10-Q 1 a20023rd10q.txt FORM 10-Q FOR THE QUARTERLY PERIOD ENDED 110202 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 1O-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended November 2, 2002 ---------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1932 For the transition period from...............to................ Commission File Number: 1-10089 FACTORY 2-U STORES, INC. (Exact name of registrant as specified in its charter) Delaware 51-0299573 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 4000 Ruffin Road, San Diego, CA 92123-1866 ------------------------------- ---------- (Address of principal executive office) (Zip Code) (858) 627-1800 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] YES [ ] NO The number of shares outstanding of the registrant's common stock, as of December 16, 2002 was 13,244,910 shares. FACTORY 2-U STORES, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED NOVEMBER 2, 2002 INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Factory 2-U Stores, Inc. Balance Sheets as of November 2, 2002 (Unaudited), November 3, 2001 (Unaudited) and February 2, 2002 ..................................................F-1 Factory 2-U Stores, Inc. Statements of Operations (Unaudited) for the 13 weeks and 39 weeks ended November 2, 2002 and November 3, 2001 ..F-3 Factory 2-U Stores, Inc. Statements of Cash Flows (Unaudited) for the 39 weeks ended November 2, 2002 and November 3, 2001 ...............F-4 Factory 2-U Stores, Inc. Notes to Financial Statements (Unaudited)..F-5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................3 Item 3. Quantitative and Qualitative Disclosures About Market Risk...........10 Item 4. Controls and Procedures .............................................10 PART II. OTHER INFORMATION Item 1. Legal Proceedings ...................................................11 Item 2. Changes in Securities and Use of Proceeds............................11 Item 3. Defaults Upon Senior Securities......................................11 Item 4. Submission of Matters to a Vote of Security Holders..................11 Item 5. Other Information ...................................................11 Item 6. Exhibits and Reports on Form 8-K ....................................11 Signatures ................................................................13 Certifications ...............................................................14 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements
FACTORY 2-U STORES, INC. Balance Sheets (in thousands, except share and per share data) November 2, November 3, February 2, 2002 2001 2002 ----------- ----------- ----------- (Unaudited) (Unaudited) ASSETS Current assets: Cash $ 5,922 $ 6,059 $ 17,390 Merchandise inventory 83,461 85,416 54,860 Accounts receivable 2,613 1,823 2,013 Income taxes receivable 7,820 1,489 - Prepaid expenses 6,109 6,393 6,357 Deferred income taxes 3,553 2,503 3,553 ----------- ----------- ----------- Total current assets 109,478 103,683 84,173 Leasehold improvements and equipment, net 34,856 42,311 37,042 Deferred income taxes 7,182 4,992 7,182 Other assets 985 1,066 1,011 Excess of cost over net assets acquired, less accumulated amortization of $13,344, $12,944 and $13,344, respectively 26,301 26,701 26,301 ----------- ---------- ----------- Total assets $ 178,802 $ 178,753 $ 155,709 =========== ========== ===========
The accompanying notes are an integral part of these financial statements. (continued) F-1
FACTORY 2-U STORES, INC. Balance Sheets (in thousands, except share and per share data) (continued) November 2, November 3, February 2, 2002 2001 2002 ----------- ----------- ----------- (Unaudited) (Unaudited) LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt $ 2,000 $ 2,058 $ 2,019 Accounts payable 42,047 50,472 36,271 Taxes payable 3,234 3,310 3,332 Accrued expenses 26,322 17,711 27,918 ---------- ---------- ---------- Total current liabilities 73,603 73,551 69,540 Revolving credit facility 30,046 8,143 - Long-term debt 9,181 10,088 8,376 Other long-term obligations 3,578 4,346 3,578 Deferred rent 3,291 3,706 3,649 ---------- ---------- ---------- Total liabilities 119,699 99,834 85,143 ---------- ---------- ---------- Stockholders' equity: Common stock, $0.01 par value; 35,000,000 shares authorized and 12,969,910 shares, 12,823,370 shares and 12,842,146 shares issued and outstanding, respectively 130 128 128 Stock subscription notes receivable (2,149) (2,225) (2,225) Additional paid-in capital 122,323 120,794 121,370 Accumulated deficit (61,201) (39,778) (48,707) ---------- ---------- ---------- Total stockholders' equity 59,103 78,919 70,566 ---------- ---------- ---------- Total liabilities and stockholders' equity $ 178,802 $ 178,753 $ 155,709 ========== ========== ==========
The accompanying notes are an integral part of these financial statements. F-2
FACTORY 2-U STORES, INC. Statements of Operations (in thousands, except per share data) (Unaudited) 13 Weeks Ended 39 Weeks Ended -------------- -------------- November 2, November 3, November 2, November 3, 2002 2001 2002 2001 ----------- ----------- ----------- ----------- Net sales $ 134,506 $ 145,568 $ 379,545 $ 410,646 Cost of sales 89,854 95,308 252,706 268,807 ----------- ----------- ----------- ----------- Gross profit 44,652 50,260 126,839 141,839 Selling and administrative expenses 49,057 49,065 144,936 139,503 Pre-opening and closing expenses 366 989 1,069 2,881 Amortization of intangibles - 422 - 1,267 Stock-based compensation expense - - - 456 ----------- ----------- ----------- ----------- Operating loss (4,771) (216) (19,166) (2,268) Interest expense, net 515 342 1,083 1,123 ----------- ----------- ----------- ----------- Loss before income taxes (5,286) (558) (20,249) (3,391) Income tax benefit (1,770) (234) (7,755) (1,424) ----------- ----------- ----------- ----------- Net loss $ (3,516) $ (324) $ (12,494) $ (1,967) =========== =========== =========== =========== Loss per share Basic $ (0.27) $ (0.03) $ (0.97) $ (0.15) Diluted $ (0.27) $ (0.03) $ (0.97) $ (0.15) Weighted average common shares outstanding Basic 12,970 12,823 12,943 12,780 Diluted 12,970 12,823 12,943 12,780
The accompanying notes are an integral part of these financial statements. F-3
FACTORY 2-U STORES, INC. Statements of Cash Flows (in thousands) (Unaudited) 39 Weeks ended -------------- November 2, November 3, 2002 2001 ----------- ----------- Cash flows from operating activities Net loss $ (12,494) $ (1,967) Adjustments to reconcile net loss to net cash provided by (used in) operating activities Depreciation and amortization 11,424 12,438 Loss on disposal of equipment 48 133 Deferred rent (330) 296 Stock-based compensation expense - 456 Changes in operating assets and liabilities Merchandise inventory (28,601) (32,972) Prepaid expenses and other assets (8,117) (256) Accounts payable 5,775 25,278 Accrued expenses and other liabilities (2,008) 88 ----------- ----------- Net cash provided by (used in) operating activities (34,303) 3,494 ----------- ----------- Cash flows from investing activities Purchases of leasehold improvements and equipment (8,065) (10,622) ----------- ----------- Net cash used in investing activities (8,065) (10,622) ----------- ----------- Cash flows from financing activities Borrowings on revolving credit facility 74,421 76,146 Payments on revolving credit facility (44,375) (68,003) Payments on long-term debt and capital lease obligations (19) (132) Payment of deferred debt issuance costs (121) (40) Proceeds from exercise of stock options 918 477 Payments of stock subscription notes receivable 76 - ----------- ----------- Net cash provided by financing activities 30,900 8,448 ----------- ----------- Net increase (decrease) in cash (11,468) 1,320 Cash at the beginning of the period 17,390 4,739 ----------- ----------- Cash at the end of the period $ 5,922 $ 6,059 =========== =========== Supplemental disclosure of cash flow information Cash paid during the period for Interest $ 377 $ 320 Income taxes $ 1,323 $ 5,523 Supplemental disclosure of non-cash financing activities Issuance of common stock to board members as compensation $ 19 $ 90
The accompanying notes are an integral part of these financial statements. F-4 FACTORY 2-U STORES, INC. Notes to Financial Statements (Unaudited) (1) Unaudited Interim Financial Statements The accompanying unaudited financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements and should be read in conjunction with the financial statements for the fiscal year ended February 2, 2002 included in our Form 10-K as filed with the Securities and Exchange Commission. We believe that the unaudited financial statements as of and for the 13 weeks and 39 weeks ended November 2, 2002 and November 3, 2001 reflect all adjustments necessary to present fairly the financial position, results of operations and cash flows for the periods presented. Due to the seasonal nature of our business, the results of operations for the interim period may not necessarily be indicative of the results of operations for a full year. Certain prior period amounts have been reclassified to conform their presentation to the current period financial statements. (2) Recent Accounting Pronouncements In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", which rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and an amendment of that Statement, and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers." SFAS No. 145 amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. F-5 In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses significant issues regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. This statement requires that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is effective for all exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. (3) Restructuring Charge In January 2002, we recorded a restructuring charge of $21.2 million in conjunction with the decision to close 28 under-performing stores, as well as the realignment of our field organization and workforce reductions (Fiscal 2001 restructuring initiatives). The purpose of the restructuring was to improve store profitability, streamline field operations, reduce costs and improve efficiency. As of December 16, 2002, we have closed 24 of the 28 under-performing stores, completed 18 lease terminations, and have substantially completed the realignment of our field organization and workforce reductions. The balance of the liability related to the restructuring charge at November 2, 2002 was as follows: Balance at Balance at February 2, Cash Non-cash November 2, (in thousands) 2002 Payments Charges 2002 ----------- --------- ---------- ------------ Lease termination costs* $ 13,724 $ (5,244) $ 326 $ 8,806 Inventory liquidation costs 2,870 - (1,289) 1,581 Fixed asset write-downs 2,052 - (1,393) 659 Employee termination costs 1,159 (1,059) - 100 Other costs 1,349 (956) - 393 ----------- --------- ---------- ------------ $ 21,154 $ (7,259) $ (2,356) $ 11,539 ----------- --------- ---------- ------------
* The non-cash charge portion consists primarily of the write-off of deferred rent. As part of our on-going evaluation of the adequacy of the liability related to this restructuring charge, we have noted a favorable experience related to the cost of closing the 24 stores. Accordingly, subsequent to November 2, 2002, we expect to reduce our reserve for store closures by approximately $5.0 million. This adjustment will be reflected in the operating results of our fourth quarter ending February 1, 2003. See Note 11. F-6 (4) Adoption of SFAS No. 142, "Goodwill and Other Intangible Assets" In June 2001, the FASB issued SFAS No. 142 "Goodwill and Other Intangible Assets", which requires that upon adoption, amortization of goodwill will cease and instead, the carrying value of goodwill be evaluated for impairment at least annually using a fair value test. Identifiable intangible assets will continue to be amortized over their useful lives and reviewed at least annually for impairment using a method appropriate to the nature of the intangible asset. As required, we adopted SFAS No. 142 on February 3, 2002 and ceased the amortization of goodwill accordingly. The following table presents the reconciliation of net income and per share data to what we would have reported had the new rules been in effect during the 13-week and 39-week periods ended November 3, 2001 (in thousands, except per share data): 13 Weeks Ended 39 Weeks Ended November 3, 2001 November 3, 2001 ---------------- ---------------- Reported net loss $ (324) $ (1,967) Add back goodwill amortization, net of tax 232 697 ---------------- ---------------- Adjusted net loss $ (92) $ (1,270) ---------------- ---------------- Basic net loss per common share Reported net loss $ (0.03) $ (0.15) Goodwill amortization, net of tax $ 0.02 $ 0.05 Adjusted net loss $ (0.01) $ (0.10)
(5) Revolving Credit Facility We have a $50.0 million revolving credit facility, under which generally we may borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined. Under the terms of the credit facility, the interest rate may increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.0 % and LIBOR borrowings from LIBOR plus 1.5% to LIBOR plus 3.0%. The credit facility expires on March 3, 2006, subject to automatic one-year renewal periods, unless terminated earlier by either party in accordance with the terms of the revolving credit facility agreement. We are obligated to pay fees equal to 0.125% per annum on the unused amount of the credit facility. The credit facility is secured by a first lien on accounts receivable and inventory. At November 2, 2002, based on eligible inventory and accounts receivable, we were eligible to borrow $50.0 million under the revolving credit facility; and we had outstanding borrowings of $30.0 million and outstanding standby letters of credit of $5.6 million. F-7 (6) Long-Term Debt Our long-term debt consists of Junior Subordinated Notes (the "Notes"), which are non-interest bearing and are reflected on our balance sheets at the present value using a discount rate of 10%. As of November 2, 2002, the Notes had a face value of $13.3 million and a related unamortized discount of $2.2 million, resulting in a net carrying value of $11.1 million. The discount is amortized to interest expense as a non-cash charge over the term of the Notes. We made a principal payment on the Notes of $2.0 million in December 2001. Additional principal payments are scheduled on December 31, 2002 ($2.0 million), December 31, 2003 ($3.0 million), December 31, 2004 ($3.0 million) and May 28, 2005 ($5.3 million). (7) Income (loss) per Share We compute income (loss) per share in accordance with SFAS No. 128, "Earnings Per Share." Under the provisions of SFAS No. 128, basic earnings (loss) per share is computed based on the weighted average shares outstanding. Diluted earnings per share is computed based on the weighted average shares outstanding and potentially dilutive common equivalent shares. Common stock equivalent shares totaling 0, 92,783, 239,162 and 272,967, respectively, are not included in the computation of diluted loss per share for the 13 weeks and 39 weeks ended November 2, 2002 and November 3, 2001 because the effect would be anti-dilutive. (8) Provision for Income Taxes Based on our estimated effective tax rate for the entire fiscal year, which is subject to ongoing review and evaluation, we recorded an income tax benefit of $1.8 million and $7.8 million for the 13 weeks and 39 weeks ended November 2, 2002, respectively. (9) Stock Options and Warrants As of November 2, 2002, we had outstanding options to purchase 1,309,939 shares of our common stock. Included in these outstanding stock options are 4,520 performance-based options, which will become exercisable if the market price hurdle of $49.78 has been achieved and maintained for 60 consecutive trading days. Should this occur, we will incur a non-cash compensation expense in the minimum amount of $187,000. These performance-based options will expire on April 29, 2003. At November 2, 2002, warrants to purchase 82,690 shares of our common stock were outstanding. These warrants have an exercise price of $19.91 and expire May 2005. F-8 (10) Note Receivable In July 2002, we entered into a temporary bridge financing agreement (the "Agreement") with one of our trade vendors (the "Borrower") in which we, subject to the terms and conditions of the Agreement, provided a $4.0 million revolving line of credit facility to the Borrower. Advances made to the Borrower under this Agreement are secured by the Borrower's accounts receivable, inventory, personal property and other assets including cash. Borrowings under this facility are also secured by personal guarantees from the principals of the Borrower. This Agreement expired on October 11, 2002, and we have not made any direct advances to the Borrower thereafter. As of November 2, 2002, there were outstanding borrowings of approximately $1.4 million, net of allowance for receivable, under this Agreement. Subsequently, we have collected approximately $215,000 from the Borrower. (11) Subsequent Events On December 3, 2002, our Board of Directors adopted a Fiscal 2002 restructuring plan and other initiatives to improve operating results and liquidity. The plan and other initiatives include (1) the closure of 23 under-performing stores, of which 12 will be closed immediately and 11 will be closed during Fiscal 2003, (2) inventory liquidation in conjunction with the store closures and a reduction of inventory levels chain-wide, and (3) consolidation of both our distribution center network and corporate overhead structure. We estimate these initiatives will result in approximately $5.0 million in cost savings in Fiscal 2003. In addition, we announced our intent to reduce the current reserve balance related to our Fiscal 2001 restructuring efforts by approximately $5.0 million. This reduction is a result of favorable experience related to the costs of closing 28 stores previously identified in our Fiscal 2001 restructuring efforts. See Note 3. We currently anticipate these initiatives and net of the reduction of the prior year restructuring reserve to result in after-tax charges of approximately $13.2 million ($6.9 million non-cash), or $1.02 per share, in our fourth quarter ending February 1, 2003. (11) Legal Matters, Commitments and Contingencies We are at all times subject to pending and threatened legal actions that arise in the normal course of business. In the opinion of our management, based in part on the assessment of legal counsel, the ultimate disposition of these current matters will not have a material adverse effect on our financial position or results of operations. F-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with our Financial Statements and notes thereto, included elsewhere in this Form 10-Q. General As of November 2, 2002, we operated 261 "Factory 2-U" off-price retail stores which sell branded casual apparel for the family, as well as selected domestics and household merchandise at prices which generally are significantly lower than the prices offered by other discount chains. We had 273 stores in operation as of November 3, 2001. We opened 4 new stores during the 13-week period ended November 2, 2002; we opened 12 new stores and closed 2 stores during the same period last year. For the 39-week period ended November 2, 2002, we opened 12 new stores and closed 30 stores as compared to 33 new store openings and 3 stores closing for the comparable period last year. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Specifically, we must make estimates in the following areas: o Inventory valuation. Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method ("RIM") on a first-in, first-out basis. Under the RIM, the valuation of inventory at cost and the resulting gross margin are calculated by applying a computed cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventory at the lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventory. Inherent in the RIM calculation are certain significant management judgments and estimates regarding markdowns and shrinkage, which may from time to time cause adjustments to the gross margin in the subsequent period. Factors that can lead to distortion in the calculation of the inventory balance include applying the RIM to a group of merchandise items that is not fairly uniform in terms of its cost and selling price relationship and turnover, and applying RIM to transactions over a period of time that includes different rates of gross profit, such as those relating to seasonal merchandise items. To minimize the potential of such distortions in the valuation of inventory from occurring, we utilize 83 sub-departments in which fairly homogeneous classes of merchandise items having similar gross margin are grouped. In addition, failure to take timely markdowns may result in an overstatement of cost under the lower of cost or market principle. We believe that the use of our RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market. 3 o Valuation of goodwill, intangible and other long-lived assets. We use certain assumptions in establishing the carrying value and estimated lives of our long-lived assets and goodwill. The criteria used for these evaluations include management's estimate of the asset's continuing ability to generate income from operations and positive cash flows. If assets are considered to be impaired, the impairment recognized is measured by the amount that the carrying value of the assets exceeds the fair value of the assets. Useful lives and related depreciation or amortization expense are based on our estimate of the period that the assets will generate revenues or otherwise be used in operations. Factors that would influence the likelihood of a material change in our reported results include a significant decline in our stock price and market capitalization compared to our net book value, significant changes in an asset's ability to generate positive cash flows, significant changes in our strategic business objectives and utilization of the asset. o Accrued restructuring costs. We have estimated an amount for the charge and the related liability regarding our restructuring initiatives including store closures, realignment of our field organization and workforce reductions in accordance with the Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Materially different reported results would be likely if the timing and extent of the adopted restructuring plan were changed. o Litigation reserves. Based in part on the assessment of our legal counsel, estimated amounts for litigation and claims that are probable and can be reasonably estimated are recorded as liabilities in the balance sheet. The likelihood of a material change in these estimated reserves would be dependent on new claims as they may arise and the favorable or unfavorable outcome of the particular litigation. We anticipate these reserves will be re-evaluated as new facts come to light in any particular case. o Worker's compensation accrual. At the beginning of fiscal 2001, we transitioned to a self-insured worker's compensation program. This new program has both specific and aggregate stop-loss limits. The maximum specific stop-loss is $250,000 per occurrence and the aggregate stop-loss is $3.2 million for the policy year ended January 31, 2002. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy year ended January 31, 2002 were estimated to be approximately $2.6 million. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above. For the policy year ending January 31, 2003, our self-insured worker's compensation program includes a maximum specific stop-loss limit of $250,000 per occurrence with no aggregate stop-loss limit. 4 o Valuation of deferred income taxes. Valuation allowances are established, if deemed necessary, to reduce deferred tax assets to the amount expected to be realized. The likelihood of a material change in our expected realization of these assets is dependent on future taxable income, our ability to use the net operating loss carryforwards, the effectiveness of our tax planning and strategies among the various tax jurisdictions that we operate in, and any significant changes in the tax treatment we currently receive. Results of Operations Net sales were $134.5 million for the 13 weeks ended November 2, 2002 compared to $145.6 million for the 13 weeks ended November 3, 2001, a decrease of $11.1 million, or 7.6%. Comparable store sales for the 13-week period ended November 2, 2002 decreased 5.6% versus a decrease of 10.5% for the same period last year. For the 39 weeks ended November 2, 2002, net sales were $379.5 million versus $410.6 million for the same period last year, a decrease of $31.1 million or 7.6%. Comparable store sales decreased 8.5% in the first 39 weeks of this year compared to a decrease of 6.6% for the same period last year. The decline in net sales for the 13 and 39 weeks ended November 2, 2002 from the comparable periods last year was primarily due to lower average number of stores in operation, reduced customer traffic, and lower average customer purchase size. Gross profit was $44.7 million or 33.2% of net sales for the 13 weeks ended November 2, 2002 compared to $50.3 million or 34.5% of net sales for the 13 weeks ended November 3, 2001. For the 39 weeks ended November 2, 2002 and November 3, 2001, gross profit was $126.8 million or 33.4% of net sales and $141.8 million or 34.5% of net sales, respectively. The decline in gross profit as a percentage of net sales for the 13 and 39 weeks ended November 3, 2002 from the comparable periods last year was primarily related to higher markdown volume and lower initial mark-up. These impacts for the 39 weeks ended November 3, 2002 were partially offset by improved efficiency in our distribution centers operation. As a percentage of net sales, our distribution centers costs for the 13 weeks ended November 3, 2002 were flat compared to the 13 weeks ended November 3, 2001. The higher markdown rate for the 13 weeks ended November 3, 2002 was a result of clearing slow-moving inventory and retail price reductions on selected items to reinforce the value image of our stores. In addition to the clearance of slow-moving inventory and retail price reductions, the higher markdown volume for the 39 weeks ended November 3, 2002 was also due to increased promotional activity this year, which included our July chain-wide grand re-opening event. 5 For the 13 weeks ended November 2, 2002, the selling and administrative expenses were $49.1 million, which was consistent with the same period last year. Included in the selling and administrative expenses for the third quarter this year were consulting fees of $910,000. As a percentage of net sales, selling and administrative expenses for the third quarter this year were 36.5%, 280 basis points higher compared to the same period last year. The increase in the selling and administrative expenses ratio this year was due to lower sales volume and the consulting fees mentioned above. Excluding the consulting fees, our selling and administrative expenses were $48.1 million or 35.8% of net sales. For the 39 weeks ended November 2, 2002, the selling and administrative expenses were $144.9 million or 38.2% of net sales compared to $139.5 million or 34.0% of net sales for the same period last year. Included in these amounts was a charge of $2.1 million recorded during the second quarter of this year in conjunction with the settlement of litigation, and a charge of $1.2 million recorded during the second quarter of last year related to the retirement and replacement of an executive officer. In addition, the current year's selling and administrative expenses included consulting fees of $2.6 million. Excluding these charges, selling and administrative expenses were $140.2 million or 36.9% of net sales and $138.4 million or 33.7% of net sales for the 39 weeks ended November 2, 2002 and November 3, 2001, respectively. The dollar increase in selling and administrative expenses was primarily a result of increased spending for advertising and store occupancy. Selling and administrative expenses increased as a percentage of net sales due to lower sales volume and increased spending related to the items cited above. Pre-opening and closing expenses were $366,000 for the 13 weeks ended November 2, 2002 compared to $1.0 million for the same period last year, a decrease of approximately $623,000 or 63.0%. For the 39 weeks ended November 2, 2002, pre-opening and closing expenses were $1.1 million versus $2.9 million for the same period last year, a decrease of approximately $1.8 million. The decrease in pre-opening and closing expenses for the 13 and 39 weeks ended November 2, 2002 from the comparable periods last year was due to the opening of 8 and 21 fewer new stores, respectively, during the current periods versus the same periods last year. We did not record any amortization of intangibles for the 13 weeks and 39 weeks ended November 2, 2002 versus $422,000 and $1.3 million, respectively, recorded during the same periods last year. This change was due to the elimination of goodwill amortization in conjunction with the adoption of SFAS No. 142 and cessation of amortization associated with prior business acquisitions. For the 39 weeks ended November 3, 2001, we recorded a stock-based compensation expense of $456,000 due to the removal of the price target of certain stock options. Interest expense, net was $515,000 and $1.1 million for the 13 weeks and 39 weeks ended November 2, 2002, respectively, compared to $342,000 and $1.1 million for the comparable periods last year. The increase in the interest expense for the current quarter was due to higher average outstanding borrowings on the revolving credit facility. 6 We recorded an income tax benefit of $1.8 million and $7.8 million for the 13 weeks and 39 weeks ended November 2, 2002, respectively, compared to $234,000 and $1.4 million for the 13 weeks and 39 weeks ended November 3, 2001. The increase in income tax benefit was the result of an increased pre-tax loss compared to the same periods a year ago. For the 13 weeks and 39 weeks ended November 2, 2002, the net loss was $3.5 million and $12.5 million as compared to $324,000 and $2.0 million for the 13 weeks and 39 weeks ended November 3, 2001. The increase in net loss was a result of the operating and other factors cited above. Liquidity and Capital Resources General We finance our operations through credit provided by vendors and other suppliers, amounts borrowed under our $50.0 million revolving credit facility, and internally generated cash flow. Credit terms provided by vendors and other suppliers are usually net 30 days. Amounts, which may be borrowed under the revolving credit facility, are based on a percentage of eligible inventory and accounts receivable, as defined, outstanding from time to time, as more fully described in Note 5 of Notes to Financial Statements. At November 2, 2002, the availability under our revolving credit facility was $14.4 million versus $40.4 million as of November 3, 2001. During the 39 weeks ended November 2, 2002, we used $34.3 million in operating activities, $8.1 million in investing activities and generated $30.9 million from financing activities, which resulted a net decrease in cash of $11.5 million. For the same period last year, we generated $3.5 million from operating activities, used $10.6 million in investing activities and generated $8.4 million from financing activities, which resulted a net increase in cash of $1.3 million. The change in cash flows from operating activities was primarily due to the higher cumulative operating loss and the reduced number of days payables were outstanding this year. The decrease in cash used in investing activities was due to a reduction in capital expenditures associated with fewer new store openings this year. We believe that our sources of cash, including the revolving credit facility, will be adequate to finance our operations, capital requirements and debt obligations as they become due for the next twelve months. Capital Expenditures We anticipate capital expenditures of approximately $1.5 million for the remainder of the current fiscal year ending February 1, 2003, primarily in connection with the construction of our new distribution center in San Diego, California, in which we plan to consolidate both of our existing San Diego 7 distribution centers. This distribution center will approximate 600,000 square feet and have the capability to service up to 400 stores. We anticipate that it will become operational in our second quarter of fiscal 2003. We estimate the total capital expenditures for this distribution center at approximately $4.5 million, of which we have already paid $1.3 million. We believe the capital expenditures for this facility and other capital requirements will be financed from internal cash flow. Store Closures and Restructuring Initiatives As of December 16, 2002, we have closed 24 of the 28 under-performing stores as identified in our Fiscal 2001 restructuring efforts. In addition, we have closed six other stores, as a result of either non-renewable leases or relocation opportunities. We estimate the cash requirement for the remainder of this current fiscal year for the Fiscal 2001 restructuring efforts will be approximately $1.6 million, which we intend to fund from our sources of cash, including the revolving credit facility. With respect to our Fiscal 2002 restructuring initiatives, as previously discussed in this report, we have already begun closing activities for 12 stores, which we expect will be closed by the end of January 2003. We also expect to complete the consolidation of our corporate overhead structure by February 1, 2003. We will begin the consolidation of our distribution center network beginning with the closure of two distribution centers in San Diego, California. We expect these distribution centers to close during the second quarter of Fiscal 2003 when our new San Diego distribution facility becomes operational. Contractual Obligations and Commitments The following table summarizes our significant contractual obligations, as well as estimated cash requirements related to our restructuring initiatives, as of November 2, 2002. These should be read in conjunction with "Note 3 - Restructuring Charge" and "Note 6 - Long-Term Debt" in the accompanying unaudited financial statements, as well as our fiscal 2001 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. (in thousands) Junior Accenture Subordinated Operating Restructuring Consulting Notes Leases Charge* Agreement Total ------------- --------- ------------- ---------- ----------- Fiscal Year: 2002 (Remaining 3 months) $ 2,000 $ 837 $ 1,600 $ 196 $ 4,633 2003 3,000 33,726 5,864 - 42,590 2004 3,000 30,851 - - 33,851 2005 5,300 24,113 - - 29,413 2006 - 17,736 - - 17,736 Thereafter - 54,647 - - 54,647 ------------- --------- ------------- ---------- ----------- $ 13,300 $161,910 $ 7,464 $ 196 $ 182,870 ------------- --------- ------------- ---------- -----------
* Amounts reflect management's best estimate to complete store closures and other restructuring initiatives 8 In the first quarter of fiscal 2002, we entered into a master Consulting Services Agreement (the "Agreement") with Accenture LLP ("Accenture") to provide consulting services on merchandise assortment planning and in-season management, advertising effectiveness and brand development. The Agreement was generally terminable on a 30-day notice. In August 2002, this Agreement was amended to reflect a reduction in the scope of services to be provided by Accenture. On November 12, 2002, we terminated the Agreement. In the aggregate, we paid Accenture approximately $2.8 million under the Agreement. During the first quarter of fiscal 2002, we entered into a lease agreement for our new San Diego distribution facility. The lease is for a term of 12 years. The monthly minimum base rent payment of approximately $225,000 is expected to commence in June 2003. Forward-Looking Statements In this Quarterly Report on Form 10-Q, we have made both historical and forward-looking statements. All of our statements other than those of historical fact are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are not based on historical facts, but rather reflect our current expectations concerning future results and events. These forward-looking statements generally may be identified by the use of phrases such as "believe", "expect", "anticipate", "intend", "plan", "foresee", "likely", "will" or other similar words or phrases. Similarly, statements that describe our objectives, plans or goals are or may be forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be different from any future results, performance or achievements expressed or implied by these statements. The following important factors, among others, could affect our future results, causing these results to differ materially from those expressed in any of our forward-looking statements: general economic and business conditions, trends in our business and consumer preferences, especially as may be impacted by economic weakness on consumer spending, the effects of government regulations and legislation, litigation and other claims that may be asserted against us, the effects of intense competition, changes in our business strategy or development plans, including anticipated growth strategies and capital expenditures, the costs and difficulties of attracting and retaining qualified personnel, the effects of increasing labor, utility, fuel and other operating costs, our ability to obtain adequate quantities of suitable merchandise at favorable prices and on favorable terms and conditions, the effectiveness of our operating initiatives and advertising and promotional strategies and other risk factors described in our fiscal 2001 Annual Report on Form 10-K and in our other filings with the Securities and Exchange Commission. We do not undertake to publicly update or revise any of our forward-looking statements, whether as a result of new information, future events and developments or otherwise, except to the extent that we may be obligated to do so by applicable law. 9 Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to interest rate risk on our Junior Subordinated Notes, which are non-interest bearing and discounted at an annual rate of 10%. At November 2, 2002, our long-term debt had a face value of $13.3 million with a net carrying value of $11.2 million. While generally an increase in market interest rates will decrease the value of this debt, and decreases in interest rates will have the opposite effect, we are unable to estimate the impact that interest rate changes will have on the value of this debt as there is no active public market for the debt and we are unable to determine the market interest rate at which alternate financing would have been available at November 2, 2002. Item 4. Controls and Procedures Evaluation. Within 90 days prior to the date of this Quarterly Report on Form 10-Q, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended. This evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Limitations. Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures will necessarily prevent all errors. Such controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that their objectives are met. Conclusions. Based upon our evaluation, we have concluded that, subject to the limitations noted above, our disclosure controls and procedures are effective to ensure that material information relating to the Company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date or our last evaluation of such internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. 10 PART II - OTHER INFORMATION Item 1. Legal Proceedings As disclosed in our financial statements for the fiscal year ended February 2, 2002 included in our Form 10-K as filed with the Securities and Exchange Commission, in December 2000, a former employee in our Alameda, California store filed a lawsuit against us (the "O'Hara Lawsuit"). This lawsuit alleged that we violated the California Labor Code and Internal Wage Commission Orders, by classifying store managers and assistant managers as exempt salaried employees and thereby failing to pay them overtime. On November 7, 2002, the court entered an order approving the settlement. However, the settlement does not become effective until the later of 60 days after November 7, 2002 (January 6, 2003) and until any appeals from the court's order are resolved. To date, we are unaware of any appeal of the court's order. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by William R. Fields, Chief Executive Officer. 99.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Douglas C. Felderman, Executive Vice President and Chief Financial Officer. 11 (b) Reports on Form 8-K Item 5 - On November 19, 2002, we filed a report on Form 8-K regarding the appointment of William R. Fields as Chairman and Chief Executive Officer of the Company effective November 7, 2002 and the appointment of Ronald Rashkow as the Lead Director of the Board of Directors effective November 4, 2002. 12 SIGNATURES Pursuant to the requirements 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. FACTORY 2-U STORES, INC. Date: December 17, 2002 By: /s/Douglas C. Felderman ------------------------ Name: Douglas C. Felderman Title: Executive Vice President and Chief Financial Officer (duly authorized officer and principal financial officer) 13 CERTIFICATION I, William R. Fields, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Factory 2-U Stores, Inc. (the "Registrant"). 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report. 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report. 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and 14 (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: December 17, 2002 /s/ William R. Fields --------------------- Name: William R. Fields Title: Chief Executive Officer 15 CERTIFICATION I, Douglas C. Felderman, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Factory 2-U Stores, Inc. (the "Registrant"). 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report. 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report. 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and 16 (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: December 17, 2002 /s/ Douglas C. Felderman ------------------------ Name: Douglas C. Felderman Title:Executive Vice President and Chief Financial Officer 17