Item 1. Business
GENERAL
We operate a chain of off-price retail apparel and housewares stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores.
Our stores average approximately 15,000 square feet and are located mostly in shopping centers. Our products include a broad range of family apparel, domestic goods and houseware products. Our typical customers are families with more than the average number of children and average household income of approximately $35,000, which generally are profiled as discount store shoppers. Our merchandising strategy is to offer first quality recognizable national and discount store brands at a substantial discount, generally 20% to 50% below prices offered by other discount chains. Our stores are well lit and present the merchandise primarily on hanging fixtures. We also use strategically placed in-store signage to emphasize savings and create increased customer awareness.
We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal 2003).
We were incorporated in Delaware in March 1987 as BMA Life Care Corp., changed our name later that month to The Longwood Group, Ltd. and changed our name in May 1992 to DRS Industries, Inc. In December 1992, we acquired an interest in General Textiles while it was operating under Chapter 11 of the Bankruptcy Code. General Textiles operated an off-priced apparel retail chain known as Family Bargain Center. In May 1993, we contributed additional equity to General Textiles and thereby increased our ownership of General Textiles to 100%, at which time General Textiles emerged from bankruptcy protection. In January 1994, we changed our name to Family Bargain Corporation. In November 1995, we acquired Capin Mercantile Corporation and changed its name to Factory 2-U, Inc. and began to coordinate the purchasing, warehousing and delivery operations for the Family Bargain Center and Factory 2-U chains. In July 1998, General Textiles and Factory 2-U, Inc. were merged into a new corporate entity, General Textiles, Inc., which was a wholly-owned subsidiary of Family Bargain Corporation. In November 1998, General Textiles, Inc. was merged into Family Bargain Corporation, at which time we converted our previous three classes of stock into a single class of common stock and changed our corporate name from Family Bargain Corporation to Factory 2-U Stores, Inc.
Recent Developments
We experienced a continuation of declining sales volume in fiscal 2003 with a decrease of 4.4% in comparable store sales for the year. We believe there were a number of factors that contributed to the lower sales in fiscal 2003: (1) lower inventory levels for most of our first quarter due to a tightening of credit by our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor strikes in the southern California region in the third quarter, (4) decrease in retail price points, and (5) a continuation of a very soft retail environment impacted by general price deflation and heavy promotion, particularly in apparel.
As a result of our financial results over the past two fiscal years, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after our fiscal 2002 Christmas selling season we experienced a tightening of credit extended to us by our vendors and the credit community for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and, to a lesser extent, March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing. In addition, in response to a very competitive retail environment, we increased our advertising expenditures above originally planned levels and equivalent to the prior year. We also increased our in-store promotional efforts with weekly in-store specials.
In an effort to improve our liquidity, obtain more favorable credit terms and provide for a consistent flow of merchandise, we initiated a series of financing transactions and took steps to accelerate the receipt of refunds related to tax loss carry-back benefits. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting the placement fees and other offering expenses. In addition, during March of 2003, we received an $8.2 million federal tax refund as a result of utilizing tax loss carry-back benefits. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note and a $1.0 million term note. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses.
Despite our efforts to improve sales and our liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code.
PROCEEDINGS UNDER CHAPTER 11 OF THE UNITED STATES BANKRUPTCY CODE
On January 13, 2004 (the "Petition Date"), we filed a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code in the Court, which is currently pending as case number 04-10111(PJW) (the "Chapter 11 filing"). As the debtor, we remain in possession of our properties, and continue to operate our business as debtor-in-possession ("DIP") in accordance with the applicable provisions of the Bankruptcy Code.
We decided to seek judicial reorganization in order to implement a comprehensive operational and financial restructuring due to the tightening of credit extended by our vendors and the credit community and a decline in our liquidity caused by declining sales volume and deteriorating operating margin in a very soft retail environment. As the debtor, we are authorized to continue to operate as an ongoing business, but may not engage in transactions outside the ordinary course of business without the approval of the Court after notice and an opportunity for a hearing.
At hearings held on January 14, 2004 concerning our first day motions, the Court entered orders granting us authority, among other things, to (1) continue our centralized cash management system, (2) pay pre-petition wages and continue our employee benefit plans and other employee programs, (3) continue customer related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers and vendors in full for all goods and services provided on or after the Petition Date and (6) continue ongoing pre-petition "going out of business sales" for four store locations completed by January 31, 2004. In addition, the Court also gave interim approval for a $45.0 million DIP financing facility (DIP financing facility) that was committed by The CIT Group/Business Credit, Inc. and GB Retail Funding, LLC.
On February 2, 2004, the Court granted final approval of the $45.0 million DIP financing facility. We intend to utilize this financing, in addition to cash flow from operations, to fulfill business obligations during the Chapter 11 process. A full description of this DIP financing facility is included in Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations.
Additionally, on February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of the Great American Group ("Great American") as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases.
On February 17, 2004, we filed with the Court our schedules of assets and liabilities and statements of financial affairs setting forth, among other things, the assets and liabilities as shown on our books and records as of the Petition Date, subject to the assumptions contained in certain notes filed in connection therewith. The schedules of assets and liabilities and statements of financial affairs remain subject to further amendment or modification. We have mailed notices to all known creditors that the deadline for filing proofs of claim with the Court is June 15, 2004. Differences between amounts we have scheduled and claims by creditors will be investigated and resolved in connection with our claims resolution process. As we are at an early stage of the bankruptcy and we do not yet have a plan of reorganization, the ultimate distribution with respect to allowed claims is not presently ascertainable.
The United States Trustee has appointed an unsecured creditors committee and may consider the appointment of an equity committee. There can be no assurance that the unsecured creditors committee or equity committee, if any, will support our positions in the bankruptcy case or the plan of reorganization once proposed, and any disagreements could protract the bankruptcy case, negatively impact our ability to operate during bankruptcy, and/or delay our emergence from bankruptcy.
Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well as most other pending litigation, are stayed and other contractual obligations against us generally may not be enforced. Absent an order of the Court, substantially all pre-petition liabilities are subject to compromise under a plan of reorganization to be voted upon and approved by the Court. Although we expect to file a reorganization plan that provides for emergence from bankruptcy, there can be no assurance that a plan of reorganization will be proposed by us or confirmed by the Court, or that any such plan will be consummated.
We also may assume or reject executory contracts and unexpired leases, including our store and distribution center leases, subject to the approval of the Court and our satisfaction of certain other requirements. In the event we choose to reject an executory contract or unexpired lease, parties affected by these rejections may file claims with the Court-appointed claims agent as prescribed by the Bankruptcy Code and/or orders of the Court. Unless otherwise agreed, the assumption of an executory contract or unexpired lease will require us to cure all prior defaults under such executory contract or lease, including all pre-petition liabilities, some of which may be significant. In addition, in this regard, we expect that liabilities that will be subject to compromise through the Chapter 11 process will arise in the future as a result of the rejection of additional executory contracts and/or unexpired leases, and from the determination by the Court (or agreement by parties in interest) of allowed claims for items that we now claim as contingent or disputed. Conversely, we would expect that the assumption of additional executory contracts may convert some liabilities shown on our financial statements as subject to compromise to post-petition liabilities. Due to the uncertain nature of many of the potential claims, we are unable to project the magnitude of such claims with any degree of certainty. We have incurred, and will continue to incur, significant costs associated with the reorganization.
Under the priority scheme established by the Bankruptcy Code, certain post-petition liabilities and pre-petition liabilities need to be satisfied before shareholders are entitled to receive any distribution. The ultimate recovery to creditors and shareholders, if any, will not be determined until confirmation of a plan of reorganization. We can give no assurance as to what values, if any, will be ascribed in the bankruptcy case to each of these constituencies.
A plan of reorganization could also result in holders of our common stock receiving no distribution on account of their interests and cancellation of their interests. In addition, under certain conditions specified in the Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its rejection by an impaired class of equity holders and notwithstanding the fact that equity holders do not receive or retain property on account of their equity interests under the plan. Moreover, as discussed above, there can be no assurance that a plan of reorganization will be confirmed by the Court. In light of the foregoing, we consider, as described above, the value of the common stock to be highly speculative and caution equity holders that the stock may ultimately be determined to have no value. Accordingly, we urge that appropriate caution be exercised with respect to existing and future investments in our common stock or in any claims related to pre-petition liabilities and our other securities.
At this time, it is not possible to predict the effect of the Chapter 11 filing on our business, various creditors and shareholders or when we will be able to exit Chapter 11. Our future results are dependent upon our confirming and implementing a plan of reorganization.
Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following:
- developing and implementing a long-term strategy to revitalize our business and return to profitability;
- taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations;
- operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants,
- generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms;
- attracting, motivating and retaining key executives and associates; and
- developing, negotiating, and, thereafter, a plan of reorganization confirmed by the Court.
These challenges are in addition to other operational and competitive challenges faced by us in connection with our business as an off-price retailer. See the section below titled "Risk Factors" for a discussion of these items.
A plan of reorganization could materially change the amounts reported in the financial statements, which do not give effect to all adjustments of the carrying value of assets or liabilities that might be necessary as a consequence of a plan of reorganization.
The financial statements contained herein have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business, and in accordance with Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Our ability to continue as a going concern, as described above, is predicated upon, among other things, the development and confirmation of a plan of reorganization, compliance with the provisions of the DIP financing facility and the ability to generate cash flows from operations and obtain financing sources sufficient to satisfy our future obligations. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 2 of the Notes to Financial Statements in Item 8. Financial Statements and Supplementary Data, for additional information.
OPERATIONS
Operating Strategy
Our strategy is to be an off-price casual apparel, domestic goods, and housewares retailer to families with more than the average number of children and whose average household income is approximately $35,000 in the markets we serve.
The major element of our operating strategy is to provide value to our customers by selling merchandise offered by national and discount store chains at savings of generally 20 to 50% below their prices. We primarily buy excess in-season inventory of recognized brands at bargain prices and pass along the savings to our customers. We believe we are positioned to help families dress, decorate their homes, and entertain their children at a great value.
Buying and Distribution
We purchase merchandise from domestic manufacturers, jobbers, importers, and other vendors. Historically, our payment terms have typically been net 30 days, although during the pendency of the Chapter 11 case, many of our vendors have reduced the amount of time in which we must pay for goods. We do not maintain any long-term or exclusive purchase commitments or agreements with any vendors. We believe that there are sufficient sources of supply of first quality, national and discount store branded merchandise that will meet our inventory needs.
Unlike traditional department stores and discount retailers (that primarily purchase merchandise in advance of the selling season, for example, back-to-school is purchased by March), we primarily purchase our merchandise in-season (i.e., during the selling season). These in-season purchases generally represent closeouts of vendors' excess inventories remaining after the traditional wholesale selling season and are often created by other retailers' order cancellations. We believe that in-season buying practices are well suited to our customers, who tend to make purchases on an as-needed basis during the season. For years, our customers have substantiated this pattern, which has helped shape the way we do business.
Our in-season buying practice is facilitated by our ability to efficiently process orders and ship merchandise through our distribution center to our stores. At our administrative headquarters, we receive daily store sales and inventory information from point-of-sale equipment located at each of our stores. This data is reported by stock keeping unit (SKU), permitting us to tailor purchasing and distribution decisions on an as-needed basis. Our chain-wide computer network, recently upgraded with a view to enhanced allocation capabilities, also facilitates communications between store management with timely pricing and distribution information.
Generally, manufacturers ship goods directly to our distribution center or freight consolidators who then ship directly to our distribution center. We then deliver merchandise from our distribution center to our stores within ten to 14 days of receipt utilizing the services of independent trucking companies. We do not typically store merchandise at our distribution center from season to season. We believe we are a desirable customer for vendors seeking to liquidate inventory because we can take immediate delivery of large quantities of in-season goods. We rarely request markdown concessions, advertising allowances or special shipping requirements, but insist on the lowest price possible.
Merchandising and Marketing
Our merchandise selection, pricing strategies and store formats are designed to reinforce the concept of value and maximize customer enjoyment of shopping at our stores. Our stores offer customers a diverse selection of first quality, in-season merchandise at prices that generally are lower than those of competing discount stores in their local markets. Our stores generally carry an assortment of brand name labels, including nationally recognized brands.
We attempt to deliver new merchandise to our stores at least weekly to encourage frequent shopping trips by our customers and to maximize our inventory turns. As a result of our purchasing practices and the nature of the off-price retail industry, store inventory may not always include a full range of colors, sizes and styles in a particular item. We believe that price, quality and product mix are more important to our customers than the availability of a specific item at a given time.
It is important that we emphasize inventory turns in our merchandising and marketing strategy. Our merchandise presentation, pricing below discounters, weekly store deliveries, staggered vendor shipments, promotional advertising, store-tailored distribution and prompt price reductions on slow-moving items are all designed to increase inventory turns. We believe that the pace of our inventory turns can lead to increased profits, lower markdowns, and efficient use of capital and customer urgency to make purchase decisions.
Our stores are characterized by easily accessible merchandise displayed on hanging fixtures and open shelves in well-lit areas. Our prices are clearly marked with the comparative retail-selling price often noted on the price tag.
Our major advertising vehicle is the use of full-color advertising circulars showing photos of our merchandise and emphasizing value to customers. Our print media is delivered to consumers through both direct mail and newspaper inserts. We also conduct local promotional activities at various stores throughout our chain from time to time.
Seasonality
We experience three primary selling seasons: Spring, Back to School and Holiday. We have historically realized our highest levels of sales during the Holiday season, which represents approximately 25% of our sales during the fiscal year. The Back to School season historically has generated our second highest level of sales for the fiscal year, representing approximately 17% of our sales.
Competition
We operate in a highly competitive marketplace. We compete with large national and discount store retail chains in most of our markets, such as Wal-Mart, K-Mart, Target and Mervyn's. In fiscal 2003, we experienced a decrease in market share due to our store closings and the growth of our major competitors. We expect that this trend will continue due to the 44 stores we have closed in fiscal 2004. While these retail chains offer a larger assortment of merchandise than we do and may provide a higher level of customer service, given our off-price format, our competitive advantage is that we sell our merchandise at prices typically 20% to 50% below the prices of these chains. We also carry national and recognizable brands that may not be carried by these retail chains. We also compete in most of our markets with other off-price retail chains, such as TJ Maxx, Ross Stores, Marshall's, and Big Lots. For the most part, these off-price chains serve the middle and upper-middle income markets offering apparel that is typically found in department store chains (such as Robinsons-May, Nordstrom and Dillard's), whereas we serve the lower and lower-middle income markets and offer apparel that is targeted at a discount store shopper. These national, discount store and off-price chains may have substantially greater resources than we do. We also compete with independent or small chain retailers and flea markets (also known as "swap meets"), which have a similar price strategy as we do, but generally offer lower service levels. In the future, new companies may enter the deep-discount retail industry.
Over the past few years, the retail industry has experienced price deflation, primarily due to a soft economy and intense competition. We expect the competition will continue and increase in the future. In addressing this competitive environment, we have initiated new merchandise strategies and a revised print advertising program; all designed to improve store contribution.
Our Stores
Our stores emphasize value and satisfaction to develop customer loyalty and generate repeat business. Most of our sales are for cash, although we accept checks, debit and credit cards. We also offer layaway and gift card programs. Our layaway program is important to our customers, many of whom do not possess credit cards, because it permits them to pay for purchases over time. In general, our store business hours are from 9:00 am to 9:00 pm.
On January 22, 2004, we filed a motion with the Court seeking authorization for closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases.
We continually review store performance and may close additional stores that do not meet our minimum financial performance criteria. The costs associated with closing stores consist primarily of inventory liquidation costs, provisions to write down assets to net realizable value, teardown costs and the estimated cost with respect to disposition of the lease.
As of April 23, 2004, we operated 195 stores located in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington, under various operating leases with third parties. Our stores are generally located in shopping centers in densely populated urban areas, lower to moderate income suburban communities and certain rural locations. Our stores range in size from 6,000 square feet to 35,000 square feet, averaging approximately 15,000 square feet.
We generally lease previously occupied store sites on terms that we believe are more favorable than those available for newly constructed facilities. We select store sites based on demographic analysis of the market area, sales potential, local competition, occupancy costs, operational fit and proximity to existing store locations.
Our stores typically employ one store manager, two to three assistant store managers and/or store supervisors, and 15 to 20 sales associates, most of whom are part-time employees. We train new store managers and assistant store managers in all aspects of store operations through our management-training program. Our management training program provides for the training of our store management candidates over a two to three week period in one of our training stores. Each of our 20 operating districts has a training store in which the store manager is responsible to train the store management candidates for that district. The training program covers operational procedures, merchandising skills, employee selection and other human resource skills. Our other store personnel are trained on site. We often promote experienced assistant store managers to fill open store manager positions.
We maintain customary workers' compensation, commercial liability, fire, theft, business interruption and other insurance policies for all store, distribution and corporate office locations.
At January 31, 2004, we operated 239 stores under the name Factory 2-U. The number of stores we operated in each quarter during fiscal year 2003, 2002 and 2001 were as follows:
Subsequent to January 31, 2004, we closed 44 stores in connection with our reorganization efforts as discussed above.
As of April 23, 2004, our stores were located as follows:
Employees
As of April 23, 2004, we had 3,550 employees (2,020 of whom were part-time employees). Of that total, 1,301 were store employees and store field management, 155 were executives and administrative employees and 74 were warehouse employees. None of our employees are subject to collective bargaining agreements and we consider relations with our employees to be generally good.
Trademarks
Except for the trade names "Factory 2-U" and "Family Bargain Center", which are federally registered trademarks, we do not have any material trademarks.
Government Regulation
Our business operations are subject to federal, state and local laws, regulations and administrative practices. We believe we are in substantial compliance with all federal, state and local laws and regulations governing our business operations and we have obtained all material licenses and permits required to operate our business. We believe that the compliance burdens and risks relating to these laws and regulations do not have a material adverse effect on our business.
RISK FACTORS
Our High Store Concentration in California Leaves Us Particularly Susceptible to Risks of Doing Business in California
As of April 23, 2004, we operated 111 stores in California, representing over half of our total store base. Accordingly, our results of operations and financial condition are significantly more dependent upon trends and events in California than are those of our competitors with more geographically balanced store locations. Operating costs, such as workers' compensation and utilities in California have been significantly higher than other regions in the country where we currently operate. If operating costs continue to increase in California, they could continue to reduce our operating margins.
The costs associated with workers' compensation insurance in the state of California have increased significantly over the past few years. These cost increases are related to the average cost per claim and the related state benefits. In California, the average workers' compensation claim is significantly higher than other states where we currently operate. With these continued workers' compensation cost increases, there can be no assurance that we will be able to obtain workers' compensation insurance at favorable rates. Additionally, with the uncertain economy, the continued rise in benefits could reduce our earnings.
Utility costs for electricity and natural gas in California have risen significantly. These costs may continue to increase due to the actions of federal and state governments and agencies, as well as other factors beyond our control. We have attempted to mitigate such increases through energy conservation measures and other cost cutting steps. However, we can make no assurances that these measures and other steps taken will be adequate to control the impact of these utility cost increases in the future. In addition, increasing utility and gasoline costs, together with high unemployment, may significantly reduce the disposable income of our target customers. Our sales could be reduced if our target customers have less disposable income.
In addition, California historically has been vulnerable to certain natural disasters and other risks, such as earthquakes and fires. At times, these events have disrupted the local economy. These events could also pose physical risks to our properties.
We Could Experience Disruptions in Receiving and Distribution
Well-organized and managed receiving and shipping schedules and the avoidance of interruptions are vital to our success. From time to time, we may face unexpected demands on our distribution operations that could cause delays in delivery of merchandise from our distribution center to our stores. A fire, earthquake or other disaster at our distribution center that disrupts the flow of merchandise could severely impair our ability to maintain inventory in our stores and thus reduce sales.
During fiscal 2003, we closed two distribution centers in San Diego, California and one in Lewisville, Texas and consolidated their operations into a single, new distribution center in San Diego, California. We may face unexpected or unforeseen demands, disruptions or costs, which may result from earthquakes or mechanical breakdowns, that could adversely affect our distribution center operations and delay or interfere with our ability to deliver merchandise from our distribution facility to our stores in connection with this consolidation. Any such delay or interference could lead to a reduction in sales.
We Depend Upon, But Do Not Have Long-Term Agreements With, Our Vendors for the Supply of Close-Out and Excess In-Season Merchandise
Our success depends in large part on our ability to locate and purchase quality close-out and excess in-season merchandise at attractive prices from our vendors. We cannot be certain that such merchandise will continue to be available in the future. Further, we may not be able to find and purchase merchandise in quantities necessary to accommodate our needs.
We do not have long-term agreements with any vendor. As a result, we must continuously seek out buying opportunities from our existing suppliers and from new sources. We compete for these opportunities with other wholesalers and retailers, discount and deep-discount chains, and mass merchandisers. Although we do not depend on any single vendor or group of vendors and believe we can successfully compete in seeking out new vendors, a disruption in the availability of merchandise at attractive prices could result in reductions in sales and gross margins.
We Rely on Credit Support From Our Vendors and the Credit Community
Our ability to purchase merchandise depends upon our receiving credit support from trade vendors or the credit community that extends financing terms to certain of our vendors. In light of our recent Chapter 11 filing, certain vendors and factors have significantly reduced our credit support. Any improvement in our credit terms will be contingent upon, among other things, our results of operations, liquidity and a plan of reorganization. Any further withdrawal or reduction of the extension of credit from the credit community and our vendors may result in our not being able to purchase merchandise at attractive prices, disrupt product flow, reduce our liquidity and result in a reduction in sales and profit margins. It may also impair our ability to finance our operations, pay our debt obligation, and complete our reorganization efforts over the next twelve months.
Our Sales Fluctuate According to Seasonal Buying Patterns, Which Expose Us to Excess Inventory Risk
We have historically realized our highest levels of sales and income during the third and fourth quarters of our fiscal year (the quarters ending in October and January) as a result of the Back to School and Holiday seasons. Any adverse events during the third and fourth quarters could therefore reduce sales. In anticipation of the Back to School and Holiday seasons, we may purchase substantial amounts of seasonal merchandise. If for any reason, including periods of sustained inclement weather, our net sales during these seasons were to fall below seasonal norms and/or our expectations, a seasonal merchandise inventory imbalance could result. If such an imbalance were to occur, markdowns are required to clear excess inventory. Our sales, gross margins and net income could be reduced by higher than expected markdowns.
We Face Intense Competition
We operate in a highly competitive marketplace. We compete with large national and discount store retail chains, such as Wal-Mart, K-Mart, Target and Mervyn's, and other off-price chains, such as TJ Maxx, Ross Stores, Marshall's and Big Lots, some of which have substantially greater resources than ours. We also compete with independent and small chain retailers and flea markets (also known as "swap meets"), which serve the same low and low-middle income market. Over the past few years, the retail industry has experienced price deflation, primarily due to a weak economy and intense competition. We compete in the discount retail merchandise business, which is a highly competitive environment that subjects us to the price competition, the potential for lower net sales and decreased operating margins. We expect the competition will continue and increase in the future. In addressing this competitive environment, we have initiated new merchandise strategies and a revised print advertising program; all designed to improve store contribution. However, we can make no assurances that these strategies and other actions taken will be adequate to minimize our exposure to reduced sales and lower gross margins due to competition.
We Handle Certain Materials that Could Expose Us to Liability Under Environmental Laws
In the ordinary course of our business, we sometimes handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations. We have adopted policies regarding the handling and disposal of these products and we train our employees on how to handle and dispose of them. We cannot assure that our policies and training will successfully help us avoid potential violations of these environmental laws and regulations in the future.
Our Anti-Takeover Provisions Could Depress Our Stock Price
In addition to some governing provisions in our Certificate of Incorporation and Bylaws, we are also subject to certain Delaware laws and regulations which could delay, discourage and prevent others from initiating a potential merger, takeover or other change in control, even if such actions would benefit our shareholders and us.
The Market Price of Our Existing Common Stock is Subject to Substantial Fluctuation and Ultimately May Have No Value
The market price of our common stock has fluctuated substantially since our recapitalization occurred in November 1998. In addition, a final plan of reorganization, if any, confirmed by the Court may result in the cancellation of our existing common stock with holders thereof receiving no distributions under the plan of reorganization other than, possibly, for a minor interest in a creditor litigation trust to be established pursuant to the plan of reorganization. In light of the foregoing, we consider the value of our common stock to be highly speculative and caution equity holders that the stock may ultimately be determined to have no value.
On January 22, 2004, we were delisted from the Nasdaq national market as we were not in compliance with certain of the Nasdaq National Market continued listing requirements. Our stock is currently trading in an "over-the-counter" market and accordingly trading prices for our common stock could fluctuate significantly due to many factors, including:
o the depth of the market for our common stock; o changes in expectations of our future financial performance, including financial estimates by securities analysts and investors; o our ability to reorganize under Chapter 11; o variations in our operating results and financial conditions; o conditions or trends in our industry; o additions or departures of key personnel; and o future issuances of our common stock.
We Face Exposure in Lawsuits
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the possible entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations.
In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit.
We are periodically subject to legal actions that arise in the ordinary course of business that could subject us to substantial money damages or injunctive relief.
Our Customers Might Reduce their Houseware and Apparel Purchases as a Result of Downturns in the United States and Local Economy
Our typical customers are families with more than the average number of children and with an average annual household income of approximately $35,000. This customer base is particularly vulnerable to economic recessions, depressions and general slowdowns in the overall United States and local economy. During periods of general economic weakness, our customers may choose to reduce their houseware and apparel purchases in favor of housing and food expenditures, which could result in a reduction in our sales.
We Face Uncertainties Relating to Our Bankruptcy Case
At this time, it is not possible to predict the effect of our Chapter 11 filing on our business, creditors and shareholders or when we will be able to exit Chapter 11. Our ability to continue as a going concern is predicated upon numerous issues, including our ability to develop a long-term strategy to revitalize our business and return to profitability; take appropriate actions to offset the negative impacts that the Chapter 11 filing has had on our business and the impairment of vendor relations; operate within the framework of our DIP financing facility including limitations on capital expenditures and compliance with financial covenants; generate cash flows from operations or seek other sources of financing and the availability of projected vendor credit terms; attract, motivate and retain key executives and associates; and develop, negotiate, confirm and consummate a plan of reorganization in a timely manner.
AVAILABLE INFORMATION
We make available on our web site, www.factory2-u.com, our filings on Form 10-K, 10-Q, 8-K and amendments thereto, as soon as reasonably practical after we file or furnish such materials with the Securities and Exchange Commission. All such materials are available free of charge. Any information that is included on or linked to our Internet site is not a part of this report or any registration statement that incorporates this report by reference.
Item 2.
Item 2. Properties
As of April 23, 2004, we operated 195 retail stores located in seven states, under various operating leases with third parties. Our store locations include shopping centers, downtown business districts, malls and freestanding sites. Each store lease is separately negotiated. The lease term for our stores is between five to ten years with renewal options typically in five-year increments. Approximately 98% of our leases are "triple net leases" under which we are required to reimburse landlords for insurance, real estate taxes and common area maintenance costs; however, for many of those leases, we have negotiated reimbursement limitations on common area costs. As well as the monthly minimum base rent, some of our store leases require additional rent, which generally is based on an agreed percentage of sales in excess of a specified sales level. Our store rent expense for the fiscal year ended January 31, 2004 was approximately $36.1 million.
Subsequent to January 31, 2004, we closed 44 stores in conjunction with our reorganization efforts. As of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases.
During fiscal 2003, we completed the consolidation of our two former San Diego distribution centers and our Lewisville, Texas distribution center into one single distribution center, which is located at a new facility in San Diego, California. As part of our bankruptcy case, we have rejected the lease of our San Diego distribution center located at 7130 Miramar Road and the lease of our Lewisville, Texas distribution center at 1875 Waters Ridge Drive.
We continue to lease the space at our headquarters, located in a 208,460 square-foot multi-use facility at 4000 Ruffin Road, San Diego, California. This facility consists of 58,460 square feet of office space and 150,000 square feet of distribution space.
The lease of our new distribution facility located at 2020 Piper Ranch Road in San Diego, California expires in July 2015 and provides for an annual base rent of approximately $2.6 million.
Item 3.
Item 3. Legal Proceedings
On January 13, 2004, we filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. We retain control of our assets and are authorized to operate the business as a debtor-in-possession while being subject to the jurisdiction of the Court. As of the Petition Date, most pending litigation is stayed, and absent further order of the Court, substantially all pre-petition liabilitities are subject to settlement under a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 case or its effect on our business. If it is determined that the liabilities subject to compromise in the Chapter 11 case exceed the fair value of the assets, unsecured claims may be satisfied at less than 100% of their fair value and the equity interests of our shareholders may have no value. See Item 1. Business Proceedings Under Chapter 11 of the Bankruptcy Code.
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations.
In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit.
There are numerous other matters filed with the Court in our reorganization proceedings by creditors, landlords or other third parties related to our business operations or the conduct of our reorganization activities. Although none of these individual matters which have been filed to date have had or are expected to have a material adverse effect on us, our ability to successfully manage the reorganization process and develop an acceptable reorganization plan could be negatively impacted by adverse determinations by the Court on certain of these matters.
We are at all times subject to pending and threatened legal actions that arise in the normal course of business.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for Factory 2-U Stores, Inc. Common Equity and Related Stockholder Matters
Market Information
On January 22, 2004 our Common Stock was suspended from trading on the NASDAQ National Market and began trading on the "Over-the-Counter" (OTC) market under the symbol of "FTUSQ.PK." Prior to January 22, 2004, our Common Stock was traded on NASDAQ under the symbol of "FTUS."
The following table sets forth the range of high and low trading prices of each of our fiscal quarters in fiscal 2002 and 2003. For Fiscal 2002 and through the 13 weeks ended November 1, 2003 the prices were based on the NASDAQ National Market of the Common Stock, as reported by NASDAQ. Prices for the 13 weeks ended January 31, 2004 were based on prices as reported by NASDAQ and Pinksheets LLC. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.
As of April 23, 2004, we had approximately 230 stockholders of record and approximately 2,200 beneficial stockholders.
Dividend Policy
We have never paid cash dividends on our Common Stock and do not anticipate paying cash dividends in the foreseeable future. The declaration and payment of any cash dividends on our Common Stock in the future will be determined by the Board of Directors in light of conditions then existing, including our earnings, financial condition, cash requirements and contractual, legal and regulatory restrictions relating to the payments of dividends and any other factors that our Board of Directors deems relevant. During the pendency of the Chapter 11 proceedings, any such dividend would be remote and, in any event, subject to the approval of the Court. We are contractually prohibited from paying cash dividends on our Common Stock under the terms of our existing DIP financing facility without the consent of the lenders. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - DIP Financing Facility."
Equity Compensation Plan Information
The following table sets forth information as of January 31, 2004 with respect to our common stock that may be issued upon the exercise of stock options under our Amended and Restated 1997 Stock Option Plan, together with information relating to our common stock that may be issued under plans not approved by stockholders.
Item 6.
Item 6. Selected Financial Data
The selected financial data set forth below, except for Operating Data, is derived from our audited financial information and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our Financial Statements, including the Notes, and Supplementary Data included in this Annual Report on Form 10-K.
(1) Includes the following pre-tax items: (a) $26.3 million adjustment related to the impairment of goodwill (reorganization items), (b) $7.8 million inventory valuation allowance, net of a $0.5 million adjustment for the reserve established at the end of fiscal 2002 for slow moving and aged items (cost of sales), (c) $1.5 million adjustment to reduce the reserves for the fiscal 2002 and 2001 restructuring plans (restructuring charge, net), (d) $2.4 million related to impairment of fixed assets associated with the 44 closing stores, (reorganization items), (e) $1.7 million related to inventory sold below cost at our 44 closing stores (reorganization items), (f) $1.3 million related to professional services and other expenses as a result of the Chapter 11 filing (reorganization items), (g) $1.0 million related to separation with former executives (selling and administrative expenses), and (h) $0.7 million favorable adjustment to the stock subscription notes receivable valuation allowance established at the end of fiscal 2002 (selling and administrative expenses).
(2) Included the following pre-tax items: (a) $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance (cost of sales), (b) $2.8 million related to a long-term consulting project, which was terminated in November 2002, (c) $2.1 million related to a litigation settlement, (d) $14.4 million related to fiscal 2002 restructuring efforts, partially offset by a $5.0 million reserve reduction related to the fiscal 2001 restructuring efforts (as a result of favorable experience with lease termination costs), (e) $0.8 million related to the separation agreement of our former Chief Executive Officer, and (f) $2.2 million write-down of shareholders and trade notes receivable. (3) Included pre-tax expenses of $21.2 million related to fiscal 2001 restructuring efforts, $0.5 million non-cash stock option charge, and $1.1 million related to the retirement and replacement of our former General Merchandising Manager. (4) Fiscal year included 53 weeks. Included pre-tax expenses of $4.8 million non-cash charge for performance-based stock options, partially offset by a $1.2 million condemnation award and $2.9 million after-tax reduction to our tax valuation allowance. (5) Included a pre-tax $2.1 million non-cash charge related to performance-based stock options. (6) We averaged 230, 217, 179, 152 and 151 comparable stores for fiscal years 2003, 2002, 2001, 2000 and 1999, respectively. We define comparable stores as follows: o New stores are considered comparable after 18 months from date of opening. o When a store relocates within the same market, it is considered comparable after 6 months of operations. o Store expansion greater than 25% of the original store size is treated like a new store and becomes comparable after 18 months of operations. Store expansion less than 25% of the original store size remains in the comparable store base. (7) As of January 31, 2004, working capital and long term debt and revolving credit facility, including current portion, do not include liabilities classified as subject to compromise.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the information set forth under "Selected Financial Data" and "Financial Statements and Supplementary Data."
General
We operate a chain of off-price retail apparel and houseware stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores.
In fiscal 2002, we continued to experience declining transaction counts, declining purchase size, increased competition, rising operating costs and a slow economy. These factors were exacerbated by the lingering effects of the September 11 terrorist attacks and fear of war in Iraq. In December 2002, we announced the fiscal 2002 restructuring initiatives needed to improve operating results. These initiatives included the closure of 23 under-performing stores and consolidation of our distribution center network and corporate overhead structure. In connection with the fiscal 2002 restructuring, we recorded a pre-tax restructuring charge of approximately $14.4 million. We also announced efforts to liquidate our slow-moving and aged inventory chain-wide. We incurred a pre-tax charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance.
We experienced a continuation of declining sales volume in fiscal 2003 with a decrease of 4.4% in comparable store sales for the year. We believe there were a number of factors that contributed to the lower sales in fiscal 2003: (1) lower inventory levels for most of our first quarter due to a tightening of credit by our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor strikes in the southern California region in the third quarter, (4) decrease in retail price points, and (5) a continuation of a very soft retail environment impacted by general price deflation and heavy promotion, particularly in apparel.
As a result of our financial results in fiscal 2001 and 2002, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after the fiscal 2002 Christmas selling season we experienced a tightening of credit extended to us by vendors, factors and others for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and to a lesser extent March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing.
In an effort to improve our liquidity, obtain more reasonable credit terms and provide for a consistent flow of merchandise, we initiated a series of financing transactions and took steps to accelerate the receipt of refunds related to tax loss carry-back benefits. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deduction the placement fees and other offering expenses. In addition, during March of 2003, we received an $8.2 million federal tax refund as a result of utilizing a tax loss carry-back benefit. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note secured primarily by inventory and a $1.0 million term note secured primarily by equipment and other assets. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses.
Despite our efforts to improve sales and our liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code on January 13, 2004.
Under Chapter 11, we are operating our business as a debtor-in-possession. As of the Petition Date, actions to collect pre-petition indebtedness as well as most other pending litigation, are stayed and other pre-petition contractual obligations generally may not be enforced against us. In addition, under the Bankruptcy Code, we may assume or reject executory contracts and unexpired leases, subject to approval of the Court and our satisfaction of certain other requirements. Parties affected by these rejections may file claims in accordance with the reorganization process. Absent an order of the Court, substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court.
At hearings held on January 14, 2004 concerning our first day motions, the Court entered orders granting us authority, among other things, to (1) continue our centralized cash management system, (2) pay pre-petition wages and continue our employee benefit plans and other employee programs, (3) continue customer related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers and vendors in full for all goods and services provided on or after the Petition Date and (6) continue ongoing pre-petition "going out of business sales" for four store locations completed by January 31, 2004. In addition, the Court also gave interim approval for a $45.0 million DIP financing facility that was committed by The CIT Group/Business Credit, Inc. and GB Retail Funding, LLC.
On February 2, 2004, the Court granted final approval of the $45.0 million DIP financing facility. We intend to utilize this financing, in addition to cash flow from operations, to fulfill business obligations during the Chapter 11 case.
Additionally, on February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases.
In connection with our Chapter 11 case, the United States Trustee has appointed an unsecured creditors committee and may consider the appointment of an equity committee. These official committees and their legal representatives often take positions on matters that come before the Court, and are the entities with which we plan to negotiate the terms of our plan of reorganization. There can be no assurance that the unsecured creditors committee or equity committee, if any, will support our positions in the bankruptcy case or the plan of reorganization once proposed, and any disagreements could protract the bankruptcy case, negatively impact our ability to operate during bankruptcy, and/or delay our emergence from bankruptcy.
See additional information regarding the Chapter 11 case in Item 1. Business -- Proceedings Under Chapter 11 of the United States Bankruptcy Code, of this Form 10-K.
Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following:
- developing and implementing a long-term strategy to revitalize our business and return to profitability;
- taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations;
- operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants;
- generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms;
- attracting, motivating and retaining key executives and associates; and
- developing, negotiating, and, thereafter, having a plan of reorganization confirmed by the Court.
These challenges are in addition to those operational and competitive challenges faced by Factory 2-U in connection with our business as an off-price retailer. See " Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995" immediately preceding Item 1 of this Form 10-K.
We started fiscal 2004 with numerous issues and tasks that we need to resolve and achieve. The Chapter 11 filing right before the beginning of our fiscal 2004 provides us an opportunity to improve our business operations, reduce our cost structure and restructure our financial affairs. Our primary goal for fiscal 2004 is to improve our cash flows. We have started taking steps and continue to focus on our major management objectives including:
- improving store performance - closing 44 non-core underperforming stores (all these stores were closed by March 18, 2004);
- improving our gross margin - raising our initial mark up and adjusting our retail price points;
- reducing advertising spend - reducing the number of advertising circulars and improving productivity of our advertising circulars; and
- reducing our selling, general and administrative expenses - monitoring store payroll and reducing costs at the corporate headquarters.
With respect to store openings and closings in fiscal 2004, we have already closed 44 stores as discussed above and we currently plan to open one new store for which the lease was signed before our Chapter 11 filing. We continue to review and monitor our store performance by evaluating each existing store's market and financial performance and we may close additional stores that do not meet our minimum financial performance criteria.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The financial statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business. Based on guidance in SOP 90-7, all pre-petition liabilities subject to compromise have been segregated in the Balance Sheet and are classified as Liabilities subject to compromise, at the estimated amount of allowable claims. Liabilities not subject to compromise are separately classified as current and non-current. Expenses, realized losses, and provision for losses resulting from the reorganization are reported separately as reorganization items.
We believe the following represents the areas where the most critical estimates and assumptions are used in the preparation of the financial statements:
o Inventory valuation. Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method ("RIM") on a first-in, first-out basis. Under the RIM, the valuation of inventory at cost and the resulting gross margin are calculated by applying a computed cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventory at the lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventory. Inherent in the RIM calculation are certain significant management judgments and estimates regarding markdowns and shrinkage, which may from time to time cause adjustments to the gross margin in the subsequent period. Factors that can lead to distortion in the calculation of the inventory balance include applying the RIM to a group of merchandise items that is not fairly uniform in terms of its cost and selling price relationship and turnover, and applying RIM to transactions over a period of time that includes different rates of gross profit, such as those relating to seasonal merchandise items. To minimize the potential of such distortions in the valuation of inventory from occurring, we utilize 82 sub-departments in which fairly homogeneous classes of merchandise items having similar gross margin are grouped. In addition, failure to take markdowns currently may result in an overstatement of cost under the lower of cost or market principle. As of January 31, 2004, we had an inventory valuation allowance of approximately $9.1 million representing our estimate of the cost in excess of the net realizable value of all clearance items. In addition, we had an allowance of approximately $2.2 million representing additional inventory shrink reserve. We believe that our RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market.
o Valuation of goodwill, intangible and other long-lived assets. We use certain assumptionsin establishing the carrying value and estimated lives of our long-lived assets and goodwill. The criteria used for these evaluations include management's estimate of the asset's continuing ability to generate income from operations and positive cash flows. If assets are considered to be impaired, the impairment recognized is measured by the amount that the carrying value of the assets exceeds the fair value of the assets. Useful lives and related depreciation or amortization expense are based on our estimate of the period that the assets will generate revenues or otherwise be used in operations. Factors that would influence the likelihood of a material change in our reported results include a significant decline in our stock price and market capitalization compared to our net book value, significant changes in an asset's ability to generate positive cash flows, significant changes in our strategic business objectives and utilization of the asset. In conjunction with our Chapter 11 filing, we recorded an impairment charge of $26.3 million for our goodwill. Additionally, as a result of the closure of 44 stores, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores.
o Accrued restructuring costs. We have estimated amounts for the charges and the related liabilities regarding our fiscal 2002 and fiscal 2001 restructuring initiatives including store closures, realignment of our field organization and workforce reductions in accordance with the Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Depending on our ability to dispose of the remaining lease obligations for the store and distribution center closures, the actual costs to complete the restructuring initiatives may be different from our estimated costs. As of January 31, 2004, we evaluated our accrued restructuring costs and recorded a favorable adjustment of $1.5 million primarily related to the adjustment of lease termination costs, which is based on the maximum amount allowed by the Bankruptcy Code.
o Litigation reserves. Based in part on the advice of our legal counsel, estimated amounts for litigation and claims that are probable and can be reasonably estimated are recorded as liabilities in the balance sheet. The likelihood of a material change in these estimated reserves would be dependent on new claims as they may arise and the favorable or unfavorable outcome of the particular litigation. We continuously evaluate the adequacy of these reserves and, as new facts come to light, adjust these reserves when necessary.
o Workers' compensation accrual. At the beginning of fiscal 2001, we transitioned to a partially self-insured workers' compensation program. The program for the policy year ended January 31, 2002 had both a specific and aggregate stop loss amount of $250,000 and $3.2 million, respectively. The program for the policy years ended January 31, 2004 and January 31, 2003 had a specific stop loss amount of $250,000 with no aggregate stop loss limit. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy year ended January 31, 2004, 2003 and 2002 were estimated to be approximately $3.6 million, $4.7 million and $4.3 million ($3.2 million aggregate stop loss), respectively. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above.
o Valuation of deferred income taxes. Valuation allowances are established, if deemed necessary, to reduce deferred tax assets to the amount expected to be realized. The likelihood of a material change in our expected realization of these assets is dependent on future taxable income, our ability to use the net operating loss carryforwards, the effectiveness of our tax planning and strategies among the various tax jurisdictions that we operate in, and any significant changes in the tax treatment we currently receive. In light of our significant net operating losses and our Chapter 11 filing, we provided for a 100% valuation allowance on our deferred tax assets as of January 31, 2004.
Results of Operations
The financial statements contained herein have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business, and in accordance with SOP 90-7. Upon emergence from bankruptcy, the amounts reported in subsequent financial statements may materially change, due to the restructuring of our assets and liabilities as a result of the plan of reorganization, if any, and the application of "Fresh Start" accounting.
We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal 2003). The following table sets forth operating data expressed as a percentage of net sales for the fiscal years indicated. Due to operational and strategic changes, year-to-year comparisons of financial results may not be meaningful and the historical results of our operations may not be indicative of our future results.
We operated 239 stores, 244 stores and 279 stores as of January 31, 2004, February 1, 2003 and February 2, 2002, respectively. The average number of stores in operation in fiscal 2003 was 243 versus 259 in fiscal 2002 and 252 in fiscal 2001.
In addition, we averaged 230, 217 and 179 comparable stores for fiscal 2003, 2002 and 2001, respectively. We define comparable stores as follows:
o New stores are considered comparable after 18 months from date of opening.
o When a store relocates within the same market, it is considered comparable after 6 months of operations.
o Store expansion greater than 25% of the original store size is treated like a new store and becomes comparable after 18 months of operations. Store expansion less than 25% of the original store size remains in the comparable store base.
Fiscal 2003 Compared to Fiscal 2002
Net sales were $493.3 million for fiscal 2003 compared to $535.3 million for fiscal 2002, a decrease of $42.0 million or 7.8%. Comparable store sales decreased 4.4% in fiscal 2003 versus a decrease of 7.7% in fiscal 2002. The decrease in net sales was due to negative comparable store sales as well as fewer stores in operation as a result of our fiscal 2002 restructuring.
Gross profit was $153.2 million for fiscal 2003 compared to $162.4 million for fiscal 2002, a decrease of $9.2 million or 5.6%. As a percentage of net sales, gross profit was 31.1% in fiscal 2003 compared to 30.3% in fiscal 2002, or an 80 basis-point improvement versus fiscal 2002. Included in fiscal 2003 cost of sales were a non-cash inventory valuation allowance charge of $7.8 million, net and a non-cash adjustment of $217,000 to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2002 and 2001 restructuring plans. Of the $7.8 million, $6.1 million represented a "lower of cost or market" adjustment related to approximately $19.2 million of aged and slow-moving items that we decided to liquidate during the first quarter of fiscal 2004, $2.2 million represented additional shrink reserve based on unfavorable shrink results we experienced during physical inventory taken at our
stores in February 2004, and an adjustment of $523,000 to reduce excess inventory reserve established at the end of fiscal 2002. As previously reported, included in fiscal 2002 cost of sales were (1) a non-cash charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance, (2) a non-cash charge of $1.1 million related to the expected inventory liquidation cost for store closings identified in the previously mentioned fiscal 2002 restructuring, and (3) a non-cash adjustment of $1.3 million to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2001 restructuring plan. The inventory valuation allowance represented a "lower of cost or market" adjustment related to approximately $16.3 million of aged and slow-moving items that we decided to liquidate in the first quarter of fiscal 2003.
Selling and administrative expenses were $180.9 million for fiscal 2003 compared to $196.4 million for fiscal 2002, a decrease of $15.5 million or 7.9%. Included in fiscal 2003 selling and administrative expenses were $1.0 million charge in connection with separation of two former executives and an income of approximately $708,000 to adjust the valuation allowance established at the end of fiscal 2002 related to certain of our stock subscription notes receivable. Included in fiscal 2002 selling and administrative expenses were: (1) consulting fees of $2.8 million in connection with a consulting agreement, which was terminated in November 2002; (2) a charge of $2.1 million recorded during the second quarter in conjunction with the settlement of litigation; (3) a non-cash charge of $1.2 million to adjust the value of certain shareholders' notes receivable; and (4) a non-cash valuation allowance of $1.0 million for an uncollectible note receivable due from one of our vendors. Excluding these special items in fiscal 2003 and 2002, the selling and administrative expenses for fiscal 2003 was $180.5 million or 36.6 % of net sales compared to $189.3 million or 35.4% of net sales for fiscal 2002. The decrease of $8.8 million or 4.7% was primarily due to fewer stores in operation. The average number of stores in operation for fiscal 2003 was 243, 6.2% lower than fiscal 2002. The increase in selling and administrative expenses as a percentage of net sales was primarily due to the loss of sales volume.
In fiscal 2003, we recorded pre-opening and closing expenses of $292,000, which primarily consisted of start-up expenses for our new distribution center. The decrease of $794,000, or 73.1% from fiscal 2002 was primarily due to the opening of ten fewer new stores in fiscal 2003. In addition, fiscal 2002's pre-opening and closing expenses also included a $250,000 lease termination fee for a store we decided not to open.
Restructuring charge for fiscal 2003 was a favorable adjustment of approximately $1.5 million to reduce the reserves for the fiscal 2002 and 2001 restructuring plans. This favorable adjustment was primarily related to the lease termination reserve adjustment in accordance with the maximum claim for rejected leases as allowed by the Bankruptcy Code. During the fourth quarter of fiscal 2002, we recorded a charge of $14.4 million in relation to our fiscal 2002 restructuring efforts. The charge of $14.4 million included a non-cash inventory liquidation cost of $1.1 million, which was included in cost of sales. In addition, as a result of favorable experience related to the costs of closing the 28 stores included in our fiscal 2001 restructuring plan, we recorded a favorable adjustment of approximately $5.0 million to reduce the reserve established for the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3 million related to inventory liquidation cost, which was reported as part of cost of sales. As such, the total amount reported as a restructuring charge for fiscal 2002 was $9.9 million.
Reorganization items for fiscal 2003 were $31.7 million and consisted of: (1) a non-cash goodwill impairment charge of $26.3 million; (2) a non-cash impairment charge of $2.4 million for fixed assets associated with the 44 stores closed subsequent to January 31, 2004 as part of our reorganization efforts; (3) a non-cash inventory valuation reserve of $1.7 million related to the sale inventory at the 44 stores below cost; and (4) $1.3 million of professional fees and other expenses related to the bankruptcy case and reorganization efforts.
Interest expense, net was $3.7 million in fiscal 2003 versus $1.6 million in fiscal 2002, an increase of $2.1 million or 131.3%. The increase in interest expense from fiscal 2002 is due to increased borrowings at higher interest rates and the write-off of remaining unamortized debt issuance costs of approximately $353,000 as a result of the Chapter 11 filing.
Income tax expense increased from a credit for income taxes of $18.2 million in fiscal 2002 to an expense for income taxes of $24.1 million in fiscal 2003. The credit for income taxes recorded during fiscal 2002 reflected the recognition of a tax benefit associated with our net operating losses. Fiscal 2003 results reflected the establishment of a valuation reserve against certain previously recorded deferred tax assets. Due to our significant net operating losses and our Chapter 11 filing, we now beleive that our ability to recover previously recorded deferred tax assets in the near term has diminished and that it is appropriate to establish a valuation allowance to fully reserve our previously recorded deferred tax assets.
Fiscal 2002 Compared to Fiscal 2001
Net sales were $535.3 million for fiscal 2002 compared to $580.5 million for fiscal 2001, a decrease of $45.2 million or 7.8%. Comparable store sales decreased 7.7% in fiscal 2002 versus a decrease of 8.7% in fiscal 2001. The decrease in net sales was due to fewer stores in operation as well as negative comparable store sales. Comparable store sales decreased primarily as a result of continuing slow economy, threat of terrorist attacks, threat of war with Iraq, increased price competition, and to a lesser extent, increased utilities and fuel costs in California, our largest market. As a result of these factors, we experienced fewer transactions and a reduced purchase size. Compounding this, apparel is considered a deferrable purchase for our core customers who have limited discretionary income. Apparel and houseware purchases may be reduced and deferred in favor of more current needs such as food, housing, utilities and transportation.
Gross profit was $162.4 million for fiscal 2002 compared to $195.1 million for fiscal 2001, a decrease of $32.7 million or 16.8%. As a percentage of net sales, gross profit was 30.3% in fiscal 2002 compared to 33.6% in fiscal 2001, or a 330 basis-point decline versus fiscal 2001. Included in fiscal 2002 cost of sales were: (1) a non-cash charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance; (2) a non-cash charge of $1.1 million related to the expected inventory liquidation cost for store closings identified in the previously mentioned fiscal 2002 restructuring; and (3) a non-cash adjustment of $1.3 million to reduce excess reserve for inventory
liquidation cost related to stores closed under the fiscal 2001 restructuring plan. The inventory valuation allowance represented a "lower of cost or market" adjustment related to approximately $16.3 million of aged and slow-moving items that we decided to liquidate by April 2003. As previously reported, the fiscal 2001 gross margin reflected a non-cash charge of $2.9 million related to the estimated inventory liquidation cost for the closing of 28 under-performing stores identified in the fiscal 2001 restructuring plan. After giving effect to restructuring charges in both years, gross profit margin declined primarily due to higher markdown volume (260 basis points). The higher markdown volume was related to a very heavy promotional environment and clearance of slow-moving and aged merchandise.
Selling and administrative expenses were $196.4 million for fiscal 2002 compared to $188.3 million for fiscal 2001, an increase of $8.1 million or 4.3%. As a percentage of net sales, selling and administrative expenses were 36.6% for fiscal 2002 compared to 32.4% for fiscal 2001. The increase in selling and administrative spending as a percentage of net sales was both spending related and sales volume related. Included in fiscal 2002 selling and administrative expenses were: (1) consulting fees of $2.8 million in connection with a consulting agreement, which was terminated in November 2002; (2) a charge of $2.1 million recorded during the second quarter in conjunction with the settlement of litigation; (3) a non-cash charge of $1.2 million to adjust the value of certain shareholders' notes receivable; and (4) a non-cash valuation allowance of $1.0 million for an uncollectible note receivable due from one of our vendors. In addition to these items, we experienced an increase of approximately $3.5 million in advertising expense. The higher advertising expense was due to increased advertising circulars in response to a very competitive promotional environment. Other store selling expenses, which included store labor and store occupancy, were lower than fiscal 2001 primarily due to the lower average number of stores in operation.
Pre-opening expenses were $1.1 million for fiscal 2002 compared to $3.1 million for fiscal 2001, a decrease of $2.0 million, or 64.8%. The decrease in pre-opening expenses was primarily related to 12 new store openings this year versus 39 new store openings last year. Current year pre-opening expenses included a $250,000 lease termination fee for a store we decided not to open.
Amortization of intangibles was not recorded for fiscal 2002 compared to $1.7 million for fiscal 2001. The change was due to the elimination of goodwill amortization in conjunction with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 142 and cessation of amortization associated with prior business acquisitions.
During the fourth quarter of this year, we recorded a charge of $14.4 million in relation to our previously announced fiscal 2002 restructuring efforts. The charge of $14.4 million included a non-cash inventory liquidation cost of $1.1 million, which was included in cost of sales. In addition, as a result of favorable experience related to the costs of closing the 28 stores included in our fiscal 2001 restructuring plan, we recorded a favorable adjustment of approximately $5.0 million to reduce the reserve established for the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3 million related to inventory liquidation cost, which was reported as part of cost of sales. As such, the total amount reported as a restructuring charge for fiscal 2002 was $9.9 million versus $18.3 million for fiscal 2001. The restructuring charge of $18.3 million in fiscal 2001 was part of the $21.2 million charge related to our restructuring initiatives, as previously discussed. We recorded $2.9 million of the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which was included in cost of sales.
We recorded non-cash stock-based compensation expense related to certain performance-based stock options during fiscal 2001 in the amount of $456,000. During the second quarter of fiscal 2001, we removed the market price hurdle of $49.78 for 19,361 stock options held by a former Executive Vice President who retired in August 2001. As a result of the removal of the market price hurdle, we incurred a non-cash charge of $456,000. There was no stock-based compensation expense incurred in fiscal 2002.
Interest expense, net was $1.6 million in fiscal 2002 versus $960,000 in fiscal 2001, an increase of $651,000 or 67.8%. The increase was due to higher average outstanding borrowings on the revolving credit facility.
We recorded a federal and state income tax benefit of $18.2 million in fiscal 2002 versus $6.9 million in fiscal 2001, an increase of $11.3 million or 165.0%. The increase was due to an increased pre-tax loss incurred in the current year compared to the prior year.
Liquidity and Capital Resources
General
We finance our operations through credit provided by vendors and other suppliers, amounts borrowed under our revolving credit facilities, internally generated cash flow, and other financing resources. Credit terms provided by vendors and other suppliers have historically been approximately 30 days net, although during the pendency of the Chapter 11 case, many of our vendors have reduced the amount of time in which we must pay for goods. Amounts that may be borrowed under the DIP financing facility are based on a percentage of eligible inventory and accounts receivable, as defined.
During fiscal 2003, we completed a series of financing transactions designed to improve liquidity and strengthen our financial position. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting the placement fees and other offering expenses. On April 10, 2003, we completed a $7.5 million debt financing transaction, which consists of a $6.5 million junior term note and a $1.0 million term note. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses. In addition to these financing transactions, we also received a federal tax refund of $8.2 million in March 2003.
After the completion of our private equity offerings, debt financing transaction and receipt of the federal tax refund, the vendor and credit community provided support and extended credit terms for merchandise shipments. However, despite our efforts to improve sales and liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code on January 13, 2004.
DIP Financing Facility
In conjunction with our Chapter 11 filing, we entered into a financing agreement with The CIT Group/Business Credit, Inc. (the Tranche A Lender) and GB Retail Funding, LLC (the Tranche B Lender), (collectively the "Lenders") in which the Lenders provide us a $45.0 million revolving credit facility for working capital needs and other general corporate purposes while we operate as a debtor-in-possession (the "DIP financing facility"). This DIP financing facility with a maturity date of January 14, 2005 has since been amended twice, the first amendment on January 30, 2004 and the second amendment on March 10, 2004.
The DIP financing facility has a superpriority claim status in our Chapter 11 case and is collateralized by first liens on substantially all of our assets, subject to valid and unavoidable pre-petition liens and certain other permitted liens. Under the terms of the DIP financing facility, we may borrow up to 85% of our eligible accounts receivable and up to 70% of our eligible inventory, as defined. However, the DIP financing facility provides for a $5.0 million availability block against our availability calculation, as defined. The DIP financing facility also includes a $20.0 million sub-facility for letters of credit. Interest on the outstanding borrowings under the DIP financing facility is payable monthly and accrues at the rate equal to, at our option, either the prime rate (as announced by JP Morgan Chase Bank) plus 1.50% per annum or LIBOR plus 3.5% per annum. The Tranche B Lender will fully fund $4.0 million within five business days after demand by the Tranche A Lender when the outstanding borrowing provided by the Tranche A Lender first equals or exceeds $6.5 million for three consecutive business days. In the event that there is any outstanding borrowing provided by the Tranche B Lender, such borrowing bears interest at 14.5% per annum payable monthly. We are also obligated to pay a monthly fee equal to 0.375% per annum on the unused available line of credit and a fee equal to 2.5% per annum on the outstanding letters of credit.
Under the terms of the DIP financing facility, capital expenditure for fiscal 2004 is restricted to $2.0 million. In addition, we are required to be in compliance with financial covenants and other customary covenants. The financial covenants include average minimum availability, cumulative four-week rolling average of cash receipts from store sales and cumulative rolling four-week average of inventory receipts, as defined. The customary covenants include certain reporting requirements and covenants that restrict our ability to incur or create liens, indebtedness and guarantees, make dividend payments, sell or dispose of assets, change the nature of our business and enter into affiliate transactions, mergers and consolidations. Failure to satisfy these covenants would (in some cases, after the expiration of a grace period) result in an event of default that could cause, absent the receipt of appropriate waivers, the funds necessary to maintain our operations to become unavailable. The DIP financing facility contains other customary events of default including certain ERISA events, a change of control and the occurrence of certain specified events in the Chapter 11 case. In addition, during the period from December 28, 2004 through January 11, 2005, we are not allowed to have any outstanding borrowings under the revolving credit facility and our outstanding letters of credit cannot exceed $11.0 million.
As of January 31, 2004, we were in compliance with our covenants and had no borrowings outstanding under the revolving credit facility and outstanding letters of credit of $10.1 million under the sub-facility for letters for credit. As of January 31, 2004, based on our eligible inventory and accounts receivable, we were eligible to borrow $33.8 million under the revolving credit facility and had $17.6 million available after giving effect for the availability block, as defined.
Cash Flows
Net cash provided by operating activities was $225,000 in fiscal 2003 as compared to $8.1 million used in operating activities in fiscal 2002. Net cash generated by operating activities in fiscal 2003 was primarily due to our obligations to pay for liabilities incurred prior to the Petition Date were suspended in conjunction with the Chapter 11 filing.
Net cash used for investing activities was $3.5 million in fiscal 2003 compared to $11.0 million in fiscal 2002. Fiscal 2003 investing activities were primarily related to the final stage of capital improvement at our new Otay Mesa distribution center and the installation of a new information system for our planning and allocation department. Fiscal 2002's investing activities were primarily related to capital expenditures for the Otay Mesa distribution center, new store development, replacement capital for existing stores, information system hardware upgrades and replacements, and other general corporate purposes.
Net cash provided by financing activities was $9.8 million in fiscal 2003 compared to $5.2 million in fiscal 2002. In fiscal 2003, our financing activities included $17.1 million of net proceeds from private offerings, offset by $6.3 million of net payments on our revolving credit facility and $1.1 million of payments of debt issuance costs. In fiscal 2002, our financing activities included $6.3 million of net borrowings on our revolving credit facility, $918,000 in proceeds from the exercise of stock options, partially offset by $2.0 million in repayments of our junior subordinated notes and capital lease obligations.
Due to the seasonal nature of our business, where merchandise sales and cash flows from operations are historically higher in the fourth quarter than any other period, a disproportionate amount of operating income and cash flows from operations are earned in the fourth quarter. Our results of operations and cash flows are primarily dependent upon the large sales volume generated during the fourth quarter of our fiscal year. Fourth quarter sales represented 29.1% of total net sales in fiscal 2003. As a result, operating performance for the interim periods is not necessarily indicative of operating performance for the entire year. To support generally higher seasonal sales volume we experience a seasonal inventory build in October and November and therefore our usage of credit facilities is higher during this period of the year. We believe that our DIP financing facility will be adequate to support our projected seasonal borrowing needs.
Our cash needs are satisfied through working capital generated by our business and funds available under our DIP financing facility. The level of cash generated by our business is dependent, to a great extent, on our level of sales and the credit extended by our vendors and the factor community. If we experience a significant disruption of terms with our vendors and factors, the DIP financing facility for any reason becomes unavailable, or actual results differ materially from those projected, our compliance with financial covenants and our cash resources could be adversely affected.
Pre-petition Revolving Credit Facility
Prior to the Petition Date, we had a $50.0 million revolving credit facility agreement (the "Financing Agreement") with a financial institution expiring in March 2006. Under this Financing Agreement, we could borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The revolving credit facility provided for a $7.5 million availability block against our availability calculation, as defined. The Financing Agreement also included a $15.0 million sub-facility for letters of credit. Under the terms of the Financing Agreement, the interest rate could increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. We were obligated to pay fees equal to 0.125% per annum on the unused amount of the revolving credit facility. We were contractually prohibited from paying cash dividends on our common stock under the terms of the Financing Agreement without consent of the lender. As amended on April 10, 2003, the facility was secured by a first lien on all company assets excluding furniture, fixtures, machinery and equipment.
On February 14, 2003, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which was secured by a junior lien on the Collateral, as defined.
On April 10, 2003, we amended the terms of our Financing Agreement (the "Amended and Restated Financing Agreement") to add $7.5 million of term loans, to add financial covenants, and to amend certain reporting provisions and other terms. The term loans consisted of a $6.5 million junior term note secured by all company assets excluding furniture, fixtures, machinery and equipment and a $1.0 million junior term note secured by furniture, fixtures, machinery and equipment. These notes bore interest at the rate of 14.5% per annum on the then current outstanding balance and a maturity date of April 10, 2004.
On December 22, 2003, we amended the terms of our Amended and Restated Financing Agreement ("First Amendment") to shorten the period that we were required to have zero borrowings, or "clean-up", under the revolving credit facility from 15 consecutive days beginning December 22, 2003 to eight consecutive days beginning December 29, 2003. The First Amendment also required us to pay the full unpaid balance of $600,000 under the Tranche B Loan II on or before December 23, 2003, and we paid it accordingly.
On January 12, 2004 we amended the terms of our Amended and Restated Financing Agreement ("Second Amendment") in which we were required to pay the full unpaid balance of $6.5 million on or before January 12, 2004, and we paid it accordingly.
Junior Subordinated Notes
The Junior Subordinated Notes (the "Notes") are non-interest bearing and were reflected on our balance sheets at the present value using a discount rate of 10%. We are prohibited from paying cash dividends on our common stock under the terms of the Notes without the consent of the note holders.
As of January 31, 2004, we were in default under the terms of our Notes and have included the net carrying value of $10.3 million (face value of $11.3 million net of a related unamortized discount of $1.0 million) in the line Liabilities subject to compromise. On the Petition Date, we stopped amortizing debt discount related to the Notes, in accordance with SOP 90-7.
Under the Bankruptcy Code, the claims of holders of the Notes are subject to disallowance to the extent they represent a claim for unmatured interest, i.e., the portion of face value representing unamortized discount. The amount so disallowed may differ from the unamortized discount maintained on our books and records.
Capital Expenditure
We anticipate capital expenditure of approximately $1.0 million in fiscal 2004, which includes necessary costs for replacement capital at existing stores.
Store Closures
As of April 23, 2004, we had closed 20 of the 23 stores identified in our Fiscal 2002 restructuring efforts and completed the consolidation of our distribution network and corporate overhead structure. The remaining three stores have not been closed at this time due to lease concessions agreed to by the landlords. We have completed the consolidation of our two former San Diego distribution centers and our Lewisville, Distribution center into one distribution center, which is also located in San Diego, California. In conjunction with our Chapter 11 filing, we have ceased to make cash payments for any remaining obligations regarding our Fiscal 2002 restructuring plan except the lease obligation of one of our former San Diego distribution centers (located in the same building as our corporate headquarters) and certain satellite communication service fee obligations. We estimate the cash requirement for these obligations for fiscal 2004 will be approximately $1.2 million, which we intend to fund from our sources of cash, including the DIP financing facility.
With respect to our Fiscal 2001 restructuring efforts, we closed all 28 stores during fiscal 2002. In conjunction with our Chapter 11 filing, we have ceased to make cash payments for any remaining obligations regarding our Fiscal 2001 restructuring plan except certain satellite communication service fee obligations. The cash requirement for such obligations for fiscal 2004 will be minimal and we intend to fund them from our sources of cash, including the DIP financing facility.
On February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores open as of January 31, 2004. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at the 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases.
Reorganization Efforts
In connection with our bankruptcy case and reorganization efforts, we project to incur approximately $5.3 million of professional fees and other related expenses for fiscal 2004. We believe that our sources of cash, including the DIP financing facility, should be adequate to fund the cash requirement for our reorganization efforts.
Contractual Obligations and Commitments
The following table summarizes, as of January 31, 2004, certain of our contractual obligations, as well as estimated cash requirements related to our fiscal 2002 and 2001 restructuring initiatives. This table should be read in conjunction with "Note 4 Fiscal 2002 Restructuring Charge", "Note 5 Fiscal 2001 Restructuring Charge", "Note 10 Long-Term Debt and Revolving Credit Facilities" and "Note 12 Lease Commitments" in the accompanying financial statements.
Certain amounts included in the above table are related to executory contracts or lease obligations, which we have neither assumed nor rejected as of January 31, 2004. Under the Bankruptcy Code, we may assume or reject executory contracts, including lease obligations. Therefore, the commitments shown in the above table may not reflect actual cash outlays in the future periods.
Reorganization Items
Reorganization items represent amounts we incurred as a result of the Chapter 11 proceedings in accordance with SOP 90-7. The amounts for Reorganization items in the Statements of Operations include: (1) a $26.3 million impairment of goodwill; (2) a $2.4 million charge to accelerate depreciation on the remaining fixed assets associated with the 44 closing stores; (3) a $1.7 million charge for inventory sold below cost at our 44 closing stores; and (4) $1.3 million of professional fees related to the bankruptcy case.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (the "FASB") issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standard (the "SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement provides clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The adoption of this statement did not have a material impact on our financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity and is effective for financial instruments entered into or modified after May 31, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Currently, our exposure to market risks results primarily from changes in interest rates, principally with respect to the DIP financing facility, which is a variable rate financing agreement. We do not use swaps or other interest rate protection agreements to hedge this risk. As of January 31, 2004, we had no borrowings outstanding under our DIP financing facility.
Item 8.
Item 8. Financial Statements and Supplementary Data
FACTORY 2-U STORES, INC. Page - ------------------------ ----
Report of Independent Public Accountants
Report of Independent Public Accountants (Arthur Andersen LLP)
Balance Sheets as of January 31, 2004 and February 1, 2003
Statements of Operations for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002
Statements of Stockholders' Equity (Deficit) for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002
Statements of Cash Flows for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002
Notes to Financial Statements
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On April 24, 2002, our Board of Directors, on the recommendation of the Audit Committee, determined not to renew the engagement of its independent public accountants, Arthur Andersen LLP ("Andersen"), for the fiscal year ended February 1, 2003.
During our fiscal years ended February 2, 2002 and February 3, 2001, and the subsequent interim period through April 24, 2002, there were no disagreements between us and Andersen on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Andersen, would have caused Andersen to make reference to the matter of the disagreement in connection with their reports. Andersen's reports on our financial statements for each fiscal year ended February 2, 2002 and February 3, 2001 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.
Andersen's report on our financial statements for the fiscal year ended February 2, 2002, dated February 27, 2002, was issued on an unqualified basis in conjunction with the filing of our Annual Report on Form 10-K for the fiscal year ended February 2, 2002 filed on April 19, 2002 with the Securities and Exchange Commission.
None of the reportable events described under Item 304 (a) (1) (v) of Regulation S-K occurred within our two most recent fiscal years and subsequent interim period through April 24, 2002.
Item 9A.
Item 9A. Controls and Procedures
Evaluation. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. This evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO).
Conclusions. Based upon our evaluation, our CEO and CFO have concluded that our disclosure controls and procedures are effective to ensure that material information relating to the Company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared.
Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of our last evaluation of such internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Directors
The following table sets forth, as of April 23, 2004, certain information concerning our directors.
Peter V. Handal has been a director since February 1997. Mr. Handal is President and Chief Executive Officer of Dale Carnegie & Associates. Since 1990, he has been President of COWI International Group (a management consulting firm). Mr. Handal is also Chief Executive Officer of J4P Associates LP (a real estate developer). He serves on the Board of Directors of Dale Carnegie & Associates and Cole National Corporation.
Ronald Rashkow was appointed by the Board of Directors to the position of Lead Director in November 2002. Mr. Rashkow has been a director since February 1997. He has been a principal of RPMS, Inc., an investment banking firm, since January 2004. Prior to that, he was a principal of Chapman Partners, L.L.C., an investment banking firm, from September 1995 to December 2003. For more than five years prior to that, he served as Chief Executive Officer and Chairman of the Board of Directors of Handy Andy Home Improvement Centers, Inc. (a building supply retailer started by his family in 1946).
Wm. Robert Wright II has been a director since November 1998. He has been a managing partner of Grey Mountain Partners, LLC, a private equity firm that invests in middle market companies, since its founding in January 2003. Prior to that, he was employed by Three Cities Research, Inc., a firm engaged in the investment and management of private capital, from 1992 through 2002, except for a period from July 1993 to August 1995 when he was in a graduate program at Harvard University. His last position with Three Cities Research, Inc. was "managing partner", a title he held from 1999 to 2002.
Willem F.P. de Vogel has been a director since December 2000. Mr. de Vogel has served as President of Three Cities Research, Inc. since 1982.
Norman G. Plotkin has been a director since March 2004 and has been Chief Executive Officer since December 2003. Prior to his appointment as Chief Executive Officer, Mr. Plotkin was our Executive Vice President, Store Development, Human Resources and General Counsel. He also assumed responsibility over our Store Operations for a period during 2002. Mr. Plotkin joined us in July 1998 in the position of Senior Vice President, Store Development and General Counsel. Prior to joining us, Mr. Plotkin was the President of Normark Real Estate Services, Ltd., a commercial real estate firm based in Des Plaines, Illinois. Prior to that, from 1988 until 1996, Mr. Plotkin was the Senior Vice President of Finance and Administration and General Counsel of Handy Andy Home Improvement Centers, Inc. Additionally, Mr. Plotkin was engaged in the private practice of law from 1980 to 1988.
Executive Officers
The following table sets forth certain information concerning our executive officers who are not directors.
A.J. Nepa is Executive Vice President and General Merchandise Manager. Mr. Nepa joined us in November 2003. Prior to joining us, Mr. Nepa was the General Merchandise Manager for Forman Mills, a privately held off-price retail chain headquartered in Pennsylvania. He previously served as Senior Vice President and General Merchandise Manager of One Price Clothing Stores from 1998 to 2000 and General Merchandise Manger for It's Fashion, a division of Cato Stores, from 1992 to 1998.
Norman Dowling is Executive Vice President and Chief Financial Officer. Mr. Dowling joined us in March 2004. Prior to joining us, Mr. Dowling served as Vice President, Finance of PETCO Animal Supplies, Inc., from November 1999 to March 2004. Prior to joining PETCO, he served as Chief Financial Officer and Secretary of CinemaStar Luxury Theaters, Inc. from 1997 to 1999. CinemaStar Luxury Theaters, Inc. filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in January 2001. Previously, Mr. Dowling was Director of Finance at Advanced Marketing Services, Inc. from 1993 to 1997. From 1990 to 1993, Mr. Dowling was Controller and then Director of Mergers & Acquisitions at Medical Imaging Centers of America, Inc.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended requires the Company's directors, executive officers and beneficial owners of more than ten percent (10%) of the Common Stock to file with the SEC initial reports of ownership and reports of changes in ownership of Common Stock of the Company. SEC regulations also require such persons to furnish the Company with copies of all such reports.
Based solely upon its review of the copies of such reports furnished to it, or written representations from the reporting persons that no forms were required to be filed, the Company believes that during the fiscal year ended January 31, 2004 all section 16(a) filing requirements applicable to its executive officers, directors and greater than ten percent beneficial owners were complied with.
Audit Committee
The Company's Board of Directors has identified Wm. Robert Wright II as its Audit Committee Financial Expert, as defined by Item 401 of Regulation S-K. Mr. Wright is an independent Board member, as defined by Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act.
Code of Ethics
We have adopted the Factory 2-U Stores, Inc. Standards of Business Conduct, which is applicable to all of our employees, including our chief executive officer, chief financial officer, controller and all vice presidents. Our Standards of Business Conduct complies with the requirements of the Sarbanes-Oxley Act of 2002 and the regulations promulgated by the Securities and Exchange Commission thereunder. We have filed a copy of our Standards of Business Conduct as an exhibit to this annual report.
Item 11.
Item 11. Executive Compensation
Compensation of Directors
We pay each director who is not a Lead Director or an employee of ours an annual fee of $12,000 plus $1,250 for attendance at each meeting of the Board of Directors ($250 for a telephonic meeting). Additionally, prior to our Chapter 11 filing, at the end of each fiscal quarter, we granted each director who was not an employee 250 shares of common stock and awarded a cash payment equal to the closing market price of our common stock on such date times 500 shares. Since the Petition Date, we have discontinued such equity-related grants and awards.
We also reimburse all directors for any out-of-pocket travel expenses incurred in attending meetings.
Ronald Rashkow Lead Director Agreement
On November 4, 2002, Mr. Rashkow was appointed to the newly created position of Lead Director by our Board of Directors under the terms of an agreement. We have neither assumed nor rejected the agreement under the federal bankruptcy laws. Mr. Rashkow's service as Lead Director will continue at the pleasure of the Board of Directors for up to three years. Under the terms of his agreement, Mr. Rashkow receives monthly compensation of $12,500, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director. He is also entitled to receive $3,500 per day, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director, for each day of service in excess of six days per quarter.
As an inducement to secure his services as Lead Director, Mr. Rashkow also received options to purchase 50,000 shares of our common stock on November 4, 2002 at an exercise price of $1.61, the fair market value of our common stock on the date of grant. The options vested immediately and are exercisable for five years from the date of grant. As a further inducement to secure his services, Mr. Rashkow also received 25,000 shares of restricted common stock, subject to his completion of 12 months of service as Lead Director. Mr. Rashkow has a target grant of 25,000 similar shares of restricted common stock, subject to his completion of 24 months of service, and another 25,000 shares subject to his completion of 36 months of service. His receipt of these restricted shares, in addition to the length of service requirement, will be commensurate with our Chief Executive Officer's achievement of his performance goals for the applicable year. If the goals are not attained, the shares will not be granted.
Compensation of Executive Officers
Employment Contracts with Named Executive Officers
The following employment agreements and other arrangements with respect to our named executive officers are described as in effect as of January 31, 2004. We have neither assumed nor rejected the employment agreements under the federal bankruptcy laws.
Norman Plotkin Employment Agreement
Prior to Mr. Plotkin's appointment as Chief Executive Officer on December 10, 2003, we employed Mr. Plotkin as Executive Vice President - Store Development, Human Resources and General Counsel, pursuant to a one-year employment agreement dated May 20, 2003 that was entered into prior to the Petition Date. His employment agreement was automatically extended under its terms for an additional one-year period, and will continue to be extended on each anniversary thereafter, unless either Mr. Plotkin or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended.
Under the employment agreement, Mr. Plotkin's base salary was $285,000 annually. After his appointment as Chief Executive Officer, his base salary was increased to $400,000 annually. Mr. Plotkin's target bonus for the fiscal year ended January 31, 2004 was 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year Mr. Plotkin's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. Also, the employment agreement provides that if the performance objectives accepted by the Compensation Committee are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Plotkin will not be entitled to any bonus.
On May 20 2003, we granted Mr. Plotkin non-qualified options to purchase 50,000 shares of our common stock at an exercise price of $3.26 per share, the fair market value of our stock on the date of grant. These options vest in tranches of 3,125 shares on each March, June, September and December 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche.
In addition, on September 17, 2003, we granted Mr. Plotkin 50,000 restricted shares of our common stock for $500. These restricted shares will vest in installments as follows: 16,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 16,666.7 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 16,666.7 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Plotkin's right to receive any shares of restricted stock that has not vested prior to April 10, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Plotkin will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement.
Melvin Redman Employment Agreement
Mr. Redman resigned his position with us as of April 27, 2004. Prior to his appointment as Executive Vice President and Chief Operating Officer on January 13, 2004, we employed Mr. Redman as Executive Vice President - Store Operations and Distribution, pursuant to a one-year employment agreement dated January 6, 2003 that was entered into prior to the Petition Date. His employment agreement was automatically extended under its terms for an additional one-year period, and would have continued to be extended on each anniversary thereafter.
Under the employment agreement, Mr. Redman's base salary was $500,000 annually. Mr. Redman received a signing bonus in the amount of $100,000 upon beginning his employment. Mr. Redman's target bonus for the fiscal year ended January 31, 2004 was 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year, Mr. Redman's target bonus would have been based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer had been exceeded in any year, the annual bonus would have increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. Mr. Redman would have received no bonus if the performance objectives were not met.
As an inducement necessary to secure his services, on January 6, 2003, we granted Mr. Redman non-qualified options to purchase 125,000 shares of our common stock at an exercise price per share of $3.13, the fair market value of our stock on the date of grant. These options vested in tranches of 7,812.5 shares on each March 30, 2003, June 30, 2003, September 30, 2003 and December 30, 2003, and would have vested in tranches of 7,812.5 shares on the 30th of each December, March, June and September during the next three years of his employment term. The non-qualified options in each tranche would have been exercisable for a period of five years after the vesting of that tranche.
As a further inducement necessary to secure his services, we also granted Mr. Redman on January 6, 2003, 125,000 restricted shares of our common stock for $1,250. These restricted shares would have vested in installments as follows: 41,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 41,666.7 shares when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 41,666.7 shares would have vested when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Redman's right to receive any shares of restricted stock that has not vested terminated as a result of his resignation, and all of such restricted shares were forfeited.
A.J. Nepa Employment Agreement
We employed A.J. Nepa, Executive Vice President - General Merchandise Manager, pursuant to a one-year employment agreement dated November 10, 2003 that expires on November 9, 2004, provided that at the scheduled end of the initial employment term, and on each anniversary thereafter, his employment term will be automatically extended for an additional one-year period unless either Mr. Nepa or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended.
Under the employment agreement, Mr. Nepa's base salary is $250,000 annually. Mr. Nepa's target bonus for the fiscal year ending January 29, 2005 is 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year, Mr. Nepa's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Nepa will not be entitled to any bonus.
As an inducement to secure his services, on November 10, 2003 we granted Mr. Nepa non-qualified options to purchase 50,000 shares of our common stock at an exercise price per share of $2.56, the fair market value of our stock on the date of grant. These options vest in tranches of 3,125 shares on each March, June, September and December 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche.
As a further inducement to secure his services, we also granted Mr. Nepa on November 10, 2003, 50,000 restricted shares of our common stock for $500. These restricted shares will vest in installments as follows: 16,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 16,666.7 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 16,666.7 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Nepa's right to receive any shares of restricted stock that has not vested prior to November 10, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Nepa will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement.
Severance Agreements
On December 10, 2003, William R. Fields' employment with us was terminated. Under the terms of his employment agreement with us, he was entitled to twelve months of his base salary, all accrued but unpaid compensation, vacation pay and reimbursable business expenses through his termination date, payable in a lump sum in the amount of approximately $1.0 million. In addition, he was entitled to the amounts or benefits owing under benefit plans and policies, exclusive of cash severance policies and up to three years of COBRA premiums. We have neither assumed nor rejected Mr. Fields' employment agreement under the federal bankruptcy laws. As a result of the Chapter 11 filing on January 13, 2004, Mr. Fields' severance payments have not been made.
On January 5, 2004, Douglas C. Felderman's employment with us was terminated. Under the terms of his employment agreement with us, he was entitled to twelve months of his base salary in the total amount of $285,000, of which $50,000 was paid. We have neither assumed nor rejected Mr. Felderman's employment agreement under the federal bankruptcy laws. As a result of the Chapter 11 filing on January 13, 2004, no further severance payments have been made to Mr. Felderman.
Compensation Committee Report on Executive Compensation
The discussion below describes our compensation practices and principles for fiscal 2003 prior to the Petition Date. During the pendency of our bankruptcy case, our compensation practices and principles are subject to the jurisdiction of the Court. We have submitted to the Court a proposed key employee retention plan with respect to which the Court has yet to act.
The Compensation Committee of the Board of Directors is composed entirely of outside directors. The Compensation Committee is responsible for establishing and administering the compensation policies applicable to our executive officers. All decisions by the Compensation Committee are subject to review and approval by the full Board of Directors.
Our executive compensation philosophy and specific compensation plans tie a significant portion of executive compensation to our success in meeting specific profit, growth and performance goals.
Our compensation objectives include attracting and retaining the best possible executive talent, motivating executive officers to achieve our performance objectives, rewarding individual performance and contributions, and linking executives' and stockholders' interests through equity based plans.
Our executive compensation consists of three key components: base salary, annual incentive compensation and stock options, each of which is intended to complement the others and, taken together, to satisfy our compensation objectives. The Compensation Committee's policies with respect to each of the three components are discussed below.
Base Salary. In the early part of each fiscal year, the Compensation Committee reviews the base salary of the Chief Executive Officer (subject to requirements of his employment agreement) and the recommendations of the Chief Executive Officer with regard to the base salary of all other executive officers, and approves, with any modifications it deems appropriate, annual base salaries for each of our executive officers. We base the recommended base salaries of the executive officers on an evaluation of the individual performance of the executive officer, including satisfaction of annual objectives. The recommended base salary of the Chief Executive Officer is based on achievement of our annual goals relating to financial objectives, including earnings growth and return on capital employed, and an evaluation of individual performance.
Recommended base salaries of the executive officers are also based in part upon an evaluation of the salaries of executives who hold comparable positions at comparable companies.
Annual Incentive Compensation. Our executive officers participate in a discretionary incentive bonus plan which provides for the payment of annual bonuses in cash or stock (or both), based on our success in attaining financial objectives, and subjective factors established from time to time by the Compensation Committee or the Board of Directors. With the exception of those executives who have separate employment agreements with us, the Compensation Committee normally considers aggregate incentive cash and stock bonus payments to the executive officers, as a group, of up to 50% of their base salaries, and any bonus payments in excess of 50% of the aggregate base salaries, may be paid in cash or stock, at the discretion of the Compensation Committee. The Compensation Committee did not award annual incentive bonus payments to any of our executive officers for fiscal 2003.
Compensation of the Chief Executive Officer. Mr. Plotkin was appointed Chief Executive Officer on December 10, 2003 and elected as a director on our Board of Directors in March 2004. Mr. Plotkin's base salary is $400,000 annually. The Compensation Committee determined Mr. Plotkin's compensation by considering his prior experience, expertise and compensation paid to other executives with similar experience in comparable companies. In determining Mr. Plotkin's compensation, the Compensation Committee took into account Mr. Plotkin's extensive prior experience. Mr. Plotkin has been with us since July 1998 and has held the positions of Executive Vice President of Store Development, Human Resources and General Counsel and for a period in 2002 he assumed responsibility over Store Operations. The Compensation Committee concluded that Mr. Plotkin's compensation was commensurate with the compensation paid to other executives with similar experience in comparable companies.
Compensation of the former Chief Executive Officer. Mr. Fields joined the Company in November 2002 as Chairman of our Board of Directors and Chief Executive Officer. Under the terms of his employment agreement, Mr. Fields' base salary was $750,000 annually. For the first year of his employment term, Mr. Fields received a guaranteed bonus of $375,000, that was payable in 12 monthly installments. The Compensation Committee determined Mr. Fields' compensation by considering his prior experience and expertise, compensation paid to other executives with similar experience in comparable companies, and what would be required in order to induce Mr. Fields to join the Company. In determining Mr. Fields' compensation, the Compensation Committee took into account Mr. Fields' extensive prior experience, including his 24 years of experience with Wal-Mart, culminating in his serving as Chief Executive Officer and President of Wal-Mart Stores Division during 1993 through 1996, as well as his experience as Chairman and Chief Executive Officer of Blockbuster Entertainment Group during 1996 and 1997 and as Chief Executive Officer and President of Hudson's Bay Company during 1997 though 1999. The Compensation Committee concluded that Mr. Fields' compensation was required in order to induce him to join the Company and that it was commensurate with the compensation paid to other executives with similar experience in comparable companies.
Stock Options. The primary objective of the stock option program is to link our interests and those of our executive officers and other selected employees to those of the stockholders through significant grants of stock options. The Compensation Committee bases the aggregate number of options it recommends on practices of comparable companies, while grants of stock options to specific employees reflect their expected long-term contribution to our success. As a result of the Chapter 11 filing, the Company is not currently granting stock options to its employees.
Compensation Committee:
Willem F.P. de Vogel, Chairman Peter V. Handal
Compensation Committee Interlocks and Insider Participation
No member of the Compensation Committee of the Board of Directors was, during fiscal 2003 or at any other time, one of our officers or employees.
Summary of Cash and Other Compensation
The following table contains information about the compensation during fiscal 2003 of our former principal executive officer; current principal executive officer; our two other most highly paid executive officers who served as executive officers at the end of fiscal 2003 and received salary and bonus in excess of $100,000 during fiscal 2003; and two other named executive officers who were not serving as executive officers at the end of fiscal 2003:
Note:The aggregate amount of any other annual compensation is less than the lesser of $50,000 or 10% of such person's total annual salary and bonus.
(1) We refer to a fiscal year by the year in which most of the activity occurred (for example, we refer to fiscal year ended January 31, 2004 as fiscal 2003).
(2) "All Other Compensation" for fiscal 2003 includes (i) matching contributions under our 401(k) Savings Plan of $1,973 for Mr. Felderman, $2,071 for Mr. Plotkin and $881 for Mr. Swygert; (ii) payment of moving expenses of $326,944 for Mr. Fields and $123,694 for Mr. Redman; (iii) final vacation pay of $35,129 for Mr. Felderman and $8,695 for Mr. Wong; and (iv) severance payments of $50,000 for Mr. Felderman and $41,538 for Mr. Wong.
(3) Mr. Fields was Chief Executive Officer and Chairman of the Board until his termination of employment on December 10, 2003. Mr. Fields received $312,500 during fiscal 2003 and $62,500 during fiscal 2002, of his guaranteed first year bonus of $375,000 under the terms of his employment agreement.
(4) Mr. Plotkin was appointed Chief Executive Officer effective December 10, 2003 and a member of the Board of Directors effective March 16, 2004.
(5) As of January 5, 2004, Mr. Felderman was no longer an employee.
(6) As of April 27, 2004, Mr. Redman was no longer an employee.
(7) As of February 20, 2004, Mr. Swygert was no longer an employee.
(8) As of August 11, 2003, Mr. Kelley was no longer an employee.
Grants of Stock Options
The following table sets forth information concerning the award of stock options during fiscal 2003. We have never granted stock appreciation rights.
(1) Amounts shown represent the potential value of granted options if the assumed annual rates of stock appreciation are maintained over the terms of the granted options. The assumed rates of appreciation are established by regulation and are not intended to be a forecast of our performance or to represent our expectations with respect to the appreciation, if any, of the common stock.
Any value of our common stock underlying the options will depend on the value, if any, ascribed to our common stock in any plan of reorganization which may be confirmed. As described earlier, we believe that, in light of the Chapter 11 filing, the value of our common stock is highly speculative. Accordingly, we are not presently ascribing any value to the above options. Nevertheless, in order to comply with SEC rules, this column sets forth the estimated present value of the options granted during fiscal year 2003.
(2) As of December 10, 2003, Mr. Fields was no longer an employee. All such options expired unexercised 3 months after that date.
(3) As of January 5, 2004, Mr. Felderman was no longer an employee. All such options expired unexercised 3 months after that date.
(4) As of April 27, 2004, Mr. Redman was no longer an employee.
(5) As of February 20, 2004, Mr. Swygert was no longer an employee. All such options expired unexercised 60 days after that date.
(6) As of August 11, 2003, Mr. Kelley was no longer an employee. All such options expired unexercised on that date.
Exercise of Stock Options and Holdings
The following table sets forth information concerning exercises of stock options during fiscal 2003 and the fiscal year-end value of unexercised options. We have never granted stock appreciation rights.
(1) As of December 10, 2003, Mr. Fields was no longer an employee. All such options expired unexercised 3 months after that date.
(2) As of January 5, 2004, Mr. Felderman was no longer an employee. All such options expired unexercised 3 months after that date.
(3) As of April 27, 2004, Mr. Redman was no longer an employee. All such options will expire 3 months after that date.
(4) As of February 20, 2004, Mr. Swygert was no longer an employee. All such options expired unexercised 60 days after that date.
(5) As of August 11, 2003, Mr. Kelley was no longer an employee. All such options expired unexercised on that date.
Long-Term Incentive Plans - Awards in Last Fiscal Year
(1) Mr. Plotkin received a restricted stock grant of 50,000 shares of common stock on September 17, 2003 when the closing market price of our common stock was $4.26 per share. Mr. Plotkin's right to receive any shares of restricted stock that have not vested prior to September 17, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Plotkin will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the date of grant. Mr. Plotkin is entitled to receive dividends that are paid on common stock and he has the right to vote his restricted shares.
(2) As of January 5, 2004, Mr. Felderman was no longer an employee. Mr. Felderman received a restricted stock grant of 50,000 shares of common stock on September 17, 2003 when the closing market price of our common stock was $4.26 per share. Mr. Felderman's right to receive any shares of restricted stock terminated as a result of the termination of his employment and the restricted stock has been returned to us.
(3) As of April 27, 2004, Mr. Redman was no longer an employee.
(4) As of February 20, 2004, Mr. Swygert was no longer an employee.
(5) As of August 11, 2003, Mr. Kelley was no longer an employee.
PERFORMANCE CHART
The following chart compares the five-year cumulative total return (change in stock price plus reinvested dividends) on our common stock with the total returns of the Nasdaq Composite Index, a broad market index covering stocks listed on the Nasdaq National Market, the Dow Jones Retailers Broadline Index ("Industry Index") which currently encompasses 22 companies, and the companies in the Family Clothing Retail industry (SIC Code 5651), a group currently encompassing 23 companies (the "SIC Index"). This information is provided through January 31, 2004, the end of fiscal 2003.
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN AMONG FACTORY 2-U STORES, INC., NASDAQ MARKET INDEX, INDUSTRY INDEX AND SIC INDEX
The composition of the Industry Index is as follows: BJ's Wholesale Club, Inc., Bon-Ton Stores, Inc., Coles Myer Ltd., Controladora Comer Mex, Cost-U-Less, Inc., Costco Wholesale Corp., Daiei Inc ADR, Dillard's, Inc., Dollar General Corp., Duckwall-Alco Stores, Inc., Family Dollar Stores, Inc., Federated Dept. Stores, Fred's, Inc., Ltd., J.C. Penney Holding Co., May Department Stores, Overstock.com Inc., Pricesmart, Inc., Retail Ventures, Inc., Sears, Roebuck & Co., Shopko Stores Inc., Target Corporation and Wal-Mart Stores, Inc.
The composition of the SIC Index is as follows: Abercrombie & Fitch Co., Aeropostale, Inc., American Eagle Outfitter, Big Dog Holdings, Inc., Buckle, Inc., Burlington Coat Factory Warehouse, Casual Male Retail Group, Chico's FAS, Inc., Children's Place Retail Stores, Factory 2-U Stores, Inc., Freestar Technologies, Gadzooks, Inc., Gap, Inc., Goody's Family Clothing, Gymboree Corp., Harold's Stores, Inc., Nordstrom, Inc., Ross Stores, Inc., Stage Stores, Inc., Stein Mart, Inc., Syms Corp., Urban Outfitters, Inc., and Wilsons the Leather Expert.
Source: Media General Financial Services
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Principal Stockholders
The following persons are known by us, based solely upon information filed by such persons with the Securities Exchange Commission, to have owned beneficially more than 5% of any class of our voting securities as of April 23, 2004:
(1) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is One Maritime Plaza, 11th Floor, San Francisco, CA 94111. Lonestar Partners, L.P. ("Lonestar") filed its 13G with the SEC on January 23, 2004 and claimed beneficial ownership of 1,584,000 shares, or 8.8% of our common stock. The statement was filed by Lonestar a Delaware limited partnership, with respect to Shares owned by it, Lonestar Capital Management LLC, a Delaware limited liability company ("LCM"), the investment adviser to and general partner of Lonestar, with respect to the Shares held by Lonestar, and Jerome L. Simon ("Simon"), the manager and sole member of LCM, with respect to Shares held by Lonestar. The Shares reported hereby for Lonestar are owned directly by Lonestar. LCM, as general partner and investment adviser to Lonestar, may be deemed to be the beneficial owner of all such Shares owned by Lonestar. Simon, as the manager and sole member of LCM, may be deemed to be the beneficial owner of all such Shares held by Lonestar. Each of LCM and Simon hereby disclaim any beneficial ownership of any such Shares.
(2) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 100 Crescent Court, Suite 490, Dallas, Texas 75201. Gryphon Master Fund, L.P. ("Master Fund") filed its 13G with the SEC on January 27, 2004 and claimed beneficial ownership of 1,205,269 shares, or 6.7% of our common stock. The statement was filed by Master Fund, Gryphon Partners L.P. ("Gryphon Partners"), Gryphon Management Partners, L.P. ("GMP"), Gryphon Advisors, LLC ("Gryphon Advisors"), and E.B. Lyon, IV ("Lyon"). The shares of our common stock are owned directly by Master Fund. The General Partner of Master Fund is Gryphon Partners, L.P., which may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. The General Partner of Gryphon Partners is GMP, which may be deemed to be the beneficial owner of all such shares of our common stock owned by Mater Fund. The General Partner of GMP is Gryphon Advisors, which may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. Lyon controls Gryphon Advisors and may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. Each of Gryphon Partners, GMP, Gryphon Advisors and Lyon disclaims any beneficial ownership of any such shares of our common stock owned by Master Fund.
(3) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The statement filed on March 29, 2004 was jointly filed by Couchman Partners, L.P. ("CP"), Capital LLC ("CC"), and Jonathan Couchman (together with CP and CC, the "Reporting Persons"). Because Jonathan Couchman is the sole member of the Management Board of CC, which in turn is the partner of CP, the Reporting Persons may be deemed, pursuant to Rule 13d-3 of the Securities Exchange Act of 1934, as amended (the "Act"), to be the beneficial owners of all shares of our common stock held by CP. The Reporting Persons are filing this joint statement, as they may be considered a "group" under Section 13(d)(3) of the Act. However, neither the fact of this filing nor anything contained herein shall be deemed to be an admission by the Reporting Persons that such a group exists. The principal business address of CP is c/o Hedge Fund Services (BVI) Limited, James Frett Building, PO Box 761, Wickhams Cay 1, Road Town, Tortola, British Virgin Islands. The principal business of CC and Mr. Couchman is 800 Third Avenue, 31st Floor, New York, New York 10022.
(4) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is One Rockefeller Plaza, 19th Floor, New York, New York 10020. Conus Partners, Inc. filed its Schedule 13G with the SEC on January 22, 2004 and claimed beneficial ownership of 1,011,450 shares, or 5.6% of our common stock.
(5) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 150 California Street, Fifth Floor, San Francisco, CA 94111. Cannell Capital LLC filed its Schedule 13G with the SEC on November 5, 2003 and claimed beneficial ownership of 900,000 shares, or 5.0% of our common stock. This statement was filed by (i) Cannell Capital, LLC, a California limited liability company and California licensed investment adviser ("IA"), (ii) J. Carlo Cannell ("Managing Member"), (iii) The Anegada Fund Limited ("Anegada"), (iv) The Cuttyhunk Fund Limited ("Cuttyhunk"), (v) Tonga Partners, L.P. ("Tonga"), (vi) GS Cannell Portfolio, LLC ("GS Cannell") and (vii) Pleiades Investment Partners, LP ("Pleiades") (collectively, the Reporting Persons). Managing Member controls IA by virtue of Managing Member's position as
managing member and majority owner of IA. IA's beneficial ownership of the Common Stock is direct as a result of IA's discretionary authority to buy, sell, and vote shares of such Common Stock for its investment advisory clients. Managing Member's ownership of Common Stock is indirect as a result of Managing Member's ownership and management of IA. The beneficial ownership of Managing Member is reported solely because Rules 13d-1(a) and (b) under the Securities Exchange Act of 1934, as amended, require any person who is "directly or indirectly" the beneficial owner of more than five percent of any equity security of a specified class to file a Schedule 13G. The answers in blocks 6, 8, 9 and 11 above and the response to item 4 by Managing Member are given on the basis of the "indirect" beneficial ownership referred to in such Rule, based on the direct beneficial ownership of Common Stock by IA and the relationship of Managing Member to IA referred to above.
On April 23, 2004, The Depository Trust Company owned of record 17,003,657 shares of common stock, constituting 94.88% of our outstanding common stock. We understand these shares were held beneficially for members of the New York Stock Exchange, some of whom may in turn have been holding shares beneficially for customers.
Management Stockholders
As of April 23, 2004, our directors and executive officers beneficially owned the following amounts of our voting securities:
(1) Includes shares which may be acquired within 60 days through the exercise of stock options or warrants, as follows: Mr. de Vogel, 3,000 shares; Mr. Handal, 6,500 shares; Mr. Nepa, 6,250 shares; Mr. Plotkin, 86,902 shares; Mr. Rashkow, 56,500 shares; Mr. Redman, 39,063 shares; and Mr. Wright, 6,500 shares; all officers and directors as a group, 204,715 shares.
(2) Includes shares considered beneficially owned under SEC rules, but that are subject to restrictions on disposition, as follows: Mr. Nepa, 50,000 shares; Mr. Plotkin, 50,000 shares; and Mr. Redman, 125,000 shares.
(3) Includes 45,525 shares of common stock held by Mr. Rashkow's spouse, 2,340 shares of common stock held by a limited partnership of which Mr. Rashkow is the general partner and 56,500 shares, which Mr. Rashkow may acquire within 60 days through the exercise of stock options.
(4) As of April 27, 2004, Mr. Redman was no longer an employee. His right to receive any shares of restricted stock that has not vested terminated, and all of such restricted shares were forfeited. In addition, his options will expire 3 months after that date.
Item 13.
Item 13. Certain Relationships and Related Transactions
Transactions with Management and Others
In March 1997, we entered into an agreement with Three Cities Research, Inc. ("TCR") engaging TCR to act as financial advisors to us. Under this agreement, we paid TCR an annual fee of $50,000 and reimbursed TCR all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. As of January 31, 2004, we no longer engage TCR as our financial advisors. We reimbursed TCR for out-of-pocket expenses in the amounts of $46,000, $47,000 and $34,000 during fiscal 2003, 2002 and 2001, respectively. In addition, we paid legal fees in the amount of $24,000 to TCR in connection with our private equity placements during fiscal 2003. As of January 31, 2004, TCR did not own any of our outstanding common stock, however a principal of TCR is still a member of our Board of Directors.
On March 6, 2003, Three Cities Fund II L.P. purchased 240,793 shares of our common stock and Three Cities Offshore II C.V. purchased 407,207 shares of our common stock in a private placement at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000.
Also on March 6, 2003, Mr. Rashkow purchased 72,700 shares of our common stock in the private placement at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925.
Indebtedness of Management
During fiscal years 1997 and 1998, we sold to our executive management shares of our Series B Preferred Stock, which were subsequently converted to common stock. With the exception of Michael M. Searles, our former Chief Executive Officer, and Johnathan W. Spatz, our Former Chief Financial Officer, each of the executives paid for his or her shares by giving us a full-recourse promissory note secured by the purchased stock. Each note accrues interest at 8% per annum and requires principal payments equivalent to 16.25% of the annual bonus paid to the purchaser (if such bonus is actually paid in a given year) and a balloon payment of the unpaid principal and interest at maturity. Each of the notes matures five years after the date it was made.
Mr. Searles' promissory note in the principal amount of $1,400,000 was partial-recourse and was due on April 29, 2003. Mr. Searles was liable for the payment of principal and accrued but unpaid interest on his note up to $600,000 (including the value of the shares of our stock securing the note) and we had the right to retain the stock securing his note with respect to the balance of any principal and accrued interest on his note to the extent such stock had a value in excess of $600,000 (but not in excess of the outstanding balance of principal and accrued interest). We had forgiven interest payments aggregating $157,808 through November 7, 2002, but Mr. Searles' note accrued interest from November 7, 2002 to April 29, 2003. On April 29, 2003, the principal and accrued interest due on Mr. Searles' note was $1,458,608 and we foreclosed on the collateral which had a market value of $1,198,750, resulting in a deficiency of $259,858, for which Mr. Searles does not have personal liability under the terms of the note.
Mr. Plotkin's promissory note was outstanding during fiscal 2002, but as of March 21, 2003, Mr. Plotkin had repaid his promissory note in full in the amount of $101,008.
On April 29, 2003, the principal and accrued interest on two notes due from Mr. Spatz, were $688,197 and the collateral's market value on that date was $376,744, resulting in a deficiency of $311,453, for which Mr. Spatz is personally liable for $136,614 of the deficiency under the terms of his notes. Based on Mr. Spatz's current financial condition, we have elected, at this time, to forbear our collection efforts regarding the amount for which he is personally liable.
Additionally, on April 29, 2003, the principal and accrued interest on the notes due from Tracy W. Parks, our former Executive Vice President and Chief Operating Officer, was $117,042. On that date, we foreclosed on the collateral which had a market value of $82,197, resulting in a deficiency of $34,845, for which Mr. Parks was personally liable under the terms of his notes. In August 2003, we received payment in full from Mr. Parks to repay the outstanding principal balance of his note plus interest.
Item 14.
Item 14. Principal Accounting Fees and Services
The following table shows the aggregate fees billed to us by Ernst & Young LLP for fiscal years ended January 31, 2004 and February 1, 2003.
(1) Includes fees for professional services provided in conjunction with the audit of our financial statements and review of our quarterly financial statements;
(2) Includes fees for assurance and related professional services primarily related to services provided in connection with our registration statements on Form S-3 filed with respect to the resale of securities sold in the private offerings in March 2003 and August 2003.
Our Audit Committee's policy is to pre-approve all audit and permissible audit-related services provided by the independent auditors. Our Audit Committee considers annually for pre-approval a list of specific services and categories of services, including audit and audit-related services, for the upcoming or current fiscal year. All non-audit services are approved by our Audit Committee in advance on a case-by-case basis. Any service that is not included in the approved list of services or that does not fit within the definition of a pre-approved service is required to be presented separately to our Audit Committee for consideration at its next regular meeting or, if earlier consideration is required, by other means of communication.
All fees were pre-approved in accordance with our Audit Committee pre-approval policy. Our Audit Committee considered and concluded that the provision of those services provided by Ernest & Young LLP was compatible with the maintenance of the auditor's independence in conducting auditing functions.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) 1. Financial Statements.
See Index to Financial Statements contained in Item 8.
2. Financial Statement Schedules.
Schedule II Valuation and Qualifying Accounts contained on page 59.
All other schedules are omitted because of the absence of conditions under which they are required or because the required information is set forth in the financial statements and notes thereto.
3. Exhibits. See Item 15(c).
(b) Reports on Form 8-K.
On December 24, 2003, we filed a report on Form 8-K regarding an amendment to our Amended and Restated Financing Agreement, announcing an agreement in principle with holders of our Junior Subordinated Notes to amend the scheduled payment dates and announcing revised expectations for sales and operating results for the fourth quarter ended January 31, 2004. The full text of our press release dated December 23, 2003 was attached as an exhibit to the Form 8-K.
On January 7, 2004, we filed a report on Form 8-K regarding the termination of Douglas C. Felderman as Chief Financial Officer effective January 5, 2004, and the appointment of John Swygert as Chief Financial Officer on an interim basis. The full text of our press release dated January 6, 2004 was attached as an exhibit to the Form 8-K.
On January 16, 2004, we filed a report on Form 8-K regarding the following: (1) our filing of a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code on January 13, 2004, (2) our receipt of a commitment for a $45 million DIP financing facility from the CIT Group/Business Credit, Inc. and GB Retail Funding, LLC, (3) our appointment of Norman G. Plotkin as Chief Executive Officer and John W. Swygert as Chief Financial Officer, (4) the discontinuation of our mid-month sales updates and monthly sales press releases, and (5) the notice from Nasdaq of its determination to delist us and our intention not to appeal. The full text of the press releases dated January 13, 2004 and January 15, 2004 related to items (1), (2) and (3) above were furnished and attached as an exhibit to the Form 8-K. The full text of the press release dated January 16, 2004 related to item (5) above was furnished and attached as an exhibit to the Form 8-K. In addition, the full text of our DIP financing facility agreement was filed and attached as an exhibit to the Form 8-K.
On January 22, 2004, we furnished a report on Form 8-K regarding our filing of a motion with the Court seeking authorization to close 44 stores. The full text of our press release dated January 22, 2004 was furnished and attached as an exhibit to the Form 8-K.
On February 3, 2004, we furnished a report on Form 8-K regarding the decision by the Court to grant final approval for the use of the entire $45 million debtor-in-possession financing agreement. The full text of our press release dated February 2, 2004 was furnished and attached as an exhibit to the Form 8-K.
On February 17, 2004, we filed a report on Form 8-K regarding the resignation of John W. Swygert as Chief Financial Officer, effective February 20, 2004.
On March 22, 2004, we filed a report on Form 8-K regarding the appointment of Norman Dowling as Executive Vice President and Chief Financial Officer effective March 22, 2004 and the election of Norman G. Plotkin to our Board of Directors effective March16, 2004. The full text of our press release dated March 22, 2004 was furnished and attached as an exhibit to the Form 8-K.
(c) Exhibits.
Reference is made to the Index to Exhibits immediately preceding the exhibits thereto.
Index to Exhibits
Exhibit Number Document - -------------------------------------------------------------------------------- 2.1 (1) Plan and Agreement of Merger dated June 18, 1998 between Family Bargain Corporation and General Textiles, Inc. 3.1 (2) (i) Restated Certificate of Incorporation (ii) Bylaws 4.1 (1) Junior Subordinated Note Agreement dated April 30, 1998 among General Textiles, American Endeavour Fund Limited and London Pacific Life & Annuity Company 4.2 (1) Form of Warrant dated April 30, 1998 10.1 (3) Factory 2-U Stores, Inc. Employee Stock Purchase Plan 10.2 (4) Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan 10.3 (5) Factory 2-U Stores, Inc. Employee Compensation Agreements 10.4 (6) Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 2000 10.5 (6) First Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 10.6 (6) Amended Employment Agreement between Factory 2-U Stores, Inc. and Michael M. Searles 10.7 (7) Second Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 10, 10.8 (7) Third Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 9, 10.9 (8) Fourth Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of September 16, 2002 10.10 (10) Fifth Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of February 14, 2003 10.11 (10) Sixth Amendment to the Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated as April 10, 2003 10.12 (9) Employment Agreement, dated as of November 7, 2002, by and between Factory 2-U Stores, Inc. and William R. Fields 10.13 (9) Letter Agreement, dated as of November 4, 2002, by and between Factory 2-U Stores, Inc. and Ronald Rashkow 10.14 (10) Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Melvin Redman 10.15 (10) Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Larry I. Kelley 10.16 (10) Industrial/Commercial Single-Tenant Lease as of March 8, 2002, by and between Factory 2-U Stores, Inc. (as Tenant) and ORIX Otay, LLC (as Landlord) 10.17 (11) Employment Agreement, dated as of May 20, 2003, by and between Factory 2-U Stores, Inc. and Douglas C. Felderman 10.18 (11) Employment Agreement, dated as of May 20, 2003, by and between Factory 2-U Stores, Inc. and Norman G. Plotkin 10.19 (12) Employment Agreement, dated as of November 10, 2003, by and between Factory 2-U Stores, Inc. and A.J. Nepa 10.20 (13) First Amendment to Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated December 23, 2003 10.21 (14) Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated January 12, 2004 10.22 * Second Amendment to Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated January 12, 2004
10.23 * First Amendment to the Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower) , and GB Retail Funding LLC (a Lender), dated January 30, 2004 10.24 * Agency Agreement, dated as of February 10, 2004, by and between The Great American Group and Factory 2-U Stores, Inc. 10.25 * Second Amendment to the Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower) , and GB Retail Funding LLC (a Lender), dated March 10, 2004 14.1 * Standards of Business Conduct 23.1 * Consent of Ernst & Young LLP, Independent Auditors 23.2 * Information regarding consent of Arthur Andersen LLP 31.1 * Certification of the Chief Executive Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 * Certification of the Chief Financial Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Norman G. Plotkin, Chief Executive Officer 32.2 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Norman Dowling, Executive Vice President and Chief Financial Officer
(1) Incorporated by reference to Registration Statement on Form S-2, No. 333-58797 filed with the SEC on October 14, 1998. (2) Incorporated by reference to Registration Statement on Form S-1, No. 33-77448 filed with the SEC on April 7, 1994. (3) Incorporated by reference to Registration Statement on Form S-8 No. 333-94123 filed with the SEC on January 5, 2000. (4) Incorporated by reference to Registration Statement on Form S-8 No. 333-40682 filed with the SEC on June 30, 2000. (5) Incorporated by reference to Registration Statement on Form S-8 No. 333-89267 filed with the SEC on October 19, 1999. (6) Incorporated by reference to Form 10-K for the fiscal year ended January 29, 2000 filed with the SEC on April 24, 2000. (7) Incorporated by reference to Form 10-K for the fiscal year ended February 2, 2002 filed with the SEC on April 19, 2002. (8) Incorporated by reference to Form 10-Q for the quarterly period ended August 3, 2002 filed with the SEC on September 17, 2002. (9) Incorporated by reference to Form 8-K for report dated November 7, 2002 filed with the SEC on November 19, 2002. (10) Incorporated by reference to Form 10-K for the fiscal year ended February 1, 2003 filed with the SEC on May 2, 2003. (11) Incorporated by reference to Form 10-Q for the quarterly period ended May 3, 2003 filed with the SEC on June 17, 2003. (12) Incorporated by reference to Form 10-Q for the quarterly period ended November 1, 2003 filed with the Sec on December 16, 2003. (13) Incorporated by reference to Form 8-K for report dated December 22, 2003 filed with the SEC on December 24, 2003. (14) Incorporated by reference to Form 8-K for report dated January 13, 2004 filed with the SEC on January 16, 2004.
* Filed herewith.
** Furnished herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized.
FACTORY 2-U STORES, INC.
By:/s/ Norman G. Plotkin ---------------------------- Norman G. Plotkin Chief Executive Officer
Dated: April 30, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of this Company and in the capacities and on the date indicated.
Signature Title Date --------- ----- ----
/s/ Norman G. Plotkin Director and Chief --------------------- Executive Officer April 30, 2004 Norman G. Plotkin
/s/ Norman Dowling Executive Vice President, April 30, 2004 --------------------- Chief Financial Officer Norman Dowling (Principal Financial and Accounting Officer)
/s/ Ronald Rashkow Lead Director April 30, 2004 ------------------ Ronald Rashkow
/S/ Willem de Vogel Director April 30, 2004 -------------------- Willem de Vogel
/s/ Peter V. Handal Director April 30, 2004 ------------------- Peter V. Handal
/s/ Wm. Robert Wright II Director April 30, 2004 ------------------------ Wm. Robert Wright II
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
To the Shareholders and the Board of Directors of Factory 2-U Stores, Inc.
We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (the "Company") as of January 31, 2004 and February 1, 2003 and the related statements of operations, stockholders' equity (deficit) and cash flows for the years ended January 31, 2004 ("fiscal 2003") and February 1, 2003 ("fiscal 2002'). Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. The financial statements and financial statement schedule of the Company for the fiscal year ended February 2, 2002 ("fiscal 2001"), were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those statements in their report dated February 27, 2002.
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 fiscal 2003 and fiscal 2002 financial statements referred to above present fairly, in all material respects, the financial position of the Company as of January 31, 2004 and February 1, 2003 and the results of its operations and its cash flows for the years ended January 31, 2004 and February 1, 2003 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related fiscal 2003 and fiscal 2002 financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 8 to the financial statements, the Company changed its method of accounting for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards ("Statement") No.142 during the first quarter of fiscal 2002.
As discussed above, the financial statements of the Company as of February 2, 2002, and for the year then ended were audited by other auditors who have ceased operations. As described in Note 8, these financial statements have been updated to include the transitional disclosures required by Statement No. 142, "Goodwill and Other Intangible Assets," which was adopted by the Company as of February 3, 2002. Our audit procedures with respect to the disclosures in Note 8 for fiscal 2001 included (i) agreeing the previously reported net income (loss) to the previously issued financial statements and the adjustments to reported net income (loss) representing amortization expense (including any related tax effects) recognized in those periods related to goodwill that are no longer being amortized to the Company's underlying records obtained from management, and (ii) testing the mathematical accuracy of the reconciliation of adjusted net income (loss) to reported net income (loss), and the related net income (loss)-per-share amounts. In our opinion, the disclosures for fiscal 2001 in Note 8 related to the transitional disclosures of Statement 142 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the Company's financial statements for fiscal 2001 other than with respect to such disclosures and, accordingly, we do not express an opinion or any other form of assurance on the Company's fiscal 2001 financial statements taken as a whole.
The accompanying financial statements have been prepared assuming that Factory 2-U Stores, Inc. will continue as a going concern, which contemplates continuity of the Company's operations and realization of its assets and payments of its liabilities in the ordinary course of business. As more fully described in the notes to the financial statements, on January 13, 2004 Factory 2-U Stores, Inc. filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The uncertainties inherent in the bankruptcy process and the Company's recurring losses from operations raise substantial doubt about Factory 2-U Stores, Inc.'s ability to continue as a going concern. The Company is currently operating its business as a Debtor-in-Possession under the jurisdiction of the Bankruptcy Court, and continuation of the Company as a going concern is contingent upon, among other things, the confirmation of a Plan of Reorganization, the Company's ability to comply with all debt covenants under the existing debtor-in-possession financing agreement, and the Company's ability to generate sufficient cash from operations and obtain financing sources to meet its future obligations. If no reorganization plan is approved, it is possible that the Company's assets may be liquidated. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amount and classification of liabilities that may result from the outcome of these uncertainties.
/s/ ERNST & YOUNG LLP San Diego, California
April 19, 2004
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH FACTORY 2-U STORES, INC.'S FILING ON FORM 10-K FOR THE YEAR ENDED FEBRUARY 2, 2002. THIS AUDIT REPORT HAS NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH THIS FILING ON FORM 10-K. SEE EXHIBIT 23.2 FOR FURTHER DISCUSSION. THE BALANCE SHEET AS OF FEBRUARY 3, 2001, REFERRED TO IN THIS REPORT HAS NOT BEEN INCLUDED IN THE ACCOMPANYING FINANCIAL STATEMENTS.
To Factory 2-U Stores, Inc.:
We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (a Delaware corporation) as of February 2, 2002 and February 3, 2001, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended 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 Factory 2-U Stores, Inc. as of February 2, 2002 and February 3, 2001 and the results of its operations and its cash flows for each of the three years in the period ended February 2, 2002 in conformity with accounting principles generally accepted in the United States.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements and supplementary data is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material aspects in relation to the basic financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP
San Diego, California February 27, 2002
The accompanying notes are an integral part of these financial statements.
(continued)
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
(continued)
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Notes to Financial Statements
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Our Company and Business
We operate a chain of off-price retail apparel and houseware stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestics and household merchandise at prices, which generally are significantly lower than other discount stores.
On January 13, 2004 (the "Petition Date"), we filed a voluntary petition to reorganize under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the District of Delaware (the "Court"), which is currently pending as case number 04-10111(PJW) (the "Chapter 11 filing"). We remain in possession of our properties and continue to operate our business as debtor-in-possession ("DIP") in accordance with the applicable provisions of the Bankruptcy Code.
At January 31, 2004, we operated 239 stores under the name Factory 2-U. Subsequently, we closed 44 stores located in states listed above as well as Arkansas, Idaho and Oklahoma.
Fiscal Year
Our fiscal year is based on a 52/53 week year ending on the Saturday nearest January 31. Fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 included 52 weeks. We define our fiscal year by the calendar year in which most of the activity occurs (e.g. the fiscal year ended January 31, 2004 is referred to as fiscal 2003).
Basis of Presentation
The accompanying Financial Statements are prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business. In accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), all pre-petition liabilities subject to compromise have been segregated in the Balance Sheet as of January 31, 2004 and classified as Liabilities subject to compromise, at the estimated amount of allowable claims. Liabilities not subject to compromise are separately classified as current and non-current. Expenses, realized gains and losses, and provisions for losses resulting from the reorganization are reported separately as Reorganization items in the Statement of Operations for fiscal year ended January 31, 2004. Cash used for reorganization items is disclosed separately in the Statement of Cash Flows for fiscal year ended January 31, 2004.
Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following:
- developing and implementing a long-term strategy to revitalize our business and return to profitability;
- taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations;
- operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants,
- generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms;
- attracting, motivating and retaining key executives and associates; and
- developing, negotiating, and, thereafter, having a plan of reorganization confirmed by the Court.
These challenges are in addition to other operational and competitive challenges faced by us in connection with our business as an off-price retailer.
Bankruptcy Accounting
Since the Chapter 11 filing, we have applied the provisions of SOP 90-7, which does not significantly change the application of accounting principles generally accepted in the United States; however, it requires the financial statements for periods including and subsequent to filing Chapter 11 petition distinguish transactions and events that are directly associated with the reorganization from the ongoing operations of the business.
Cash Equivalents
We consider all liquid investments with original maturities of three months or less to be cash equivalents.
Merchandise Inventory
Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method on a first-in, first-out basis. In addition, consistent with industry practice, we capitalize direct buying (primarily salaries and wages of buyers and their traveling expenses), warehousing, storage and transportation costs. Such costs are thereafter expensed as cost of sales upon the sale of the merchandise. At January 31, 2004 and February 1, 2003, such costs included in inventory were $4.3 million and $3.4 million, respectively. As of January 31, 2004 and February 1, 2003, we had an inventory valuation allowance of $11.6 million and $8.4 million, respectively, which represented our estimate of the cost in excess of the net realizable value of all clearance and slow-moving items. The inventory valuation allowance of $11.6 million as of January 31, 2004 also included a $2.2 million shrink reserve and a $1.7 million allowance related to the sale of inventory at the 44 stores to be closed.
Leasehold Improvements and Equipment
Leasehold improvements and equipment are stated at original cost less accumulated depreciation and amortization. Tenant improvement allowances, offered by landlords from time to time, are recorded as a reduction to the original cost of leasehold improvements. Equipment under capital leases is stated at the present value of minimum lease payments at the date of acquisition. Depreciation expense for the fiscal year ended January 31, 2004, February 1, 2003 and February 2, 2002 was $11.9 million, $14.0 million and $14.0 million, respectively. We calculate depreciation and amortization using the straight-line method over the estimated useful lives as follows:
Leasehold improvements the shorter of the asset's useful life or thelease term,generally five years
Furniture, fixtures and other equipment three to five years
Goodwill
At the beginning of fiscal 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets", which ceases goodwill amortization and instead, requires us to evaluate goodwill for impairment at least annually using a fair value test. In conjunction with our Chapter 11 filing on January 13, 2004, our annual impairment test indicated that goodwill was impaired and we recorded a goodwill impairment charge of $26.3 million.
At February 1, 2003, we concluded that our goodwill was not impaired. Prior to fiscal 2002, goodwill was amortized on a straight-line basis over 25 years. Goodwill amortization was $1.6 million for the fiscal year ended February 2, 2002.
We do not have any other intangible assets recorded in our books as of January 31, 2004 and February 1, 2003.
Comprehensive Loss
Comprehensive loss for the fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 did not differ from net loss.
Asset Impairment
We assess potential asset impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which establishes an accounting model to be used for long-lived assets to be disposed of by sale or held for use and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and the accounting and reporting provisions of Accounting Principles Board ("APB") No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for the disposal of a segment of a business (as previously defined in that Opinion). This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of an asset to be held and used is measured by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount that the carrying value of the asset exceeds the fair value of the asset. In conjunction with our closure of 44 stores soon after January 31, 2004, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, receivables, payables and accrued expenses approximate fair value due to the short-term nature of such instruments. The carrying amount of the DIP financing facility approximates fair value due to the floating rate on such instrument. The carrying value of long-term debt with fixed payment terms approximates fair value.
Self-Insurance
We self-insure or retain a portion of the exposure for losses related to workers' compensation and general liability costs. The self-insured policies provide for both specific and aggregate stop-loss limits. The workers' compensation program for the policy years ended January 31, 2004 and 2003 have a specific stop loss amount of $250,000 with no aggregate stop loss limit. The program for the policy year ended January 31, 2002 had both a specific and aggregate stop loss amount of $250,000 and $3.2 million, respectively. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy years ended January 31, 2004, 2003 and 2002 were estimated to be approximately $3.6 million, $4.7 million and $4.3 million ($3.2 million aggregate stop loss), respectively. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above.
For general liability insurance, our program for fiscal 2003 provided for a specific stop loss of $35,000 per claim with no aggregate stop loss limit.
Revenue Recognition
We recognize sales revenue at the time the merchandise is sold to the customer, except for layaway and gift card sale transactions. The recognition of layaway sales and the related cost of sales are deferred until the merchandise is fully paid for and delivered to our customer. Cash received for the layaway transaction in advance is recorded as a liability, which is included in Accounts payable in the accompanying Balance Sheets. Cash received for the sale of gift cards is recorded as a liability, which is included in Accounts payable in the accompanying Balance Sheets. The related liability is reduced and revenue is recognized upon delivery of the layaway merchandise to the customer or upon redemption of the gift card.
As of January 31, 2004 and February 1, 2003, the balances of the liability recorded in relation to layaway and gift card programs were approximately $300,000.
Costs of Sales
Costs of sales include merchandise cost, transportation cost, markdowns, shrink, direct distribution and processing costs, and inventory capitalization cost.
Selling and Administrative Expenses
Selling and administrative expenses primarily consist of salaries and wages, workers compensation, employee benefits, advertising costs, occupancy costs (primarily rent), utilities, professional fees and other direct and indirect selling expenses.
Advertising Costs
Advertising costs are expensed as incurred. Advertising costs for the fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 were approximately $23.5 million, $24.7 million and $20.9 million, respectively.
Deferred Rent
Rent expense under non-cancelable operating lease agreements is recorded on a straight-line basis over the life of the respective leases. The excess rent expense over rent paid is accounted for as deferred rent.
Store Pre-opening and Closing Costs
Store pre-opening costs (costs of opening new stores, including grand opening promotions, training and store set-up costs) are expensed as incurred.
Costs associated with closing stores consist primarily of inventory liquidation costs which are recognized as incurred, fixed asset impairments as recognized in accordance with SFAS No. 144, and future lease obligations subsequent to the cease use date. Closing costs related to exit or disposal activities initiated prior to December 31, 2002 were recognized as operating expenses at the date of a commitment to an exit or disposal plan.
Debt Issuance Costs
Debt issuance costs are amortized to interest expense evenly over the life of the related debt. For fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, amortization for debt issuance costs was $833,000, $118,000 and $132,000, respectively. Debt issuance costs for the fiscal year ended January 31, 2004 included the write-off of remaining unamortized debt issuance costs of approximately $353,000 as a result of the Chapter 11 filing.
Income Taxes
Income taxes are accounted for under the asset and liability method required by SFAS No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
In evaluating exposure associated with various tax filing positions, we often accrue charges for probable exposures. The Internal Revenue Service ("IRS") is currently conducting an examination of our consolidated tax returns for the fiscal years 1998 through 2002. We expect the IRS examination to be completed within the next two years. We believe that adjustments, if any, are adequately provided for in the accrued income taxes account in the accompanying financial statements. To the extent we prevail in matters for which accruals have been established or are required to pay amounts in excess of these accruals, our effective tax rate in a given financial statement period could be materially affected.
Stock-based Compensation
We have elected under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" to continue using the intrinsic value method of accounting for employee stock- based compensation in accordance with APB No. 25, "Accounting for Stock Issued to Employees." Under the intrinsic value method, compensation expense is recognized only in the event that the exercise price of options granted is less than the market price of the underlying stock on the date of grant. The fair value method generally requires entities to recognize compensation expense over the vesting period of options based on the estimated fair value of the options granted. We have disclosed the pro forma effect of using the fair value based method to account for our stock-based compensation as required by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure."
The following table illustrates the effect on net loss and net loss per common share if we had applied the fair value recognition provisions of SFAS No. 148.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models also require the input of highly subjective assumptions such as expected option life and expected stock price volatility. Because our employee stock-based compensation plan has characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, we believe that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from those plans.
The weighted-average fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the following weighted-average assumptions:
Loss per Share
We compute loss per share in accordance with SFAS No. 128, "Earnings Per Share." Under the provisions of SFAS No. 128, basic earnings (loss) per share is computed based on the weighted average shares outstanding. Diluted income (loss) per share is computed based on the weighted average shares outstanding and potentially dilutive common stock equivalent shares. Common stock equivalent shares totaling 144,616, 127,242 and 147,000 for fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively, are not included in the computation of diluted loss per share because the effect would have been anti-dilutive.
Use of Estimates
Our management has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the 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 to prepare these Financial Statements in conformity with generally accepted accounting principles in the United States. Actual results could differ from these estimates.
Reclassifications
Certain prior period amounts have been reclassified to conform their presentation to the fiscal 2003 Financial Statements.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (the "FASB") issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations.
In April 2003, the FASB issued Statement of Financial Accounting Standard (the "SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement provides clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The adoption of this statement did not have a material impact on our financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity and is effective for financial instruments entered into or modified after May 31, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations.
2. REORGANIZATION ITEMS
Reorganization items represent amounts we incurred as a result of the Chapter 11 filing, and are recorded and presented in accordance with SOP 90-7. Reorganization items for the fiscal year ended January 31, 2004 were $31.7 million and consisted of: (1) a non-cash goodwill impairment charge of $26.3 million; (2) a non-cash impairment charge of $2.4 million for fixed assets associated with the 44 stores closed subsequent to January 31, 2004 as part of our reorganization efforts; (3) a non-cash inventory valuation reserve of $1.7 million related to the sale inventory at the 44 stores below cost; and (4) $1.3 million of professional fees and other expenses incurred in our bankruptcy case and reorganization efforts.
Cash payments resulting from reorganization through January 31, 2004 was approximately $1.2 million.
3. LIABILITIES SUBJECT TO COMPROMISE
Under the Bankruptcy Code, actions by creditors to collect indebtedness we owe prior to the Petition Date are stayed and certain other pre-petition contractual obligations may not be enforced against us. We have received approval from the Court to pay certain pre-petition liabilities including employee salaries and wages, benefits and other employee obligations. Except for secured debt, employee payroll and benefits, sales, use and other taxes, and capital lease obligations, all pre-petition liabilities have been classified as Liabilities subject to compromise in the Balance Sheet as of January 31, 2004. Adjustments to pre-petition liabilities may result from negotiations, payments authorized by Court order, additional rejection of executory contracts including leases, or other events. Therefore, the amounts below in total may vary significantly from the stated amounts of proofs of claim that will be filed with the Court.
The following table summarizes the components of Liabilities subject to compromise in our Balance Sheet as of January 31, 2004.
4. FISCAL 2002 RESTRUCTURING CHARGE
In December 2002, we recorded a restructuring charge of $14.4 million in conjunction with the decision to close 23 stores as well as to consolidate both our distribution center network and corporate overhead structure. The purpose of these restructuring initiatives was to improve store profitability, reduce costs and improve efficiency.
In fiscal 2002, the charge and the related liability were recognized in accordance with the Emerging Issues Task Force ("EITF") No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF No. 94-3 provides specific requirements as to the appropriate recognition of costs associated with employee termination and other exit costs.
As of April 23, 2004, we have closed 20 of these 23 stores and terminated the lease obligations of 14 of these closed stores. In conjunction with our Chapter 11 filing, we rejected 6 leases and recorded a non-cash reduction of $296,000 to adjust the lease termination reserve to the allowed claim amount under the Bankruptcy Code. The three remaining stores have not been closed at this time due to lease concessions agreed to by the landlords.
In addition, we have completed the consolidation of our two former San Diego distribution centers and our Lewisville, Texas distribution center into one distribution center, which is located at a new facility in San Diego, California. As a result of our Chapter 11 filing, we have rejected the lease of one of our former San Diego, CA distribution centers and the lease of our Lewisville, Texas distribution center. In conjunction with these two lease rejections, we recorded a non-cash adjustment of $355,000 to increase the related lease termination reserve to the allowed claim amount under the Bankruptcy Code. We continue to pay the rent of the other former San Diego distribution center, which is also the location of our corporate headquarters.
The balance of the liability $4.7 million (included in "Liabilities subject to compromise" in the accompanying Balance Sheet as of January 31, 2004) related to this fiscal 2002 restructuring charge was as follows:
The balances of non-cash inventory liquidation costs and fixed asset write-downs related to this fiscal 2002 restructuring charge at January 31, 2004 were as follows:
5. FISCAL 2001 RESTRUCTURING CHARGE
In January 2002, we recorded a restructuring charge of $21.2 million in conjunction with the decision to close 28 under-performing stores as well as the realignment of our field organization and workforce reductions. The purpose of the restructuring was to improve store profitability, streamline field operations, reduce costs and improve efficiency. In light of the favorable experience related to the costs of closing these stores, we recorded a non-cash adjustment to reduce the reserve for the fiscal 2001 restructuring initiatives by approximately $5.0 million during the fourth quarter of fiscal 2002. The adjustment included (1) reduction of reserve for lease termination costs by $3.8 million, (2) reduction of reserve for inventory liquidation costs by $1.3 million, offset by (3) an additional reserve for fixed asset write-downs of $94,000.
We closed all 28 stores during fiscal 2002. As of April 23 2004, we had terminated the lease obligations of 23 of these stores and rejected the remaining 5 leases. As a result of rejecting these leases, we recorded a non-cash adjustment of $161,000 to reduce the reserve to the allowed claim amount under the Bankruptcy Code. In addition, we recorded a non-cash adjustment of $832,000 to reduce the reserve for lease termination costs as a result of favorable experience related to several lease terminations.
The balance of liability $1.4 million (included in "Liabilities subject to compromise" in the accompanying Balance Sheet as of January 31, 2004) related to the fiscal 2001 restructuring charge was as follows:
As of January 31, 2004, the non-cash inventory liquidation costs and fixed asset write-downs related to this fiscal 2001 restructuring charge were zero.
6. NOTE RECEIVABLE
In July 2002, we entered into a temporary bridge financing agreement (the "Agreement") with one of our trade vendors (the "Borrower") in which we, subject to the terms and conditions of the Agreement, agreed to provide a $4.0 million revolving line of credit facility to the Borrower. Advances made to the Borrower under this Agreement are secured by the Borrower's accounts receivable, inventory, personal property and other assets including cash. Borrowings under this facility are also secured by personal guarantees from the principals of the Borrower. This Agreement expired on October 11, 2002, and we have not made any direct advances to the Borrower thereafter.
Through May 27, 2003, we made cash advances in the aggregate of approximately $3.1 million to the Borrower and received cash repayments in the aggregate of approximately $811,000. We also received approximately $1.5 million of inventory from the Borrower to partially offset the advances. On May 27, 2003, we filed a lawsuit against the Borrower and the two guarantors seeking the remaining balance plus interest of approximately $1.1 million due under the agreement. As of January 31, 2004, this amount was fully reserved.
On September 17, 2003, we entered into a settlement agreement with the Borrower in which the Borrower agreed to make payments in the amount of $500,000 with interest at the rate of 7.5% per annum as full payment for the balance due under the Agreement. Under the settlement agreement, the first payment of $50,000 became due on September 30, 2003. Through January 31, 2004, we have received $50,000 from the Borrower, however the amount was received through several smaller payments, the last payment of $9,000 having been received on January 20, 2004. As a result of this default, under the settlement agreement, we reserve the right to reinstate the original amount due under the Agreement.
Subsequent to January 31, 2004, we received $70,000 from the Borrower for payment under the settlement agreement.
7. LEASEHOLD IMPROVEMENTS AND EQUIPMENT
Leasehold improvements and equipment consist of the following (in thousands):
We assess potential asset impairment in accordance with SFAS 144. Recoverability of an asset to be held and used is measured by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount that the carrying value of the asset exceeds the fair value of the asset. In conjunction with our closure of 44 stores soon after January 31, 2004, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores.
As of February 1, 2003, we had asset impairment valuation allowances related to the fiscal 2002 and 2001 restructuring activities totaling $3.8 million. These allowances were recorded as direct reductions of the related assets.
8. GOODWILL
As required, we adopted SFAS 142 on February 3, 2002 and ceased the amortization of goodwill accordingly and instead evaluate the carrying value of goodwill for impairment at least annually using a fair value test. In conjunction with our Chapter 11 filing on January 13, 2004, our annual impairment test indicated that goodwill was impaired and we recorded a goodwill impairment charge of $26.3 million.
At February 1, 2003, we concluded that our goodwill was not impaired.
Prior to fiscal 2002, goodwill was amortized on a straight-line basis over 25 years. Goodwill amortization was $1.6 million for the fiscal year ended February 2, 2002.
The following table presents the reconciliation of net income and per share data to what would have been reported had the new rules been in effect during the fiscal year ended February 2, 2002 (in thousands, except per share data):
We do not have any other intangible assets recorded in our books as of January 31, 2004 or February 1, 2003.
9. ACCRUED EXPENSES
Accrued expenses consist of the following:
10. DIP FINANCING FACILITY, LONG-TERM DEBT AND PRE-PETITON REVOLVING CREDIT FACILITY
Long-term debt and revolving credit facilities consist of the following:
DIP Financing Facility
In conjunction with our Chapter 11 filing, we entered into a financing agreement with The CIT Group/Business Credit, Inc. (the Tranche A Lender) and GB Retail Funding, LLC (the Tranche B Lender), (collectively the "Lenders") in which the Lenders provide us a $45.0 million revolving credit facility for working capital needs and other general corporate purposes while we operate as a debtor-in-possession (the "DIP financing facility"). This DIP financing facility with a maturity date of January 14, 2005 has since been amended twice, the first amendment on January 30, 2004 and the second amendment on March 10, 2004.
The DIP financing facility has a superpriority claim status in our Chapter 11 case and is collateralized by first liens on substantially all of our assets, subject to valid and unavoidable pre-petition liens and certain other permitted liens. Under the terms of the DIP financing facility, we may borrow up to 85% of our eligible accounts receivable and up to 70% of our eligible inventory, as defined. However, the DIP financing facility provides for a $5.0 million availability block against our availability calculation, as defined. The DIP financing facility also includes a $20.0 million sub-facility for letters of credit. Interest on the outstanding borrowings under the DIP financing facility is payable monthly and accrues at the rate equal to, at our option, either the prime rate (as announced by JP Morgan Chase Bank) plus 1.50% per annum or LIBOR plus 3.5% per annum. The Tranche B Lender will fully fund $4.0 million within five business days after demand by the Tranche A Lender when the outstanding borrowing provided by the Tranche A Lender first equals or exceeds $6.5 million for three consecutive business days. In the event that there is any outstanding borrowing provided by the Tranche B Lender, such borrowing bears interest at 14.5% per annum payable monthly. We are also obligated to pay a monthly fee equal to 0.375% per annum on the unused available line of credit and a fee equal to 2.5% per annum on the outstanding letters of credit.
Under the terms of the DIP financing facility, capital expenditures for fiscal 2004 is restricted to $2.0 million. In addition, we are required to be in compliance with financial covenants and other customary covenants. The financial covenants include average minimum availability, cumulative four-week rolling average of cash receipts from store sales and cumulative rolling four-week average of inventory receipts, as defined. The customary covenants include certain reporting requirements and covenants that restrict our ability to incur or create liens, indebtedness and guarantees, make dividend payments, sell or dispose of assets, change the nature of our business and enter into affiliate transactions, mergers and consolidations. Failure to satisfy these covenants would (in some cases, after the expiration of a grace period) result in an event of default that could cause, absent the receipt of appropriate waivers, the funds necessary to maintain our operations to become unavailable. The DIP financing facility contains other customary events of default including certain ERISA events, a change of control and the occurrence of certain specified events in the Chapter 11 case. In addition, during the period from December 28, 2004 through January 11, 2005, we are not allowed to have any outstanding borrowings under the revolving credit facility and our outstanding letters of credit cannot exceed $11.0 million.
As of January 31, 2004, we were in compliance with our covenants and had no borrowings outstanding under the revolving credit facility and outstanding letters of credit of $10.1 million under the sub-facility for letters for credit. As of January 31, 2004, based on our eligible inventory and accounts receivable, we were eligible to borrow $33.8 million under the revolving credit facility and had $17.6 million available after giving effect for the availability block, as defined.
Pre-petition Revolving Credit Facility
Prior to the Petition Date, we had a $50.0 million revolving credit facility agreement (the "Financing Agreement") with a financial institution expiring in March 2006. Under this Financing Agreement, we could borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The revolving credit facility provided for a $7.5 million availability block against our availability calculation, as defined. The Financing Agreement also included a $15.0 million sub-facility for letters of credit. Under the terms of the Financing Agreement, the interest rate could increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. We were obligated to pay fees equal to 0.125% per annum on the unused amount of the revolving credit facility. We were contractually prohibited from paying cash dividends on our common stock under the terms of the Financing Agreement without consent of the lender. As amended on April 10, 2003, the facility was secured by a first lien on all company assets excluding furniture, fixtures, machinery and equipment.
On February 14, 2003, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which was secured by a junior lien on the Collateral, as defined.
On April 10, 2003, we amended the terms of our Financing Agreement (the "Amended and Restated Financing Agreement") to add $7.5 million of term loans, to add financial covenants, and to amend certain reporting provisions and other terms. The term loans consisted of a $6.5 million junior term note secured by all company assets excluding furniture, fixtures, machinery and equipment and a $1.0 million junior term note secured by furniture, fixtures, machinery and equipment. These notes bore interest at the rate of 14.5% per annum on the then current outstanding balance and a maturity date of April 10, 2004.
On December 22, 2003, we amended the terms of our Amended and Restated Financing Agreement ("First Amendment") to shorten the period that we were required to have zero borrowings, or "clean-up", under the revolving credit facility from 15 consecutive days beginning December 22, 2003 to eight consecutive days beginning December 29, 2003. The First Amendment also required us to pay the full unpaid balance of $600,000 under the Tranche B Loan II on or before December 23, 2003, and we paid it accordingly.
On January 12, 2004, we amended the terms of our Amended and Restated Financing Agreement ("Second Amendment") in which we were required to pay the full unpaid balance of $6.5 million on or before January 12, 2004, and we paid it accordingly.
Junior Subordinated Notes
The Junior Subordinated Notes (the "Notes") are non-interest bearing and were reflected on our balance sheets at the present value using a discount rate of 10%. We are prohibited from paying cash dividends on our common stock under the terms of the Notes without the consent of the note holders.
As of January 31, 2004 we were in default under the terms of our Notes and have included the net carrying value of $10.3 million (face value of $11.3 million net of a related unamortized discount of $1.0 million) in the line Liabilities subject to compromise. On the Petition Date, we stopped amortizing debt discount related to the Notes, in accordance with SOP 90-7.
Under the Bankruptcy Code, the claims of holders of the Notes are subject to disallowance to the extent they represent a claim for unmatured interest, i.e., the portion of face value representing unamortized discount. The amount so disallowed may differ from the unamortized discount maintained on our books and records.
11. INCOME TAXES
Significant components of income tax expense/(benefit) are as follows:
The principal temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below:
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, a valuation allowance has been recognized to offset deferred tax assets because management cannot conclude that it is more likely than not that the deferred tax assets will be realized in the foreseeable future. A portion of the valuation allowance for deferred tax assets relates to stock option deductions which, when recognized, will be allocated directly to additional paid-in-capital.
In evaluating exposure associated with various tax filing positions, we often accrue charges for probable exposures. The IRS is currently conducting an examination of our consolidated tax returns for the fiscal years 1998 through 2002. We expect the IRS examination to be completed within the next two years. We believe that adjustments, if any, are adequately provided for in the accrued income taxes account in the accompanying financial statements. To the extent we prevail in matters for which accruals have been established or are required to pay amounts in excess of these accruals, our effective tax rate in a given financial statement period could be materially affected.
The difference between the expected income tax expense (benefit) computed by applying the U.S. federal income tax rate of 35% to net loss from continuing operations for each of the fiscal years 2003, 2002 and 2001, and the actual tax expense (benefit) is a result of the following:
At January 31, 2004, we had net operating loss carryforwards for federal income tax purposes of approximately $61.2 million that expire starting in fiscal 2005. At January 31, 2004, we had general business credit carryforwards for federal income tax purposes of approximately $2.1 million that expire starting in fiscal year 2014. At January 31, 2004, we had net operating loss carryforwards for state income tax purposes of approximately $24.7 million that expire starting in fiscal 2012.
A portion of our federal net operating loss carryforwards are subject to annual usage limitations under Section 382 of the Internal Revenue Code, annual use of our net operating loss carry-forwards will be limited due to prior cumulative ownership changes of more than 50% within a three-year period.
12. LEASE COMMITMENTS
We operate retail stores, a distribution center and administrative offices under various operating leases. Total rent expense was approximately $40.5 million, $42.5 million and $40.7 million, including contingent rent expense of approximately $95,000, $98,000 and $228,000, for fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively.
Rent expense is recorded on a straight-line basis over the life of the lease. For fiscal 2003 and 2001, rent expense charged to operations exceeded cash payment requirements by approximately $202,000 and $264,000, respectively, and resulted in an increase to the deferred rent liability for the same amount. For fiscal 2002, cash payment requirements exceeded rent expense by $414,000.
At January 31, 2004, the future minimum lease payments under operating leases with remaining non-cancelable terms are as follows:
Amounts included in the above table are related to lease agreements, which we have neither assumed nor rejected as of January 31, 2004. Under the Bankruptcy Code, we may assume or reject executory contracts, including lease obligations. Therefore, the commitments shown in the above table may not reflect actual cash outlays in the future periods.
13. STOCKHOLDERS' EQUITY
We have 35,000,000 shares of common stock authorized for issuance at a par value of $0.01 per share. At January 31, 2004, we have reserved 3,157,980 shares of common stock for issuance in connection with our stock option plan. We have also reserved 263,102 shares for issuance under the employee stock purchase plan and 270,190 shares for issuance related to outstanding warrants.
On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting placement fees and other offering expenses. In addition to the placement fees, the placement agent received warrants to purchase 75,000 shares of our common stock at an exercise price of $3.50 per share, a 30% premium over the closing price of $2.68 on March 6, 2003. These warrants will expire in March 2006.
On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting placement fees and other offering expenses. This transaction also provides for warrants to purchase 490,000 shares at the same price as the initial shares purchased, which expired on December 23, 2003. In addition to the placement fees, the placement agent received warrants to purchase 112,500 shares of our common stock at an exercise price of $6.00 per share, a 7% premium over the closing price of $5.62 on August 20, 2003. These warrants will expire in August 2006.
We used the net proceeds of these two private offerings primarily for working capital purposes.
In fiscal 2002, we issued a total of 450,000 restricted shares of common stock to certain of our new senior management members as an inducement to accept employment at the time they were hired. In fiscal 2003, we issued an additional 150,000 restricted shares of common stock to existing and new management members. Of these 600,000 restricted shares, 375,000 shares were forfeited in fiscal 2003 as a result of employment terminations. The remaining 225,000 restricted shares shall vest in installments; 75,000 shares at such time as the closing market price of our common stock equals or exceeds $10.00 per share for 20 consecutive trading days in any three-month period, 75,000 shares at such time as the closing market price of our common stock equals or exceeds $20.00 per share for 20 consecutive trading days in any three-month period, and the final 75,000 shares at such time as the closing market price of our common stock equals or exceeds $30.00 per share for 20 consecutive trading days in any three-month period. In the event that the closing market price of our common stock equals or exceeds $10.00, $20.00 and $30.00 per share for 20 consecutive trading days in any three-month period, at a minimum we may incur non-cash charges of approximately $750,000, $1.5 million, and $2.3 million, respectively.
We have never paid cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future. During the pendency of the Chapter 11 proceedings, any such dividend would be remote and, in any event, subject to the approval of the Court. We are contractually prohibited from paying cash dividends on our common stock under the terms of our DIP financing facility without the consent of the lenders.
14. STOCK SUBSCRIPTION NOTES RECEIVABLE
At February 1, 2003, the outstanding stock subscription notes receivable balance was $1.1 million, net of a valuation allowance. All outstanding stock subscription notes receivable, which were secured by the underlying common stock of the Company, at that time were due from either current or former members of management with a five-year term and had maturity dates ranging from April 29, 2003 to July 29, 2003 and an interest rate of 8.0% per annum. On March 21, 2003, two stock subscription notes in the principal amount of $92,642 and $50,000, respectively, plus accrued interest, were paid in full by current members of management.
On April 29, 2003, the remaining stock subscription notes matured and we foreclosed on the shares of our common stock that served as collateral as of the close of business. The principal and accrued interest on the note due from Michael M. Searles, our former President and Chief Executive Officer, was $1,458,608 and the collateral's market value on April 29, 2003 was $1,198,750, resulting in a deficiency of $259,858, for which Mr. Searles was not personally liable under the terms of the note. In addition, the principal and accrued interest on two notes due from Jonathan W. Spatz, our former Chief Financial Officer, were $688,197 and the collateral's market value on April 29, 2003 was $376,744, resulting in a deficiency of $311,453, for which Mr. Spatz is personally liable for $136,614 of the deficiency under the terms of his notes. Additionally, on April 29, 2003, the principal and accrued interest on the notes due from Tracy W. Parks, our former Chief Operating Officer, was $117,042 and the collateral had a market value of $82,197, resulting in a deficiency of $34,845, for which he is personally liable under the terms of his notes.
In conjunction with the foreclosures as discussed above, we recorded income of approximately $708,000 to adjust the valuation allowance established as of February 1, 2003 as a result of the increase in the market value of our common stock on April 29, 2003 as compared to February 1, 2003.
In August 2003, we received payment in full from Mr. Parks to repay the outstanding principal balance of his note plus interest. Based on Mr. Spatz's current financial condition, we have elected, at this time, to forbear our collection efforts regarding the amount for which he is personally liable. The outstanding amount of $136,614 plus accrued interest was fully reserved as of January 31, 2004.
15. WARRANTS AND STOCK OPTIONS
At January 31, 2004, warrants to purchase 270,190 common shares were outstanding. These warrants have an exercise prices in the range of $3.50 to $19.91 (weighted average exercise price of $9.56) and expire on various dates between May 2005 and August 2006.
We have a stock option plan, the Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan (the "Plan") that provides for the granting of incentive or nonqualified stock options. Under the Plan, we may grant up to 3,157,980 options. The options are issued at fair market value with exercise prices equal to our stock price on the date of grant. Options vest over three to five years; are exercisable in whole or in installments; and expire from five to ten years from the date of grant.
Our Board of Directors has granted stock options to members of the Board and to our management. A summary of our stock option activity and related information is as follows:
The following table summarizes information about the stock options outstanding at January 31, 2004:
In fiscal 2001, we recorded non-cash stock-based compensation expense of $456,000 as a result of the removal of the market price hurdle of 19,361 stock options held by former Executive Vice President who retired in August 2001.
In fiscal 2003 and 2002, there was no event related to our stock options triggered by the market price hurdle; and therefore, we did not record any non-cash stock-based compensation expense.
16. EMPLOYEE BENEFITS
We sponsor a defined contribution plan, qualified under Internal Revenue Code Section 401(k), for the benefit of employees who have completed twelve months of service and who work a minimum of 1,000 hours during that twelve-month period. We make a matching contribution equal to 20% of participating employees' voluntary contributions. Participants may contribute from 1% to 15% of their compensation annually, subject to IRS limitations. We contributed approximately $184,000, $238,000 and $232,000 in fiscal 2003, 2002 and 2001, respectively.
We also sponsor the Factory 2-U Stores, Inc. Employee Stock Purchase Plan (the "ESPP") which allows eligible employees to acquire shares of our Common Stock at a discount from market price, at periodic intervals, paid for with accumulated payroll deductions. The discount is 15% of the lower of the market price per share as quoted on the NASDAQ National Market on the first and last day of an offering period. The ESPP will terminate when all 350,000 shares available for issuance are sold although the ESPP may be terminated earlier by us at any time. At December 31, 2003 the ESPP was temporarily suspended. As of January 31, 2004, eligible employees had purchased 86,898 shares of our common stock under the ESPP.
17. LEGAL MATTERS, COMMITMENTS AND CONTINGENCIES
On January 13, 2004, we filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. We retain control of our assets and are authorized to operate the business as a debtor-in-possession while being subject to the jurisdiction of the Court. As of the Petition Date, most pending litigation is stayed, and absent further order of the Court, substantially all pre-petition liabilitities are subject to settlement under a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 case or its effect on our business. If it is determined that the liabilities subject to compromise in the Chapter 11 case exceed the fair value of the assets, unsecured claims may be satisfied at less than 100% of their fair value and the equity interests of our shareholders may have no value. See Item 1. Business Proceedings Under Chapter 11 of the Bankruptcy Code.
On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations.
In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending.
Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit.
There are numerous other matters filed with the Court in our reorganization proceedings by creditors, landlords or other third parties related to our business operations or the conduct of our reorganization activities. Although none of these individual matters which have been filed to date have had or are expected to have a material adverse effect on us, our ability to successfully manage the reorganization process and develop an acceptable reorganization plan could be negatively impacted by adverse determinations by the Court on certain of these matters.
We are at all times subject to pending and threatened legal actions that arise in the normal course of business.
18. RELATED PARTY TRANSACTIONS
In March 1997, we entered into an agreement with Three Cities Research, Inc. ("TCR") engaging TCR to act as financial advisor to us. Under this agreement, we paid TCR an annual fee of $50,000 and reimburse TCR for all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. As of January 31, 2004, we no longer engage TCR as our financial advisors. We reimbursed TCR for out-of-pocket expenses in the approximate amounts of $46,000, $47,000 and $34,000 during fiscal 2003, 2002 and 2001, respectively. In addition, we paid legal fees in the amount of $24,000 to TCR in connection with our private equity placements during fiscal 2003. As of January 31, 2004, TCR did not own any of our outstanding common stock, however a principal of TCR is still a member of our Board of Directors.
On November 4, 2002, with the approval of the Board of Directors, we appointed Ronald Rashkow to a newly-created position as the Lead Director to our Board for three years. In connection with his Lead Director duties, we granted 50,000 options at an exercise price of $1.68 per share, the fair market value of our common stock on the date of grant. These options are fully vested and are exercisable for five years from the date of grant. We also issued 25,000 shares of restricted common shares to Mr. Rashkow at a price of $0.01 per share. These options vested on November 4, 2003, after his completion of 12 months of service as Lead Director. In addition to this equity compensation, we are also required to pay Mr. Rashkow a monthly fee of $12,500 plus reimbursement of all reasonable out-of-pocket expenses.
On March 6, 2003, two individual investment entities controlled by TCR, Three Cities Offshore II, C.V. and Three Cities Fund II, L.P., participated in our private offering transaction and acquired 407,207 shares and 240,793 shares of our common stock, respectively, at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000. Mr. Rashkow, our Lead Director, also participated in this private offering transaction and acquired 72,700 shares of our common stock at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925. Including these 72,700 shares, Mr. Rashkow's total current direct and indirect ownership of our outstanding common stock is approximately 1.8%.
19. SUBSEQUENT EVENT
On February 2, 2004, the Court authorized the closure of 44 stores. On February 11, 2004, the Court approved the agreement between the Great American Group ("Great American") and us in which Great American acts as an exclusive agent to conduct store closing sales at the 44 stores location. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases with these stores and rejected the remaining 31 leases.
Under the terms of the agreement with Great American, we receive a percentage of the aggregate retail price of the merchandise at the 44 stores as of February 11, 2004, as defined. In addition, we receive reimbursement of sale expenses, as defined, incurred during the store closing sales. Sales proceeds, net of sales tax, received during the store closing sales goes to Great American. As of April 23, 2004, we have received $3.4 million as partial payment for the sale of inventory to Great American. In addition, we have received approximately $1.5 million sale expenses reimbursement. These amounts are subject to final agreed upon reconciliation.
20. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The results of operations for fiscal 2003 and 2002 were as follows:
As a result of rounding differences, total amounts disclosed in the Statements of Operations may not agree to the sum of the amounts disclosed above for the four quarters.