ITEM 1. BUSINESS
We are a leading specialty retailer of premium pet food, supplies and services with 716 stores in 47 states and the District of Columbia. Our pet-related products include food, supplies, grooming products, toys, novelty items, vitamins, small pets such as fish, birds and other small animals (excluding cats and dogs), and veterinary supplies. Our strategy is to offer our customers a complete assortment of pet-related products and services at competitive prices, with superior levels of customer service at convenient locations and through our e-commerce site www.petco.com.
Our stores offer the broad merchandise selection, convenient location and knowledgeable customer service of a neighborhood pet supply store. We believe that this combination differentiates our stores and provides us with a competitive advantage. Our principal format is a 12,000 to 15,000 square foot store, conveniently located near local neighborhood shopping destinations, including supermarkets, bookstores, coffee shops, dry cleaners and video stores, where our target “pet parent” customer makes regular weekly shopping trips. We believe that our stores are well positioned, both in terms of product offerings and location, to benefit from favorable long-term demographic trends, a growing pet population and an increasing willingness of pet owners to spend on their pets. Since the middle of 2001, all new stores have been opened in our newer formats, which incorporate a more dramatic presentation of our companion animals and emphasize higher-margin supplies categories.
Unless otherwise indicated, all references in this Annual Report to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year. For example, references to fiscal 2004 refer to the fiscal year beginning on February 1, 2004 and ended on January 29, 2005.
In this annual report, “PETCO,” “Company,” “we,” “our,” and “us” refer to PETCO Animal Supplies, Inc. and its subsidiaries, unless the context requires otherwise.
The Pet Food, Supplies and Services Industry
General. We believe the pet food, supplies and services industry is benefiting from a number of favorable demographic trends that are continuing to support a steadily growing pet population. The U.S. pet population has now reached 378 million companion animals, including 143 million cats and dogs, with an estimated 62% of all U.S. households owning at least one pet, and three quarters of those households owning two or more pets. We believe the trend to more pets and more pet-owning households will continue, driven by an increasing number of children under 18 and a growing number of empty nesters whose pets have become their new “children.” We estimate that U.S. retail sales of pet food, supplies, small animals (excluding cats and dogs) and services increased to approximately $30 billion in 2003. We believe we are well positioned to benefit from several key growth trends within the industry.
Pet Food. Packaged Facts, an independent provider of market research reports, estimates that dog and cat food sales, which represent the vast majority of all pet food sales, accounted for approximately $11.4 billion in sales for 2003. Sales of premium dog and cat food represented approximately 37.9% of the total dog and cat food market in 2003 and are expected to increase to approximately 41.2% of the total dog and cat food market by 2008. Sales of dog and cat food accounted for $565 million, or 30%, of our fiscal 2004 net sales, of which $523 million, or 93%, was generated from premium dog and cat food sales.
Historically, the pet food industry has been dominated by national supermarket brands such as Alpo, Kal Kan and Purina, which are primarily sold through grocery stores, supermarkets, convenience stores and mass merchants. In recent years, supermarkets’ share of total pet food sales has steadily decreased as a result of competition from warehouse clubs, mass merchants and specialty pet store chains as well as the growing proportion of premium pet food sales. Premium pet foods, such as Science Diet, Nutro and Eukanuba, currently are not sold through supermarkets, warehouse clubs or mass merchants due to manufacturers’ restrictions but are sold primarily through specialty retailers like PETCO, veterinarians and farm and feed stores.
The growth of the premium pet food market is attributable to both the marketing of premium brands by vendors and a heightened nutritional awareness among pet owners. In recent years, premium pet food manufacturers have launched numerous new specialty food products, such as all-natural products and products for pets with sensitive skin and stomachs, as well as oral care products. Management expects expanded product offerings by premium pet food manufacturers to continue, and that distribution of these products primarily through specialty retailers will continue to draw customers away from supermarkets and mass merchants.
Pet Supplies and Small Animals. Based on reports from Packaged Facts, sales of pet supplies and small animals (excluding cats and dogs) accounted for approximately $8.1 billion in sales for 2003 and will grow at a compound annual growth rate, or CAGR, of 8.2% over the next few years. Sales of pet supplies and small animals (excluding cats and dogs) accounted for $1.2 billion, or 65%, of our fiscal 2004 net sales.
The market for pet supplies consists of items such as collars and leashes, cages and habitats, toys, treats, aquatic supplies, pet carriers, vitamins and supplements, and grooming and veterinary products. The channels of distribution for pet supplies are highly fragmented with products sold by many types of retailers, including supermarkets, warehouse clubs and other discounters, mass merchants, specialty pet store chains, direct mail and veterinarians. Specialty retailers such as PETCO, with wide assortments of pet supplies and higher levels of customer service, represent a growing channel for sales of pet supplies.
The market for small animals (other than cats and dogs) includes sales of fish, birds, reptiles, rabbits, hamsters, mice and other small pets. Because of the overpopulation of cats and dogs and the controversial practices of some breeders, we have elected to limit our selection of animals to birds, fish, reptiles and other small animals. We do, however, participate in pet adoption programs for cats, dogs and other animals, which are administered through local animal welfare programs.
Pet Services. Pet services are estimated to account for the remaining $10.5 billion of the overall $30 billion market projected by management for 2003. The market for pet services includes grooming, obedience training, day care and overnight boarding, and vaccinations and other veterinary services. We offer obedience training in most of our stores, grooming in the majority of our stores and limited veterinary services, such as routine vaccinations, at a number of stores. In fiscal 2004, we opened our first “Doggie Day Camp” to service our customers’ day care needs. Although services represented only 4.5% of our fiscal 2004 net sales, services represent an increasing portion of our net sales, and we believe that offering selected pet services better serves our customers and increases traffic flow to our stores. For fiscal 2004, services sales increased 19% from fiscal 2003.
Distribution Channels. Our industry is highly fragmented, with an estimated 9,000 independent pet supply stores operating in the United States. PETCO is one of only two national specialty retailers of pet food, supplies and services. Between 1991 and 2003, the last year for which data is available, specialty pet store chains such as PETCO experienced significant market share gains in the pet food and supplies categories, largely at the expense of supermarkets. We believe that this shift primarily results from (1) the enhanced merchandising effort and product mix offered by specialty pet store chains and (2) the growing demand for premium pet food as nutritional awareness among the general population extends to pet owners and their pets.
Business Strategy
Our strategy is to strengthen our position as a leading specialty retailer of premium pet food, supplies and services by offering our customers a complete assortment of pet-related products and services at competitive prices with superior levels of customer service at convenient locations. We intend to continue to pursue the following elements of our strategy:
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Continue To Increase Sales and Profitability. We have increased our net sales from $1.15 billion in fiscal 2000 to $1.81 billion in fiscal 2004. We also increased our operating income from $13.4 million in fiscal 2000, which includes unusual charges and expenses totaling $57.0 million, to $158.0 million in
fiscal 2004. The principal contributors to this improvement in our financial performance include: (1) our ability to generate continuous comparable store net sales growth, driven partly by our continuing initiative of remodeling certain stores to our newer store formats; (2) strategic expansion in both existing and new markets; (3) innovative store formats that offer superior customer service, convenience and a fun and exciting shopping environment; (4) targeted merchandising efforts to drive greater sales of higher-margin pet accessories, supplies and services, which have grown to approximately 71% of net sales in fiscal 2004, up from approximately 66% of net sales in fiscal 2000; (5) our expanding store base, which offers economies of scale and purchasing efficiencies; and (6) a broad product offering of over 10,000 high quality pet-related products, most of which are not found in typical supermarkets or mass merchants.
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Capitalize Upon Our Maturing Store Base. We have historically found that the most dramatic growth in a store’s net sales and operating income occurs in the first five years following a store’s opening. During this store maturation phase, we have historically experienced an increase in store-level contribution from an approximate average of 6% of net sales in the store’s first year to an approximate average of over 15% of net sales in year five. More than 40% of our stores were opened in the past five years and to date our newly opened stores have been maturing in accordance with historical rates. We believe that our maturing store base provides us with an opportunity to significantly increase our net sales and store-level operating income with only modest incremental capital expenditures for these stores.
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Expand Using Our Proven New Store Model. We believe that the highly fragmented pet food, supplies and services market offers compelling opportunities for us to increase our presence and gain market share. To capitalize on these opportunities and consistent with our existing strategy, we plan to increase our aggregate store square footage by approximately 10% per year on a long-term basis, both by focusing on existing markets and by targeting one or two new geographic markets per year. Our year-over-year increase in square footage in fiscal 2004 was 12.2%, and our total store square footage at January 29, 2005 was approximately 10.1 million square feet. We plan to open approximately 90 new stores in fiscal 2005, or approximately 70 stores net of relocations and closings. We carefully measure each proposed store opening against demographic, economic and competitive factors. Historically, our new stores generally have become profitable by the end of their first year of operation, and we target for each store a five-year return on investment of more than 20%. In fiscal 2005, we intend to remodel up to 50 of our existing stores into our latest format, and we plan to remodel additional existing stores in the future.
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Continue Our Focus on Expanding Our Services Business. We continue to expand our offerings of services to our customers, including grooming, canine education, day care and vaccinations. These services broaden our relationship with customers and encourage more frequent visits to our stores, which result in additional sales of pet food, supplies and small animals (other than cats and dogs). As such, the growing services portion of our business complements our overall customer relationship initiatives.
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Utilize Our Logistics Expertise. Our distribution system has over one million square feet of distribution capacity, including an integrated network of three national and five regional distribution centers. This network enables us to reduce our costs by reducing the delivered cost of merchandise and limiting the need to carry excess inventory in our stores. Our inventory control systems provide for effective replenishment of inventory and allow us to improve in-stock levels at our stores. Our logistics expertise has enabled us to increase inventory turns from 6.7x for fiscal 2000 to 7.7x for fiscal 2004.
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Capitalize Upon Our Brand Awareness and Highly Successful Customer Loyalty Program. The “PETCO” brand name and our slogan “PETCO, where the pets go” are well known by pet owners. We believe that this awareness reinforces the fun and enjoyable shopping experience that we seek to create for our customers and their pets. P.A.L.S., our highly successful customer loyalty program, further enhances and reinforces the loyalty, brand awareness and satisfaction of our customers. Our customers have recently been signing up for approximately one million new P.A.L.S. cards per quarter. Our
P.A.L.S. members account for over 75% of our net sales. Our program fosters a long-term, one-on-one relationship with the customer and builds brand loyalty and customer retention. Our program also provides us with one of the largest databases of customer information in the industry. Information on our customers’ buying preferences allows us to more precisely deliver targeted marketing efforts and assists us in more effectively catering to our customers’ needs.
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Continue to Provide Superior, Knowledge-Based Customer Service. We seek to enhance our customers’ shopping experience by providing knowledgeable and friendly customer service and creating a fun and exciting shopping environment. We seek to hire store managers and sales associates who themselves are pet owners and enthusiasts and, therefore, are more eager and better able to assist customers with their needs. We believe it is better to hire animal lovers and train them in retail rather than hire experienced retailers and hope they like animals. We believe that our customer service differentiates us from our competitors, leading to increased sales, attracting new customers and building customer loyalty.
Purchasing and Distribution
We currently operate three central and five regional distribution centers. The central distribution centers are located in Mira Loma, California; Monroe, New Jersey; and Joliet, Illinois. Bulk items for all stores are either shipped to regional distribution centers for redistribution or are sent directly to store locations. Manufacturers ship non-bulk supplies to the central distribution facilities, which we then distribute either to regional centers or directly to store locations. We also provide order fulfillment services for our Internet customers through our three central distribution centers.
Marketing and Advertising
Our marketing department creates and implements a wide variety of national, regional and local advertising, direct marketing and sales promotion programs. These television, radio, circular and direct mail programs are designed to increase sales and consumer awareness of the PETCO brand name.
Our P.A.L.S. database is integrated with our point of sale (POS) system, allowing us to track the purchasing activity and shopping habits of our P.A.L.S. cardholders. This allows us to effectively target customers with personalized direct mail or e-mail messages, to provide promotional offers directly related to past purchases and to adjust our products and services mix to more effectively cater to our customers’ needs. The breadth of understanding of customer behavior we have accumulated and continue to accumulate has impacted our marketing, our merchandising and our vendor relationships, and allows us to enhance customer retention and heighten customer satisfaction. Our P.A.L.S. strategy is highly integrated and fully complementary with our high-low pricing strategy, and the integration of these strategies allows us to reward our best customers with competitive retail prices while optimizing our overall operating margins.
Local store marketing activities are conducted on a regular basis in most stores. These marketing activities include store grand opening events, in-store pet adoptions, informational seminars, school field trips, pet photos, product demonstrations, pet fairs and a variety of other local contests or cross-promotion events.
We are the naming rights sponsor for PETCO Park, a baseball stadium in San Diego, California, which is the home of the San Diego Padres major league baseball team. As part of this arrangement, we also receive certain other promotional benefits from the San Diego Padres.
Competition
The pet food, supplies and services business is highly competitive. This competition can be categorized into three different segments: (1) supermarkets, warehouse clubs and mass merchants; (2) specialty pet store chains; and (3) traditional pet stores and independent service providers. We believe that the principal competitive factors
influencing our business are product selection and quality, convenient store locations, customer service and price. We believe that we compete effectively within our various geographic areas. However, some of our competitors are much larger in terms of sales volume and have access to greater capital and management resources than we do.
Suppliers and Vendors
We purchase most of our merchandise directly from specialty suppliers and manufacturers of national brands. We purchase the majority of our pet food products from three vendors: Hill’s Pet Products, Inc. (which produces Science Diet), Nutro Products, Inc. and The Iams Company. Supplies of products from these vendors accounted for approximately 8%, 8% and 7%, respectively, of our net sales in fiscal 2004 and approximately 9%, 8% and 8%, respectively, of our net sales in fiscal 2003. While we do not maintain long-term supply contracts with any of our vendors, we believe that we enjoy a favorable and stable relationship with each of these vendors.
Many of the premium pet food brands we offer, such as Science Diet, Nutro and Eukanuba, are not presently available to supermarkets, warehouse clubs or mass merchants due to manufacturers’ restrictions. One of our pet food vendors, The Iams Company, distributes its Iams brand of pet food to supermarkets, warehouse clubs and mass merchants across the country. The Eukanuba brand of premium pet food, which is also manufactured by The Iams Company, continues to be sold exclusively by specialty channels such as PETCO.
Information Systems
Our integrated information systems provide our management team with timely information on sales trends, inventory tracking and operational data at the individual store level. These systems empower regional, district and store managers to increase sales, control inventory and enhance customer satisfaction. Our in-store POS system tracks all sales by stockkeeping unit (SKU) using bar codes and allows management to compare current performance against historical performance and current year’s budget on a daily basis. The information gathered by this system supports automatic replenishment of in-store inventory from our regional and central distribution centers and is integrated into product buying decisions. Store labor planning and visual presentation levels are also supported by sales management information systems. We use Electronic Data Interchange (EDI) with a majority of suppliers for efficient transmittal of purchase orders, shipping notices and invoices. Management believes that the systems we have developed enable us to continue to improve customer service, operational efficiency and management’s ability to monitor critical performance indicators. We continue to invest in supply chain technologies, human resources management, financial planning tools and continued improvement to the POS systems located in all stores.
Internet Operations
We operate the e-commerce site www.petco.com, which complements our retail stores, increases brand awareness of our products and provides our customers with pet-related content and community. The information contained or incorporated in our web site is not a part of this Annual Report.
Trademarks and Licenses
We have registered numerous service marks and trademarks with the United States Patent and Trademark Office. We believe the PETCO trademark has become an important component in our merchandising and marketing strategy. We believe we have all licenses necessary to conduct our business.
Employees
As of January 29, 2005, we employed approximately 16,900 associates, of whom approximately 9,000 were employed full-time. Approximately 92% of our employees were employed in stores or in direct field supervision, approximately 4% in distribution centers and approximately 4% in our national support center in San Diego. We are not party to any collective bargaining arrangements, and we believe our labor relations are generally good.
Regulation
The transportation and sale of small animals is governed by various state and local regulations. To date, these regulations have not had a material effect on our business or operations. Prior to the opening of each store, we review the regulations of the relevant state and local governments. We then ensure ongoing compliance by keeping apprised of industry publications and maintaining contacts with our aquatics and small animal suppliers and the appropriate regulatory agency within each relevant state and local government.
Available Information
Our Internet address is www.petco.com. We make available free of charge through our Internet web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.
Certain Cautionary Statements
Market data used throughout this Annual Report, including information relating to our relative position in the pet food, supplies and services retailing industry, is based on the good faith estimates of management, which estimates are based upon their review of internal surveys, independent industry publications and other publicly available information, including Packaged Facts reports and information prepared by the American Pet Products Manufacturers Association and Business Communications Company, Inc. Although we believe that these sources are reliable, we do not guarantee the accuracy or completeness of this information, and we have not independently verified this information.
Some of the statements in this Annual Report, including, but not limited to, “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934. These statements are therefore entitled to the protection of the safe harbor provisions of these laws. We generally identify forward-looking statements in this Annual Report using words like “believe,” “intend,” “target,” “expect,” “estimate,” “may,” “should,” “plan,” “project,” “contemplate,” “anticipate,” “predict” or similar expressions. You can also identify forward-looking statements by discussions of strategy, plans or intentions. These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Such risks, uncertainties and other factors include, but are not limited to, the following:
If we are unable to profitably open and operate new stores, maintain the profitability of our existing stores and successfully complete our store remodel program, our business, financial condition and results of operations may be harmed.
One of our strategies is to open new stores by focusing on both existing markets and by targeting new geographic markets. We have opened between 40 and 81 stores per year (not including closures of existing stores) between fiscal 1999 and fiscal 2004. We plan to increase our aggregate store square footage by approximately 10% per year on a long-term basis, both by focusing on existing markets and by targeting one or two new geographic markets per year. Our year-over-year increase in square footage in fiscal 2004 was 12.2%, and our total store square footage at January 29, 2005 was approximately 10.1 million square feet. We plan to open approximately 90 new stores in fiscal 2005, or approximately 70 stores net of relocations and closings.
There can be no assurance that we will be able to open stores at this rate. The rate of our expansion will depend on several factors, including general economic and business conditions affecting consumer confidence
and spending, the availability of desirable locations, the negotiation of acceptable lease terms, the availability of qualified personnel and our ability to manage the operational aspects of our growth. The rate of our expansion will also depend on the availability of adequate capital, which in turn will depend in large part on cash flow generated by our business and the availability of equity and debt capital. There can be no assurance that we will be able to obtain equity or debt capital on acceptable terms or at all. Moreover, our senior credit facility and the indenture governing our senior subordinated notes contain provisions that restrict the amount of debt we may incur in the future. If we are not successful in obtaining sufficient capital, we may be unable to open additional stores as planned, which may adversely affect our results of operations.
Our continued growth also depends, to a significant degree, on our ability to increase sales in our new and existing stores. Our comparable store net sales increased by 8.0%, 5.6% and 6.2% for fiscal 2002, 2003 and 2004, respectively. As a result of new store openings in existing markets and because mature stores will represent an increasing proportion of our store base over time, our comparable store net sales increases in future periods may be lower than historical levels or our comparable store net sales may not increase at all.
There also can be no assurance that our existing stores will maintain their current levels of sales and profitability or that new stores will generate sales levels necessary to achieve store-level profitability, much less profitability comparable to that of existing stores. New stores that we open in our existing markets may draw customers from our existing stores and may have lower sales growth relative to stores opened in new markets. New stores also may face greater competition and have lower anticipated sales volumes relative to previously opened stores during their comparable years of operations. These factors, together with increased pre-opening expenses at our new stores, may reduce our average store contribution and operating margins. In addition, we are opening new stores in, and are remodeling some of our existing stores into, our latest format, which incorporates our most recent merchandising strategies. There can be no assurance that our latest formats will be as or more profitable than our existing stores, and may be less profitable than historical levels for our other stores. If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, our business, financial condition and results of operations may be harmed.
We may be unable to successfully execute our expansion strategy or manage and sustain our growth and, as a result, our business may be harmed.
Our ability to open new stores depends on a number of factors, including:
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adequate capital resources for leasehold improvements, fixtures, inventory and pre-opening expenses;
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our ability to locate and obtain favorable store sites and negotiate acceptable lease terms;
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our ability to obtain and distribute adequate product supplies to our stores, including by expanding our distribution facilities;
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our ability to hire, train and retain skilled managers and personnel; and
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our ability to continue to upgrade our information and other operating systems to control the anticipated growth and expanded operations.
Our senior credit facility and the indenture governing our senior subordinated notes also contain covenants that may restrict or impair our growth plans. We currently expect to finance our store expansion plans from cash flow from operations, lease financing and capacity under our senior credit facility. To the extent that we are unable to obtain adequate financing for new store growth on acceptable terms, our ability to open new stores will be negatively impacted. As a result, there can be no assurance that we will be able to achieve our current plans for the opening of new stores. In addition, our failure to expand our distribution facilities or other internal systems or procedures in accordance with our growth plans, or difficulties we may incur in operating our distribution facilities, could adversely affect our ability to deliver merchandise to our stores in a timely fashion. As a result, our ability to support our planned new store growth may be harmed.
In addition, we routinely evaluate our strategic alternatives with respect to each of our stores and our other operating assets and investments. In connection with this evaluation, we may elect to close stores or to sell or otherwise dispose of selected assets or investments. Excluding store relocations, we closed six stores in fiscal 2002, two stores in fiscal 2003 and one store in fiscal 2004. There can be no assurance that any future sale or disposition would be achieved on terms favorable to us because we incur closing costs or may lose sales to our competitors as a result.
Our level of debt may limit the cash flow available for our operations and place us at a competitive disadvantage.
As of January 29, 2005, our debt consisted primarily of (1) $85.0 million outstanding under our senior revolving credit facility (total available revolving credit of $200.0 million (reduced by the outstanding amount of letters of credit of $24.9 million at January 29, 2005) with an option to increase the available credit by an additional $125.0 million, subject to certain conditions) and (2) $104.0 million in principal amount of our senior subordinated notes. Our level of indebtedness has important consequences. For example, our level of indebtedness may:
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require us to use a substantial portion of our cash flow from operations to pay interest and principal on our debt, which would reduce the funds available to use for working capital, capital expenditures and other general corporate purposes;
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limit our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other investments, which may limit our ability to carry out our business strategy;
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result in higher interest expense if interest rates increase on our floating rate borrowings; or
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heighten our vulnerability to downturns in our business or in the general economy and restrict us from exploiting business opportunities or making acquisitions.
The agreements governing our debt impose restrictions on our business.
The agreement governing our senior credit facility and the indenture governing our senior subordinated notes contain a number of covenants imposing significant restrictions on our business. These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. These covenants place restrictions on our ability to, among other things:
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incur more debt;
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pay dividends, redeem or repurchase our stock or make other distributions;
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make acquisitions or investments;
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enter into transactions with affiliates;
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merge or consolidate with others;
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dispose of assets or use asset sale proceeds;
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create liens on our assets; and
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extend credit.
If compliance with our debt obligations materially hinders our ability to operate our business and adapt to changing industry conditions, we may lose market share, our revenue may decline and our operating results may suffer.
Our failure to satisfy covenants in our debt instruments would cause a default under those instruments.
In addition to imposing restrictions on our business and operations, our debt instruments include a number of covenants relating to financial ratios and tests. Our ability to comply with these covenants may be affected by
events beyond our control, including prevailing economic, financial and industry conditions. The breach of any of these covenants would result in a default under these instruments. An event of default would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest. Moreover, the lenders under our senior credit facility would have the option to terminate any obligation to make further extensions of credit under our senior credit facility. If we are unable to repay debt to our senior lenders, these lenders could proceed directly against our assets.
The loss of any of our three key vendors, or of our exclusive distribution arrangements with our vendors, would negatively impact our business.
We purchase significant amounts of products from three key vendors: Hill’s Pet Products, Inc. (which produces Science Diet), Nutro Products, Inc. and The Iams Company. Supplies of products from these vendors accounted for approximately 8%, 8% and 7%, respectively, of our net sales in fiscal 2004 and approximately 9%, 8% and 8%, respectively, of our net sales of fiscal 2003. We do not maintain long-term supply contracts with any of our vendors. While we believe that our vendor relationships are satisfactory, any vendor could discontinue selling to us at any time. The loss of any of our three key vendors or any other significant vendors of premium pet food or pet supplies offered by us would have a negative impact on our business, financial condition and results of operations.
In addition, a change in how our key products are distributed could have a material adverse effect on our business. It could materially adversely affect our business if any premium pet food manufacturers were to make premium pet food products widely available in supermarkets or through mass merchants, or if the premium brands currently available to supermarkets and mass merchants were to increase their market share at the expense of the premium brands sold only through specialty pet food and supplies retailers.
None of the premium pet food brands that we purchase from Hill’s Pet Products, Inc. and Nutro Products, Inc. is widely available in supermarkets, warehouse clubs or mass merchants. One of our pet food vendors, The Iams Company, distributes its Iams brand of pet food to supermarkets, warehouse clubs and mass merchants across the country. The Eukanuba brand of premium pet food, which is also manufactured by The Iams Company, continues to be sold exclusively through specialty channels such as PETCO.
Our principal vendors also currently provide us with certain incentives such as volume purchasing, trade discounts, cooperative advertising and market development funds. A reduction or discontinuance of these incentives would increase our costs and could reduce our profitability.
We also purchase significant amounts of pet supplies from a number of vendors with limited supply capabilities. There can be no assurance that our current pet supply vendors will be able to accommodate our anticipated growth and expansion of our stores. We continually seek to expand our base of pet supply vendors and to identify new pet-related products. An inability of our existing vendors to provide products in a timely or cost-effective manner could impair our business, financial condition and results of operations.
Competition in the markets in which we operate is strong and if we are unable to compete effectively, our ability to generate sales may suffer and our operating income and net earnings would decline.
The pet food and supplies retailing industry is highly competitive. We compete with a number of specialty pet store chains and traditional pet stores. We also compete with supermarkets, warehouse clubs and mass merchants. Many of these competitors are larger and have access to greater capital and management resources than we do.
There can be no assurance that in the future we will not face greater competition from national, regional and local retailers. In particular, if any of our major competitors seeks to gain or retain market share by reducing prices or by introducing additional products, we may be required to reduce prices on our key products in order to remain competitive, which may negatively impact our profitability.
A prolonged economic downturn could result in reduced sales and lower revenues and profitability.
Purchases of pet-related supplies may be affected by prolonged, negative trends in the general economy that adversely affect consumer spending. Any reduction in consumer confidence or disposable income in general may affect companies in pet-related and other retail industries more significantly than companies in industries that rely less on discretionary consumer spending. In addition, due to our level of debt we are more susceptible to some of these adverse economic effects than are some of our competitors that have greater financial and other resources than we do.
Our operating results could be harmed if we are unable to integrate acquired companies into our operations.
The pet food and supplies retailing industry is highly fragmented. We may pursue expansion and acquisition opportunities in the future, and we must efficiently integrate and combine operations of acquired companies to realize the anticipated benefits of acquisitions. To be successful, the integration process requires us to achieve the benefits of combining the companies, including generating operating efficiencies and synergies and eliminating or reducing redundant costs. Since we often have limited prior knowledge of acquired companies, there can be no assurance that the anticipated benefits of these acquisitions will be fully realized without incurring unanticipated costs or diverting management’s attention from our core operations. Our operating results could be harmed if we are unable to efficiently integrate newly acquired companies into our operations. Any future acquisitions also could result in potentially dilutive issuances of equity securities, or the incurrence of additional debt or the assumption of contingent liabilities.
We have made investments in the past and may make investments in the future without being able to achieve an adequate return, if any, on our investment.
In the past we have made, and in the future we may make, investments in strategic ventures or other complementary businesses in an effort to expand internationally or to otherwise grow our business. These investments typically involve many of the same risks posed by acquisitions, particularly those risks associated with the diversion of our resources, the inability of the new venture to generate sufficient revenues, the management of relationships with third parties and potential expenses. Strategic ventures have the added risk that the other strategic venture partners may have economic, business or legal interests or objectives that are inconsistent with our interests and objectives. Although we have no present plans to make any such investment, there can be no assurance that any investment we make in the future would achieve an adequate return, if any. In addition, in the past we have terminated, and in the future we may terminate, our relationship in a strategic venture after we have made substantial investments in that strategic venture.
If we are required to restructure our operations to comply with regulations governing our business, it could have a material effect on our business and operations.
The transportation and sale of small animals is governed by various state and local regulations. These laws vary from state to state and are enforced by the courts and by regulatory authorities with broad discretion. While we seek to structure our operations to comply with the laws and regulations of each state in which we operate, there can be no assurance that, given varying and uncertain interpretations of these laws, we would be found to be in compliance in all states. A determination that we are in violation of applicable laws in any state in which we operate could require us to restructure our operations to comply with the requirements of that state, which could have a material adverse effect on our business and operations.
Negative publicity arising from claims that we do not properly care for animals we sell could adversely affect how we are perceived by the public and reduce our revenues and profitability.
From time to time, we are subject to claims or complaints that we do not care properly for some of the animals we sell. For example, allegations were made in a complaint filed in June 2002 in the San Francisco
Superior Court by the San Francisco City Attorney’s office to the effect that certain associates did not properly care for companion animals for sale in our two San Francisco stores. The complaint, which was subsequently transferred to the Santa Clara Superior Court, sought damages, penalties and an injunction against the sale of companion animals in our San Francisco stores. The complaint and related news reports caused negative publicity. We take seriously any allegations regarding the proper care of companion animals and have taken steps to reiterate to all our associates the importance of proper care for all companion animals in all our stores. Without admitting any of the allegations of the City of San Francisco’s complaint, we reached a settlement of the matter in May 2004, pursuant to which the City of San Francisco agreed to drop its claims in consideration of a $50,000 payment and our agreement to conduct or continue certain training and animal care practices currently implemented in our San Francisco stores. We recorded accruals for estimated losses related to this matter at January 31, 2004 and May 1, 2004, which were paid during fiscal 2004 and which did not have a material impact on our results of operations or financial condition. However, any similar allegations or actions which could be filed in the future could cause negative publicity which could have a material adverse effect on our results of operations.
We depend on key personnel, and if we lose the services of any of our principal executive officers, including Mr. Devine, our Chairman, Mr. Myers, our Chief Executive Officer, and Mr. Hall, our President and Chief Operating Officer, we may not be able to run our business effectively.
We are dependent upon the efforts of our principal executive officers. In particular, we are dependent upon the management and leadership of Brian K. Devine, our Chairman, James M. Myers, our Chief Executive Officer, and Bruce C. Hall, our President and Chief Operating Officer. The loss of Mr. Devine, Mr. Myers, Mr. Hall or certain of our other principal executive officers could affect our ability to run our business effectively.
Our success will depend on our ability to retain our current management and to attract and retain qualified personnel in the future. Competition for senior management personnel is intense and there can be no assurance that we can retain our personnel. The loss of a member of senior management requires the remaining executive officers to divert immediate and substantial attention to seeking a replacement. The inability to fill vacancies in our senior executive positions on a timely basis could adversely affect our ability to implement our business strategy, which would negatively impact our results of operations.
Our management has determined that there was a material weakness in our system of internal control over financial reporting and as a result concluded that our internal control over financial reporting was not effective as of January 29, 2005. If we are unable to correct the deficiency that resulted in this material weakness, we may not be able to accurately report our future financial results, which could cause investors to lose confidence in our reported financial information and result in a decline in the market price of our common stock.
Our management assessed the effectiveness of our internal control over financial reporting as of January 29, 2005, and this assessment identified a material weakness in our internal control over financial reporting. As a result our management concluded that our internal control over financial reporting was not effective as of January 29, 2005. For a discussion of this material weakness and our responsive measures, please see “Item 9A. Controls and Procedures” of this report. Although we have taken steps to correct the internal control deficiency that resulted in this material weakness, the efficacy of the steps we have taken are subject to continuing management review supported by confirmation and testing. We cannot be certain that these measures will ensure that we will be able to implement and maintain adequate internal control over our financial reporting processes in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation could prevent us from accurately reporting our financial results or cause us to fail to meet our reporting obligations in the future. Also, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. As a result, insufficient internal control over financial reporting could cause investors to lose confidence in our reported financial information, which could result in a decline in the market price of our common stock.
We have been named as a party to several class action and derivative action lawsuits, and we may be named in additional litigation, all of which could require time and attention from certain members of management and result in significant legal expenses. An unfavorable outcome in one or more of these lawsuits could have a material adverse effect on our business, financial condition, results of operations and cash flows.
After we announced on April 15, 2005 that we discovered instances of errors within our Distribution Operation in which certain expenses were under-accrued, several separate complaints purporting to be securities class actions or shareholder derivative actions were filed in federal and state court, respectively, alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934 and California law. While we have tendered these matters to our insurance carriers, the expense of defending such litigation may be costly and divert attention by certain members of management from the day-to-day operations of our business, which could adversely affect our business, results of operations and cash flows, resulting in a decline in the market price of our common stock. In addition, though we believe that any damages, if any, would be covered by our insurance, there can be no assurance that an unfavorable outcome in such litigation would not have a material adverse effect on our business, results of operations and cash flows, resulting in a decline in the market price of our common stock.
Terrorism and the uncertainty of war may have a material adverse effect on our operating results.
Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, and other acts of violence or war may affect the operations of the United States securities markets, the markets in which we operate and our operations and profitability. Further terrorist attacks against the United States or U.S. businesses may occur. The potential near-term and long-term effect these attacks may have for our customers, the markets for our services and the U.S. economy are uncertain. The consequences of any terrorist attacks, or any armed conflicts which may result, are unpredictable, and we may not be able to foresee events that could have an adverse effect on our business.
Future sales of shares of our common stock in the public market may depress our stock price.
If our existing stockholders sell substantial amounts of our common stock in the public market or if there is a perception that these sales may occur, the market price of our common stock could decline. As of May 31, 2005, we had 57,765,653 shares of common stock outstanding. Substantially all of these shares are freely tradable in the public market without restriction or further registration under the Securities Act, unless the shares are held by “affiliates” of ours as such term is defined in Rule 144 of the Securities Act.
We also have 5,054,519 shares of common stock reserved for issuance under our stock option and incentive plans, of which 4,119,400 shares were subject to outstanding options as of May 31, 2005. In March 2002, we filed a registration statement on Form S-8 to register all of the shares of common stock which could be purchased upon the exercise of stock options outstanding on that date and all other shares of common stock reserved for future issuance under our stock option and incentive plans. Accordingly, shares issued upon exercise of such options are freely tradable by holders who are not our affiliates and, subject to the volume and other limitations of Rule 144, by holders who are affiliates.
The price of our common stock may be volatile.
Since our initial public offering in February 2002, the price at which our common stock has traded has been subject to significant fluctuation. The market price for our common stock in the future may continue to be volatile. In addition, the stock market periodically experiences significant price and volume fluctuations that in many instances have been unrelated or disproportionate to the operating performance of specific companies. In the past, following periods of volatility in the market price of a particular company’s securities, securities class-action litigation has often been brought against that company. If similar litigation were instituted against us, it could result in substantial costs and divert management’s attention and resources from our core business.
Our stock price may be adversely affected because our results of operations may fluctuate from quarter to quarter.
The timing of new store openings, related pre-opening expenses and the amount of revenue contributed by new and existing stores may cause our quarterly results of operations to fluctuate. Our business is also subject to seasonal fluctuation. Historically, we have realized a higher portion of our net sales during the month of December than during the other months of the year. If our quarterly revenue and operating results fall below the expectations of securities analysts and investors, the market price of our common stock could fall substantially.
Operating results also may vary depending on a number of factors, many of which are outside our control, including:
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changes in our pricing policies or those of our competitors;
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the hiring and retention of key personnel;
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wage and cost pressures;
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changes in fuel prices or electrical rates;
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costs related to acquisitions of businesses; and
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seasonal and general economic factors.
Takeover defense provisions may adversely affect the market price of our common stock.
Various provisions of the Delaware general corporation law, or the DGCL, and of our corporate governance documents may inhibit changes in control not approved by our board of directors and may have the effect of depriving our stockholders of an opportunity to receive a premium over the prevailing market price of our common stock in the event of an attempted hostile takeover. In addition, the existence of these provisions may adversely affect the market price of our common stock. These provisions include:
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a classified board of directors;
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a prohibition on stockholder action through written consents;
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a requirement that special meetings of stockholders be called only by our board of directors, our chairman or our president;
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advance notice requirements for stockholder proposals and nominations; and
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availability of “blank check” preferred stock.
You are cautioned not to place undue reliance on forward-looking statements, which reflect management’s view only as of the date of this Annual Report. Except as required by applicable law, including the securities laws of the United States, and the rules and regulations of the Securities and Exchange Commission, we do not plan to publicly update or revise any forward-looking statements after the date of this Annual Report, whether as a result of any new information, future events or otherwise.
ITEM 2.
ITEM 2. PROPERTIES
We lease all of our store and distribution center locations. The original lease terms for our stores generally range from ten to fifteen years, with many of these leases containing renewal options. Leases on 161 stores expire within the next three years. Of these leases, 125 contain renewal options.
Our headquarters, located in San Diego, California, consists of three owned facilities comprising a total of 156,000 square feet. One of the San Diego facilities is financed under an obligation that expires in February 2006. We also lease three central and five regional distribution centers. Our three central distribution centers
collectively occupy approximately 950,000 square feet of space in Monroe, New Jersey; Joliet, Illinois; and Mira Loma, California under leases that expire in May 2018, March 2010 and September 2005, respectively. Our five regional distribution centers collectively occupy approximately 240,000 square feet of space in Stockton, California; Portland, Oregon; New Hope, Minnesota; Mansfield, Massachusetts; and Garland, Texas under leases that expire in April 2009, February 2007, September 2007, December 2008 and October 2009, respectively. Except with respect to the leases for our Monroe, New Jersey; Stockton, California; Portland, Oregon; and Mansfield, Massachusetts facilities, all of our distribution center leases contain a renewal option.
Below is a table listing, for our 716 stores at January 29, 2005, the number of stores by state:
Number of PETCO Stores
as of January 29, 2005
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On April 18, 2005, we and two of our officers, James M. Myers, our Chief Executive Officer, and Rodney Carter, our Chief Financial Officer, were named as defendants in a purported class action filed in United States District Court for the Southern District of California alleging violations of Sections 10 and 20 of the Securities Exchange Act of 1934. The named plaintiff, Plumbers and Pipefitters Local 51 Pension Fund, purports to represent a class of purchasers of our stock during the period November 18, 2004 to April 14, 2005, and alleges that during such period the defendants misrepresented our financial position and that the plaintiff and the purported class of purchasers during that period were damaged by paying artificially and falsely inflated prices for our stock. The complaint seeks unspecified monetary damages. On April 26, 2005, another class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above. The April 26 suit named Brian K. Devine, our Chairman, as an additional defendant.
The named plaintiffs in the April 26 suit, Richard and Loretta Hochreiter, purport to represent an identical class of investors as that identified in the April 18 lawsuit. On April 27, 2005, another class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above, naming Roger Lieberman as its representative plaintiff. On May 5, 2005, an additional class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above, naming Messrs. Myers, Carter and Devine as defendants. The May 5 complaint names Dikran Toroser as its representative plaintiff. We have tendered these matters to our insurance carriers, and do not believe the outcome of these matters will have a material adverse impact on our consolidated financial position or results of operations in any future period.
In addition, certain law firms have announced that they are seeking plaintiffs in order to file a class action lawsuit against us based on unasserted claims similar to those described above. Upon receipt of any formal complaint relating to such claims, we intend to tender these matters and any other similar matters to our insurance carriers, and do not believe the outcome of these matters will have a material adverse impact on our consolidated financial position or results of operations in any future period.
On April 22, 2005, Angela Carr, an alleged owner of our stock, derivatively sued all of our directors and our Chief Executive Officer and Chief Financial Officer, purportedly on our behalf, alleging that such officers and directors engaged in breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and other violations of California law during the period November 18, 2004 to the present. The complaint, filed in Superior Court of the State of California for the County of San Diego, seeks to recover on our behalf alleged unspecified damages sustained by us as a result of such alleged actions, treble damages, disgorgement of profits from the sale of our securities and benefits and compensation obtained by the individual defendants, and extraordinary equitable and/or injunctive relief as permitted by law. Also on April 22, 2005, another shareholder derivative action was filed in Superior Court of the State of California for the County of San Diego on behalf of Gwen Jordan against the same defendants and with substantially similar allegations to those described above. We have tendered these matters to our insurance carriers, and do not believe the outcome of these matters will have a material adverse impact on our consolidated financial position or results of operations in any future period.
We are involved in other routine litigation arising in the ordinary course of our business. While the results of such litigation cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our stockholders during the fourth quarter of fiscal 2004.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Until May 23, 2005, our common stock has been listed on The Nasdaq Stock Market’s National Market under the symbol “PETC” since it was initially offered to the public on February 22, 2002. Prior to February 22, 2002, there had not been a market for our common stock. On May 23, 2005, as a result of our delinquency in filing this Annual Report with the Securities and Exchange Commission, our trading symbol for our securities changed from “PETC” to “PETCE”. We expect our trading symbol to change back to “PETC” soon after the filing of this Annual Report with the Securities and Exchange Commission. The following table shows the high and low per share sale prices of our common stock, as reported on the Nasdaq National Market for the periods indicated:
On May 31, 2005, the last reported sale price of our common stock on the Nasdaq National Market was $30.09. As of May 31, 2005, there were approximately 60 holders of record of our common stock.
Dividend Policy
We have not paid cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in the operation of our business and we do not anticipate paying cash dividends in the foreseeable future. In addition, our senior credit facility and the indenture governing our senior subordinated notes place limitations on our ability to pay dividends or make other distributions in respect of our common stock. Any future determination as to the payment of dividends on our common stock will be restricted by these limitations, will be at the discretion of our board of directors and will depend on our results of operations, financial condition, capital requirements and other factors deemed relevant by the board of directors, including the DGCL, which provides that dividends are only payable out of surplus or current net profits.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected historical consolidated financial data as of and for the fiscal years ended February 3, 2001, February 2, 2002, February 1, 2003, January 31, 2004, and January 29, 2005 presented below under the captions “Statement of Operations Data” and “Balance Sheet Data,” have been derived from our audited consolidated financial statements as of those dates and for those periods. The selected historical consolidated financial data and notes should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements.
(1) The fiscal year ended February 3, 2001 consisted of 53 weeks, as compared to 52 weeks for each of the fiscal years ended February 2, 2002, February 1, 2003, January 31, 2004 and January 29, 2005.
(2) Operating income includes the following unusual charges and expenses for the periods indicated:
(a) Management fees were paid pursuant to our management services agreement, which we entered into in October 2000 in connection with our leveraged recapitalization. We terminated the management services agreement shortly after our initial public offering for a fee of $12.5 million.
(b) Financing and legal expenses related to our initial public offering in February 2002.
(c) In connection with the increase in fair value related to outstanding stock options as a result of our initial public offering, we recorded non-cash stock-based compensation totaling $17.4 million in the fiscal year ended February 2, 2002, of which $14.4 million and $3.0 million are recorded in stock-based compensation and other costs and cost of sales and occupancy costs, respectively, and $8.4 million in the fiscal year ended February 1, 2003, of which $7.0 million and $1.4 million are recorded in stock-based compensation and other costs and cost of sales and occupancy costs, respectively.
(d) Related to the settlement of California overtime litigation.
(3) Calculated by dividing cost of sales and occupancy costs, excluding the impact of the 53rd week in fiscal 2000, for the most recent four quarters, by average fiscal quarter end inventory for the five most recent quarters. Fiscal 2003 and 2004 reflect the adoption of Emerging Issues Task Force, or EITF, Issues 02-16 and 03-10, which have the effect of decreasing cost of sales and occupancy costs and decreasing inventory turns as compared to fiscal 2000, 2001 and 2002, which do not reflect the adoption of these standards.
(4) A new store becomes a comparable store on the first day of the fiscal month following 12 full fiscal months of operation. Relocated stores become comparable stores on the first day of operation. Comparable stores also include expanded stores and exclude closed stores as of the first day of the month of closing.
(5) Includes capital leases and other obligations.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion of our financial condition and results of operations with our consolidated financial statements and related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in Item 1 of this Annual Report under the heading “Certain Cautionary Statements.” Our actual results may differ materially from those contained in any forward-looking statements.
Executive Summary
PETCO is a leading specialty retailer of premium pet food, supplies and services. At January 29, 2005, we operated 716 stores in 47 states and the District of Columbia. Our strategy is to offer our customers a complete assortment of pet-related products and services at competitive prices, with superior levels of customer service at convenient locations. Our stores combine the broad merchandise selection, convenient location and knowledgeable customer service of a neighborhood pet supply store. We believe that this combination differentiates our stores and provides us with a competitive advantage. Our principal format is a 12,000 to 15,000 square foot store, conveniently located near local neighborhood shopping destinations, including supermarkets, bookstores, coffee shops, dry cleaners and video stores, where our target “pet parent” customer makes regular weekly shopping trips. We believe that our stores are well positioned, both in terms of product offerings and location, to benefit from favorable long-term demographic trends, a growing pet population and an increasing willingness of pet owners to spend on their pets. Since the middle of 2001, all new stores have been opened in our newer formats, which incorporate a more dramatic presentation of our companion animals and emphasize higher-margin supplies categories. We remodeled 50 stores to our newer formats during fiscal 2004 and now have a total of 336 stores in our newer formats.
We increased our net sales from $1.15 billion in fiscal 2000 to $1.81 billion in fiscal 2004. We also increased our operating income from $13.4 million in fiscal 2000, which includes unusual charges and expenses totaling $57.0 million, to $158.0 million in fiscal 2004. The principal contributors to this improvement in our financial performance include: (1) our ability to generate continuous comparable store net sales growth, driven partly by our continuing initiative of remodeling certain stores to our newer store formats; (2) strategic expansion in both existing and new markets; (3) innovative store formats that offer superior customer service, convenience and a fun and exciting shopping environment; (4) targeted merchandising efforts to drive greater sales of higher-margin pet accessories, supplies and services, which have grown to approximately 71% of net sales in fiscal 2004, up from approximately 66% of net sales in fiscal 2000; (5) our expanding store base, which offers economies of scale and purchasing efficiencies; and (6) a broad product offering of over 10,000 high quality pet-related products, most of which are not found in typical supermarkets or mass merchants.
We plan to increase our aggregate store square footage by approximately 10% per year on a long-term basis, both by focusing on existing markets and by targeting one or two new geographic markets per year. Our year-over-year increase in square footage in fiscal 2004 was 12.2%, and our total store square footage at January 29, 2005 was approximately 10.1 million square feet. We plan to open approximately 90 new stores in fiscal 2005, or approximately 70 stores net of relocations and closings. Historically, our new stores generally have become profitable by the end of their first year of operation, and we target for each store a five-year return on investment of more than 20%. In fiscal 2005, we intend to remodel up to 50 of our existing stores into our latest format, and we plan to remodel additional existing stores in the future. We also plan to relocate certain existing stores and close certain under-performing stores. As a result of our store expansion strategy, operating results in any future year may reflect lower average store contribution and operating margins due to increased store pre-opening and remodel expenses and lower anticipated sales volumes of newer stores.
The pet food, supplies and services business is highly competitive. This competition can be categorized into three different segments: (1) supermarkets, warehouse clubs and mass merchants; (2) specialty pet store chains;
and (3) traditional pet stores and independent service providers. We believe that the principal competitive factors influencing our business are product selection and quality, convenient store locations, customer service and price. Our strategy is to focus our assortment on specialty products and premium pet foods, which minimizes the potential overlap with supermarkets, warehouse clubs and mass merchants. We believe that we compete effectively within our various geographic areas. However, some of our competitors are much larger in terms of sales volume and have access to greater capital and management resources than we do.
Results of Operations
The following table sets forth selected results of our operations expressed as a percentage of net sales for the periods indicated. As a result of operational and strategic changes, period-to-period comparisons of financial results may not be meaningful and the results of our operations for historical periods may not be indicative of our future results.
Fiscal Year Ended January 29, 2005 Compared with Fiscal Year Ended January 31, 2004
Net sales increased 12.5% to $1.81 billion for fiscal 2004 from $1.61 billion for fiscal 2003. The increase in net sales resulted primarily from the comparable store net sales increase of 6.2% and the increase in our store square footage of 12.2% in fiscal 2004. We added 81 new stores in fiscal 2004, or 62 stores net of relocations and closings. The increase in comparable store net sales accounted for approximately $98.6 million, or 48.9%, of the net sales increase. The net increase in our store base accounted for approximately $103.1 million, or 51.1%, of the net sales increase. The comparable store net sales increase was attributable to improvements in our product mix to higher-price categories, increased customer traffic and price increases in certain product categories.
We adopted Emerging Issues Task Force, or EITF, Issue 03-10 during the first quarter of fiscal 2004. EITF 03-10 addresses the accounting for consideration received by a reseller in the form of a reimbursement by the vendor for honoring the vendor’s sales incentives offered directly to consumers, and requires such consideration to be accounted for as a reduction of cost of sales and occupancy costs unless certain criteria are met. Previously, we recognized such vendors’ sales incentives as net sales. In accordance with EITF 03-10, the consolidated financial statements for fiscal 2003 have been reclassified to conform to this accounting change. For fiscal 2003, the adoption of EITF 03-10 resulted in the reclassification of $43.7 million of vendors’ sales incentives as a reduction of both net sales and cost of sales and occupancy costs. For fiscal 2004, the corresponding amount of vendors’ sales incentives recorded as a reduction of cost of sales and occupancy costs was $49.1 million. This is the last period that we will report an EITF Issue 03-10 effect, as the first quarter of fiscal 2005 will be fully comparable with the prior year.
Gross profit, defined as net sales less cost of sales including store occupancy costs, increased $81.3 million, or 14.8%, to $630.8 million for fiscal 2004 from $549.5 million for fiscal 2003. Gross profit as a percentage of net sales increased to 34.8% for fiscal 2004 from 34.1% in fiscal 2003. An increase of approximately 1.0% of net sales was due to the continuing change in our sales mix from lower-margin pet food to higher-margin categories, improvements in pet food margins and, to a lesser extent, a reduction of inventory shrinkage costs. Offsetting these increases was a decrease of approximately 0.5% of net sales caused by higher fuel prices and overall distribution costs, partly related to our penetration into new markets with high initial entry costs, and a decrease of approximately 0.5% of net sales caused by increased store occupancy costs as a percentage of net sales associated with delays in new store openings and increased store closing costs. In addition, we recorded an adjustment in fiscal 2004 for unrecorded distribution costs related to prior periods in the amount of $2.7 million, resulting in a decrease in gross profit of approximately 0.1% of net sales. The remainder of the increase, or approximately 0.8% of net sales, is a result of our adoption of EITF No. 02-16 in the first quarter of fiscal 2003. This accounting change results in the initial deferral of substantially all of our vendor support as a reduction of inventory, which is realized as a reduction of cost of sales and occupancy costs as the related inventory is sold. In periods prior to the first quarter of fiscal 2003, we recorded certain vendor support, including cooperative advertising reimbursement, as a reduction of selling, general and administrative expenses when earned. EITF 02-16 applied prospectively to vendor arrangements entered into or modified subsequent to December 31, 2002. Because we follow a practice of continually negotiating new arrangements with suppliers, the effects of this accounting change were phased in over the course of fiscal 2003. As of the beginning of fiscal 2004, substantially all of our supplier arrangements are accounted for pursuant to EITF 02-16. This is the last period that we will report an EITF Issue 02-16 effect, as the first quarter of fiscal 2005 will be fully comparable with the prior year.
Selling, general and administrative expenses increased $61.0 million, or 14.8%, to $472.8 million for fiscal 2004 from $411.8 million for fiscal 2003. As a percentage of net sales, selling, general and administrative expenses increased to 26.1% for fiscal 2004 from 25.6% in fiscal 2003. This increase resulted primarily from the adoption of EITF No. 02-16, which accounted for an increase in selling, general and administrative expenses of 0.5% of net sales. In addition, an increase in selling, general and administrative expenses of 0.2% of net sales was due to an increase in store pre-opening expenses, offset by a decrease of 0.2% of net sales related to store and general and administrative operating expenses.
Operating income was $158.0 million in fiscal 2004, or 8.7% of net sales, compared with operating income of $137.7 million in fiscal 2003, or 8.5% of net sales.
Net interest expense was $19.3 million in fiscal 2004, compared with net interest expense of $26.1 million in fiscal 2003. The reduction in interest expense was due mainly to the repurchase of $50.0 million in principal amount of our 10.75% senior subordinated notes in January 2004, the early repayment of $50.0 million on the term loan under our prior senior credit facility in August 2003, and a reduction of interest rates on the term loan under our prior senior credit facility during fiscal 2003 and 2004, including a 0.5% reduction in the interest rate in connection with an amendment of the prior senior credit facility in August 2003.
In the fourth quarter of fiscal 2004, we incurred debt retirement costs totaling $4.0 million related to the early repayment and subsequent termination of our prior senior facility. We also incurred debt retirement costs of $2.8 million, consisting primarily of a prepayment premium, related to the repurchase of $16.0 million in principal amount of our 10.75% senior subordinated notes in the fourth quarter of fiscal 2004. In fiscal 2003, we incurred debt retirement costs of $10.6 million, consisting primarily of a prepayment premium, related to the repurchase of $50.0 million in principal amount of our 10.75% senior subordinated notes in the fourth quarter. We also incurred debt retirement costs of $1.6 million related to the early repayment of $50.0 million on the term loan under our prior senior credit facility in the second quarter of fiscal 2003.
Income taxes were $49.5 million in fiscal 2004, compared with income taxes of $34.7 million in fiscal 2003. Income taxes as a percentage of earnings before income taxes increased to 37.6% in fiscal 2004 from 34.9% in
fiscal 2003. The increase in fiscal 2004 is due primarily to the favorable resolution of an income tax accrual in fiscal 2003 which resulted in a benefit of $3.4 million, and the recognition, in fiscal 2003, of additional benefits with respect to certain net operating losses and federal and state credits which had not previously been realized in prior periods. The increase in tax expense for fiscal 2004 was partially offset by the recognition in fiscal 2004 of certain state deferred tax assets, and the treatment of other deferred tax items.
Net earnings in fiscal 2004 increased 27.3% to $82.4 million, or $1.41 per diluted share, compared with net earnings of $64.7 million, or $1.11 per diluted share, in fiscal 2003.
Fiscal Year Ended January 31, 2004 Compared with Fiscal Year Ended February 1, 2003
Net sales increased 9.1% to $1.61 billion for fiscal 2003, from $1.48 billion for fiscal 2002. The increase in net sales resulted primarily from the comparable store net sales increase of 5.6% and the addition of 63 new stores, or 54 stores net of relocations and closures. Our store base increased to 654 stores as of January 31, 2004, and our year-over-year increase in square footage in fiscal 2003 was 10.5%. The comparable store net sales increase was attributable to increased customer traffic, improvements in product mix to higher-price categories such as pet accessories, supplies and services and, to a lesser extent, increased prices. The increase in comparable store net sales accounted for approximately $82.0 million, or 46.2%, of the net sales increase. The net increase in our store base accounted for approximately $95.5 million, or 53.8%, of the net sales increase. These increases are offset by a decrease of $43.7 million in net sales in fiscal 2003 as compared to the prior period, as a result of the reclassification of vendors’ sales incentives as a reduction of both net sales and cost of sales in fiscal 2003 upon the adoption of EITF 03-10 in the first quarter of fiscal 2004.
Gross profit, defined as net sales less cost of sales including store occupancy costs, increased $89.1 million, or 19.4%, to $549.5 million for fiscal 2003, from $460.4 million for fiscal 2002. Gross profit as a percentage of net sales increased to 34.1% for fiscal 2003 from 31.2% in the prior year period. The increase was driven partly by the continuing change in mix from lower-margin premium pet food sales to higher-margin categories such as pet accessories, supplies and services, which accounted for an increase in gross profit of 0.9% of net sales. An increase of 0.9% of net sales was as a result of the reclassification of vendors’ sales incentives as a reduction of both net sales and cost of sales in fiscal 2003 upon the adoption of EITF 03-10 in the first quarter of fiscal 2004. The balance of the increase is a result of our adoption in fiscal 2003 of EITF Issue No. 02-16. For fiscal 2003, the effect of this accounting change consisted of the reclassification of $24.2 million, or 1.5% of net sales, of vendor consideration from selling, general and administrative expenses to cost of sales and occupancy costs, before the deferral of $6.5 million, or 0.4% of net sales, as a reduction of inventory.
Selling, general and administrative expenses increased $68.1 million, or 19.8%, to $411.8 million for fiscal 2003, from $343.8 million for fiscal 2002. As a percentage of net sales, selling, general and administrative expenses increased to 25.6% for fiscal 2003 from 23.3% in the prior year period. Most of this increase resulted from the adoption of EITF Issue No. 02-16, which accounted for an increase in selling, general and administrative expenses of $24.2 million, or 1.5% of net sales, in fiscal 2003 compared with the prior year. An increase of 0.7% of net sales was a result of the reclassification of vendors’ sales incentives as a reduction of both net sales and cost of sales in fiscal 2003 upon the adoption of EITF 03-10 in the first quarter of fiscal 2004. Increased store remodel costs and increased depreciation expense, slightly offset by the benefit from the leveraging of store and other operating costs, resulted in an increase in selling, general and administrative expenses of 0.1% of net sales in fiscal 2003 from the prior year.
In fiscal 2002, we incurred management fees and termination costs of $12.8 million related to a management services agreement that we entered into in conjunction with our leveraged recapitalization in fiscal 2000. We paid $12.5 million in termination costs to terminate this agreement in February 2002 in conjunction with our initial public offering.
In fiscal 2002, we incurred non-cash stock-based compensation and other costs of $8.4 million primarily related to stock options granted in periods prior to our initial public offering in February 2002. All outstanding
options prior to the initial public offering were modified and became fully vested at the time of the initial public offering. Stock-based compensation and other costs in fiscal 2002 also included $1.2 million of financing and legal expenses related to the initial public offering.
In fiscal 2002, we incurred a litigation settlement of $3.5 million relating to the settlement of a complaint filed against us alleging violations of the California Labor Code and the Business and Professions Code requirements to pay overtime to certain employees.
Operating income was $137.7 million in fiscal 2003, or 8.5% of net sales, compared with operating income of $92.0 million in fiscal 2002, or 6.2% of net sales. Operating income in fiscal 2002 included management fees and termination costs of $12.8 million pursuant to the management services agreement that was terminated in connection with our initial public offering in February 2002, non-cash stock-based compensation and other costs of $9.6 million, and a litigation settlement of $3.5 million. Together, these items made up 1.8% of net sales in fiscal 2002.
Net interest expense was $26.1 million in fiscal 2003, compared with net interest expense of $32.7 million in fiscal 2002. The reduction in interest expense related primarily to a reduction in interest expense on our senior credit facility. This decrease was due mainly to a reduction in variable interest rates and the early repayment of $50.0 million on our term loan facility in the second quarter of fiscal 2003.
In fiscal 2003, we incurred debt retirement costs of $10.6 million, including a premium of $10.0 million, related to the repurchase of $50.0 million in principal amount of our 10.75% senior subordinated notes in the fourth quarter. We also incurred debt retirement costs of $1.6 million related to the early repayment of $50.0 million on the term loan under our senior credit facility in the second quarter. In fiscal 2002, we incurred debt retirement costs of $3.3 million related to the repurchase of $30.0 million in principal amount of our 10.75% senior subordinated notes.
Income taxes were $34.7 million in fiscal 2003, compared with income taxes of $23.8 million in fiscal 2002. Income taxes as a percentage of net earnings before income taxes decreased from 42.6% in fiscal 2002 to 34.9% in fiscal 2003. During fiscal 2003, we realized a tax benefit of approximately $0.4 million with respect to certain state net operating losses, a tax benefit of approximately $3.4 million with respect to certain federal net operating losses, and a tax benefit of approximately $0.4 million with respect to certain federal and state credits. In fiscal 2002, we did not recognize any tax benefits related to certain expenses, including stock-based compensation, which resulted in income taxes as a percentage of net earnings before income taxes being higher.
Net earnings were $64.7 million in fiscal 2003, compared with net earnings of $32.1 million in fiscal 2002. Our fiscal 2002 results included management fees and termination costs pursuant to the management services agreement that was terminated in connection with our initial public offering in February 2002, non-cash stock-based compensation and other costs, and a litigation settlement totaling $19.8 million on a net-of-tax basis.
Quarterly Data
The following tables set forth the unaudited quarterly results of operations for fiscal 2003 and fiscal 2004. This information includes all adjustments management considers necessary for fair presentation of such data. The results of operations for historical periods are not necessarily indicative of results for any future period. We expect quarterly results of operations to fluctuate depending on the timing and amount of net sales contributed by new stores.
We believe that our business is moderately seasonal, with net sales and earnings generally higher in the fourth fiscal quarter due to year-end holiday purchases.
(1) In the second quarter of fiscal 2003, we incurred debt retirement costs of $1.6 million related to the early repayment of $50.0 million on the term loan under our senior credit facility.
(2) In the third quarter of fiscal 2003, we realized a tax benefit of approximately $3.4 million with respect to certain federal net operating losses.
(3) In the fourth quarter of fiscal 2003, we incurred debt retirement costs of $10.6 million related to the repurchase of $50.0 million in principal amount of our 10.75% senior subordinated notes.
(4) In the fourth quarter of fiscal 2004, we incurred debt retirement costs of $6.8 million related to the repurchase of $16.0 million in principal amount of our senior subordinated notes and the full repayment of $140.8 million on the term loan under our prior senior credit facility and the subsequent termination of the facility. In addition, we recorded an adjustment in the fourth quarter of fiscal 2004 to correct the accounting for operating lease tenant improvement allowances, resulting in a $1.3 million increase in cost of sales and occupancy costs, which related to annual and quarterly periods prior to the fourth quarter of fiscal 2004. We also recorded an adjustment in the fourth quarter of fiscal 2004 to accrue for additional distribution costs related to prior periods, resulting in a $4.4 million increase in cost of sales and occupancy costs.
Liquidity and Capital Resources
We finance our operations and store expansion program primarily through cash generated from operating activities. Net cash provided by operating activities was $133.5 million, $156.9 million and $172.6 million for fiscal 2002, 2003 and 2004, respectively. Our sales are substantially on a cash basis, and therefore provide a significant source of liquidity. We use net operating cash principally to purchase inventory, to fund our capital expenditures and to make interest payments on our debt. A portion of the inventory we purchase is financed through vendor credit terms.
We use cash in investing activities primarily to construct leasehold improvements and purchase fixtures and equipment for new stores, to remodel certain existing stores and, to a lesser extent, to purchase distribution center and office fixtures, equipment and computer hardware and software in support of our distribution and administrative functions. We estimate that our purchases of fixed assets for fiscal 2005 will be approximately $135 million, which includes the opening of approximately 90 new stores and the estimated cost of remodeling up to 50 existing stores to our latest format. Cash used in investing activities was $56.0 million, $98.7 million and $124.4 million for fiscal 2002, 2003 and 2004, respectively, and consisted primarily of capital expenditures. We opened 61, 63 and 81 new stores during fiscal 2002, 2003 and 2004, respectively.
Net cash used in financing activities was $4.8 million, $105.0 million and $73.6 million in fiscal 2002, 2003 and 2004, respectively, and consisted primarily of debt repayments net of borrowings. During fiscal 2004, we reduced our overall level of debt by $72.3 million, primarily through the full repayment of the term loan under our prior senior credit facility and the repurchase of $16.0 million of our senior subordinated notes, which was partially offset by borrowings on our new senior credit facility. During fiscal 2003, we reduced our overall level of debt by $102.1 million, primarily through the early repayment and repurchase of $100.0 million of debt.
On January 13, 2005, we terminated our prior senior credit facility and obtained a new senior credit facility consisting of a $200 million secured revolving credit facility, which we refer to as the revolving credit facility. The revolving credit facility expires on January 31, 2010, although we have the option to extend the expiration of the revolving credit facility for an additional one-year period, subject to the satisfaction of certain conditions. We have the option to increase the amount of credit available under the revolving credit facility, subject to the satisfaction of certain conditions, by an additional $125 million though April 30, 2007. After April 30, 2007, the amount by which available borrowings under the revolving credit facility may be increased is reduced to $50 million.
Borrowings under the revolving credit facility are secured by substantially all of our personal property assets and bear interest at our option, at the agent bank’s base rate plus a margin of up to 0.75%, or LIBOR plus a margin of up to 1.875%, in each case based on our leverage ratio at the time. In addition, we have pledged all of the capital stock of our domestic subsidiaries to secure our obligations under the revolving credit facility. We incur a fee of up to 2.1% on letters of credit issued under the revolving credit facility and a fee of up to 0.3% on the unused commitment under the revolving credit facility, which is reduced for any letters of credit. The credit agreement contains certain affirmative and negative covenants related to, among other things, indebtedness, capital expenditures, fixed charges coverage and total leverage. The revolving credit facility specifies a number of events of default (some of which are subject to applicable cure periods), including, among others, the failure to make payments when due, defaults under other agreements or instruments of indebtedness and noncompliance with covenants. Upon the occurrence of an event of default, the lenders may terminate the facility and declare all amounts outstanding under the revolving credit facility to be immediately due and payable.
At January 29, 2005, we were in compliance with all of the covenants under our revolving credit facility, and the outstanding balance of our revolving credit facility was $85.0 million. Amounts outstanding under our revolving credit facility are due in full on January 31, 2010. The interest rate at January 29, 2005 on the borrowings under our revolving credit facility was 4.1%. At January 29, 2005, we had outstanding $24.9 million in letters of credit used for general business purposes, which reduce the availability under our revolving credit facility.
In the fourth quarter of fiscal 2004, we repurchased through privately negotiated transactions $16.0 million in principal amount of our 10.75% senior subordinated notes, leaving $104.0 million in principal amount of our senior subordinated notes outstanding at January 29, 2005. In addition, on February 17, 2005, we repurchased an additional $14.7 million in principal amount of our senior subordinated notes, leaving $89.3 million in principal amount of our senior subordinated notes outstanding at February 17, 2005. The senior subordinated notes mature on November 1, 2011, and interest on the senior subordinated notes accrues at a rate of 10.75% per annum and is payable semi-annually in arrears. The indenture governing the senior subordinated notes specifies a number of events of default (many of which are subject to applicable cure periods), including, among others, the failure to make payments when due, defaults under other agreements or instruments of indebtedness and noncompliance with covenants. Upon the occurrence of an event of default, the holders of the senior subordinated notes may declare all amounts outstanding to be immediately due and payable. We may redeem the senior subordinated notes at our option at any time on or after November 1, 2006, in whole or in part, based upon an agreed upon schedule of redemption prices. We may from time to time pursue additional repurchases of some or all of our senior subordinated notes in open market purchases, negotiated transactions or otherwise. The scope of such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. Such repurchases may have a material effect on our liquidity, financial condition and results of operations.
At January 29, 2005, we had available net loss carryforwards of $1.7 million for state income tax purposes, which begin expiring in 2007.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations
The following summarizes our contractual obligations at January 29, 2005, and the effect such obligations could have on our liquidity and cash flow in future periods:
(1) Purchase obligations are defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms including (a) fixed or minimum quantities to be purchased, (b) fixed, minimum or variable price provisions, and (c) the approximate timing of the transaction. Aggregate purchase obligations in the above table include noncancelable obligations under our advertising and marketing agreements, noncancelable purchase orders, future interest payments (assuming the existing long-term debt remains outstanding and, for our revolving credit facility, based on the interest rate in effect at January 29, 2005), commitment and other fees associated with our revolving credit facility, employment contracts, and noncancelable maintenance and service contracts.
(2) No amounts have been included for this category because most of the balance consists of deferred rent and other liabilities related to operating leases, and future operating lease obligations have been included in a different category. The remaining future obligations related to other long-term liabilities are not material, and we are not currently able to estimate the timing of such obligations.
Off-Balance Sheet Arrangements
At January 29, 2005, we had outstanding $24.9 million in letters of credit used for general business purposes, which reduce the availability under our revolving credit facility.
At January 31, 2004 and January 29, 2005, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, variable interest or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Critical Accounting Policies and Estimates
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates and judgments, including those related to inventories, asset impairment, accruals for self-insured workers compensation and general liability costs, allowance for doubtful accounts and accounting for income taxes. We state these accounting policies in the notes to our consolidated financial statements and at relevant sections in this discussion and analysis. These estimates are based on information that is currently available and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could vary from those estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
We assess our inventory for estimated obsolescence or unmarketable inventory and write down the difference between the cost of inventory and the estimated market value based upon historical write-downs and assumptions about future sales and supply on-hand. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. We also record an accrual for estimated losses related to inventory shrink between physical inventories. This accrual is based on actual historical shrink results and current trends in the business. Changes in actual shrink results from completed physical inventories could result in revisions to our previously estimated shrink accruals. We believe we have sufficient current and historical knowledge to record reasonable estimates for both inventory valuation and inventory shrink.
We assess the impairment of long-lived assets, primarily fixed assets, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:
•
significant underperformance of our stores relative to expected historical or projected future operating results;
•
significant changes in the manner of our use of assets or the strategy for our overall business;
•
significant negative industry or economic trends; or
•
planned store closings.
When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we recognize an impairment loss when the undiscounted estimated future net cash flows expected to be generated by an asset (or group of assets) is less than its carrying value. We measure impairment losses as the amount by which the asset’s carrying value exceeds its
fair value. To the extent actual future cash flows are less than anticipated, additional impairment charges may result. We also review the estimated useful lives of the assets and reduce such lives if necessary. Impairment losses on fixed assets were $0.2 million, $0.7 million and $1.7 million during fiscal 2002, 2003 and 2004, respectively. These write-downs related to fixed assets of closed and underperforming stores.
We have recorded significant amounts of goodwill resulting from the acquisitions we have completed. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is not amortized. We perform our required annual impairment test during the second quarter of each year, and perform additional impairment tests whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable at the store level. We record impairment charges for any store with allocated goodwill in excess of its fair value, which is calculated based on the present value of the estimated future net cash flows expected to be generated by the store. To the extent actual cash flows for certain stores are less than anticipated, additional impairment charges may result. Impairment charges on goodwill were not significant in fiscal 2002, 2003 or 2004.
We maintain accruals for self-insured workers compensation and general liability costs. We determine these accruals based on historical experience and trends related to claims and payments, information provided to us by our insurance broker, and industry experience and trends. All estimates of ultimate loss and loss adjustment expense, and resulting reserves, are subject to inherent variability caused by the nature of the insurance process. The potentially long period of time between the occurrence of an incident and the final resolution of a claim and the possible effects of changes in the legal, social and economic environments contribute to this variability. Actual results should be expected to vary from estimated results and such variation could be substantial.
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability to collect receivables, most of which are due from vendors. We determine the adequacy of this allowance by continually evaluating individual receivables, the vendor’s financial condition, and current economic conditions. If the financial conditions of our vendors were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Our actual receivable write-offs have not varied significantly from our estimates.
We estimate our income taxes in each of the jurisdictions in which we operate. This involves estimating our actual current taxes and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. We also assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not more likely than not, we establish a valuation allowance. The valuation allowance is based on our estimates of taxable income in the jurisdictions in which we operate and the period over which our deferred tax assets will be recoverable. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets, and changes in estimates of current taxes and valuation allowances could be significant.
New Accounting Standards
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the fair value of employee stock options and other forms of employee stock-based compensation. SFAS No. 123 allowed companies to disclose the pro forma effects of expensing the fair value of employee stock-based compensation in the footnotes to the financial statements. SFAS No. 123(R) applies to all stock-based compensation transactions with employees in which a company acquires services by issuing its stock or other equity instruments, except through arrangements resulting from employee stock-ownership plans, or by incurring liabilities that are based on the company’s stock price. In March 2005, the Securities and Exchange Commission (SEC) released SEC Staff Accounting Bulletin No. 107, Share-Based Payment (“SAB No. 107”).
SAB No. 107 provides the SEC staff’s position regarding the application of SFAS No 123(R) and certain SEC rules and regulations, and also provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. In April 2005, the SEC approved an amendment to Rule 4-01(a) of Regulation S-X to amend the date for compliance with SFAS No. 123(R). In accordance with this amendment, the accounting provisions of SFAS No. 123(R) are effective for annual periods beginning after June 15, 2005. We are required to adopt SFAS No. 123(R) no later than the first quarter of fiscal 2006. We are currently evaluating the requirements of SFAS No. 123(R) and SAB No. 107 and expect the adoption of these pronouncements to have a significant impact on our consolidated results of operations.
Inflation
Although we cannot accurately anticipate the effect of inflation on our operations, we do not believe that inflation has had, or is likely in the foreseeable future to have, a material impact on our net sales or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risks relating to our operations result primarily from changes in short-term London Interbank Offered Rates, or LIBOR, as our revolving credit facility utilizes a portfolio of short-term LIBOR contracts. These LIBOR contracts are fixed rate instruments for a period of between one and six months, at our discretion. Our portfolio of LIBOR contracts vary in length and interest rate, such that adverse changes in short-term interest rates could affect our overall borrowing rate when contracts are renewed. We entered into a $75.0 million interest rate collar agreement, or hedge, in December 2000 to offset this interest rate risk. This hedge expired in December 2002 with no further liability. Changes in the intrinsic value of the hedge were recorded as accumulated other comprehensive income (loss). Amounts received or paid under the hedge were recorded as reductions of or additions to interest expense. We periodically evaluate alternative hedging strategies, although currently we have no hedges outstanding. We do not enter into derivative financial instruments for trading or speculative purposes.
All of the $85.0 million in debt under our revolving credit facility as of January 29, 2005 was subject to variable interest rate fluctuations. Based on this debt level, a hypothetical 10% increase in variable rates from the applicable rates at January 29, 2005 would increase net interest expense by approximately $0.2 million on an annual basis, and would decrease both net earnings and cash flows for that annual period by a corresponding amount. We cannot predict market fluctuations in interest rates and their impact on debt, nor can there be any assurance that long-term fixed-rate debt will be available at favorable rates, if at all. Consequently, future results may differ materially from estimated results due to adverse changes in interest rates or debt availability.
We did not have any material foreign exchange or other significant market risk at January 29, 2005.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements required by this Item are set forth at the pages indicated in Item 15(a) of this Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
1. Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports we file pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
We carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Annual Report. Based on this evaluation, our CEO and CFO concluded that, as a result of the material weakness in internal control over financial reporting discussed below, our disclosure controls and procedures were not effective as of January 29, 2005.
We believe our financial statements fairly present in all material respects the financial position, results of operations and cash flows for the interim and annual periods presented in our annual report on Form 10-K and quarterly reports on Form 10-Q. The unqualified opinion of our independent registered public accounting firm on our financial statements as of and for each of the years in the three year period ended January 29, 2005 is included in Part IV, Item 15 of this Form 10-K.
2. Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Internal control over financial reporting refers to the process designed by, or under the supervision of, our CEO and CFO, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
(1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our management and directors; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Management has used the framework set forth in the report entitled Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO, to evaluate the effectiveness of the Company’s internal control over financial reporting as of January 29, 2005.
As a result of our assessment, management identified a material weakness in internal control over financial reporting as of January 29, 2005. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
As of January 29, 2005, we did not have appropriate policies and procedures relating to the review of the inventory warehousing and distribution function (“Distribution”) accruals for vendor invoices and the performance of Distribution vendor statement reconciliations. Specifically, Distribution accruals were prepared and reviewed by the same Distribution personnel, and Distribution vendor statement reconciliations were also performed by these same Distribution personnel, resulting in inadequate segregation of duties. As a result of this deficiency, certain Distribution vendor invoices were not processed in a timely manner which caused errors in which expenses were under-accrued during fiscal 2004 and during prior interim and annual periods. These errors were corrected in the 2004 consolidated financial statements prior to their issuance. This deficiency results in a more than remote likelihood that a material misstatement of the annual or interim financial statements would not be prevented or detected on a timely basis by employees during the normal course of performing their assigned functions. Therefore, management has concluded that our internal control over financial reporting was not effective as of January 29, 2005.
Our independent registered public accounting firm, KPMG, LLP, has issued an audit report on management’s assessment of our internal control over financial reporting. That report appears below.
3. Management’s Remediation Efforts
Subsequent to our fiscal year ended January 29, 2005, management remediated the control deficiency in Distribution described above. Specifically, we have revised our policies and practices with respect to Distribution accruals and vendor statement reconciliations by implementing proper segregation of duties and requiring that all such accruals and vendor statement reconciliations be performed by accounting personnel independent of Distribution. Management believes that the deficiency noted above has been remediated by these new procedures, and that the implementation of these new procedures will result in improved control over financial reporting in subsequent periods.
4. Changes in Internal Control Over Financial Reporting
In our Quarterly Report on Form 10-Q for the fiscal period ended October 30, 2004, we reported that we had identified certain deficiencies in general controls over our information systems, including segregation of duties and access to data and applications by program developers. We tested our significant financial reporting systems to ensure that the key application controls that are dependent on these systems are operating effectively. We have designed and are currently implementing improvements that we believe will adequately mitigate these deficiencies in the future. We do not believe that these deficiencies have had or will have a material impact on our financial statements. In addition, these deficiencies did not adversely affect our assessment of our internal control over financial reporting as part of our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 as of our fiscal year end on January 29, 2005.
There has been no change in our internal control over financial reporting during the fourth quarter of fiscal 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
5. Inherent Limitation on the Effectiveness of Internal Control
Because of its inherent limitations, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives and may not prevent or detect all misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become ineffective because of changes in conditions or that the degree of compliance with established policies or procedures may deteriorate.
6. Independent Registered Public Accounting Firm Report
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
PETCO Animal Supplies, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A.2.), that PETCO Animal Supplies, Inc. (the Company) did not maintain effective internal control over financial reporting as of January 29, 2005 because of the effect of the material weakness identified in management’s assessment, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment: As of January 29, 2005, the Company did not have appropriate policies and procedures relating to the review of the inventory warehousing and distribution function (“Distribution”) accruals for vendor invoices and the performance of Distribution vendor statement reconciliations. Specifically, Distribution accruals were prepared and reviewed by the same Distribution personnel, and Distribution vendor statement reconciliations were also performed by these same Distribution personnel, resulting in inadequate segregation of duties. As a result of this deficiency, certain Distribution vendor invoices were not processed in a timely manner which caused errors in which expenses were under-accrued during fiscal 2004 and during prior interim and annual periods. This deficiency results in more than a remote likelihood that a material misstatement of the annual or interim financial statements would not be prevented or detected on a timely basis by employees during the normal course of performing their assigned functions.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of PETCO Animal Supplies, Inc. as of January 29, 2005 and January 31, 2004, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the years in the three-year period ended January 29, 2005. The aforementioned material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 consolidated financial statements, and this report does not affect our report dated May 25, 2005, which expressed an unqualified opinion on those consolidated financial statements.
In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of January 29, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of January 29, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ KPMG LLP
San Diego, California
May 25, 2005
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors
The board of directors currently consists of nine members. Our certificate of incorporation provides for the classification of the board of directors into three classes, as nearly equal in number as possible, with staggered terms of office, and provides that upon the expiration of the term of office for a class of directors, nominees for such class shall be elected for a term of three years or until their successors are duly elected and qualified. The names, ages and other information about our current directors set forth below is current as of March 31, 2005.
Name
Age
Position Held
Brian K. Devine
Chairman of the Board
James M. Myers
Chief Executive Officer
David B. Appel
Director
Sandra N. Bane
Director
Jonathan Coslet
Director
John G. Danhakl
Director
Julian C. Day
Director
Charles W. Duddles
Director
Arthur B. Laffer
Director
Brian K. Devine, Chairman of the Board, joined PETCO in August 1990. He served as President and Chief Executive Officer until March 2004 and has served as Chairman of the Board since January 1994. Prior to joining us, Mr. Devine was President of Krause’s Sofa Factory, a furniture retailer and manufacturer, from 1988 to 1989. From 1970 to 1988, Mr. Devine was employed by Toys “R” Us, a retailer of children’s toys, in various positions, including Senior Vice President, Director of Stores, and Senior Vice President, Growth, Development and
Operations. From 1963 until 1970, Mr. Devine was Statistical Advisor for Planning for the U.S. Department of Health, Education and Welfare. Mr. Devine graduated from Georgetown University in 1963 with a B.A. degree in economics and currently serves as a board member of Wild Oats Markets, Inc., a publicly held retailer and distributor of natural foods, the Retail Industry Leaders Association, the National Retail Federation, Students in Free Enterprise, Georgetown University Board of Regents, Georgetown University College Board of Advisors, San Diego International Sports Council and the San Diego Padres.
James M. Myers, Chief Executive Officer and a director, joined PETCO in May 1990. Mr. Myers was named Chief Executive Officer in March 2004. From 1998 to 2004, Mr. Myers served as Executive Vice President and Chief Financial Officer of PETCO. From 1996 to 1998, Mr. Myers served as Senior Vice President, Finance and before that as Vice President, Finance and as Vice President and Controller of PETCO. From 1980 to 1990, Mr. Myers held various positions at the accounting firm of KPMG LLP, including Senior Audit Manager. Mr. Myers has served as a director since October 2000. Mr. Myers currently serves on the Board of Directors of Provide Commerce, Inc., a publicly held e-commerce marketplace of websites for perishable goods. Mr. Myers earned a CPA and received an accounting degree from John Carroll University.
David B. Appel has served as a director since April 2004. Mr. Appel currently serves as Chairman of Orange Glo International, a privately-held marketer of cleaning and home care products. Mr. Appel joined Orange Glo in 1999 as Chief Operating Officer, and was named Chairman in 2001. Prior to Orange Glo International, Mr. Appel was a partner with Accenture (formerly Andersen Consulting), serving retail and consumer goods companies for 17 years in San Francisco, Paris and Tokyo. Mr. Appel earned both his B.A. and M.B.A. from the University of Chicago.
Sandra N. Bane has served as a director since April 2004. Ms. Bane is a retired audit partner from KPMG LLP, having served 24 years with the firm. While at KPMG LLP, Ms. Bane headed the Western Region’s Merchandising practice, helped establish the Employee Benefits audit specialist program and was partner-in-charge of the Western Region’s Human Resource department for two years. She is a member of the American Institute of Certified Public Accountants and the California Society of CPAs. Ms. Bane serves on the Board of Directors of Big 5 Sporting Goods, Inc. and Trans America Premier Funds. Ms. Bane graduated from California State University Long Beach in 1975 with a degree in accounting.
Jonathan Coslet has served as a director since October 2000. Mr. Coslet has been a partner of Texas Pacific Group since 1993 and is currently a senior partner and member of the firm’s Executive, Management, and Investment Committees. Prior to joining Texas Pacific Group, Mr. Coslet worked at Donaldson, Lufkin & Jenrette, specializing in leveraged acquisitions from 1991 to 1993. From 1987 to 1989, Mr. Coslet worked at Drexel Burnham Lambert. Mr. Coslet received his M.B.A. from Harvard Graduate School of Business Administration in 1991. Mr. Coslet received his B.S.E. in Economics (Finance) from the University of Pennsylvania Wharton School. Mr. Coslet serves on the Boards of Directors of Burger King Corporation, J. Crew Group, Quintiles Transnational Corp., Iasis Healthcare Corp., and Fidelity National Information Services.
John G. Danhakl has served as a director since October 2000. Mr. Danhakl has served as a partner at Leonard Green & Partners, L.P. since 1995. Prior to becoming a partner at Leonard Green & Partners, Mr. Danhakl was a Managing Director at Donaldson, Lufkin & Jenrette Securities Corporation, or DLJ, and had been with DLJ since 1990. Prior to joining DLJ, Mr. Danhakl was a Vice President at Drexel Burnham Lambert from 1985 to 1990. Mr. Danhakl presently serves on the Boards of Directors of The Arden Group, Inc., Big 5 Sporting Goods, Inc., Diamond Auto Glass Works, Liberty Group Publishing, Leslie’s Poolmart, Inc., VCA Antech, Inc. and on the Board of Managers of AsianMedia Group LLC. Mr. Danhakl is a 1980 graduate of the University of California at Berkeley. He received his M.B.A. in 1985 from the Harvard Business School.
Julian C. Day has served as a director since November 2000. In March 2002, Mr. Day became the President and Chief Operating Officer of Kmart Corporation, and in January 2003, became Chief Executive Officer and a Director of Kmart. In October 2004, Mr. Day gave up his executive responsibilities at Kmart and currently serves
as a Director of Sears Holding Corporation following the merger of Kmart and Sears. From 1999 to 2000, Mr. Day was with Sears Roebuck, most recently as Executive Vice President and Chief Operating Officer. From 1992 to 1998, Mr. Day was with Safeway, Inc., where he became Executive Vice President and Chief Financial Officer. Mr. Day is a graduate of Oxford University.
Charles W. Duddles has served as a director since March 2002. Mr. Duddles served most recently as Executive Vice President, Chief Financial Officer and Chief Administrative Officer of Jack in the Box Inc., the operator and franchiser of the Jack in the Box restaurant chain, where he spent more than 21 years until his retirement in August 2001. Mr. Duddles was formerly a CPA and received an accounting degree from Ferris State University.
Arthur B. Laffer has served as a director since June 2002. Dr. Laffer has been Chairman of Laffer Associates, an economic research and financial consulting firm, since 1979; Chief Executive Officer of Laffer Advisors Inc., a broker-dealer, since 1981; and Chief Executive Officer of Laffer Investments, an investment management/firm, since 1999. Dr. Laffer presently serves on the Boards of Directors of Nicholas Applegate Growth Fund, Oxigene, Inc., Provide Commerce, Inc., MPS Group, Inc. and Veolia Environment. Dr. Laffer is a 1963 graduate of Yale University. He received his M.B.A. in 1965 and his Ph.D. in economics in 1971, each from Stanford University.
Executive Officers
The names, ages and other information about our executive officers set forth below is current as of March 31, 2005.
Name
Age
Present Position
Brian K. Devine
Chairman of the Board
James M. Myers
Chief Executive Officer and Director
Bruce C. Hall
President and Chief Operating Officer
Rodney Carter
Senior Vice President and Chief Financial Officer
Frederick W. Major
Senior Vice President, Information Systems
Keith G. Martin
Senior Vice President, Operations
Janet D. Mitchell
Senior Vice President, Human Resources and Administration
Razia Richter
Senior Vice President, Supply Chain
William M. Woodard
Senior Vice President, Business Development
For information on Messrs. Devine and Myers, see “Directors.”
Bruce C. Hall, President and Chief Operating Officer, joined PETCO in April 1997. Mr. Hall was named President in March 2004 and has been serving as Chief Operating Officer since March 2001. Mr. Hall spent 34 years from 1963 to 1997 with Toys “R” Us, a retailer of children’s toys, where he progressively advanced from field operations through a number of positions, including Senior Vice President of Operations.
Rodney Carter, Senior Vice President and Chief Financial Officer, joined PETCO in March 2004. From 2000 to 2003, Mr. Carter was Executive Vice President and Chief Financial Officer of CEC Entertainment, Inc. He spent 12 years with J. C. Penney Company, Inc. from 1988 to 2000, where he progressively advanced through a number of positions including CFO of JCPenney Credit and CFO of JCPenney Direct Marketing Services, Inc. Prior to J.C. Penney, Mr. Carter was in corporate banking for five years. Mr. Carter has a bachelor’s degree from Texas Tech University, an M.B.A. from Southern Methodist University, and a Masters in International Management from Thunderbird, The Garvin School of International Management.
Frederick W. Major, Senior Vice President, Information Systems, joined PETCO in April 1988 and became Senior Vice President, Information Systems in March 2002. Mr. Major initially served as Management
Information Systems Manager and then as Director of Information Systems and most recently as Vice President of Information Systems. From 1983 to 1988, Mr. Major was a Systems Analyst at General Dynamics Corporation. Mr. Major graduated from National University with a degree in computer science.
Keith G. Martin, Senior Vice President, Operations, joined PETCO in July 2001. From 1999 to 2001, Mr. Martin was President of Country Stores for Gateway, Inc. From 1994 to 1999, Mr. Martin was with Office Depot, Inc., where he held various management positions and was ultimately named Senior Vice President, Stores. From 1974 to 1994, Mr. Martin held various management positions with a number of retailers. Mr. Martin has over 25 years of retail experience. Mr. Martin received a bachelor’s degree from State University of New York.
Janet D. Mitchell, Senior Vice President, Human Resources and Administration, joined PETCO in February 1989. From 1989 to 1998, Ms. Mitchell served as Vice President, Human Resources. From 1981 to 1989, Ms. Mitchell held various management positions in human resources with the Southland Corporation’s 7-Eleven stores. From 1978 to 1981, Ms. Mitchell held various positions with the El Torito Restaurant chain. Ms. Mitchell holds a B.A. degree from San Diego State University.
Razia Richter, Senior Vice President, Supply Chain, joined PETCO in 1991 and became Senior Vice President, Supply Chain in March 2004. Ms. Richter was most recently Vice President of Southwest Store Operations. Prior to that Ms. Richter held various positions with us including Vice President, Inventory Management and Analytical Services; Vice President, Business Development; and Controller. Prior to joining PETCO, Ms. Richter held various accounting positions at the accounting firm KPMG LLP. She earned her CPA, and has an accounting degree from San Diego State University and an M.B.A. from the University of San Diego.
William M. Woodard, Senior Vice President, Business Development, joined PETCO in January 1991. From 1991 to 1999, Mr. Woodard served as Senior Vice President, Store Operations. From 1987 to 1990, Mr. Woodard was Vice President, Director of Marketing at J. M. Jones, Inc., a wholesale division of SuperValu Stores, Inc. From 1970 to 1987, Mr. Woodard was employed by Safeway Stores, Inc., a grocery retailer, in a number of positions including Retail Operations Manager and Marketing Operations Manager. Mr. Woodard holds an administrative management degree from North Texas State University and an M.B.A. in marketing from the University of Southern California.
Audit Committee
We have an audit committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The Audit Committee currently consists of Ms. Bane, Mr. Duddles and Dr. Laffer. Mr. Day served as a member of the Audit Committee during all of fiscal 2003 and until his resignation in April 2004, when Ms. Bane was added as a member of the Audit Committee. During fiscal 2004, the Audit Committee held seven meetings. The Audit Committee is governed by a written charter approved by the Board of Directors. The Audit Committee is responsible for engaging the independent auditors to audit our financial statements, and for reviewing the scope of the audit effort. The Audit Committee oversees our internal audit function, and reports its recommendations as to the approval of our financial statements to the Board of Directors. In addition, the Audit Committee members meet periodically with management, the independent auditors and internal auditors to review matters relating to our financial statements, accounting principles and systems of internal accounting controls.
The Board has determined that all of members of the Audit Committee are “independent” for purposes of the listing standards of the National Association of Securities Dealers, Inc., and for purposes of Section 10A(m)(3) of the Securities Exchange Act of 1934. The Board based these determinations primarily on a review of the responses of the directors and executive officers to questions regarding employee and compensation history, affiliations and family and other relationships and on discussions with the directors. The Board has determined that each of Ms. Bane and Mr. Duddles qualifies as an “audit committee financial expert,” as defined by the rules and regulations of the Securities and Exchange Commission.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires our directors and executive officers, and persons who own more than ten percent of a registered class of our equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of our common stock and other equity securities. Officers, directors and greater than ten percent stockholders are required by Securities and Exchange Commission regulations to furnish us with copies of all Section 16(a) forms they file.
To our knowledge, based solely on a review of the copies of such reports furnished to us and written representations that no other reports were required, during the fiscal year ended January 29, 2005, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were complied with, except with respect to a Form 3 filed on behalf of Razia Richter on March 10, 2004 that was due on February 25, 2004.
Code of Ethics
We have adopted a Code of Ethics, which is subject to review on an annual basis, applicable to all of our employees, including our Chief Executive Officer, Chief Financial Officer and other senior financial officers.
Copies of our Code of Ethics and Board Committee Charters are available on our website, and can be found under the Investor Relations and Governance links. Our website is www.petco.com. Copies of these documents are also available in print, free of charge, by writing to Investor Relations, PETCO Animal Supplies, Inc., 9125 Rehco Road, San Diego, California 92121. We may post amendments to or waivers of the provisions of the Code of Ethics, if any, on its website. Please note, however, that the information contained on the website is not incorporated by reference in, or considered part of, this annual report on Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information with respect to compensation awarded to, earned by or paid to each person who served as our Chief Executive Officer or was one of our four other most highly compensated executive officers during the fiscal year ended January 29, 2005. These officers are referred to as the named executive officers.
Summary Compensation Table
(1) Mr. Devine also served as our President and Chief Executive Officer until March 2004.
(2) Mr. Myers became our Chief Executive Officer in March 2004. Prior to that time, he served as our Executive Vice President and Chief Financial Officer.
(3) Mr. Hall became our President and Chief Operating Officer in March 2004. Prior to that time, he served as an Executive Vice President and Chief Operating Officer.
(4) Mr. Brann’s employment with us terminated effective February 15, 2005.
(5) Includes (A) $19,060, representing our reimbursement of tax consulting services for each of Messrs. Devine, Myers and Hall, (B) $15,828, $20,800 and $17,525, representing other perquisite compensation amounts, including reimbursement of medical costs, financial counseling, and membership dues and fees, and the gross-up of taxes associated with certain amounts, for Messrs. Devine, Myers and Hall, respectively, (C) $13,508, $11,800 and $17,182, representing our reimbursement of automobile expenses for Messrs. Devine, Myers and Hall, respectively, and (D) $23,263 representing compensation for personal aircraft travel provided to Mr. Devine.
(6) Includes (A) $19,293 representing our reimbursement of tax consulting services for Messrs. Devine and Hall, respectively, and (B) $46,221 and $53,726, representing other perquisite compensation amounts, including reimbursement of automobile expenses, medical costs, financial counseling, membership dues and fees, and the gross-up of taxes associated with certain amounts, for Messrs. Devine and Hall, respectively.
(7) Includes (A) $24,409 and $19,832, representing our reimbursement of tax consulting services for Messrs. Devine and Myers, respectively, and (B) $67,344 and $50,633, representing other perquisite compensation
amounts, including reimbursement of automobile expenses, medical costs, financial counseling, membership dues and fees, and the gross-up of taxes associated with certain amounts, for Messrs. Devine and Myers, respectively.
(8) Includes (A) $43,478, $19,732, $20,792, $12,163 and $11,830, representing our allocation to deferred compensation plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, (B) $7,524, $1,710, $7,524, $2,622 and $2,622, representing our payment of premiums on term life insurance for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, (C) $2,737, $3,075, $2,734, $3,075 and $2,873, representing our allocation to defined contribution plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, and (D) $338 and $341 representing other compensation for Messrs. Devine and Hall, respectively.
(9) Includes (A) $38,308, $16,413, $18,200, $10,852 and $3,669, representing our allocation to deferred compensation plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, (B) $7,524, $1,710, $4,902, $2,622 and $2,622, representing our payment of premiums on term life insurance for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, and (C) $3,000 representing our allocation to defined contribution plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively.
(10) Includes (A) $48,034, $19,626, $18,267, $13,354 and $9,475, representing our allocation to deferred compensation plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, (B) $7,524, $1,710, $4,902, $2,622 and $2,548, representing our payment of premiums on term life insurance for Messrs. Devine, Myers, Hall, Brann and Martin, respectively, and (C) $3,101, $3,000, $3,000, $2,498 and $1,252, representing our allocation to defined contribution plans for Messrs. Devine, Myers, Hall, Brann and Martin, respectively.
The following table sets forth certain information concerning grants of options made during the fiscal year ended January 29, 2005 by us to each of the named executive officers:
Option Grants in Last Fiscal Year
(1) The options granted in fiscal 2004 to the officers listed above become exercisable as to all of the shares issuable upon exercise of such options on the third anniversary of the date of grant. All options listed above were granted at an exercise price equal to the fair market value of our common stock as determined by the Board of Directors on the date of grant.
(2) In fiscal 2004, we granted options to employees to purchase an aggregate of 1,385,050 shares of common stock.
(3) These columns show the hypothetical gains of the options granted based on assumed annual compound stock price appreciation rates of 5% and 10% over the full ten-year terms of the options. The 5% and 10% assumed rates are specified in the rules of the SEC and do not represent PETCO’s estimated or projected future prices of its common stock. The assumed annual rates of stock price appreciation of 5% and 10% would result in the price of PETCO’s common stock increasing to approximately $53.74 and $85.57, respectively, over the ten-year term of the options.
Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values
The following table sets forth, for each of the named executive officers, information regarding the exercise of stock options to purchase shares of our common stock during the fiscal year ended January 29, 2005, the number of shares of common stock underlying stock options held at fiscal year end and the value of options held at fiscal year end.
(1) “Value Realized” is an estimated value and was calculated based on the closing price of our common stock on the NASDAQ National Market on the date of exercise (fair market value) minus the applicable per share exercise price.
(2) The dollar values have been calculated by determining the difference between the fair market value of the shares underlying the options at January 29, 2005 and the exercise price of the options.
Compensation of Directors
Outside directors receive $7,500 for each board meeting, $2,500 for each separately scheduled committee meeting and $1,500 for each telephonic meeting that they attend. The Chairman of the Audit Committee receives an annual retainer of $6,000. Outside directors also receive grants of options to purchase shares of common stock under our 2002 Incentive Award Plan as described below. Directors may also be reimbursed for the actual reasonable costs incurred in connection with attendance at board or committee meetings.
2002 Incentive Award Plan. Our board of directors and stockholders have adopted the 2002 Incentive Award Plan of PETCO Animal Supplies, Inc., which is referred to as the Incentive Plan. The principal purpose of the Incentive Plan is to attract, retain and motivate selected officers, employees, consultants and directors through the granting of stock-based compensation awards. The Incentive Plan provides for a variety of awards, including non-qualified stock options, incentive stock options (within the meaning of Section 422 of the Internal Revenue Code), stock appreciation rights, restricted stock, deferred stock, dividend equivalents, performance awards, stock payments, and other stock-related benefits. With respect to grants under the Incentive Plan to our non-employee directors, the aggregate share limit under the Incentive Plan is equal to the sum of (1) 55,750 shares of common stock, plus (2) on March 1 of each year during the term of the Incentive Plan commencing on March 1, 2003, a number of shares of common stock equal to 0.1% of the total number of issued and outstanding shares of common stock as of the last day of the fiscal year immediately preceding such March 1.
The Incentive Plan provides that at certain times our non-employee directors will automatically be granted options to purchase shares of our common stock. All options granted to non-employee directors will have an exercise price per share equal to the fair market value of a share of common stock as of the date of grant and all such options shall be fully exercisable as of the date of grant. Each individual who was a non-employee director at the time of our initial public offering was granted an option to purchase 15,000 shares of common stock at the time of the initial public offering and, provided he or she is serving on the board of directors as a non-employee director at the time, will be granted an option to purchase an additional 3,000 shares of common stock on each anniversary of the initial public offering during the term of the Incentive Plan. Non-employee directors who are initially elected or appointed to the board of directors following our initial public offering will be granted an option to purchase 15,000 shares of common stock on the date of such initial election or appointment and,
provided he or she is serving on the board of directors as a non-employee director at the time, will be granted an option to purchase an additional 3,000 shares of common stock on each anniversary of the date of such initial election or appointment during the term of the Incentive Plan.
Employment Agreements
We have employment agreements with Messrs. Devine, Myers and Hall.
Brian K. Devine. We have an employment agreement with Mr. Devine, the Chairman of our Board of Directors and our former President and Chief Executive Officer, for a term of three years. This term is continually extended until we give Mr. Devine notice that we no longer wish to extend the term. The employment agreement also provides for Mr. Devine to receive a minimum annual base salary subject to annual increase, and to participate in a bonus plan.
Mr. Devine’s employment agreement provides for customary employment benefits, including, among others, group life, medical, disability and other benefits provided to our executives. In 2004, Mr. Devine received an amount of base salary in lieu of certain perquisite compensation to which he was entitled and has permanently waived the right to receive such perquisites. The employment agreement additionally entitles Mr. Devine to keep his office equipment and his company car for nominal consideration upon completion of his employment term.
Mr. Devine’s employment agreement may be terminated by him with or without good reason (as defined in the employment agreement), or by us with or without cause (as defined in the employment agreement), pursuant to customary termination provisions. Depending upon the circumstances of his termination, including termination following a change of control, Mr. Devine will be entitled to: (1) his base salary for a period of either 18 or 36 months; (2) an amount equal to either his highest bonus for a single fiscal year in the five fiscal years immediately preceding his termination or three times his average annual bonus for the three years immediately preceding his termination; (3) participate in our supplemental executive retirement program; (4) the immediate vesting of, or lapse of restrictions upon, all our equity interests held by Mr. Devine at the time of termination; and (5) additional tax gross-up payments in the amount of any excise tax imposed upon Mr. Devine in connection with the foregoing.
In connection with Mr. Devine’s employment agreement, we entered into a consulting agreement and supplemental executive retirement program with Mr. Devine. Subject to certain exceptions, the consulting agreement allows us to obtain Mr. Devine’s services for up to ten hours per week for a period of ten years following the end of Mr. Devine’s full-time employment with us. Under the consulting agreement, we will pay Mr. Devine 25% of his final base salary immediately preceding his termination of full-time employment with us. Under the supplemental executive retirement program, we will pay Mr. Devine 25% of his final base salary for the first ten years following the end of his employment with us and 50% of his final base salary for the next ten years or upon the earlier death or disability of Mr. Devine. All payments under the supplemental executive retirement program will be reduced by any other qualified retirement plan payments payable to Mr. Devine other than under his 401(k) plan.
James M. Myers. We have an employment agreement with Mr. Myers, our Chief Executive Officer, for a term of three years. This term is continually extended until we give Mr. Myers notice that we no longer wish to extend the term. The employment agreement also provides for Mr. Myers to receive a minimum annual base salary subject to annual increase, and to participate in a bonus plan. The provisions of Mr. Myers’ employment agreement are substantially the same as those of Mr. Devine outlined above except that Mr. Myers will not be entitled to participate in our supplemental executive retirement program upon termination.
Mr. Myers’ employment agreement includes customary termination provisions which are substantially the same as those of Mr. Devine outlined above, with the following exceptions. Depending upon the circumstances of his termination, including termination following a change of control, Mr. Myers will be entitled to his base
salary for a period of either nine or 18 months, and an amount equal to either his highest bonus for a single fiscal year in the five fiscal years immediately preceding his termination or one-and-a-half times his average annual bonus for the three years immediately preceding his termination.
Bruce C. Hall. We have an employment agreement with Mr. Hall, our President and Chief Operating Officer, for a term of three years. This term is continually extended until we give Mr. Hall notice that we no longer wish to extend the term. The employment agreement also provides for Mr. Hall to receive a minimum annual base salary subject to annual increase, and to participate in a bonus plan. The provisions of Mr. Hall’s employment agreement are substantially the same as those of Mr. Devine outlined above with the exception that Mr. Hall will not be entitled to participate in our supplemental executive retirement program upon termination.
Mr. Hall’s employment agreement includes customary termination provisions which are substantially the same as those of Mr. Devine outlined above, with the following exceptions. Depending upon the circumstances of his termination, including termination following a change of control, Mr. Hall will be entitled to his base salary for a period of either nine or 18 months, and an amount equal to either his highest bonus for a single fiscal year in the five fiscal years immediately preceding his termination or one-and-a-half times his average annual bonus for the three years immediately preceding his termination.
Retention Agreements
We have retention agreements with each of our senior officers, other than Messrs. Devine, Hall and Myers which require us, among other things, to provide severance benefits to each officer upon termination of the officer’s employment by us without cause or by the officer for good reason if the termination is in connection with, or within one year after, the occurrence of a change of control of us. These benefits consist of (1) continuation of base salary and benefits for up to 12 months following termination of the officer, and (2) a lump-sum payment, payable upon termination, in an amount equal to the bonus that the officer would have received if the officer had been employed during the 12 months following termination. In addition, in the event of a change in control, all of the officers’ rights to exercise options held by the officer at the time of the change in control will vest and become immediately exercisable.
Compensation Committee Interlocks and Insider Participation
None of our executive officers currently serves, or in the past year has served, as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving on our board of directors or compensation committee. None of the members of our compensation committee at any time has been one of our officers or employees.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information regarding beneficial ownership of the shares of our common stock as of June 3, 2005 by (1) each of our named executive officers (as defined under “Executive Compensation and Other Information-Executive Compensation”); (2) each of our directors; (3) our executive officers and directors as a group; and (4) each person known by us to beneficially own five percent or more of our outstanding common stock.
Beneficial ownership of shares is determined under the rules of the Securities and Exchange Commission and generally includes any shares over which a person exercises sole or shared voting or investment power. Except as indicated by footnote, and subject to applicable community property laws, each person identified in the table possesses sole voting and investment power with respect to all shares of common stock held by them. Shares of common stock subject to options currently exercisable or exercisable within 60 days of June 3, 2005 are deemed outstanding for calculating the percentage of outstanding shares of the person holding these options, but are not deemed outstanding for calculating the percentage of any other person. Unless otherwise indicated, the address for each of the stockholders listed below is c/o PETCO Animal Supplies, Inc., 9125 Rehco Road, San Diego, California 92121.
* Less than one percent.
(1) Includes 1,650,000 shares held by Devine Investments, LLC and 70 shares held in an IRA, for which Mr. Devine has sole voting and disposition authority, and 253,364 shares held by the Devine Family Trust U/A/D 2/1/02, for which Mr. Devine and his wife share voting and disposition authority. Also includes 40,000 shares held equally by Mr. Devine’s children, Brooke K. Devine and Brian K. Devine, Jr., for which Mr. Devine disclaims beneficial ownership.
(2) Shares are held by the Myers Family Trust U/A/D 6/21/02, for which Mr. Myers and his wife share voting and disposition authority.
(3) Represents shares held by the Hall Family Trust DTD 7/21/03, for which Mr. Hall and his wife share voting and disposition authority.
(4) Mr. Brann’s employment with us terminated effective February 15, 2005.
(5) Includes 194,047 shares held jointly with Mr. Brann’s wife.
(6) Includes 11,000 shares held by the Martin Living Trust DTD 1/2/02, for which Mr. Martin and his wife share voting and disposition authority and 209,000 shares of common stock subject to options which are currently exercisable or exercisable within 60 days of June 3, 2005.
(7) Represents shares of common stock subject to options which are currently exercisable or exercisable within 60 days of June 3, 2005.
(8) Includes 511 shares of common stock held by the Day Annuity Trust, for which Mr. Day has sole voting and disposition authority. Mr. Day disclaims beneficial ownership of such shares of common stock. Also includes 9,000 shares of common stock subject to options which are currently exercisable or exercisable within 60 days of June 3, 2005.
(9) Includes 414,000 shares of common stock subject to options which are currently exercisable or exercisable within 60 days of June 3, 2005.
(10) Represents 2,670,782 shares of common stock beneficially owned by Barclays Global Investors, NA, 83,685 shares of common stock beneficially owned by Barclays Global Fund Advisors, 40,389 shares of common stock beneficially owned by Barclays Global Investors, Ltd, and 97,240 shares of common stock beneficially owned by Palomino Limited. Certain affiliates of Barclays Global Investors, NA may be deemed to beneficially own these shares. This information is based solely upon information contained in a Schedule 13G filed with the Securities and Exchange Commission on February 14, 2005. The address for Barclays Global Investors, NA is 45 Fremont Street, San Francisco, CA 94105.
(11) This information is based solely upon information contained in a Schedule 13G filed with the Securities and Exchange Commission on February 7, 2005. The address for Goldman Sachs Asset Management, L.P. is 32 Old Slip, New York, NY 10005.
(12) Federated Investors, Inc. is the parent holding company of Federated Equity Management Company of Pennsylvania and Federated Investment Management Corp., which act as investment advisers to registered investment companies and separate accounts that own shares of common stock. Voting Shares Irrevocable Trust, which owns all of the voting stock of Federated Investors, Inc., and the trustees of Voting Shares Irrevocable Trust may be deemed to beneficially own these shares. This information is based solely upon information contained in a Schedule 13G filed with the Securities and Exchange Commission on February 14, 2005. The address for Federated Investors, Inc. is Federated Investors Tower, Pittsburgh, PA 15222-3779.
(13) Represents 3,772,500 shares of common stock beneficially owned by Fidelity Management & Research Company. FMR Corp., Edward C. Johnson III, Chairman of FMR Corp., and Abigail P. Johnson, a Director of FMR Corp., may be deemed to beneficially own these shares. This information is based solely upon information contained in a Schedule 13G/A filed with the Securities and Exchange Commission on February 14, 2005. The address for FMR Corp. is 82 Devonshire Street, Boston, Massachusetts 02109.
Equity Compensation Plan Information
The following table sets forth certain equity compensation plan information for PETCO as of January 29, 2005:
(1) Includes shares of our common stock reserved for issuance under the 1994 Stock Option and Restricted Stock Plan for Executives and Key Employees and the Incentive Plan of PETCO Animal Supplies, Inc.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Stockholders Agreement
We are a party to an amended and restated stockholders agreement with certain stockholders and certain of our directors and officers. Some of the parties to the amended and restated stockholders agreement, including certain of our directors and officers, may demand that we file a registration statement under the Securities Act of 1933, as amended (the “Securities Act”), covering some or all of the stockholder’s registrable securities. In addition, if we propose to register any of our equity securities under the Securities Act, other than in connection with a demand registration or other excluded registration, these stockholders may require us to include all or a portion of their registrable securities in the registration and in any related underwriting. In an underwritten offering, the managing underwriter, if any, has the right, subject to specified conditions, to limit the number of registrable securities. In general, we will bear all fees, costs and expenses of registrations, other than underwriting discounts and commissions.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The audit committee of the board of directors has selected KPMG LLP as our independent registered public accounting firm for the fiscal year ending January 28, 2006. Representatives of KPMG LLP are expected to be present at the annual meeting. They will have an opportunity to make a statement if they so desire and will be available to respond to appropriate questions.
Audit Fees. This category includes the audit of our annual financial statements, audit of internal control over financial reporting, review of financial statements included in our Form 10-Q Quarterly Reports, and services that are normally provided by the independent registered public accounting firm in connection with regulatory filings or engagements for those fiscal years. The aggregate audit fees billed by KPMG LLP for fiscal 2004 were $1,963,200. For fiscal 2003, the aggregate audit fees billed by KPMG LLP were $502,975. The increase in fiscal year 2004, compared to fiscal year 2003, was primarily due to the work to express an opinion on management’s assessment of internal control over financial reporting and an opinion on the effectiveness of our internal control over financial reporting.
Audit-Related Fees. The aggregate audit-related fees billed by KPMG LLP during the fiscal year ended January 29, 2005 were $30,000, which pertained to the audit of our 401(k) plan. The aggregate audit-related fees billed by KPMG LLP during the fiscal year ended January 31, 2004 were $24,750, which also pertained to the audit of our 401(k) plan.
Tax Fees. The aggregate fees billed by KPMG LLP for professional tax services during the fiscal year ended January 29, 2005 were $79,725, which primarily pertained to advice on the timing of tax deductions and professional tax compliance services. The aggregate fees billed by KPMG LLP for professional tax services during the fiscal year ended January 31, 2004 were $397,097, which primarily pertained to advice on tax accounting methods, advice on certain costs related to our initial public offering, and professional tax compliance services.
Financial Information Systems Design and Implementation Fees. There were no fees billed by KPMG LLP for financial information systems design and implementation during the fiscal years ended January 29, 2005 and January 31, 2004.
All Other Fees. There were no other fees billed by KPMG LLP for any other services during the fiscal years ended January 29, 2005 and January 31, 2004.
Audit Committee Policies and Procedures for Pre-Approval of Audit and Permissible Non-Audit Services. Except as permitted under the de minimus exception for non-audit services described in Section 10A(i)(l)(B) of the Exchange Act and any rules of the Securities and Exchange Commission thereunder, the audit committee pre-approves the hiring or retention of the independent registered public accounting firm for any audit services, audit-related services or permitted non-audit services, and approves the fees to be paid to the independent registered public accounting firm and any other terms of the engagement of the independent registered public accounting firm. All of the audit-related fees and tax fees billed by KMPG LLP during the fiscal years ended January 29, 2005 and January 31, 2004 were pre-approved by the audit committee pursuant to this policy. The audit committee may delegate to one or more designated members of the audit committee the authority to grant the required pre-approvals, provided that such approvals are presented to the audit committee at a subsequent meeting.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) List the following documents filed as a part of this report:
1. All financial statements.
The Consolidated Financial Statements required by this Item are submitted in a separate section beginning on page of this Annual Report on Form 10-K.
2. Financial Statement Schedules
None.
3. Exhibits
The exhibits listed under Item 15(b) hereof are filed as part of this Annual Report on Form 10-K.
Exhibit Index
(1) Incorporated by reference to PETCO Animal Supplies, Inc.’s (as successor registrant to PETCO Animal Supplies Stores, Inc.) Registration Statement on Form S-1, as amended (File No. 333-75830).
(2) Incorporated by reference to PETCO Animal Supplies, Inc.’s Annual Report on Form 10-K for the fiscal year ended February 2, 2002, as amended.
(3) Incorporated by reference to PETCO Animal Supplies, Inc.’s Registration Statement on Form S-8 (File No. 333-100397).
(4) Incorporated by reference to PETCO Animal Supplies, Inc.’s Proxy Statement relating to the 2003 Annual Meeting of Stockholders, filed with the Securities and Exchange Commission pursuant to Regulation 14A on May 16, 2003.
(5) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on January 14, 2005 (with respect to the holding company reorganization of PETCO).
(6) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on January 14, 2005 (with respect to the execution of the Credit Agreement).
(7) Incorporated by reference to PETCO Animal Supplies, Inc.’s Registration Statement on Form S-8 (File No. 333-84130).
(8) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on April 29, 2005.
(9) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on June 3, 2005.
 Filed herewith.
# Indicates a management contract or compensatory plan or arrangement.
* These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Exchange Act and are not to be incorporated by reference into any filing of PETCO Animal Supplies, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.
(c) Financial Statement Schedules.
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PETCO ANIMAL SUPPLIES, INC.
By:
/s/ JAMES M. MYERS
James M. Myers
Chief Executive Officer
By:
/s/ RODNEY CARTER
Rodney Carter
Senior Vice President and Chief Financial Officer
Date: June 28, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
P ETCO ANIMAL SUPPLIES, INC.
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of January 31, 2004 and January 29, 2005
Consolidated Statements of Operations for the Years Ended February 1, 2003, January 31, 2004 and January 29, 2005
Consolidated Statements of Stockholders’ Equity (Deficit) for the Years Ended February 1, 2003, January 31, 2004 and January 29, 2005
Consolidated Statements of Cash Flows for the Years Ended February 1, 2003, January 31, 2004 and January 29, 2005
Notes to Consolidated Financial Statements
PETCO ANIMAL SUPPLIES, INC.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
PETCO Animal Supplies, Inc.:
We have audited the accompanying consolidated balance sheets of PETCO Animal Supplies, Inc. and subsidiaries as of January 29, 2005 and January 31, 2004, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended January 29, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of PETCO Animal Supplies, Inc. and subsidiaries as of January 29, 2005 and January 31, 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended January 29, 2005 in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1(e) to the consolidated financial statements, the Company adopted EITF No. 03-10, Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers, and accordingly, changed its method of accounting for vendor consideration in 2004. Also as discussed in Note 1(e) to the consolidated financial statements, the Company adopted Emerging Issues Task Force (EITF) No. 02-16, Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor, and accordingly, changed its method of accounting for vendor consideration in 2003. Also as discussed in Note 1(v) to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections, and accordingly, changed its method of accounting for gains and losses from the extinguishment of debt in 2003.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 29, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated May 25, 2005 expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
San Diego, California
May 25, 2005
PETCO ANIMAL SUPPLIES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
PETCO ANIMAL SUPPLIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
PETCO ANIMAL SUPPLIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
For the years ended February 1, 2003, January 31, 2004 and January 29, 2005
(In thousands)
See accompanying notes to consolidated financial statements.
PETCO ANIMAL SUPPLIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements.
PETCO ANIMAL SUPPLIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended February 1, 2003, January 31, 2004 and January 29, 2005
(In thousands, except per share data)
1. Summary of Significant Accounting Policies
(a) Description of Business:
PETCO Animal Supplies, Inc., a Delaware corporation, and its subsidiaries (collectively, the “Company” or “PETCO”), is a national specialty retailer of premium pet food, supplies and services with 716 stores in 47 states and the District of Columbia as of January 29, 2005. The Company’s pet-related products include food, supplies, grooming products, toys, novelty items, vitamins, small pets such as fish, birds and other small animals (excluding cats and dogs), and veterinary supplies.
(b) Basis of Presentation:
The consolidated financial statements include the accounts of PETCO Animal Supplies, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
The preparation of these financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.
Certain amounts reported in prior fiscal years have been reclassified to conform with the current period presentation.
(c) Fiscal Year:
The Company’s fiscal year ends on the Saturday closest to January 31, resulting in years of either 52 or 53 weeks. All references to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year. For example, references to fiscal 2004 refer to the fiscal year beginning on February 1, 2004 and ending on January 29, 2005.
(d) Cash Equivalents:
Cash equivalents represent all liquid investments with original maturities of three months or less and include money market funds.
(e) Vendor Rebates and Allowances:
Most of the Company’s receivables are due from vendors. Receivables are stated net of an allowance for doubtful accounts for estimated losses resulting from the inability to collect these receivables, which is determined by continually evaluating individual receivables, the vendor’s financial condition and current economic conditions. The allowance for doubtful accounts was $1,597 and $1,747 at January 31, 2004 and January 29, 2005, respectively.
The Company adopted Emerging Issues Task Force, or EITF, 02-16, Accounting by a Customer (including a Reseller) for Cash Consideration Received from a Vendor, for arrangements with vendors entered into or modified subsequent to December 31, 2002. EITF 02-16 addresses how a customer should account for cash
consideration received from a vendor and requires all amounts received from vendors to be accounted for as a reduction of the cost of the products purchased unless certain criteria are met to allow presentation as a reduction of selling, general and administrative expenses. The transition provisions applied prospectively to arrangements with vendors entered into or modified subsequent to December 31, 2002 and did not allow for prior period reclassification. Pursuant to the adoption of EITF 02-16, substantially all vendor support is initially deferred as a reduction of the cost of inventory purchased and then recognized as a reduction of cost of sales and occupancy costs as the related inventory is sold. Prior to the adoption of EITF 02-16, certain vendor support was recorded as a reduction of selling, general and administrative expenses when earned. Certain cooperative advertising reimbursements continue to be classified as a reduction of advertising expenses within selling, general and administrative expenses, because they represent a reimbursement of specific, incremental and identifiable advertising costs incurred by the Company in selling certain vendors’ products. The total amount of such reimbursements is immaterial to the Company’s consolidated financial position and results of operations.
The Company adopted EITF 03-10, Application of EITF Issue No. 02-16, “Accounting by a Customer (including a Reseller) for Cash Consideration Received from a Vendor,” by Resellers to Sales Incentives Offered to Consumers by Manufacturers, during the first quarter of fiscal 2004. EITF 03-10 addresses the accounting for consideration received by a reseller in the form of a reimbursement by a vendor for honoring a vendor’s sales incentives offered directly to consumers, and requires such consideration to be accounted for as a reduction of cost of sales unless certain criteria are met. Prior to the adoption of EITF 03-10, such vendors’ sales incentives were recognized as net sales. The transition provisions apply prospectively to arrangements with vendors entered into or modified in fiscal periods beginning in the Company’s first quarter of fiscal 2004. In accordance with EITF 03-10, the fiscal 2003 consolidated financial statements have been reclassified to conform to this accounting change. For fiscal 2003, the adoption of EITF 03-10 resulted in the reclassification of $43.7 million of vendors’ sales incentives as a reduction of both net sales and cost of sales and occupancy costs. For fiscal 2004, the corresponding amount of vendors’ sales incentives recorded as a reduction of cost of sales and occupancy costs was $49.1 million.
(f) Merchandise Inventories:
Merchandise inventories represent finished goods and are stated at the lower of cost or market. Cost is determined by the average cost method. Physical inventories are taken on a regular basis to ensure that inventories reflected in the accompanying consolidated balance sheets are properly stated. During the period between physical inventory counts, the Company accrues for estimated losses related to shrink based on historical shrink results and current trends in the business. Shrink may occur due to theft, loss or the deterioration of goods, among other things. The Company assesses its inventory for estimated obsolescence or unmarketable inventory and writes down the difference between the cost of inventory and the estimated market value based upon historical write-downs and assumptions about future sales and supply on-hand.
(g) Fixed Assets and Depreciation and Amortization:
Fixed assets are stated at cost less accumulated depreciation. Equipment under capital leases is stated at the present value of minimum lease payments at the inception of the lease. Maintenance and repairs are expensed as incurred.
Buildings, equipment, furniture and fixtures are depreciated using the straight-line method over the estimated useful life of the asset. Leasehold and building improvements are amortized using the straight-line method over the term of the lease or the estimated useful life of the improvement, whichever is shorter. Amortization of fixed assets financed through capital leases is included in depreciation expense. The Company’s fixed assets are depreciated or amortized using the following estimated useful lives:
Buildings
30 years
Equipment
3 to 7 years
Furniture and fixtures
4 to 7 years
Leasehold and building improvements
5 to 10 years
(h) Operating Leases:
Rent expense under operating leases is recognized on a straight-line basis over the terms of the leases, which generally range from ten to 15 years for store and distribution center sites and five years for equipment. Costs incurred in negotiating and signing an operating lease agreement are capitalized and recognized on a straight-line basis over the term of the lease. Reimbursements from lessors of tenant improvement costs are recorded as deferred rent and amortized on a straight-line basis over the term of the lease.
In addition, note 1(x) discusses the Company’s change in accounting policy related to recent lease accounting clarifications by the Securities and Exchange Commission.
(i) Debt Issuance Costs:
The Company has capitalized debt issuance costs at January 31, 2004 and January 29, 2005 of $5,469 and $1,327, net of accumulated amortization. Debt issuance costs are amortized to interest expense over the life of the related debt using the straight-line method. Accumulated amortization at January 31, 2004 and January 29, 2005 was $4,419 and $278, respectively.
(j) Goodwill, Other Intangible Assets and Long-Lived Assets:
Goodwill represents the excess of the cost of acquired businesses over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets, goodwill is not amortized. The Company performs its required annual impairment test during the second quarter of each year, and performs additional impairment tests whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable at the store level. Impairment charges are recorded for any store with allocated goodwill in excess of its fair value, which is calculated based on the present value of estimated future net cash flows expected to be generated by the store. Impairment charges were not significant in fiscal 2002, 2003 or 2004.
Non-compete agreements and acquired lease rights, which comprise substantially all of the Company’s other intangible assets, have defined lives and are included in other current and other long-term assets in the accompanying consolidated balance sheets. Non-compete agreements had a gross carrying value of $3,737 and $3,337 and accumulated amortization of $920 and $1,141 at January 31, 2004 and January 29, 2005, respectively. Non-compete agreements are amortized using the straight-line method over their estimated useful lives of two and five years. Acquired lease rights had a gross carrying value of $0 and $4,947 and accumulated amortization of $0 and $96 at January 31, 2004 and January 29, 2005, respectively. Acquired lease rights are amortized using the straight-line method over the term of the leases, which range from 8 to 12 years.
The Company periodically assesses its other long-lived assets, primarily fixed assets, for impairment under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. An impairment loss is recognized when the undiscounted future cash flows expected to be generated by an asset (or group of assets) are less than its carrying value. Any required impairment losses are measured as the amount by which the asset’s carrying value exceeds its fair value, and are recorded as a reduction in the carrying value of the related asset and charged to results of operations. Impairment assessments of long-lived assets resulted in write-downs of fixed assets of $150, $736 and $1,715 during fiscal 2002, 2003 and 2004, respectively. These write-downs relate to fixed assets of closed and underperforming stores and are recorded in cost of sales and occupancy costs in the accompanying consolidated statements of operations.
(k) Self-Insurance Accruals:
The Company maintains accruals for self-insured workers compensation costs, which is classified in accrued salaries and employee benefits in the accompanying consolidated balance sheets, and self-insured
general liability costs, which is classified in accrued expenses and other liabilities in the accompanying consolidated balance sheets. The Company determines these accruals based on historical experience and trends related to claims and payments, information provided by the Company’s insurance broker, and industry experience and trends. All estimates of ultimate loss and loss adjustment expense, and resulting reserves, are subject to inherent variability caused by the nature of the insurance process. The potentially long period of time between the occurrence of an incident and the final resolution of a claim and the possible effects of changes in the legal, social and economic environments contribute to this variability.
(l) Store Closing Costs:
The Company adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, for exit or disposal activities initiated after December 31, 2002. In accordance with SFAS No. 146, all costs associated with exit or disposal activities are recognized when they are incurred or when the Company ceases using a property. Prior to the adoption of this standard, the Company charged costs associated with store closures to operations upon commitment to close a store within 12 months of the date of commitment. Store closing costs consist of lease obligations, property taxes and common area maintenance costs, net of expected sub-lease income. Store closing costs are calculated using the net present value method, at a risk-free interest rate, over the remaining life of the lease, and are recorded in cost of sales and occupancy costs in the accompanying consolidated statements of operations. For fiscal 2002, 2003 and 2004, store closing costs charged to operations were $2,109, a net credit of $322, and $3,914, respectively. Total accrued store closing costs were $1,052 and $3,043 as of January 31, 2004 and January 29, 2005, respectively, and are included in accrued expenses and other liabilities (short-term portion) and deferred rent and other liabilities (long-term portion).
(m) Advertising Expenses:
The Company charges advertising costs to expense as incurred and classifies advertising costs within selling, general and administrative expenses. Total advertising expenses were $16,396, $41,665 and $55,952 for fiscal 2002, 2003 and 2004, respectively.
(n) Cost of Sales and Occupancy Costs:
Cost of sales and occupancy costs includes the following types of expenses: direct costs associated with products sold, including inbound freight charges; shipping and handling costs; inventory shrink costs; payroll costs of pet groomers and trainers and other direct costs of the services line of business; store occupancy and utilities costs; purchasing costs; warehousing and receiving costs; internal transfer costs; and other costs of the Company’s distribution network. Also included in cost of sales and occupancy costs is certain consideration received from vendors for vendor rebates, allowances and discounts.
(o) Selling, General and Administrative Expenses:
Selling, general and administrative expenses includes the following types of expenses: payroll costs of store employees and management; other costs associated with store operations; store pre-opening and remodeling costs; advertising expenses; and general and administrative costs, including payroll and other costs associated with the Company’s management and other support functions.
(p) Fair Value of Financial Instruments:
Because of their short maturities, the carrying amounts for cash equivalents, receivables, accounts payable, accrued expenses and other liabilities, and accrued salaries and employee benefits approximate fair value. The estimated fair value of the senior subordinated notes was approximately $122 million at January 29, 2005, based upon prices recently paid by the Company for these instruments. The carrying amounts for the senior credit facility and other debt obligations approximate fair value as the interest rates and terms are substantially similar to those that could be obtained currently for similar instruments.
(q) Income Taxes:
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in operations in the period that includes the enactment date. Valuation allowances are recorded against net deferred tax assets when it is considered more likely than not that some portion or all of a deferred tax asset may not be recoverable.
(r) Stock-Based Compensation:
The Company accounts for its stock option plans using the intrinsic value method prescribed by Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and recognizes compensation expense if the market price of the underlying stock exceeds the exercise price on the date of grant. Stock-based compensation costs are amortized to expense over the vesting period of the option. Had compensation costs for the Company’s stock option plans been determined based on the fair value of the awards at the grant date, consistent with the methodology prescribed under SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s net earnings and net earnings per share would have been as presented below:
The estimated weighted-average fair value per share of the options granted during fiscal 2002, 2003 and 2004 was estimated to be $8.76, $7.41 and $12.95, respectively. The weighted-average fair value per share was calculated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
In connection with fixed plan stock option awards granted to employees in fiscal 2001, the Company recorded deferred compensation of $9,288 equal to the aggregate difference between the exercise prices of the options granted and the fair value of the underlying stock. Deferred compensation was amortized over the vesting
periods of the options. During fiscal 2002, the Company recorded amortization in the amount of $8,439. In connection with the Company’s initial public offering of its common stock in fiscal 2002 (see Note 7), all outstanding options prior to the initial public offering were modified and became fully vested. Total stock-based compensation for fiscal 2002 was $8,651 and is recorded in cost of sales and occupancy costs and stock-based compensation and other costs in the amounts of $1,460 and $7,191, respectively, in the accompanying consolidated statements of operations. See Note 8 for a summary of stock options outstanding.
(s) Comprehensive Income:
SFAS No. 130, Reporting Comprehensive Income, requires that certain items of comprehensive income other than net earnings be reported in the consolidated financial statements. During fiscal 2002, the Company recorded $1,467, net of tax expense of $868, to other comprehensive income related to the increase in fair value of the Company’s interest rate hedge, which expired in December 2002.
(t) Revenue Recognition:
Revenue from sales of the Company’s products is recognized at the point of sale for retail stores. For merchandise shipped to customers, revenue, including outbound shipping charges, is recognized and title and risk of loss pass at the time of shipment. Revenue from pet grooming, training and other services is recognized when services are performed. Revenue is recorded net of discounts and promotions offered to customers, including those offered under the Company’s customer loyalty program. The Company records an allowance for estimated returns in the period of sale.
(u) Pre-opening Costs:
Costs incurred in connection with opening new stores are expensed as incurred and are recorded in selling, general and administrative expenses. Such costs include advertising, payroll, initial store supplies and utilities.
(v) Debt Retirement Costs:
Debt retirement costs consist of prepayment premiums, the write off of unamortized debt issuance costs, and legal and closing costs associated with the extinguishment of debt. In fiscal 2003, the Company adopted SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which provides guidance on the classification of gains and losses from the extinguishment of debt and on the accounting for certain specified lease transactions. Upon the adoption of SFAS No. 145, the Company reclassified the fiscal 2002 debt retirement costs from extraordinary losses on debt extinguishment to expenses from recurring operations in the accompanying consolidated statements of operations.
(w) Segment Reporting:
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, requires annual and interim reporting for an enterprise’s operating segments and related disclosures about its products, services, geographic areas and major customers. An operating segment is defined as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses, and about which separate financial information is regularly evaluated by the chief operating decision maker in deciding how to allocate resources. All of the Company’s stores are aggregated into one reportable segment given the similarities in economic characteristics among the operations represented by the stores and the common nature of the products, customers and methods of distribution.
(x) Change in Accounting Policy:
On February 7, 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (SEC) issued a letter to the Center for Public Company Audit Firms, American Institute of Certified Public Accountants
regarding certain accounting matters related to operating leases and their application under U.S. generally accepted accounting principles. This clarification addressed, among other things, the SEC staff’s view of the appropriate accounting for tenant improvement allowances received from lessors. As a result of this letter and based on an internal review, the Company identified an error in its accounting practices associated with tenant improvement allowances. Historically, these allowances were classified on the consolidated balance sheets as a reduction of leasehold improvements within fixed assets and amortized as a reduction of depreciation and amortization expense over the estimated useful lives of the leasehold improvements or the lease term, whichever was shorter. In the consolidated statements of cash flows, these allowances were historically recorded as a reduction in the purchase of fixed assets. To correct this error, the Company will now record tenant improvement allowances as a credit to deferred rent, which will be amortized as a reduction of rent expense over the lease term. This change will not affect the income statement classification of these amounts, since both leasehold improvement amortization expense and rent expense are classified in cost of sales and occupancy costs in the consolidated statements of operations. However, this change does affect historical and current period net earnings, since leasehold improvements are generally amortized over their estimated useful life of ten years while the average lease term over which rent expense is recognized is approximately 11 years.
In the fourth quarter of fiscal 2004, the Company recorded the necessary adjustments to its consolidated balance sheet as of January 29, 2005, consolidated statement of operations for the fiscal year ended January 29, 2005 and consolidated statement of cash flows for the fiscal year ended January 29, 2005. The adjustments recorded on the January 29, 2005 balance sheet were to increase fixed assets by $23.6 million and increase deferred rent by $24.9 million. The adjustment recorded on the fiscal 2004 statement of operations resulted in a $1.3 million increase in cost of sales and occupancy costs, of which $0.9 million related to fiscal years prior to fiscal 2004. This adjustment had a net of tax effect of $0.8 million, or $0.01 per basic and diluted share, for the fiscal year ended January 29, 2005. Regarding the fiscal 2004 statement of cash flows, the changes in lease accounting resulted in an $8.5 million increase in net cash provided by operating activities and an $8.5 million increase in net cash used in investing activities. The impact of these adjustments was not material to the fiscal 2004 or prior period consolidated financial statements.
(y) Future Accounting Requirements:
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the fair value of employee stock options and other forms of employee stock-based compensation. SFAS No. 123 allowed companies to disclose the pro forma effects of expensing the fair value of employee stock-based compensation in the footnotes to the financial statements. SFAS No. 123(R) applies to all stock-based compensation transactions with employees in which a company acquires services by issuing its stock or other equity instruments, except through arrangements resulting from employee stock ownership plans, or by incurring liabilities that are based on the company’s stock price. In March 2005, the Securities and Exchange Commission (SEC) released SEC Staff Accounting Bulletin No. 107, Share-Based Payment (“SAB No. 107”). SAB No. 107 provides the SEC staff’s position regarding the application of SFAS No 123(R) and certain SEC rules and regulations, and also provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. In April 2005, the SEC approved an amendment to Rule 4-01(a) of Regulation S-X to amend the date for compliance with SFAS No. 123(R). In accordance with this amendment, the accounting provisions of SFAS No. 123(R) are effective for annual periods beginning after June 15, 2005. The Company is required to adopt SFAS No. 123(R) no later than the first quarter of fiscal 2006. The Company is evaluating the requirements of SFAS No. 123(R) and SAB No. 107 and expects the adoption of these pronouncements to have a significant impact on its consolidated results of operations.
(z) Significant Fourth Quarter Adjustments:
During the fourth quarter of fiscal 2004, the Company recorded an adjustment for unrecorded distribution costs in the amount of $5.6 million, or $3.6 million net of the related tax effects. Of this amount, $4.4 million, or
$2.7 million net of the related tax effects, relates to periods prior to the fourth quarter of fiscal 2004. The $5.6 million adjustment decreased net earnings per diluted share by $0.06 for the fourth quarter of fiscal 2004. Additionally, the Company recorded an adjustment of $2.3 million to adjust its deferred taxes as a result of the Company’s year-end review of its deferred tax accounts. This adjustment increased net earnings per diluted share by $0.04. The impact of these adjustments was not material to the fiscal 2004 or prior period consolidated financial statements.
2. Net Earnings per Share:
Basic net earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted net earnings per share includes the incremental shares issuable upon the assumed exercise of potentially issuable common stock.
Net earnings and the weighted average number of common shares used to compute basic and diluted net earnings per share are presented below:
Options to purchase common shares that were outstanding but were not included in the computation of diluted net earnings per share because of their anti-dilutive impact were 46, 7 and 1,214 for fiscal 2002, 2003 and 2004, respectively.
3. Composition of Balance Sheet Accounts
Fixed Assets, Net
Fixed assets consisted of the following at the balance sheet dates:
The Company has $1,101 in fixed assets financed through capital leases at January 31, 2004 and January 29, 2005. Accumulated amortization related to these financed assets was $454 and $821 at January 31, 2004 and January 29, 2005, respectively.
Accrued Salaries and Employee Benefits
Accrued salaries and employee benefits consisted of the following at the balance sheet dates:
Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities consisted of the following at the balance sheet dates:
4. Senior Credit Facility
On January 13, 2005, the Company entered into a new senior credit facility consisting of a $200 million secured revolving credit facility (the “revolving credit facility”). The revolving credit facility expires on January 31, 2010, although the Company has the option to extend the expiration for an additional one-year period, subject to the satisfaction of certain conditions. The Company also has the option to increase the amount of available credit under the revolving credit facility, subject to the satisfaction of certain conditions, by an additional $125 million though April 30, 2007. After April 30, 2007, the amount by which available borrowings under the revolving credit facility may be increased is reduced to $50 million.
Borrowings under the revolving credit facility are secured by substantially all of the personal property assets of the Company and its subsidiaries and bear interest at the Company’s option, at the agent bank’s base rate plus a margin of up to 0.75%, or LIBOR plus a margin of up to 1.875%, in each case based on the Company’s leverage ratio at the time. In addition, the Company has pledged all of the capital stock of its domestic subsidiaries to secure the Company’s obligations under the revolving credit facility. The Company incurs a fee of up to 2.1% on letters of credit issued under the revolving credit facility and a fee of up to 0.3% on the unused commitment under the revolving credit facility, which is reduced for any letters of credit. The credit agreement contains certain affirmative and negative covenants related to, among other things, indebtedness, capital expenditures, fixed charges coverage and total leverage. The revolving credit facility specifies a number of events of default (some of which are subject to applicable cure periods), including, among others, the failure to make payments when due, defaults under other agreements or instruments of indebtedness and noncompliance with covenants. Upon the occurrence of an event of default, the lenders may terminate the facility and declare all amounts outstanding under the revolving credit facility to be immediately due and payable.
Also on January 13, 2005, the Company’s prior senior credit facility was terminated as a result of the payment in full of all amounts due and payable under the prior senior credit facility. In connection with this termination and early repayments made during the fourth quarter of fiscal 2004 prior to this termination, the
Company recorded debt retirement costs of $4.0 million related to the write off of unamortized debt issuance costs. The Company borrowed $65 million under the new revolving credit facility to repay borrowings outstanding under the prior senior credit facility. Additionally, $24.9 million of the letter of credit subfacility to the revolving credit facility was utilized to replace letters of credit outstanding under the prior senior credit facility.
During fiscal 2003, the Company made an early repayment of $50.0 million on the prior senior credit facility and recorded debt retirement costs of $1.6 million related to the write off of unamortized debt issuance costs.
At January 29, 2005, the Company was in compliance with all of the covenants under the revolving credit facility, and the outstanding balance of the revolving credit facility was $85.0 million. Amounts outstanding under the revolving credit facility are due in full on January 31, 2010. The interest rate at January 29, 2005 on the borrowings under the revolving credit facility was 4.1%. At January 29, 2005, the Company had outstanding $24.9 million in letters of credit used for general business purposes, which reduced the availability under the revolving credit facility to $90.1 million at January 29, 2005.
5. Senior Subordinated Notes
The senior subordinated notes mature on November 1, 2011, and interest accrues at a rate of 10.75% per annum and is payable semi-annually in arrears. The Company may redeem the senior subordinated notes at its option at any time on or after November 1, 2006, in whole or in part, based upon an agreed upon schedule of redemption prices. The indenture governing the senior subordinated notes specifies a number of events of default (many of which are subject to applicable cure periods), including, among others, the failure to make payments when due, defaults under other agreements or instruments of indebtedness and noncompliance with covenants. Upon the occurrence of an event of default, the holders of the senior subordinated notes may declare all amounts outstanding to be immediately due and payable.
In March 2002, the Company repurchased $30.0 million in principal amount of its senior subordinated notes and recorded debt retirement costs totaling $3.3 million, consisting primarily of a prepayment premium. In January 2004, the Company repurchased $50.0 million in principal amount of its senior subordinated notes and recorded debt retirement costs totaling $10.6 million, consisting primarily of a prepayment premium. During the fourth quarter of fiscal 2004, the Company repurchased $16.0 million in principal amount of its senior subordinated notes and recorded debt retirement costs totaling $2.8 million, consisting primarily of a prepayment premium. In addition, on February 17, 2005, the Company repurchased an additional $14.7 million in principal amount of its senior subordinated notes, leaving $89.3 million in principal amount of its senior subordinated notes outstanding at February 17, 2005.
6. Lease Commitments and Other Obligations
The Company leases distribution center and store facilities and equipment under operating leases. These operating leases generally have terms from five to 15 years. Certain store leases include additional contingent rental payments of a percentage of store revenues above defined levels. Contingent rentals during fiscal 2002, 2003 and 2004 were $143, $156 and $119, respectively. Rent expense under operating leases for fiscal 2002, 2003 and 2004 was $129,804, $145,129 and $165,653, respectively, excluding sublease income. Sublease income for fiscal 2002, 2003 and 2004 was $826, $877 and $1,140, respectively.
At January 29, 2005, future minimum lease payments under noncancelable operating leases and capital leases and other obligations were as follows:
7. Stockholders’ Equity
Common Stock
The authorized number of shares of common stock at January 31, 2004 and January 29, 2005 was 250,000 with a par value of $.001 per share. The revolving credit facility and the indenture governing the senior subordinated notes limit the Company’s ability to pay dividends or make other distributions in respect of its common stock. In addition, the Delaware general corporation law provides that dividends are only payable out of surplus or current net profits.
Preferred Stock
The authorized number of shares of preferred stock at January 31, 2004 and January 29, 2005 was 5,000 with a par value of $.01 per share. In October 2000, the Company issued 111 shares of series A senior redeemable exchangeable cumulative preferred stock and 78 shares of series B junior redeemable cumulative preferred stock. The Company redeemed, in full, all of the outstanding shares of series A and series B preferred stock in connection with its initial public offering on February 27, 2002. The liquidation preferences at redemption, including accumulated dividends and a redemption premium of 6%, were $226.2 million and $13.6 million, respectively. No shares of preferred stock were issued or outstanding at January 31, 2004 or January 29, 2005.
Public Offering
On February 27, 2002, the Company completed an initial public offering of 14,500 shares of common stock for net proceeds of approximately $254.8 million, after deducting the underwriting discount and estimated offering expenses. On March 14, 2002, the Company received additional net proceeds of approximately $17.7 million from the sale of 1,000 additional shares of common stock pursuant to the exercise of the underwriters’ over-allotment option. The Company used $239.8 million of the net proceeds of the initial public offering to redeem in full all of the Company’s then outstanding shares of series A and series B preferred stock. The Company also used approximately $32.7 million of the net proceeds, plus approximately $1.8 million in cash on-hand, to repurchase $30.0 million in principal amount of its 10.75% senior subordinated notes at 110.5% of their
face amount, plus accrued and unpaid interest through the repurchase date. Concurrent with the initial public offering, warrants to purchase 2,132 shares of common stock were exercised and all outstanding options prior to the initial public offering became fully vested.
Registration Statements
During fiscal 2003, certain selling stockholders sold a total of 12,230 shares of the Company’s common stock, pursuant to an effective shelf registration statement previously filed by the Company with the Securities and Exchange Commission. The Company did not receive any proceeds from the sale of the shares by the selling stockholders. Offering expenses of $1,423 were recorded by the Company as a direct charge to accumulated deficit during fiscal 2003. The Company terminated the shelf registration statement on June 30, 2003.
During fiscal 2004, certain selling stockholders sold a total of 12,227 shares of the Company’s common stock, pursuant to an effective shelf registration statement previously filed by the Company with the Securities and Exchange Commission. The Company did not receive any proceeds from the sale of the shares by the selling stockholders. Offering expenses of $548 were recorded by the Company as a direct charge to retained earnings during fiscal 2004. All shares of common stock available for sale under this registration statement have been sold.
8. Employee Benefit Plans
Employee Savings and Retirement Plans
The Company has employee savings plans that permit eligible participants to make contributions by salary reduction pursuant to either section 401(k) of the Internal Revenue Code or under the Company’s non-qualified deferred compensation plan. The Company matches 50% of the first 6% of compensation that is contributed by each participating employee to the plans. In connection with the required match, the Company’s contributions to the plans were $1,351 in fiscal 2002, $1,364 in fiscal 2003 and $1,474 in fiscal 2004.
Stock Option Plans
Stock options granted under the 1994 Stock Option Plan are exercisable for up to ten years following the date of grant. As of January 29, 2005, there were 373 options outstanding under the 1994 Stock Option Plan, and no further grants will be made. Options granted under the 1994 Stock Option Plan generally vest 100% on the date which is three years from the date of the grant.
The 2002 Incentive Award Plan (the “Incentive Plan”) provides for the granting of stock-based compensation awards, including stock options, stock appreciation rights, restricted stock, deferred stock, dividend equivalents, performance awards, stock payments and other stock-related benefits to officers, employees, consultants and directors. Stock options granted under the Incentive Plan generally vest 100% on the date which is three years from the date of the grant and expire ten years from the date of the grant. Except with regard to grants to independent directors, the aggregate share limit under the Incentive Plan is equal to the sum of (1) 1,115 shares of common stock, plus (2) on March 1 of each year during the term of the Incentive Plan commencing on March 1, 2003, a number of shares of common stock equal to 2.0% of the total number of issued and outstanding shares of common stock outstanding as of the last day of the fiscal year immediately preceding such March 1. With respect to grants to the Company’s independent directors, the aggregate share limit under the Incentive Plan is equal to the sum of (1) 56 shares of common stock, plus (2) on March 1 of each year during the term of the Incentive Plan commencing on March 1, 2003, a number of shares of common stock equal to 0.1% of the total number of issued and outstanding shares of common stock as of the last day of the fiscal year immediately preceding such March 1. At January 29, 2005, options to purchase 824 shares remained available for future grant under the Incentive Plan. All option grants under the Incentive Plan had an exercise price equal to the market price of the underlying common stock on the date of grant.
Information regarding the Company’s stock option plans is as follows:
The following table summarizes information about the options outstanding under the Company’s stock option plans at January 29, 2005:
See Note 1(r) for a discussion of the Company’s accounting for stock-based compensation expense.
9. Income Taxes
Income taxes consists of the following:
A reconciliation of income taxes at the federal statutory rate of 35% with the provision for income taxes follows:
The sources of significant temporary differences which gave rise to the deferred tax provision and their effects follow:
Deferred income taxes reflect the tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities follow:
Deferred taxes are reflected in the accompanying consolidated balance sheets as follows:
The valuation allowance of $8,803 and $8,768 at January 31, 2004 and January 29, 2005, respectively, relates primarily to the capital loss arising from the Company’s divestiture of an Internet investment in fiscal 2000. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the valuation allowance.
At January 29, 2005, the Company has available net loss carryforwards of $1,728 for state income tax purposes, which begin expiring in 2007.
10. Related Party Transactions
In October 2000, the Company entered into a management services agreement with two entities that were sponsors of the Company’s merger and recapitalization transaction and became the Company’s two largest
common stockholders. Under the terms of this agreement, the Company paid management fees in an aggregate amount of $260 in fiscal 2002 to these two related parties. In February 2002, the Company terminated the management services agreement and paid a termination fee of $12.5 million that was recorded in fiscal 2002.
During fiscal 2000 and 2001, the Company made loans totaling $981 to a number of officers and other members of management to fund the exercise of vested stock options and to pay certain taxes in connection with the exercise of these options. The loans were evidenced by secured promissory notes that bore interest at rates ranging from 6.00% to 6.22%, compounded annually. As of January 31, 2004 and January 29, 2005, the total outstanding balance of these loans, including accrued interest, was $527 and $0, respectively. The notes matured and were fully repaid in fiscal 2004.
11. Contingencies
On April 18, 2005, the Company and two of its officers, James M. Myers, the Company’s Chief Executive Officer, and Rodney Carter, the Company’s Chief Financial Officer, were named as defendants in a purported class action filed in United States District Court for the Southern District of California alleging violations of Sections 10 and 20 of the Securities Exchange Act of 1934. The named plaintiff, Plumbers and Pipefitters Local 51 Pension Fund, purports to represent a class of purchasers of the Company’s stock during the period November 18, 2004 to April 14, 2005, and alleges that during such period the defendants misrepresented the Company’s financial position and that the plaintiff and the purported class of purchasers during that period were damaged by paying artificially and falsely inflated prices for the Company’s stock. The complaint seeks unspecified monetary damages. On April 26, 2005, another class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above. The April 26 suit named Brian K. Devine, the Company’s Chairman, as an additional defendant. The named plaintiffs in the April 26 suit, Richard and Loretta Hochreiter, purport to represent an identical class of investors as that identified in the April 18 lawsuit. On April 27, 2005, another class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above, naming Roger Lieberman as its representative plaintiff. On May 5, 2005, an additional class action was filed in United States District Court for the Southern District of California with substantially similar allegations to those described above, naming Messrs. Myers, Carter and Devine as defendants. The May 5 complaint names Dikran Toroser as its representative plaintiff. The Company has tendered these matters to its insurance carriers, and does not believe the outcome of these matters will have a material adverse impact on its consolidated financial position or results of operations in any future period.
In addition, certain law firms have announced that they are seeking plaintiffs in order to file a lawsuit against the Company based on unasserted claims similar to those described above. Upon receipt of any formal complaint relating to such claims, the Company intends to tender these matters and any other similar matters to its insurance carriers, and does not believe the outcome of these matters will have a material adverse impact on its consolidated financial position or results of operations in any future period.
On April 22, 2005, Angela Carr, an alleged owner of the Company’s stock, derivatively sued all of the Company’s directors and its Chief Executive Officer and Chief Financial Officer, purportedly on behalf of the Company, alleging that such officers and directors engaged in breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and other violations of California law during the period November 18, 2004 to the present. The complaint, filed in Superior Court of the State of California for the County of San Diego, seeks to recover on behalf of the Company alleged unspecified damages sustained by the Company as a result of such alleged actions, treble damages, disgorgement of profits from the sale of the Company’s securities and benefits and compensation obtained by the individual defendants, and extraordinary equitable and/or injunctive relief as permitted by law. Also on April 22, 2005, another shareholder derivative action was filed in Superior Court of the State of California for the County of San Diego on behalf of Gwen Jordan against the same defendants and with substantially similar allegations to those described above. The Company has tendered these matters to its insurance carriers, and does not believe the outcome of these matters will have a material adverse impact on its consolidated financial position or results of operations in any future period.
The Company is involved in other routine litigation arising in the ordinary course of its business. While the results of such litigation cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse effect on its consolidated financial position or results of operations in any future period.
12. Supplemental Guarantor Condensed Consolidating Financial Information
Effective January 13, 2005, the Company implemented a new holding company structure. The restructuring was accomplished through a merger pursuant to which all of the stockholders of PETCO Animal Supplies, Inc. at the effective time of the merger became stockholders of the new parent holding company, and PETCO Animal Supplies, Inc. became a wholly-owned subsidiary of the new parent holding company and changed its name to PETCO Animal Supplies Stores, Inc. The business operations of the Company have not changed as a result of the restructuring. The new parent holding company has taken the PETCO Animal Supplies, Inc. name and trades under the same symbol on the NASDAQ National Market.
The Company’s senior subordinated notes are issued by PETCO Animal Supplies Stores, Inc. (the subsidiary issuer) and are guaranteed by the parent company and certain subsidiaries of the parent company (the guarantor subsidiaries) on a full and unconditional basis. Each of the guarantor subsidiaries is, directly or indirectly, 100% owned by the subsidiary issuer, and the guarantees are joint and several. Certain other subsidiaries (the non-guarantor subsidiaries) do not guarantee such debt.
The following tables present the condensed consolidating balance sheets of PETCO Animal Supplies, Inc. as of January 31, 2004 and January 29, 2005 and the related condensed consolidating statements of operations and of cash flows for each of the years in the three-year period ended January 29, 2005.
CONDENSED CONSOLIDATED PARENT COMPANY, GUARANTOR
AND NON-GUARANTOR BALANCE SHEET
January 31, 2004
(in thousands)
PETCO ANIMAL SUPPLIES, INC.
CONDENSED CONSOLIDATED PARENT COMPANY, SUBSIDIARY ISSUER, GUARANTOR
AND NON-GUARANTOR BALANCE SHEET
January 29, 2005
(in thousands)
PETCO ANIMAL SUPPLIES, INC.
CONDENSED CONSOLIDATED PARENT COMPANY, GUARANTOR
AND NON-GUARANTOR STATEMENTS OF OPERATIONS
For the year ended February 1, 2003
(in thousands)
For the year ended January 31, 2004
(in thousands)
PETCO ANIMAL SUPPLIES, INC.
CONDENSED CONSOLIDATED PARENT COMPANY, SUBSIDIARY ISSUER, GUARANTOR
AND NON-GUARANTOR STATEMENT OF OPERATIONS
For the year ended January 29, 2005
(in thousands)
CONDENSED CONSOLIDATED PARENT COMPANY, GUARANTOR
AND NON-GUARANTOR STATEMENT OF CASH FLOWS
For the year ended February 1, 2003
(in thousands)
PETCO ANIMAL SUPPLIES, INC.
CONDENSED CONSOLIDATED PARENT COMPANY, GUARANTOR
AND NON-GUARANTOR STATEMENT OF CASH FLOWS
For the year ended January 31, 2004
(in thousands)
PETCO ANIMAL SUPPLIES, INC.
CONDENSED CONSOLIDATED PARENT COMPANY, SUBSIDIARY ISSUER, GUARANTOR
AND NON-GUARANTOR STATEMENT OF CASH FLOWS
For the year ended January 29, 2005
(in thousands)
EXHIBIT INDEX
(1) Incorporated by reference to PETCO Animal Supplies, Inc.’s (as successor registrant to PETCO Animal Supplies Stores, Inc.) Registration Statement on Form S-1, as amended (File No. 333-75830).
(2) Incorporated by reference to PETCO Animal Supplies, Inc.’s Annual Report on Form 10-K for the fiscal year ended February 2, 2002, as amended.
(3) Incorporated by reference to PETCO Animal Supplies, Inc.’s Registration Statement on Form S-8 (File No. 333-100397).
(4) Incorporated by reference to PETCO Animal Supplies, Inc.’s Proxy Statement relating to the 2003 Annual Meeting of Stockholders, filed with the Securities and Exchange Commission pursuant to Regulation 14A on May 16, 2003.
(5) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on January 14, 2005 (with respect to the holding company reorganization of PETCO).
(6) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on January 14, 2005 (with respect to the execution of the Credit Agreement).
(7) Incorporated by reference to PETCO Animal Supplies, Inc.’s Registration Statement on Form S-8 (File No. 333-84130).
(8) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on April 29, 2005.
(9) Incorporated by reference to PETCO Animal Supplies, Inc.’s Current Report on Form 8-K filed on June 3, 2005.
 Filed herewith.
# Indicates a management contract or compensatory plan or arrangement.
* These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Exchange Act and are not to be incorporated by reference into any filing of PETCO Animal Supplies, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.