces of gold consigned thereunder. The daily consignment fee is based on a floating rate which, as of February 1, 2003 and February 2, 2002, was approximately 2.8% and 3.0%, respectively, per annum. In addition, Finlay is required to pay a fee of 0.5% if the amount of gold consigned has a value equal to or less than $12.0 million. Included in interest expense for the years ended February 1, 2003, February 2, 2002 and February 3, 2001 are consignment fees of $1,153,000, $1,228,000 and $979,000, respectively.
In conjunction with the Gold Consignment Agreement, Finlay Jewelry granted the gold consignor a first priority perfected lien on, and a security interest in, specified gold jewelry of participating vendors approved under the Gold Consignment Agreement and a lien on proceeds and products of such jewelry subject to the terms of an intercreditor agreement between the gold consignor and G.E. Capital.
The Gold Consignment Agreement requires Finlay Jewelry to comply with certain covenants, including restrictions on the incurrence of certain indebtedness, the creation of liens, engaging in transactions with affiliates and limitations on the payment of dividends. In addition, the Gold Consignment Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations. Finlay Jewelry was in compliance with all of its covenants as of and for the year ended February 1, 2003.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT
The Holding Company and Finlay Jewelry are parties to the Revolving Credit Agreement with G.E. Capital and the other lenders thereto which provides Finlay Jewelry with a Revolving Credit Facility of up to $225.0 million. The Revolving Credit Facility matures in January 2008, and allows borrowings based on an advance rate of (i) up to 85% of eligible accounts receivable and (ii) up to 60% of eligible owned inventory after taking into account such reserves or offsets as G.E. Capital may deem appropriate (the "Borrowing Base"). Eligibility criteria are established by G.E. Capital, which retains the right to adjust the Borrowing Base in its reasonable judgement by revising standards of eligibility, establishing reserves and/or increasing or decreasing from time to time the advance rates (except that any increase in the borrowing base rate percentage shall require the consent of other lenders). Finlay Jewelry is permitted to use up to $30 million of the Revolving Credit Facility for the issuance of letters of credit issued for the account of Finlay Jewelry. The outstanding revolving credit balance and letter of credit balance under the Revolving Credit Facility are required to be reduced each year to $50 million or less and $20 million or less, respectively, for a 30 consecutive day period (the "Balance Reduction Requirement"). Funds available under the Revolving Credit Agreement are utilized to finance working capital needs.
Amounts outstanding under the Revolving Credit Agreement bear interest at a rate equal to, at Finlay's option, (i) the Index Rate (as defined) plus a margin ranging from zero to 1.0% or (ii) adjusted Eurodollar rate plus a margin ranging from 1.0% to 2.0%, in each case depending on the financial performance of Finlay. "Index Rate" is defined as the higher of (i) the prime rate and (ii) the Federal Funds Rate plus 50 basis points per annum. A letter of credit fee which could range from 1.0% to 2.0%, per annum, depending on the financial performance of Finlay, of the face amount of letters of credit guaranteed under the Revolving Credit Agreement is payable monthly in arrears. An unused facility fee on the average unused daily balance of the Revolving Credit Facility is payable monthly in arrears equal to 0.375% per annum. Upon the occurrence (and during the continuance) of an event of default under the Revolving Credit Agreement, interest would accrue at a rate which is 2% in excess of the rate otherwise applicable, and would be payable upon demand.
The Revolving Credit Agreement is secured by a first priority perfected security interest in all of Finlay Jewelry's (and any subsidiary's) present and future tangible and intangible assets. The Revolving Credit Agreement contains customary covenants, including limitations on or relating to capital expenditures, liens, indebtedness, investments, mergers, acquisitions, affiliate transactions, management compensation and the payment of dividends and other restricted payments. The Revolving Credit Agreement also contains various financial covenants, including minimum earnings and fixed charge coverage ratio requirements and certain maximum debt limitations. Finlay was in compliance with all of its covenants as of and for the year ended February 1, 2003.
There were no amounts outstanding at February 1, 2003 or February 2, 2002 under the Revolving Credit Agreement. The maximum amounts outstanding under the Revolving Credit Agreement during 2002, 2001 and 2000 were $111,356,000, $125,231,000 and $155,559,000, respectively. The average amounts outstanding for the same periods were $61,151,000, $80,753,000 and $96,612,000, respectively. The weighted average interest rates were 3.9%, 5.5% and 8.6% for 2002, 2001 and 2000, respectively.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT (CONTINUED)
At February 1, 2003 and February 2, 2002, Finlay had letters of credit outstanding totaling $7.3 million and $4.3 million, respectively, which guarantee various trade activities. The contract amounts of the letters of credit approximate their fair value.
Long-term debt consisted of the following:
- --------------------- (a) On April 24, 1998, Finlay Jewelry issued 83/8% Senior Notes due May 1, 2008 (the "Senior Notes") with an aggregate principal amount of $150,000,000. Interest on the Senior Notes is payable semi-annually on May 1 and November 1 of each year, and commenced on November 1, 1998. Except in the case of certain equity offerings, the Senior Notes are not redeemable prior to May 1, 2003. Thereafter, the Senior Notes will be redeemable, in whole or in part, at the option of Finlay, at specified redemption prices plus accrued and unpaid interest, if any, to the date of the redemption. In the event of a Change of Control (as defined in the indenture relating to the Senior Notes (as amended, the "Senior Note Indenture")), each holder of the Senior Notes will have the right to require Finlay Jewelry to repurchase its Senior Notes at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest thereon to the repurchase date. The Senior Notes rank senior in right of payment to all subordinated indebtedness of Finlay Jewelry and pari passu in right of payment with all unsubordinated indebtedness of Finlay Jewelry. However, because the Revolving Credit Agreement is secured by a pledge of substantially all the assets of Finlay Jewelry, the Senior Notes are effectively subordinated to the borrowings under the Revolving Credit Agreement. The Senior Note Indenture contains restrictions relating to, among other things, the payment of dividends, the making of certain investments or other restricted payments, the incurrence of additional indebtedness, the creation of certain liens, entering into transactions with affiliates, the disposition of certain assets and engaging in mergers and consolidations.
The fair value of the Senior Notes at February 1, 2003, determined based on market quotes, was approximately $140,438,000.
On April 24, 1998, the Holding Company issued 9% Senior Debentures due May 1, 2008 (the "Senior Debentures") with an aggregate principal amount of $75,000,000. Interest on the Senior Debentures is payable semi-annually on May 1 and November 1 of each year, and commenced on November 1, 1998. Except in the case of certain equity offerings, the Senior Debentures are not redeemable prior to May 1, 2003. Thereafter, the Senior Debentures will be redeemable, in whole or in part, at the option of Finlay, at specified redemption prices plus accrued and unpaid interest, if any, to the date of the redemption. In the event of a Change of Control (as defined in the indenture relating to the Senior Debentures (as amended, the "Senior Debenture Indenture" and collectively, with the Senior Note Indenture, the "Senior Indentures")), each holder of the Senior Debentures will have the right to require the Holding Company to repurchase its Senior Debentures at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest thereon to the repurchase date. The Senior Debentures rank pari passu in right of payment with all unsubordinated indebtedness of the Holding Company and senior in right of payment to all subordinated indebtedness of the Holding Company. The Senior Debentures are secured by a first priority lien on and security interest in all of the issued and outstanding stock of Finlay Jewelry. However, the
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4--SHORT AND LONG-TERM DEBT (CONTINUED)
operations of the Holding Company are conducted through Finlay Jewelry and, therefore, the Holding Company is dependent upon the cash flow of Finlay Jewelry to meet its obligations, including its obligations under the Senior Debentures. As a result, the Senior Debentures are effectively subordinated to all indebtedness and all other obligations of Finlay Jewelry. The Senior Debenture Indenture contains restrictions relating to, among other things, the payment of dividends, the making of certain investments or other restricted payments, the incurrence of additional indebtedness, the creation of certain liens, entering into transactions with affiliates, the disposition of certain assets and engaging in mergers and consolidations.
The fair value of the Senior Debentures, determined based on market quotes, was approximately $67,500,000 at February 1, 2003.
Finlay was in compliance with all of the provisions of the Senior Indentures as of and for the year ended February 1, 2003.
The aggregate amounts of long-term debt payable in each of the five years in the period ending February 1, 2008 and thereafter are as follows:
Interest expense for 2002, 2001 and 2000 was $18,015,000, $20,089,000 and $23,229,000, respectively. Interest income for the same periods was $88,000, $100,000 and $112,000, respectively.
NOTE 5--LONG TERM INCENTIVE PLANS AND OTHER
The Holding Company's Long Term Incentive Plan (the "1993 Plan") permits the Holding Company to grant to key employees of the Holding Company and its subsidiaries, consultants and certain other persons, and directors of the Holding Company (other than members of the Compensation Committee of the Holding Company's Board of Directors), the following: (i) stock options; (ii) stock appreciation rights in tandem with stock options; (iii) limited stock appreciation rights in tandem with stock options; (iv) restricted or nonrestricted stock awards subject to such terms and conditions as the Compensation Committee shall determine; (v) performance units which are based upon attainment of performance goals during a period of not less than two nor more than five years and which may be settled in cash or in the Holding Company's common stock, par value $.01 per share ("Common Stock"), at the discretion of the Compensation Committee; or (vi) any combination of the foregoing. Under the 1993 Plan, the Holding Company may grant stock options which are either incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), or non-incentive stock options. As of February 1, 2003, an aggregate of 732,596 shares of the Holding Company's Common Stock has been reserved for issuance pursuant to the 1993 Plan, of which a total of 455,320 shares are subject to options granted to certain senior management, key employees and a director. The exercise prices of such
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5--LONG TERM INCENTIVE PLANS AND OTHER (CONTINUED)
options range from $7.23 per share to $16.50 per share.
On March 6, 1997, the Board of Directors of the Holding Company adopted the 1997 Long Term Incentive Plan (the "1997 Plan"), which was approved by the Holding Company's stockholders in June 1997. The 1997 Plan, which is similar to the 1993 Plan, is intended as a successor to the 1993 Plan and provides for the grant of the same types of awards as are currently available under the 1993 Plan. Of the 1,850,000 shares of the Holding Company's Common Stock that have been reserved for issuance pursuant to the 1997 Plan, a total of 1,135,015 shares, as of February 1, 2003, are subject to options granted to certain senior management, key employees and directors. The exercise prices of such options range from $7.05 per share to $24.31 per share.
Finlay has adopted the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". As permitted by SFAS No. 123, Finlay elected to continue to account for stock-based compensation using the intrinsic value method. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had the fair value method of accounting been applied to the Holding Company's stock option plans, which requires recognition of compensation cost ratably over the vesting period of the stock options, Net income would be as follows:
The fair value of options granted in 2002, 2001 and 2000 was estimated using the Black-Scholes option-pricing model based on the weighted average market price at the grant date of $12.01 in 2002, $7.48 in 2001 and $12.75 in 2000 and the following weighted average assumptions: risk free interest rate of 4.73%, 4.62% and 6.80% for 2002, 2001 and 2000, respectively, expected life of seven years for each of 2002, 2001 and 2000 and volatility of 56.56% for 2002, 51.13% for 2001 and 49.48% for 2000. The weighted average fair value of options granted in 2002, 2001 and 2000 was $4.33, $2.57 and $5.22, respectively.
The following summarizes the transactions pursuant to the Holding Company's 1993 Plan and 1997 Plan for 2002, 2001 and 2000:
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5--LONG TERM INCENTIVE PLANS AND OTHER (CONTINUED)
The options outstanding at February 1, 2003 have exercise prices between $7.05 and $24.31, with a weighted average exercise price of $11.46 and a weighted average remaining contractual life of 5.22 years. Options generally vest in five years and expire in ten years from their dates of grant.
On December 1, 2000, the Holding Company announced that its Board of Directors had approved a stock repurchase program to acquire up to $20 million of outstanding Common Stock. The Holding Company may, at the discretion of management, purchase its Common Stock, from time to time, through September 29, 2003. The extent and timing of repurchases will depend upon general business and market conditions, stock prices, availability under the Revolving Credit Facility, compliance with certain restrictive covenants and its cash position and requirements going forward. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. During 2002, the Holding Company repurchased 733,612 shares for $8,426,000 including (i) the repurchase of 526,562 shares for $5,792,000 from a partnership, the managing partner of the general partner of which is also a director of Finlay and (ii) the repurchase of an aggregate 50,000 shares for $712,500 from a partnership and a trust affiliated with a former director of Finlay and certain other persons affiliated therewith. During 2001 and 2000, the Holding Company repurchased a total of 599,330 shares for $5,367,000.
On February 4, 2001, an executive officer of Finlay was issued 100,000 shares of Common Stock of the Holding Company, subject to restrictions ("Restricted Stock"), pursuant to a restricted stock agreement. The Restricted Stock becomes fully vested after four years of continuous employment by Finlay and is accounted for as a component of the Holding Company's stockholders' equity.
NOTE 6--LEASE AGREEMENTS
Finlay conducts all of its operations as leased departments in department stores. All of these leases, as well as rentals for office space and equipment, are accounted for as operating leases. A substantial number of such operating leases expire on various dates through 2008.
Substantially all of the department store leases provide that the title to certain fixed assets of Finlay transfers upon termination of the leases, and that Finlay will receive the undepreciated value of such fixed assets from the host store in the event such transfers occur. The values of such fixed assets are recorded at the inception of the lease arrangement and are reflected in the accompanying Consolidated Balance Sheets.
In several cases, Finlay is subject to limitations under its lease agreements with host department stores which prohibit Finlay from operating departments for other store groups within a certain geographical radius of the host store.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENT
NOTE 6--LEASE AGREEMENTS (CONTINUED)
The store leases provide for the payment of fees based on sales, plus, in some instances, installment payments for fixed assets. Only minimum fees, as represented in the table below, are guaranteed by the lease agreements with host department stores. Lease expense, included in Selling, general and administrative expenses, is as follows (in thousands):
Future minimum payments under noncancellable operating leases having initial or remaining noncancellable lease terms in excess of one year are as follows as of February 1, 2003:
NOTE 7--PROFIT SHARING PLAN
Finlay maintains a defined contribution profit-sharing plan to provide retirement benefits for all personnel. This plan provides for company matching contributions of $0.25 for each $1.00 of employee contribution, up to 5% of the employee's salary, as limited by the Code, which begin to vest upon the completion of two years of employment and accrues at the rate of 20% per year. Additionally, Finlay contributes 2% of the employees' earnings annually, as limited by the Code, which begin to vest upon the completion of three years of employment and accrues at the rate of 20% per year. Finlay's contributions totaled $2,011,000, $1,856,000 and $1,989,000 for 2002, 2001 and 2000, respectively.
NOTE 8--INCOME TAXES
For income tax reporting purposes, Finlay Jewelry has an October 31 year end. Finlay Jewelry files a consolidated Federal income tax return with its wholly owned subsidiaries and its parent, the Holding Company. Finlay Jewelry's provision for income taxes and deferred tax assets and liabilities was calculated as if Finlay Jewelry filed its tax return on a stand-alone basis.
Deferred income taxes at year end reflect the impact of temporary differences between amounts of assets and liabilities for financial and tax reporting purposes.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8--INCOME TAXES (CONTINUED)
Deferred tax assets and liabilities at year end are as follows:
The components of income tax expense, before the cumulative effect of accounting change, are as follows (in thousands):
A reconciliation of the income tax provision computed by applying the federal statutory rate to Income before income taxes to the Provision for income taxes on the accompanying Consolidated Statements of Operations is as follows (in thousands):
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8--INCOME TAXES (CONTINUED)
In 2002, Finlay Jewelry recorded an income tax benefit of $11,713,000 in connection with the cumulative effect of accounting change.
At October 31, 2002, Finlay Jewelry had a net operating loss ("NOL") carryforward for tax purposes of approximately $1,600,000 which expires in 2005. At October 31, 2002, Finlay Jewelry also had Alternative Minimum Tax Credit carryovers of $566,000 which may be used indefinitely to reduce federal income taxes. SFAS No. 109 "Accounting for Income Taxes," requires that the tax benefit of such NOLs and tax credits be recorded as an asset to the extent that management assesses the utilization to be "more likely than not". As the accompanying Consolidated Financial Statements include profits earned after the tax year end at October 31 (the profit of the year-end holiday season), for financial reporting purposes only, the NOL carryforward has been absorbed in full and no NOL carryforward exists as of February 1, 2003. Management determined at February 1, 2003 that, based upon Finlay Jewelry's history of operating results and its expectations for the future, no additional valuation allowance is warranted.
NOTE 9--COMMITMENTS AND CONTINGENCIES
Finlay Jewelry, from time to time, is involved in litigation concerning its business affairs. Management believes that the resolution of all pending litigation will not have a material adverse effect on the consolidated financial statements.
Finlay has an employment agreement with one senior executive which provides for a minimum salary level as well as incentive compensation based on meeting specific financial goals. Such agreement has a remaining term of two years and has a remaining aggregate minimum value of $1,975,000 as of February 1, 2003.
The Revolving Credit Agreement, the Gold Consignment Agreement and the Senior Note Indenture currently restrict annual distributions from Finlay Jewelry to the Holding Company to 0.25% of Finlay Jewelry's net sales for the preceding fiscal year and also allow distributions to the Holding Company to enable it to make interest payments on the Senior Debentures. Other dividends and distributions, including those required to fund stock or bond repurchases, are subject to Finlay's satisfaction of certain restrictive covenants. During 2002, dividends of $17,558,000 were declared by Finlay Jewelry and $15,652,000 was distributed to the Holding Company. During 2001, dividends of $9,250,000 were declared by Finlay Jewelry and $7,231,000 was distributed to the Holding Company. During 2000, dividends of $9,032,000 were declared by Finlay Jewelry and $7,640,000 was distributed to the Holding Company.
Finlay Jewelry's concentration of credit risk consists principally of accounts receivable. Over the past three years, approximately 70% of Finlay's sales were from operations in the May Department Stores Company ("May") and departments operated in store groups owned by Federated Department Stores ("Federated"), of which approximately 47% and 23% represented Finlay's sales in May and Federated, respectively. Finlay Jewelry believes that the risk associated with these receivables, other than those from department store groups indicated above, would not have a material adverse effect on Finlay Jewelry's financial position or results of operations.
Finlay Jewelry has not provided any third-party financial guarantees as of February 1, 2003.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10--QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table summarizes the quarterly financial data for 2002 and 2001 (dollars in thousands). In accordance with SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements", the 2002 quarterly financial data has been revised to reflect Finlay Jewelry's retroactive adoption of EITF 02-16 to the beginning of 2002.
- ----------------- (a) Net income in the fourth quarter includes a credit for the Company's revision of its original estimate for closure expenses associated with the sale and closure of Sonab in the amount of $852,000, net of tax. Refer to Note 13.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11--JAY B. RUDOLPH, INC. ACQUISITION
On April 3, 2000, Finlay completed the acquisition of certain assets of Jay B. Rudolph, Inc. ("J.B. Rudolph") for $20.6 million, consisting primarily of inventory of approximately $16.3 million and fixed assets of approximately $4.0 million. By acquiring J.B. Rudolph (the "J.B. Rudolph Acquisition"), Finlay added 57 departments and also added new host store relationships with Bloomingdale's and Dayton's and Hudson's (both now operating as Marshall Field's). Finlay financed the acquisition of J.B. Rudolph with borrowings under the Revolving Credit Agreement. The J.B. Rudolph Acquisition was accounted for as a purchase, and, accordingly, the operating results of the former J.B. Rudolph departments have been included in Finlay Jewelry's consolidated financial statements since the date of acquisition. Finlay Jewelry recorded goodwill of $1.7 million.
For the year ended February 3, 2001, unaudited pro forma sales and net income were $1,010,911 and $27,009, respectively. The pro forma information is provided for informational purposes only and was prepared assuming the J.B. Rudolph Acquisition occurred at the beginning of 2000. It is based on historical information, as well as certain assumptions and estimates, and does not necessarily reflect the actual results that would have occurred nor is it necessarily indicative of future results of operations of the combined company.
NOTE 12--STORE GROUP CLOSINGS
On February 8, 2001, Federated announced its plans to close its Stern's division in which Finlay operated 23 departments. Finlay closed the majority of the Stern's departments during the second quarter of 2001 and, as a result, recorded a charge of approximately $1.0 million related to the write-off of fixed assets and employee severance. During 2001, Federated acquired the Liberty House department store chain. In 2001, Finlay recorded a charge of approximately $150,000 related to the write-off of fixed assets and employee severance. During 2002, sales were reduced by approximately $31.0 million compared to the prior year as a result of the closing of Stern's, Liberty House and another smaller host store group.
NOTE 13--SALE AND CLOSURE OF SONAB
During 1998, Societe Nouvelle d' Achat de Bijouterie - S.O.N.A.B. ("Sonab"), Finlay Jewelry's European leased jewelry department subsidiary, began to experience lower sales trends due to the transition from a promotional pricing strategy to an everyday low price strategy. This change was made as a result of Sonab reassessing its pricing policy following certain local French court decisions. The adverse impact of such change continued through 1999. As a result of the foregoing, on January 3, 2000, Sonab sold the majority of its assets for approximately $9.9 million. After the sale, the buyer operated more than 80 locations previously included in Sonab's 130-location base in France. The remaining departments were closed.
FINLAY FINE JEWELRY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13--SALE AND CLOSURE OF SONAB (CONTINUED)
Finlay Jewelry recorded a pre-tax charge in the fourth quarter of 1999 of $28.6 million for the write-down of assets for disposition and related closure expenses. The pre-tax components of the charge, the related income tax effects and the net cash portion of the charge are as follows (dollars in millions):
- -------------- (a) Including transfer of inventory, furniture removal, main office costs during close-down period, lease termination costs, litigation and professional fees.
All of Sonab's employees, excluding those that were hired by the buyer, were involuntarily terminated, including sales associates, supervisors and corporate personnel. As of February 1, 2003, Finlay Jewelry's exit plan has been completed with the exception of certain employee litigation and other legal matters. During the fourth quarter of 2002, Finlay Jewelry revised its original estimate of closure expenses to reflect its remaining liability and, as a result, recorded a credit of $1.4 million. To date, Finlay Jewelry has charged a total of $26.4 million against its revised estimate of $27.2 million. Finlay Jewelry does not believe future operating results will be materially impacted by any remaining payments.