-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, IsAbpj3uEx7RYg7YUlyHICtgfjOiUi3RKw0SL8B6VwezZRuPvWXwpKJ3C/7bHxGR hTZki+8GfEscHxeLoe7NsQ== 0000950137-04-002829.txt : 20040415 0000950137-04-002829.hdr.sgml : 20040415 20040415160403 ACCESSION NUMBER: 0000950137-04-002829 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20040131 FILED AS OF DATE: 20040415 FILER: COMPANY DATA: COMPANY CONFORMED NAME: WHITEHALL JEWELLERS INC CENTRAL INDEX KEY: 0000868984 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-JEWELRY STORES [5944] IRS NUMBER: 361433610 STATE OF INCORPORATION: DE FISCAL YEAR END: 0131 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-15615 FILM NUMBER: 04735963 BUSINESS ADDRESS: STREET 1: 155 N WACKER DR STREET 2: SUITE 500 CITY: CHICAGO STATE: IL ZIP: 60606 BUSINESS PHONE: 3127826800 MAIL ADDRESS: STREET 1: 155 NORTH WACKER STREET 2: SUITE 500 CITY: CHICAGO STATE: IL ZIP: 60606 FORMER COMPANY: FORMER CONFORMED NAME: MARKS BROS JEWELERS INC DATE OF NAME CHANGE: 19960301 10-K 1 c84514v2e10vk.txt ANNUAL REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K FOR ANNUAL REPORT AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [X] ANNUAL report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended January 31, 2004 OR [ ] TRANSITION report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from _________ to ___________ Commission file number 0-028176 WHITEHALL JEWELLERS, INC. (Exact Name of Registrant as Specified in Its Charter) DELAWARE 36-1433610 (State or Other Jurisdiction of (I.R.S. Employer Identification Number) Incorporation or Organization) 155 N. WACKER DR., STE. 500, CHICAGO, IL 60606 (Address of Principal Executive Offices) (Zip Code) (312) 782-6800 (Registrant's Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, Par Value $.001 Per Share, Including Associated Preferred Stock Purchase Rights (Title of Class) 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. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes [ ] No [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] The aggregate market value of the voting stock held by non-affiliates of the registrant as of July 31, 2003 was $169,315,283 based on the closing price of $11.90 of the registrant's common stock on the New York Stock Exchange. This calculation does not reflect a determination that persons are affiliates for any other purposes. Number of shares of Common Stock outstanding as of April 1, 2004: 13,921,518 Number of shares of Class B Common Stock outstanding as of April 1, 2004: 142 DOCUMENTS INCORPORATED BY REFERENCE Part II and Part IV -- Portions of the registrant's annual report to stockholders for the registrant's fiscal year ended January 31, 2004 (the "2003 Annual Report"), as indicated herein. Part III -- Portions of the registrant's definitive proxy statement to be distributed in conjunction with the registrant's annual stockholders' meeting to be held in 2004 (the "Proxy Statement"), as indicated herein. PART I As used herein, references to the "Company," "Whitehall Jewellers," "we," "us," and "our" refer to Whitehall Jewellers, Inc. This report contains certain forward-looking statements (as such term is defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) and information relating to the Company that are based on the current beliefs of management of the Company as well as assumptions made by and information currently available to management including statements related to the markets for our products, general trends and trends in our operations or financial results, plans, expectations, estimates and beliefs. In addition, when used in this report, the words "anticipate," "believe," "estimate," "expect," "intend," "may," "plan," "predict" and similar expressions and their variants, as they relate to the Company or our management, may identify forward-looking statements. Such statements reflect our judgment as of the date of this report with respect to future events, the outcome of which is subject to certain risks, including the factors described below, which may have a significant impact on our business, operating results or financial condition. Investors are cautioned that these forward-looking statements are inherently uncertain. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results or outcomes may vary materially from those described herein. Whitehall Jewellers undertakes no obligation to update forward-looking statements. The following factors, among others, may impact forward-looking statements contained in this report: (1) a change in economic conditions or the financial markets which negatively impacts the retail sales environment and reduces discretionary spending on goods such as jewelry; (2) reduced levels of mall traffic caused by economic or other factors; (3) our ability to execute our business strategy and the related effects on comparable store sales and other results; (4) the extent and results of our store expansion strategy and associated occupancy costs, and access to funds for new store openings; (5) the high degree of fourth quarter seasonality of our business; (6) the extent and success of our marketing and promotional programs; (7) personnel costs and the extent to which we are able to retain and attract key personnel; (8) the effects of competition; (9) the availability and cost of consumer credit; (10) relationships with suppliers; (11) our ability to maintain adequate information systems capacity and infrastructure; (12) our leverage and cost of funds and changes in interest rates that may increase such costs; (13) our ability to maintain adequate loss prevention measures; (14) fluctuations in raw material prices, including diamond, gem and gold prices; (15) developments relating to the consolidated Capital Factors actions and the related Securities and Exchange Commission ("SEC") and U.S. Attorney's office investigations and shareholder and other civil litigation, including the impact of such developments on our results of operations and financial condition and relationship with our lenders or with our vendors; (16) regulation affecting the industry generally, including regulation of marketing practices; (17) the successful integration of acquired locations and assets into our existing operations; and (18) the risk factors identified from time to time in our filings with the SEC. 2 ITEM 1. BUSINESS THE COMPANY Founded in 1895, we are a leading national specialty retailer of fine jewelry (based on number of stores) offering an in-depth selection in the following categories of merchandise: diamond, gold, precious and semi-precious jewelry and watches. Our target customers are middle to upper-middle income men and women over 25 years of age. As of April 1, 2004, we operated 384 mall-based stores in 38 states under the established brand names of Whitehall Co. Jewellers (325 stores), Lundstrom Jewelers (57 stores) and Marks Bros. Jewelers (2 stores). OPERATING STRATEGIES The principal elements of our operating strategy are as follows: Small, Flexible Store Format. We believe that we have a competitive advantage in obtaining high traffic, "center court" locations in desirable regional and super-regional malls principally due to: - our ability to adapt our average store size of approximately 870 square feet to various sizes and configurations; and - our high average sales per square foot (approximately $1,066 for the 12 months ended January 31, 2004). Our stores are typically located in high visibility mall locations and provide our customers with a comfortable and inviting shopping environment. The stores' open, attractive design appeals to customers, while facilitating foot traffic and enhancing sales opportunities for us. Furthermore, the stores' small, flexible format (which lowers our fixed occupancy costs) and high productivity are desirable to mall owners. In addition, we follow a disciplined approach when evaluating new store opportunities. We select locations for our stores based on an evaluation of individual site economics and market conditions. Because of our flexible store format and our reputation among mall developers as a strong tenant, we have historically received more offers for attractive new store sites than we accept. We believe that real estate is important to our business, and site selection is a competency of our management team. Store Operating Model. Our store model has proven to be attractive across brands and mall locations. Historically, new stores on average generate positive operating cash flow (defined as income from operations plus depreciation and amortization) within their first full 12 months of operations. Brand Imaging. We reinforce the upscale, trustworthy image of our store brand names, Whitehall Co. Jewellers and Lundstrom Jewelers, through merchandise selection and price points, store layout and fixtures, packaging, marketing and promotions. Whitehall Co. Jewellers is our primary trademark and is positioned to be somewhat more upscale than the average mall-based jewelry store. Additionally, having two strong brands allows us to enter a given mall with multiple locations, leverage our infrastructure within a given region and increase the number of potential store sites available to us. Merchandising. We offer a selection of fine jewelry in the following categories: diamond, gold, precious and semi-precious jewelry and watches. Our merchandise assortments are focused on our target customer, middle to upper-middle income men and women over 25 years of age. Within these categories, we augment our selection with consignment merchandise, providing increased selection while reducing our inventory risk. In addition, we continue to stock a broad assortment of higher price point merchandise. For example, in fiscal 2003 more than 30% of our overall sales resulted from purchases of items priced at or above $1,500. Although we have expanded our watch lines, we carry a more focused selection of watches and virtually no costume jewelry or gift merchandise as compared to some of our competitors. Sales-Oriented Store Personnel. We believe that the quality of our sales personnel is important to our success. Our sales personnel are 3 authorized to discount prices within specifically developed guidelines to assist their selling efforts. Compensation and bonus programs reinforce sales and margin goals on a daily, weekly, monthly and annual basis. We seek to enhance the selling skills of our sales associates through recruitment of experienced sales personnel and ongoing training programs. Many non-sale activities are centralized, allowing sales personnel to focus on our customers. Absence of Recourse Credit Risk. We operate based upon a "no credit risk" policy. When purchasing on credit, customers must use their personal credit cards (e.g., Visa, MasterCard, American Express and others), our private label credit card (which is available through a third party and is non-recourse to us) or other non-recourse third party credit arrangements. Our policy limits credit risk associated with a customer's failure to pay. Recourse against us is limited to those cases where the receivable itself is defective (such as incorrectly completed documentation or certain situations involving fraud). This policy also distinguishes us from some of our competitors, which not only bear such credit risk, but also rely on finance income in addition to merchandise sales. In cooperation with providers of non-recourse credit under private label programs, we often offer our customers competitive, interest-free terms and other attractive offerings in the promotion of our jewelry. Operating Controls. Our experienced management team exercises significant control over many non-sale aspects of our store operations, including site selection, purchasing, store development, financial reporting and sales training. Management has focused on a series of actions that we feel will increase our operational control as well as reduce certain expenses. We have reduced certain operating costs at our stores and corporate headquarters, and we plan to gradually reduce average store inventory levels. We closed 11 stores during each of fiscal 2003 and fiscal 2002. Emphasis on Risk Management. A strength of our management team is our disciplined approach to three principal operating strategies that are designed to mitigate risk to our business: our small, flexible store format, our non-recourse credit policy and our use of consignment inventory. Our store format, which averages approximately 870 square feet, is smaller than that of many of our mall-based competitors. This usually means that we are not competing with these competitors for the same location in a mall, which often gives us more location opportunities. In general, it also means that our rents are lower, not only because of reduced competition for space, but also because a smaller store means lower fixed occupancy costs. Secondly, we have limited credit risk. Unlike many of our competitors, we utilize a non-recourse, private label credit card program. As a result, we often limit our credit risk associated with a customer's failure to pay. Lastly, we utilize consignment inventory providing increased selection while reducing our inventory risk. Experienced Management Team. Our four-person executive management team has on average 24 years of retail industry experience and an average of over 21 years of experience with Whitehall Jewellers. In addition, this group has a combined beneficial interest in the Company in excess of 23.9% of our common stock. The Company is in the process of interviewing candidates for the newly created position of Chief Operating Officer and filling the position of Executive Vice President, Merchandising. Later this year, the Company will begin recruiting for a General Counsel. The Company has already hired a Director of Internal Audit, which is a newly created position that reports directly to the Chairman of the Audit Committee of the Board of Directors. The hiring of individuals for the new positions noted above, as well as the upgrading of certain management positions will increase the Company's personnel costs. We also have an experienced middle management team. We are focused on identifying, recruiting and retaining skilled and experienced individuals for our management organization. GROWTH STRATEGIES The important elements of our growth strategy are as follows: Enhance Sales and Marketing Initiatives. We use direct marketing and in-store promotions to stimulate store sales. We plan to continue to maintain our customer file of over 1.1 million names with targeted direct mailing initiatives. The Company has slightly reduced the size of its total direct mailings during fiscal 2003 as the Company has refined its direct mail campaign to focus its mailing selection criteria on the most responsive customers. We intend to continue to refine the direct mail program in fiscal 2004. 4 Refine Merchandising Initiatives. We continue to refine our product offerings with the long-term goal of increasing the number of customer transactions and the average transaction value per customer. We intend to continue to apply these practices by adjusting the quality, selection and price points in our key merchandise categories: diamonds, gold, precious and semi-precious jewelry and watches. New Store Growth. New stores are a part of our long-term growth plan. As of January 31, 2004, we have grown to 380 stores from 122 in 1993, entering 15 new states during this period. During fiscal 2003, we opened 21 new stores. The initial performance of these new stores closely approximated our recent historical new store sales levels. During fiscal 2004, we expect to open 6 new stores, most in existing Company markets, and anticipate that all of the openings will be completed by June. Our new stores are in what we consider to be some of the better malls in the country. We believe that our Whitehall Jewellers and Lundstrom Jewelers stores can achieve strong, long-term cash returns on investment and can operate successfully in a wide variety of geographic and demographic markets. Because of this, we believe that there is the potential to double our store base over the long-term within the United States. STORE OPERATIONS Site Selection. We are disciplined in our site selection methodology. Our stores average approximately 870 square feet and our layout is flexible. We typically locate our stores in high traffic, "center court" locations in desirable regional and super-regional malls throughout the United States. We select locations for stores based on our evaluation of individual site economics and market conditions. When deciding to enter a new market, we evaluate a number of criteria including the following: - current and future size, demographic make-up and growth potential of the market; - total store sales potential; - ability to leverage existing infrastructure, personnel and brand awareness; and - the size, strength and merchandising philosophy of existing and potential competitors in the marketplace. In choosing specific sites within a given mall, whether in a new or existing market, we apply site selection criteria taking into account numerous factors, including the following: - size of space; - store visibility; - traffic patterns; - real estate costs; - store locations of our competitors; and - overall retail potential. Store Layout. Our stores are typically located in high traffic, "center court" locations and provide our customers with a comfortable and inviting shopping environment. Most of the stores have an open entrance. Stores are brightly lit and generally are designed to have display cases situated near the lease line. Formatting the stores in this "customer-friendly" manner and without a formal entryway allows a casual mall shopper to come in close contact with the store's merchandise and personnel without the natural apprehension many have upon entering a fine jewelry store. We occasionally adjust our store concepts to blend an appropriate theme of elegance, with a goal of creating a "customer-friendly" environment. Store Management. Each of our stores is operated under the direction of a store manager who is responsible for management of all store-level operations, including sales and most personnel matters. A 5 number of non-sales related administrative functions are performed at our corporate office in Chicago. A significant portion of the compensation of store managers is based on incentives which focus on sales productivity and store profitability. The store managers are assisted by a staff that usually includes an assistant manager and four to eight sales associates, depending upon store operating hours and anticipated sales volume. We have approximately 36 district managers, each supervising between 8 and 14 stores, who concentrate their efforts on store-focused sales strategies. In addition, 8 regional supervisors oversee all field operations and concentrate their efforts on the execution of store-focused sales strategies, communication between the corporate office and field, and compliance with operating strategies. Certain senior officers spend a substantial amount of their time working with store supervisors and visiting stores to reinforce the close communication between senior executives and store personnel. Operating Cost Controls. Our store operations are designed to maintain low operating costs at the store level. Our small average store size reduces fixed costs, and the lack of recourse credit eliminates the need for most overhead expenses normally associated with credit operations. We also seek to reduce store-level operating costs through efficient sales staff utilization. To assist store personnel in their selling efforts, a number of administrative functions are performed at the corporate level. Store Employee Compensation. We seek to hire experienced sales personnel and motivate our store employees by linking a meaningful percentage of employee compensation to individual and/or store sales performance, as well as by offering opportunities for promotion within the Company. Employee Training. We believe that providing knowledgeable and responsive customer service is important to our success and, accordingly, have developed and implemented employee training programs. New sales staff receive on-the-job training during the first weeks of employment. This training continues throughout the employee's tenure following a workbook-based program of product knowledge, sales and operational process training. New store managers experience a similar sequence of learning activities. MERCHANDISING We believe that an important element of our success is our merchandising strategy that reflects our upscale customer orientation and small store format. We seek to provide an assortment of items across a broad range of price points in our product categories: diamonds (such as diamond jewelry, diamond solitaires and bridal), gold, precious and semi-precious jewelry and watches. Although we have expanded our watch lines, we carry a more focused selection of watches and virtually no costume jewelry or gift merchandise as compared to some of our competitors. On average, our stores each offer approximately 2,700 individual items, including approximately 1,450 core jewelry items. These core items, which comprise many of our more popular merchandise programs, accounted for approximately 63% of net sales in fiscal 2003. In addition, we have expanded our merchandise assortment in higher price points. A substantial portion of our sales are made at prices discounted from listed reference prices. The methodology for achieving these discounts is monitored on an on-going basis. The following table sets forth our percentage of total merchandise sales by category for the following periods:
FISCAL YEAR ENDED JANUARY 31, ----------------------------------------- 2001 2002 2003 2004 Diamonds 62.6% 64.6% 66.4% 65.2% Gold 19.5 18.6 17.4 15.7 Precious/Semi-Precious 16.5 15.3 14.2 14.6 Watches 1.4 1.5 2.0 4.5 ----------------------------------------- Total Merchandise Sales 100.0% 100.0% 100.0% 100.0% =========================================
We also customize the merchandising of our stores based upon each store's sales volume, individual market preferences and historical selling patterns. We test new items in our stores and monitor their sales performance to identify additional sales opportunities. 6 Along with our merchandise assortments, we also provide jewelry repair services to our customers (sales from which represented 2.4% of fiscal 2003 net sales) and jewelry service plans (sales from which represented 2.4% of fiscal 2003 net sales). In some of our stores, repair work is performed on-site by jewelers under independent contract. ADVERTISING AND PROMOTIONS Our advertising strategy includes in-store and point-of-sale marketing and direct mail campaigns. We believe that the quality of our customer database, which currently consists of over 1.1 million customers, has allowed us to develop targeted advertising, marketing and promotional campaigns. We test various direct mail campaigns as part of our advertising initiatives. Frequent special promotions such as our semi-annual two-day events, diamond remount events, "Vice President's Day Events" and similar promotions, as well as point-of-sale signage and in-store flyers, are designed to increase traffic through our stores and generate an urgency for customers to make purchases. These promotions vary from year to year and among stores. Publicized promotional events are an important part of our marketing efforts, and we generate a significant portion of our revenues during such events. Over the past several years, direct marketing has become an increasingly important element of our advertising and promotion strategy. We intend to continue to refine direct mail programs in fiscal 2004. We generally offer customers a 30-day return or 90-day exchange policy. We also offer a layaway program that enables our customers to hold an item at our stores and pay for it over a one-year period without interest charges. The customer is required to make an initial deposit to establish the layaway and is required to make monthly payments. We retain possession of merchandise placed in layaway until the customer has made all required payments. CREDIT We operate based upon a "no credit risk" policy. When purchasing on credit, customers must use their personal credit cards (e.g., Visa, MasterCard, American Express and others), our private label credit card, which is available through a third party and is non-recourse to us, or other non-recourse third party credit arrangements. Our policy limits credit risk associated with a customer's failure to pay. Recourse against us is restricted to those cases where the receivable itself is defective (such as incorrectly completed documentation or certain situations involving fraud.) At the same time, we believe that our ability to offer credit through our "private label" credit cards and other non-recourse arrangements is attractive to many customers, including those who prefer not to have their jewelry purchases count towards their credit limits on their personal third party credit cards. We encourage sales on our private label credit card or other non-recourse third party credit arrangements because customer purchases on this type of credit tend to generate higher average sales. In fiscal 2003, our average private label credit sale was approximately $782, compared to our average personal credit card sale of approximately $251. Our private label credit program is currently run through G.E. Capital Consumer Card Co. ("G.E.CC"). We also offer other non-recourse credit arrangements through other third parties. Under these programs customers may apply for credit for merchandise purchases. Our credit strategy and our focus on a more upscale clientele are interrelated. A substantial portion of the users of private label credit offered by many jewelers tend to be customers with more limited financial resources or a weaker credit history. In contrast, our adherence to a "no credit risk" policy limits our sales to such individuals. Thus, we have historically oriented our merchandising programs to appeal to a more affluent, less credit-reliant consumer. Under the credit programs, the credit purveyors have no recourse against us based on the customer's failure to pay; recourse against us is limited to those cases where the receivable itself is defective (such as incorrectly completed documentation or certain situations involving fraud). Our expense related to these cases was less than 0.5% of sales during fiscal 2003. Our credit card discount expense for fiscal 2003 and fiscal 2002 represented 7 3.0% and 2.9%, respectively, of credit sales. In general, our credit card discount expense is higher for our private label programs than for personal credit cards, such as Visa and MasterCard. G.E.CC provides credit to our customers using its own credit criteria and policies. We pay a fee to G.E.CC based primarily upon the volume of credit, average ticket and type of promotion extended. We have similar non-recourse arrangements with other credit purveyors, which we use in addition to G.E.CC's program to assist customers in financing their purchases. In addition, we utilize a check authorization company which, for a fee, guarantees payments on transactions involving certain personal checks. Several years ago, we introduced a "One-Year No Interest" program through G.E.CC. Under this program, G.E.CC offers customers a financing arrangement with no interest for one year, for which we pay G.E.CC a significantly higher fee than we pay under its standard program. We have successfully used this program and continue to offer this and other interest-free promotions (e.g., three-month no interest, six-month no interest) from time to time. This program enables us to offer our customers competitive, interest-free terms and other attractive promotions despite our "no credit risk" policy. During the third quarter of fiscal 2003, the Company began testing a new program through G.E.CC, which extends minimum credit limits to certain credit customers that meet the specific requirements of this new test program. Under this new test program, G.E.CC extends credit to customers that did not qualify under the standard program, for which we pay a significantly higher fee to G.E.CC than we pay under its standard program. SEASONALITY Our business is highly seasonal. During fiscal 2003, a significant portion of our sales, and net income of $4.3 million, was generated during the fourth fiscal quarter ending January 31, 2004, as compared to a net loss of $13.0 million experienced in the previous three quarters. Historically, income generated in the fourth fiscal quarter ending each January 31 represents all or a majority of the income generated during the fiscal year. The Company has historically experienced lower net sales in each of its first three fiscal quarters and expects this trend to continue. PURCHASING We do not manufacture our merchandise. We purchase substantially all of our inventory, including loose gems, directly from leading suppliers located in the United States and abroad. We purchase merchandise from approximately 120 vendors, primarily in the United States, Israel, Italy, India, China, and the Far East, who supply various jewelry products under U.S. dollar-denominated agreements. During fiscal 2003, our largest supplier and five largest suppliers accounted for approximately 11% and 46%, respectively, of the merchandise we purchased. During fiscal 2002, our largest supplier and five largest suppliers accounted for approximately 12% and 37%, respectively, of the merchandise we purchased. We also have certain subcontracting arrangements with jewelry finishers to set loose diamonds and gemstones into rings and other jewelry, using styles established by us or by other companies. We believe that the relationships we have established with our suppliers and subcontractors are good. We have not experienced difficulty in obtaining satisfactory sources of supply and believe that adequate alternative sources of supply exist for substantially all types of merchandise sold in our stores. However, the loss of one or more of our major suppliers, particularly at certain critical times during the year, could have a material adverse effect on us. We maintain a quality assurance program, with most shipments from suppliers being counted or weighed and visually inspected upon receipt at our headquarters in Chicago, Illinois. During fiscal 2003, our average net monthly investment in inventory (i.e., the total cost of inventory owned and paid for) was approximately 57% of the total cost of our on-hand merchandise with the remaining percentage being trade payables and consignment inventory. For example, as of January 31, 2004, the average amount of consignment merchandise per store was approximately $247,000. Under the terms of our vendor trading agreements for non-consignment inventory, we are often granted exchange privileges, based on a formula, which permit us to return or exchange certain unsold merchandise. Our consignment inventory permits us to have more merchandise available for sale in stores, providing increased selection while reducing our inventory risk. 8 As participants in the jewelry industry, we are affected by general industry-wide fluctuations in the prices of diamonds and gold and, to a lesser extent, other precious and semi-precious metals and stones. During fiscal 2003, diamonds, gold, precious and semi-precious jewelry accounted for approximately 95.5% of our net merchandise sales. The supply and price of diamonds in the principal world markets are significantly influenced by a single entity, the Diamond Trading Company (formerly called the Central Selling Organization), a marketing arm of DeBeers Consolidated Mines Ltd. of South Africa. The Diamond Trading Company has traditionally controlled the marketing of a majority of the world's supply of diamonds and sells rough diamonds to worldwide diamond cutters from its London office in quantities and at prices determined in its discretion. The Diamond Trading Company recently implemented a "Supplier of Choice" initiative. The impact of this initiative on the diamond supplier base is not yet known. The availability of diamonds to the Diamond Trading Company and our suppliers is to some extent dependent on the political situation in diamond producing countries, such as South Africa, Botswana, Zaire, republics of the former Soviet Union and Australia, and on continuation of the prevailing supply and marketing arrangements for raw diamonds. Until alternate sources could be developed, any sustained interruption in the supply of diamonds or any oversupply from the producing countries could adversely affect us and the retail jewelry industry as a whole. We are constantly altering the mix of our products and we have increased the percentage of higher priced items in our stores. Higher priced jewelry items tend to have a slower rate of turnover, thereby increasing the risks to us associated with price fluctuations and changes in fashion trends. INVENTORY LOSS PREVENTION We undertake substantial efforts to safeguard our jewelry inventory from loss and theft, including the use of security alarm systems and safes at each store and the taking of daily inventory of higher value items. In addition, our inventory management and control system, which tracks each item in our inventory, provides a further check against loss or theft. We have a full-time executive who directs our loss prevention department. We maintain insurance (subject to certain deductibles) covering the risk of loss of merchandise in transit, on store premises and in our distribution facility, whether owned or on consignment, in amounts that we believe are reasonable and adequate for the types and amounts of merchandise that we carry. During fiscal 2003, inventory shrinkage was less than 1.0% of sales. MANAGEMENT INFORMATION SYSTEMS We utilize customized management information systems throughout our business to facilitate the design and implementation of selling strategies and as an integral part of our financial and other operational controls. Our management information system utilizes IBM AS400 systems as its foundation. The system incorporates point-of-sale computers in our stores with a merchandise management and purchase order management system and utilizes software specifically designed or customized for the jewelry industry. The information system has been upgraded to support our current needs but further upgrading is necessary to support our growth. We use the management information system to track each individual item of merchandise from receipt to ultimate sale to the customer or return to the vendor. As a result, management can closely monitor inventory by location, sales, gross margin, inventory levels and turnover statistics, reallocating inventory among stores when beneficial. This system also enables management to review each store's and each employee's productivity and performance. Based on the sales data, we tailor each store's inventory composition and plan our purchasing requirements accordingly. The system enables us to manage our inventory at the store level, including the automatic replenishment of merchandise generally once or twice a week. The system also automatically provides a daily reconciliation of each store's transactions for prompt investigation of discrepancies. The point-of-sale computers are polled nightly by the headquarters system and updated data is available at the beginning of the following day for use by support office and store supervisory personnel, and for transfer into our accounting, merchandising and other management information systems. We have implemented, through our point-of-sale system, the ability to capture and retain selected customer data from each sale (name, address, phone, birthday, anniversaries, historical purchases, etc.). 9 Our store managers and sales associates often use this data in their efforts to contact customers and anticipate and facilitate future add-on purchases by our customers. We use the customer data in our direct marketing promotional campaigns. The point-of-sale systems also track required inspection dates for customers with diamond warranties. Sales associates are prompted by the system to contact these customers to remind them of the required in-store inspection. COMPETITION The jewelry retail business is fragmented and highly competitive. We primarily compete with national and regional jewelry chains and local independently owned jewelry stores, especially those that operate in malls, as well as with department stores, discounters, direct mail suppliers, televised home shopping networks and Internet commerce. Diamond Trading Company, a marketing arm of DeBeers, has traditionally controlled the marketing of a substantial majority of the world's supply of diamonds. Certain of our competitors are substantially larger and have greater financial resources than the Company and can take advantage of national advertising programs. We also believe that we compete for consumers' discretionary spending dollars with retailers that offer merchandise other than jewelry. We believe that the primary competitive factors affecting our operations are store location and atmosphere, quality of sales personnel and service, breadth, depth and quality of merchandise offered, pricing, credit, marketing and reputation. We emphasize our merchandise selection, sales personnel, store location and design, credit, marketing and pricing in competing in our target market. In the past few years several businesses began marketing fine jewelry via the Internet. Large scale consumer acceptance of Internet fine jewelry retailing could transform the jewelry retailing business, result in lower price points and margins, and adversely affect our results of operations or financial condition. Although we initiated an e-commerce sales program in 2000, to date our e-commerce initiatives have not resulted in significant on-line sales. We are not currently transacting Internet sales of jewelry, and we are not currently pursuing an e-commerce strategy. INTELLECTUAL PROPERTY Whitehall(R) Co. Jewellers, Lundstrom(R) Jewelers and Marks Bros.(R) Jewelers are registered trademarks in the United States. We also have registered the Internet domain names "whitehalljewellers.com" and "lundstromjewelers.com." Our trademarks are held by, and our licensing activity is conducted by, WH Inc. of Illinois, a wholly owned subsidiary of Whitehall Jewellers. During 2002, four stores operated in Japan under the name "Lundstrom" pursuant to a license agreement with Nihon Gold Chain Co-Operation. The license agreement has been terminated and the right to operate using the Lundstrom name ended January 31, 2003. EMPLOYEES As of January 31, 2004, we had 2,450 employees, including 2,292 store level employees. We usually hire a limited number of temporary employees during each Christmas selling season. None of our employees are represented by a union. We believe that our relations with our employees are good. REGULATION Our operations are affected by numerous federal and state laws that impose disclosure and other requirements upon the origination, servicing, enforcement and advertising of credit accounts, and limitations on the maximum amount of finance charges that may be charged by a credit provider. Although credit to our customers is provided by third parties without recourse to us based upon a customer's failure to pay, any restrictive change in the regulation of credit, including the imposition of, or changes in, interest rate ceilings, could adversely affect the cost or availability of credit to our customers and, consequently, our results of operations or financial condition. Our operations are also affected by federal and state laws relating to marketing practices in the retail jewelry industry. In marketing to our customers, we compare many of our prices to "reference prices." Our literature indicates to customers that our reference price for an item is our 10 general determination of the non-discounted price at which comparable merchandise of like grade or quality is advertised or offered for sale by competitive retailers. Our literature further notes that we do not know whether competitive retailers have actually made any sales at the reference price, and the reference price is not our current selling price or the price at which we formerly sold an item. We are, from time to time, subject to regulatory investigation relating to our "reference prices" in marketing to our customers. Although we believe that pricing comparisons are common in the jewelry business, there can be no assurance that this position would be upheld. AVAILABLE INFORMATION We maintain an Internet website at www.whitehalljewellers.com that includes a hypertext link to the Securities and Exchange Commission's website where our Annual Report on Form 10-K, Quarterly Reports on 10-Q, Current Reports on Form 8-K, Forms 3, 4 and 5 filed on behalf of directors and executive officers, and all amendments to those reports are available without charge, as soon as reasonably practicable following the time that they are filed with or furnished to the Securities and Exchange Commission. You may read and copy any document we file at the SEC's Public Reference Room at Room 1024, 450 Fifth Street, NW, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for information on the Public Reference Room. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The Company's Corporate Governance Guidelines, Audit Committee Charter, Compensation Committee Charter and Governance and Nominating Committee Charter are available upon written or verbal request. Requests for copies of any of these documents should be directed in writing to Whitehall Jewellers, Inc., 155 North Wacker Drive, Suite 500, Chicago, Illinois 60606, Attention: John R. Desjardins or by telephone to (312) 782-6800. ITEM 2. PROPERTIES As of April 1, 2004, we operated 384 stores in 38 states. All of these stores are leased and are located in regional or super-regional malls. Our typical new store lease has a term of 10 years plus the first partial lease year. Terms generally include a minimum base rent, a percentage rent payment based on store sales and certain other occupancy charges. At January 31, 2004 the average remaining life of the leases for our stores was approximately six years. While there can be no assurance, we expect to be generally able to renew these leases as they expire. We also lease approximately 28,400 square feet of office and administrative space in Chicago, Illinois in an office building housing our corporate headquarters, distribution functions and quality assurance operations. This lease expires on December 31, 2005. ITEM 3. LEGAL PROCEEDINGS On July 25, 2002, the Company was named a defendant in a wage hour class action suit filed in California by three former store managers. The case was based principally upon the allegation that store managers employed by the Company in California should have been classified as non-exempt for overtime purposes. The parties reached an agreement to settle the matter resulting in a pre-tax charge of $1,000,000, inclusive of the plaintiffs' attorneys' fees, interest, penalties, administrative costs and other Company costs, which was approved by the court on December 11, 2003. This settlement covers the period from July 25, 1998 through the date of final settlement approval by the court. The Company has made payments totaling approximately $1,000,000, per the terms of the settlement agreement, as of January 31, 2004. The Company was named a defendant in a wage hour suit filed in California by a former employee on May 6, 2003. The case was based principally upon the allegation that the amount of overtime paid to certain California employees was less than the amount actually earned. The suit asserted a claim for $1,000,000. The parties have reached a settlement of the suit for an amount that is not significant in relation to the Company's financial statements. 11 The Company has been named as one of 14 defendants in a lawsuit originally filed in the United States District Court for the Southern District of New York, now pending in New York State Supreme Court, Commercial Division. The case is brought by Capital Factors, Inc. ("Capital Factors"), which provided financing to defendant Cosmopolitan Gem Corp. ("Cosmopolitan"), an entity with which the Company has certain consignment and other commercial arrangements. The complaint alleges that Cosmopolitan defrauded Capital Factors into advancing funds to Cosmopolitan by misrepresenting Cosmopolitan's finances and the profitability of its operations, and that the Company, along with other persons and entities, including other jewelry retailers, aided and abetted or participated in the alleged fraud. The complaint asserts against the defendants, including the Company, claims under common law and the Racketeer Influenced and Corrupt Organizations Act ("RICO"). Capital Factors seeks aggregate damages from all of the defendants, including the Company, of $30,000,000, plus unspecified punitive damages, interest and fees. Damages, excluding punitive damages, awarded pursuant to claims asserted under RICO as well as interest on such damages are subject to trebling, within the discretion of the court. The Company has also been named as one of 13 defendants in an amended complaint filed on December 2, 2003 by International Diamonds, L.L.C. ("International") and its affiliate, Astra Diamonds Manufacturers, Ltd. ("Astra"). Astra is an Israeli diamond wholesaler that supplied diamonds to Cosmopolitan; International is a joint venture formed by Cosmopolitan and Astra to sell high quality finished diamond jewelry in the United States. The amended complaint, consolidated with the Capital Factors action described above (the "consolidated Capital Factors actions"), alleges that the Company, along with other jewelry retailers and business affiliates of Cosmopolitan, participated in Cosmopolitan's fraudulent scheme to defraud Capital Factors, and thus injured International and Astra. The complaint asserts claims under common law and RICO, seeking aggregate damages from all of the defendants, including the Company, of $6,800,000 plus interest and fees. Damages awarded pursuant to claims asserted under RICO as well as interest on such damages are subject to trebling, within the discretion of the court. In addition, the complaint alleges claims against the Company for breach of contract for approximately $2,520,000 in goods delivered and invoiced to the Company, for which International has not received payment. In connection with the consolidated Capital Factors actions in New York state court, the Company has filed an interpleader action for declaratory relief, asking the Court to determine the proper parties to whom the Company must pay amounts and deliver goods that are not in dispute related to goods received from Cosmopolitan and certain other entities. In its answer to the interpleader, Capital Factors has asserted that the Company owes Cosmopolitan $8,600,000 in accounts receivable on invoices assigned to Capital Factors. This amount is included in the $30,000,000 of losses that Capital Factors seeks in its RICO claims. In addition, Ultimo, Inc. ("Ultimo"), a jewelry supplier, is a defendant in the International action and in the interpleader action. Ultimo provided certain items of jewelry to the Company on a consignment basis and asserts that: (1) the Company has sold approximately $450,000 worth of such items, the proceeds of which it claims remain in the Company's possession; and (2) the Company continues to possess approximately $1,780,000 worth of its consignment goods. Ultimo asserts that it should receive these consignment proceeds and goods. Capital Factors and International also have asserted claims to these proceeds and goods. The Company plans to place the remaining consignment goods into escrow, and the New York State Supreme Court has announced that it will hold a hearing as early as May 2004 to determine the proper distribution of these consignment goods. The consignment proceeds already have been placed in the Company's outside counsel's escrow account pending court determination of the proper recipient. The Company is not currently aware of any accounts payable due and owing to any of the claimants in this action that are not already reflected in the Company's accounts payable and accrued liabilities. In these consolidated Capital Factors actions, document discovery has begun, but depositions have been stayed until April 19, 2004 upon consent of the parties. In addition, the Company has filed motions to dismiss both the Capital Factors and International/Astra complaints. The motions are currently pending before the court. As previously disclosed, the United States Attorney for the Eastern District of New York is conducting a criminal investigation regarding matters that include those alleged in the consolidated Capital Factors actions. The Company, among others, is a subject of this criminal investigation and is cooperating fully with the United States Attorney. 12 In addition, subsequent to the filing of the complaint by Capital Factors and as previously disclosed, the SEC initiated an informal inquiry into matters that are the subject of the consolidated Capital Factors actions. On November 3, 2003, the Company received a subpoena issued by the SEC as a part of a formal investigation by the SEC with respect to the matters that are the subject of the consolidated Capital Factors actions. The Company produced documents to the SEC in response to the SEC's subpoena and information requests. The Company is cooperating fully with the SEC in connection with this formal investigation. In accordance with Financial Accounting Standards Board Statement No. 5, "Accounting for Contingencies," the Company determines whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. As previously disclosed in a press release furnished to the SEC under cover of a Current Report on Form 8-K dated March 23, 2004, for the fourth quarter of the fiscal year ended January 31, 2004, the Company accrued a litigation reserve of $6.0 million for the consolidated Capital Factors actions and the United States Attorney and SEC investigations. Since March 23, 2004, the Company has engaged in additional settlement negotiations relating to these matters. In light of developments in the ongoing settlement discussions, the Company has accrued an additional reserve for the fourth quarter of the fiscal year ended January 31, 2004, in the amount of $2.6 million, with respect to these matters. There are no assurances that the Company will be able to reach a settlement with any of the parties to the consolidated Capital Factors actions or that such a settlement or settlements, as the case may be, will be for the amount recorded as a reserve. However, the Company currently believes that it is more likely than not that it will reach a settlement or settlements, as the case may be, pertaining to the consolidated Capital Factors actions in the near term. Given the amounts sought in the consolidated Capital Factors actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in excess of the amount recorded could occur and these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. The Company is unable at this time to predict the ultimate outcome of the consolidated Capital Factors actions or the United States Attorney and SEC investigations. Professional fees of approximately $9.6 million incurred as a result of the consolidated Capital Factors actions, the United States Attorney and SEC investigations, and the Company's internal investigation, have been expensed through January 31, 2004. On February 12, 2004, a putative class action complaint captioned Greater Pennsylvania Carpenters Pension Fund, et al. v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1007, was filed in the U.S. District Court for the Northern District of Illinois against the Company and certain of the Company's current and former officers. The complaint makes reference to the litigation filed by Capital Factors Inc. above and to the Company's November 21, 2003 announcement that it had discovered violations of Company policy by the Company's Executive Vice President, Merchandising, with respect to Company documentation regarding the age of certain store inventory. The complaint further makes reference to the Company's December 22, 2003 announcement that it would restate results for certain prior periods. The complaint purports to allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("1934 Act") and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue and inventory during the putative class period of November 19, 2001 to December 10, 2003. On February 18, 2004, a putative class action complaint captioned Michael Radigan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1196, was filed in the U.S. District Court for the Northern District of Illinois against the Company and certain of the Company's current and former officers, charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue and inventory during the putative class period of November 19, 2001 to December 10, 2003. The factual allegations of this complaint are similar to those made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed above. On February 20, 2004, a putative class action complaint captioned Milton Pfeiffer, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1285, was filed in the U.S. District Court for the Northern District of Illinois against the Company and certain of the Company's current and former officers, charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue, accounts payable, inventory, and vendor allowances during the putative class period of November 19, 2001 to December 10, 2003. The factual allegations of this complaint are similar to those made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed above. On April 6, 2004, the District Court in the Greater Pennsylvania Carpenters case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints with the Greater Pennsylvania Carpenters complaint, and on April 14, 2004, granted the plaintiffs up to 60 days from the date to file an amended consolidated complaint. 13 The Company intends to vigorously contest these putative class action complaints and exercise all of its available rights and remedies. Given that these cases are in their early stages, and no substantive proceedings have occurred, it is not possible to evaluate the likelihood of an unfavorable outcome in any of these matters, or to estimate any amount or range of potential loss, if any. While there are many potential outcomes, an adverse outcome in any of these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. It cannot be determined at this stage whether these claims will be resolved in the fiscal year ending January 31, 2005. On January 16, 2004, the Company was named as a defendant in a copyright infringement lawsuit filed in the United States District Court for the District of Minnesota by Janel Russell Designs, Inc. ("Janel Russell Designs"). Janel Russell Designs asserts that the Company is infringing its copyright in a jewelry design by selling infringing merchandise. Janel Russell Designs seeks unquantified damages. Two of the allegedly infringing pieces are supplied to the Company by Samuel Aaron Inc. and one is supplied by Princess Pride Creations. Each of the suppliers has also been sued by Janel Russell Designs in separate lawsuits. Pursuant to language in certain Vendor Trading Agreements the Company entered into with each supplier, the Company tendered the defense of the cases to Samuel Aaron and Princess Pride and demanded indemnification. Both vendors, through counsel, have indicated they will defend and indemnify the Company. The Company filed its answer on March 3, 2004. The Company is also involved from time to time in certain other legal actions and regulatory investigations arising in the ordinary course of business. Although there can be no certainty, it is the opinion of management that none of these other actions or investigations will have a material adverse effect on our results of operations or financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 14 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated herein by reference to section entitled "Market for the Registrant's Common Equity and Related Stockholder Matters" in the Company's 2003 Annual Report, which is included as Exhibit 13 to this Annual Report on Form 10-K. ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference to section entitled "Selected Historical Financial and Operating Data" in the Company's 2003 Annual Report, which is included as Exhibit 13 to this Annual Report on Form 10-K. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated herein by reference to section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 2003 Annual Report, which is included as Exhibit 13 to this Annual Report on Form 10-K. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Incorporated herein by reference to section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 2003 Annual Report, which is included as Exhibit 13 to this Annual Report on Form 10-K. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference to sections entitled "Statements of Operations," "Balance Sheets," "Statements of Stockholders' Equity," "Statements of Cash Flows" and "Notes to Financial Statements" in the Company's 2003 Annual Report, which is included as Exhibit 13 to this Annual Report on Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES The Company's management, with the participation of our Chief Executive Officer and our Chief Financial Officer, carried out an evaluation of the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended). Based upon this evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of January 31, 2004 to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. During the fiscal fourth quarter ended January 31, 2004, the Company (1) instituted a compliance program, as part of which the Company adopted a Code of Business Conduct and Ethics and appointed a Chief Corporate Compliance Officer; (2) implemented improvements in the process by which monthly statements from vendors of outstanding invoices and credits are reconciled to the Company's records; and (3) implemented additional procedures for approving purchases by the Company of merchandise inventory items previously provided to the Company on consignment. There was no other change in the Company's internal control over financial reporting that occurred during the Company's fiscal quarter ended January 31, 2004 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. In addition, following the end of the fourth quarter, the Company hired a Director of Internal Audit, who reports directly to the Chairman of the Audit Committee of the Board of Directors. 15 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the headings "Election of Directors," "Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement (which Proxy Statement we intend to file with the SEC on or about May 17, 2004) is incorporated herein by reference. The Company has adopted a Code of Conduct that applies to all of the Company's employees, officers and directors, including its principal executive officer and principal financial officer. The Company's Code of Conduct covers a variety of areas of professional conduct including conflicts of interest, disclosure obligations, insider trading, confidential information, as well as compliance with all laws, rules and regulations applicable to the Company's business. A copy of the Company's Code of Conduct is posted on its website at www.whitehalljewellers.com. In the event that an amendment to, or a waiver from, a provision of the Company's Code of Conduct that applies to any of the Company's executive officers or directors occurs, the Company intends to post such information on its website. The Company undertakes to provide without charge to any person, upon written or verbal request of such person, a copy of the Company's Code of Conduct. Requests for a copy should be directed in writing to Whitehall Jewellers, Inc., 155 North Wacker Drive, Suite 500, Chicago, Illinois 60606, Attention: John R. Desjardins or by telephone to (312) 782-6800. ITEM 11. EXECUTIVE COMPENSATION Except for information referred to in Item 402(a)(8) of Regulation S-K, the information contained under the headings "Election of Directors" and "Executive Compensation and Other Information" in the Proxy Statement (which Proxy Statement we intend to file with the SEC on or about May 17, 2004) is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement (which Proxy Statement we intend to file with the SEC on or about May 17, 2004) is incorporated herein by reference. EQUITY COMPENSATION PLAN INFORMATION TABLE The following table provides information as of January 31, 2004 regarding the number of shares of the Company's common stock that may be issued under its equity compensation plans.
(a) (b) (c) - -------------------------------------------------------------------------------------------------------------------- Number of securities remaining available for Plan Category Number of securities to be Weighted-average exercise future issuance under issued upon exercise of price of outstanding equity compensation plans outstanding options, options, warrants and (excluding securities warrants and rights rights reflected in column (a)) - -------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security holders 2,745,598 $11.875 508,907
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained under the heading "Certain Relationships and Related Transactions" in the Proxy Statement (which Proxy Statement we intend to file with the SEC on or about May 17, 2004) is incorporated herein by reference. 16 ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The information contained in the Company's Annual Proxy Statement under the section titled "Independent Public Accountants" is incorporated herein by reference in response to this item. 17 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements The following financial statements are filed as part of this report: Statements of Operations of the Company for the years ended January 31, 2004, 2003, and 2002. * Balance Sheets of the Company as of January 31, 2004 and 2003. * Statements of Stockholders' Equity of the Company for the years ended January 31, 2004, 2003, and 2002. * Statements of Cash Flows of the Company for the years ended January 31, 2004, 2003 and 2002. * Notes to Financial Statements. * Report of Independent Auditors. * * Incorporated herein by reference from the Company's 2003 Annual Report. (a)(2) Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts Page 26 Report of Independent Public Accountants on Financial Statement Schedule Page 27 All other schedules for which provision is made in the applicable accounting regulation of the SEC are not required under the related instructions or are inapplicable, and therefore have been omitted. (a)(3) Exhibits Exhibits marked with an asterisk (*) are incorporated by reference to documents previously filed by the Company with the SEC, as indicated. All other documents listed are filed with this Report. EXHIBIT NO. DESCRIPTION - ----------- ----------- *3.1 Second Restated Certificate of Incorporation of the Company. Incorporated by reference to Exhibit 3.1 of the Company's Quarterly Report on Form 10-Q for the period ended April 30, 2002, file No. 0-028176. *3.2 Amended and Restated By-Laws of the Company. Incorporated by reference to Exhibit 3.2 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176. 18 *4.1 Amended and Restated Stockholders Rights Plan. Incorporated by reference to Exhibit 99.2 of the Company's Registration Statement as amended on Form 8-A/A and filed with the Securities and Exchange Commission on April 28, 1999, file No. 0-028176. *4.2 Certificate of Designations of Series A Junior Participating Preferred Stock. Incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794). *4.3 Indenture governing the Notes dated as of April 15, 1996 between the Company and Norwest Bank Minnesota, National Association, as Trustee (the "Indenture"). Incorporated by reference to Exhibit 4.3 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *4.4 Form of Series C Notes (included in Exhibit 4.3 to this Form 10-K). Incorporated by reference to Exhibit 4.6 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *4.5 Form of Series D Notes (included in Exhibit 4.3 to this Form 10-K). Incorporated by reference to Exhibit 4.7 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *4.6 First Supplemental Indenture to Indenture. Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *4.7 Second Supplemental Indenture to Indenture. Incorporated by reference to Exhibit 4.7 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1998, file No. 0-028176. *10.1 Second Amended and Restated Registration Agreement. Incorporated by reference to Exhibit 10.1 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *10.2 Letter Agreements re: Incentive Stock Option dated September 28, 1995 between the Company and each of Hugh M. Patinkin, John R. Desjardins and Matthew M. Patinkin, respectively. Incorporated by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794).(1) *10.3 Letter Agreements re: Restricted Stock Awards dated September 28, 1995 between the Company and each of Hugh M. Patinkin, John R. Desjardins and Matthew M. Patinkin. Incorporated by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794). (1) 19 *10.4 Letter Agreements re: Incentive Compensation dated September 28, 1995 between the Company and each of Hugh M. Patinkin, John R. Desjardins and Matthew M. Patinkin. Incorporated by reference to Exhibit 10.4 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794). (1) *10.5 Company's 1995 Executive Incentive Stock Option Plan. Incorporated by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794). (1) *10.6 1996 Long-Term Incentive Plan, as amended. Incorporated by reference to Exhibit 10.7 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176.(1) *10.7 Lease dated May 14, 1992 between the Company and New York Life Insurance Company relating to the Company's corporate headquarters. Incorporated by reference to Exhibit 10.9 of the Company's Registration Statement on Form S-1, as amended, originally filed on February 29, 1996 (Registration No. 333-1794). *10.8 ESOP Restructuring Agreement, dated as of March 29, 1996, between the Company and the Whitehall Jewellers, Inc. Employee Stock Ownership Trust. Incorporated by reference to Exhibit 10.12 of the Company's Registration Statement on Form S-1 originally filed on May 17, 1996 (Registration No. 333-04043). *10.9 Amended and Restated Employee Stock Ownership Plan. Incorporated herein by reference to Exhibit 10.15 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1997, file No. 0-028176. *10.10 Form of Executive Severance Agreements, as amended, each dated May 7, 1996, between the Company and each of Hugh M. Patinkin, John R. Desjardins and Matthew M. Patinkin. Incorporated by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-3 as originally filed on January 27, 2000 (Registration No. 333-95465).(1) *10.11 Employment and Severance Agreement dated March 17, 1997 between the Company and Manny A. Brown. Incorporated by reference to Exhibit 10.22 filed with the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176.(1) *10.12 Executive Severance Agreement dated November 1, 2000, between the Company, WH Inc. of Illinois, a wholly owned subsidiary of the Company, and Lynn D. Eisenheim. Incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176.(1) 20 *10.13 1997 Long-Term Incentive Plan, as amended. Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the period ended April 30, 2002, File No. 0-028176. (1) *10.14 Form of Stock Option Agreement for Employees under the 1997 Long-Term Incentive Plan. Incorporated by reference to Exhibit 10.16 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176. (1) *10.15 Performance Based Incentive Stock Option Agreements, each dated March 18, 1999 and June 8, 1999, with each of Hugh M. Patinkin, Matthew M. Patinkin, John R. Desjardins, Manny A. Brown and Lynn D. Eisenheim, under the 1997 Long-Term Incentive Plan. Incorporated by reference to Exhibit 10.17 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176. (1) *10.16 Form of Non-Qualified Stock Option Agreement under the 1997 Non-Employee Director Stock Option Plan. Incorporated by reference to Exhibit 10.19 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176. (1) *10.17 Form of Restricted Stock Award Agreement for Executive Officers under the 1997 Long-Term Incentive Plan. Incorporated by reference to Exhibit 10.20 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176.(1) *10.18 Form of Restricted Stock Award Agreement for Non-Employee Directors under the 1997 Long-Term Incentive Plan. Incorporated by reference to Exhibit 10.21 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176. (1) *10.19 1998 Non-Employee Directors Stock Option Plan. Incorporated by reference to Exhibit 99.1 of the Company's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on April 15, 1998 (Registration No. 333-50159). (1) *10.20 Amendment Number One to the 1998 Non-Employee Directors Stock Option Plan. Incorporated by reference to Exhibit 10.14 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176.(1) *10.21 Form of Non-Qualified Stock Option Agreement under the 1998 Non-Employee Director Stock Option Plan. Incorporated by reference to Exhibit 10.24 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2001, file No. 0-028176. (1) *10.22 2003 Special Bonus Program. Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the period ended April 30, 2003, file No. 0-028176. (1) 21 *10.23 Asset Purchase Agreement dated as of June 19, 1998 by and among Whitehall Jewellers, Inc. (f/k/a Marks Bros. Jewelers, Inc.), Carlyle & Co. Jewelers, Carlyle & Co. of Montgomery and J.E. Caldwell Co. Incorporated by reference to Exhibit 2.2 of the Company's Current Report on Form 8-K dated September 10, 1998 and filed with the Securities and Exchange Commission on September 22, 1998, file No. 0-028176. *10.24 Second Amended and Restated Revolving Credit and Gold Consignment Agreement, dated as of July 29, 2003, among the Company, the Banks listed therein, LaSalle Bank National Association, ABN AMRO Bank N.V., and JP Morgan Chase Bank. Incorporated by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the period ended July 31, 2003, file No. 0-028176. *10.25 First Amendment, dated as of March 23, 2004, to the Second Amended and Restated Revolving Credit and Gold Consignment Agreement dated as of July 29, 2003 by and among the Company, LaSalle Bank National Association, as administrative agent for the banks ("Banks") party thereto, the Banks, ABN AMRO Bank, N.V., as syndication agent, JP Morgan Chase Bank, as documentation agent. Incorporated by reference to Exhibit 10.2 of the Company's Form 8-K filed on March 23, 2004, file No. 0-028176. *10.26 Letter Agreement dated December 15, 2003 relating to the Second Amended and Restated Revolving Credit and Gold Consignment Agreement dated as of July 29, 2003 by and among the Company, LaSalle Bank National Association, as administrative agent for the Banks, the Banks, ABN AMRO Bank N.V., as syndication agent, and JP Morgan Chase Bank, as documentation agent. Incorporated by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the period ended October 31, 2003, file No. 0-028176. *10.27 Letter Agreement, dated March 23, 2004, to the Second Amended and Restated Revolving Credit and Gold Consignment Agreement dated as of July 29, 2003 by and among the Company, LaSalle Bank National Association, as administrative agent for the Banks party thereto, the Banks, ABN AMRO Bank, N.V., as syndication agent, JP Morgan Chase Bank, as documentation agent. Incorporated by reference to Exhibit 10.1 of the Company's Form 8-K filed on March 23, 2004, file No. 0-028176. *10.28 401(k) Plan. Incorporated by reference to Exhibit 10.17 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1998, file No. 0-028176. (1) *10.29 Second Amendment to 401(k) Plan. Incorporated by reference to Exhibit 10.19 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176. (1) (2) *10.30 Third Amendment to 401(k) Plan. Incorporated by reference to Exhibit 10.20 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176. (1) 22 *10.31 Fourth Amendment to 401(k) Plan. Incorporated by reference to Exhibit 10.21 of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 1999, file No. 0-028176. (1) *10.32 Whitehall Jewellers, Inc. Employee Stock Purchase Plan. Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on September 28, 2001 (Registration No. 333-70510). (1) 10.33 Separation and Release Agreement dated March 3, 2004 between Jon H. Browne and the Company. (1) 13 The sections in the 2003 Annual Report entitled "Market for the Registrant's Common Equity and Related Stockholder Matters," "Selected Historical Financial and Operating Data," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Statements of Operations," "Balance Sheets," "Statements of Stockholders' Equity," "Statements of Cash Flows," "Notes to Financial Statements" and "Report of Independent Auditors" but only to the extent set forth in Items 5-7, 7A, 8 and 15 hereof. With the exception of the aforementioned information incorporated by reference in this Annual Report on Form 10-K, the 2003 Annual Report is not to be deemed "filed" as a part of this Report. 21 Subsidiaries of the Company 23 Consent of PricewaterhouseCoopers LLP 24 Powers of Attorney (included on signature page) 31.1 Certificate Pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 of the Principal Executive Officer. 31.2 Certificate Pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 of the Principal Financial Officer. 32.1 Certificate Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certificate Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. - --------------- (1) Represents management contract or compensatory plan or arrangement. 23 (2) There is no First Amendment to 401(k) Plan. (b) Reports on Form 8-K On November 6, 2003, the Company filed a Current Report on Form 8-K with the SEC to disclose information regarding a formal inquiry by the Securities and Exchange Commission. On November 10, 2003, the Company filed a Current Report on Form 8-K with the SEC to furnish a press release announcing sales for the third quarter ended October 31, 2003. On November 21, 2003, the Company filed a Current Report on Form 8-K with the SEC to disclose a press release announcing that it has placed its Executive Vice President, Merchandising, on leave. On December 11, 2003, the Company filed a Current Report on Form 8-K with the SEC to disclose a press release announcing the termination of its Chief Financial Officer and commenting on the release of financial results. On December 22, 2003, the Company filed a Current Report on Form 8-K with the SEC to furnish a press release regarding financial results for the third quarter ended October 31, 2003, comparative store sales for November, 2003 and a portion of December, 2003 and a restatement of its results for certain previous periods primarily to reflect non-cash inventory valuation adjustments. On January 29, 2004, the Company filed a Current Report on Form 8-K with the SEC to disclose a press release announcing modifications to its Board of Directors. 24 WHITEHALL JEWELLERS, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS TWELVE MONTHS ENDED JANUARY 31, 2002, 2003 AND 2004 (DOLLARS IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E -------- -------- -------- -------- -------- BALANCE AT CHARGED TO BALANCE AT BEGINNING OF COSTS AND END DESCRIPTION PERIOD EXPENSES DEDUCTION OF PERIOD ----------- ------ -------- --------- --------- Twelve months ended 1/31/02 Allowance for doubtful accounts $1,472 $ 577 $1,376 $ 673 ====== ====== ====== ====== Inventory allowance 3,527 7,475 7,423 3,579 ====== ====== ====== ====== Twelve months ended 1/31/03 Allowance for doubtful accounts $ 673 $1,686 $1,815 $ 544 ====== ====== ====== ====== Inventory allowance 3,579 7,480 7,492 3,567 ====== ====== ====== ====== Twelve months ended 1/31/04 Allowance for doubtful accounts $ 544 $ 663 $ 669 $ 538 ====== ====== ====== ====== Inventory allowance 3,567 5,987 5,823 3,731 ====== ====== ====== ======
25 REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Shareholders of Whitehall Jewellers, Inc.: Our audits of the financial statements referred to in our report dated March 22, 2004 (except for the last paragraph of Note 20 as to which the date is April 15, 2004) appearing in the 2003 Annual Report to Shareholders of Whitehall Jewellers, Inc. (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, the financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. /s/ PricewaterhouseCoopers LLP Chicago, Illinois March 22, 2004, except for the last paragraph of Note 20 of the audited financial statements as to which the date is April 15, 2004 26 SIGNATURES Pursuant to the requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934, this Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: April 15, 2004 WHITEHALL JEWELLERS, INC. (Registrant) By: /s/ John R. Desjardins ----------------------------- John R. Desjardins Executive Vice President, Chief Financial Officer, Treasurer and Secretary (Principal financial and accounting officer) POWER OF ATTORNEY AND SIGNATURES Each of the undersigned officers and directors of Whitehall Jewellers, Inc. hereby severally constitutes and appoints Hugh M. Patinkin and John R. Desjardins, and each of them singly, our true and lawful attorneys, with full power to them and each of them singly, to sign for us in our names in the capacities indicated below, all amendments to this Annual Report on Form 10-K, and generally to do all things in our names and on our behalf in such capacities to enable Whitehall Jewellers, Inc. to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission. 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 indicated on this 15th day of April, 2004.
Name Capacity ---- -------- /s/ Hugh M. Patinkin Chairman, President and Chief Executive Officer - ------------------------------------ (Principal executive officer) and Director Hugh M. Patinkin /s/ Richard K. Berkowitz Director - ------------------------------------ Richard K. Berkowitz /s/ Daniel H. Levy Director - ------------------------------------ Daniel H. Levy /s/ Norman J. Patinkin Director - ------------------------------------ Norman J. Patinkin /s/ Sanford Shkolnik Director - ------------------------------------ Sanford Shkolnik /s/ John R. Desjardins Executive Vice President, Chief Financial Officer, - ------------------------------------ Treasurer and Secretary John R. Desjardins (Principal financial and accounting officer)
EX-10.33 3 c84514v2exv10w33.txt SEPARATION AND RELEASE AGREEMENT EXHIBIT 10.33 SEPARATION AND RELEASE AGREEMENT THIS SEPARATION AND RELEASE AGREEMENT is entered into between Jon H. Browne ("Employee"), and Whitehall Jewellers, Inc., a Delaware corporation ("Whitehall"). WHEREAS, Whitehall and Employee are parties to that certain Employment and Severance Agreement dated as of January 24, 2000 (the "Employment Agreement"). WHEREAS, Whitehall has been named a defendant in International Diamonds, L.L.C., et al. v. Cosmopolitan Gem Corp., et al., Index No. 110101/03 (Sup. Ct., NY Cty.) (the "Capital Factors Action"). WHEREAS, each of Whitehall and Employee is the subject of a criminal investigation by the United States Attorney for the Eastern District of New York regarding the subject matter of the Capital Factors Action and related matters (the "US Attorney Investigation"). WHEREAS, the United States Securities and Exchange Commission (the "SEC") has initiated a formal inquiry into the matters that are the subject of the Capital Factors Action (the "SEC Investigation" and together with the US Attorney Investigation, the "Government Investigations"). WHEREAS, in connection with Whitehall's internal investigation related to the Capital Factors Action and the Government Investigations, Whitehall notified Employee of his termination for Cause (as defined in the Employment Agreement) and determined that it would not be appropriate to advance the legal costs and expenses of Employee related to the Capital Factors Action or the Government Investigations pursuant to the Second Restated Certificate of Incorporation of Whitehall (the "Certificate") and the Amended and Restated By-Laws of Whitehall (the "By-Laws"). WHEREAS, Employee has executed a letter in favor of Whitehall dated October 15, 2003 pursuant to which Employee undertook to repay all defense costs advanced to him with respect to the US Attorney Investigation if it should be ultimately determined that he was not entitled to indemnification pursuant to the Certificate and the By-Laws. WHEREAS, Whitehall and Employee wish to resolve the disputes and potential disputes by and between them with respect to (i) the indemnification of Employee by Whitehall for his defense costs incurred or to be incurred by him in defending the U.S. Attorney Investigation or the SEC Investigation, whether pursuant to the Certificate and By-Laws or otherwise, (ii) the repayment by Employee to Whitehall of defense costs advanced to Employee on or prior to the date hereof, (iii) the indemnification of Employee by Whitehall, whether pursuant to the Certificate and By-Laws or otherwise, with respect to the Capital Factors Action and any other civil action relating to the subject matter thereof and the Government Investigations and any other criminal action relating to the subject matter thereof, and (iv) the grounds for the termination of Employee under the Employment Agreement and amount owed to him thereunder, in each case, as set forth herein, and to avoid expensive and time consuming arbitration and litigation. NOW, THEREFORE, in consideration of the premises and of the mutual covenants, conditions and premises contained herein, the parties agree as follows: 1. WAIVER AND RELEASE: A. Except for breaches of this Agreement, Employee and each of his past, present and future spouses, family, relatives, successors, heirs, executors, administrators, trustees, agents, representatives, affiliates and assigns and each and every person or entity that purports to assert rights or claims through him or on his behalf (collectively, the "Employee Releasing Parties"), individually and collectively, hereby fully, finally and forever waive and unconditionally release, acquit and discharge each of Whitehall and its past, present and future affiliates, employee benefit plans and programs and other related entities (whether or not wholly owned) and the past, present and future officers, directors, employees, agents, shareholders, trustees, fiduciaries, administrators, attorneys and representatives of each of them, and any other person or entity in privity with any of them (collectively, the "Whitehall Released Parties") from, and covenant and agree not to sue any of the Whitehall Released Parties with regard to any and all claims, whether currently known or unknown, which Employee now has, ever has had or may ever have against any of the Whitehall Released Parties arising from or related to: (i) Employee's employment the Whitehall or the termination thereof, including but not limited to claims of wrongful discharge; breach of contract; employment discrimination under the Civil Rights Act of 1866, Title VII of the Civil Rights Act of 1964, the Civil Rights Act of 1991, the Age Discrimination in Employment Act, the Americans with Disabilities Act, the Rehabilitation Act of 1973, the Illinois Human Rights Act, the Chicago Human Rights Ordinance, and/or the Cook County Human Rights Ordinance, or any other statutory or common law causes of action; (ii) any demand, action, claim, liability, obligation, cost, expense, debt, cause of action, or lawsuit arising from or relating to the claims asserted in the Capital Factors Action or the Government Investigations or any other civil or criminal action arising from or relating to the subject matter thereof, including any claim for indemnification pursuant to the Certificate, the By-laws or the Delaware General Corporation Law, as the same exist or as they may be amended from time to time; and (iii) except as expressly contemplated hereby, the Employment Agreement, including any claim for any payment pursuant to section 4, 5 or 7 thereof. B. Notwithstanding the generality of the foregoing, Employee does not waive and/or release any rights that he may have to benefits under the United HealthCare Options Preferred Provider Organization Plan, the Cigna Dental PPO, Exec-U-Care Group Medical Reimbursement Insurance, the Whitehall Jewellers, Inc. 401(k) Plan, the Whitehall Jewellers, Inc., 1997 Long-Term Incentive Plan and grants thereunder, the Blanket Accident Insurance Program and the Voluntary Long-Term Disability Plan (the "Plans") to which Employee may be entitled as a result of his employment by Whitehall through the Termination Date; provided that - 2 - for the purposes of determining what rights Employee has under any of the Plans, the termination of the employment of Employee under the Employment Agreement shall be deemed to have been for Cause and shall be a Nonqualifying Termination thereunder. C. Except for breaches of this Agreement, Whitehall hereby fully, finally and forever waives and unconditionally releases, acquits and discharges Employee from, and covenants and agrees not to sue Employee with regard to any and all claims which Whitehall now has, ever has had or may ever have against Employee arising from or related to (i) any obligation of Employee to repay amounts advanced to Employee for defense costs related to the Government Investigations prior to the date hereof and (ii) any demand, action, claim, liability, obligation, cost, expense, debt, cause of action, or lawsuit arising from or relating to the claims asserted in the Capital Factors Action or the Government Investigations. D. Employee and Whitehall represent and warrant to each other that he/it has the full right and power to grant, execute, and deliver the releases, undertakings and agreements contained in this Agreement. Whitehall represents and warrants to Employee that as of the date hereof it does not have knowledge of any claim that Whitehall has against Employee other than any claim arising from or relating to the claims asserted in the Capital Factors Action or the Government Investigations. For purposes of the preceding sentence, "knowledge" shall mean the actual conscious awareness of the directors and executive officers of Whitehall. 2. EMPLOYEE'S TERMINATION DATE: Employee's employment with Whitehall terminated effective December 25, 2003 (the "Termination Date") for all purposes. 3. PAYMENTS ON BEHALF OF EMPLOYEE: Whitehall agrees to advance reasonable defense costs incurred by Employee in defending against the US Attorney Investigation, the SEC Investigation, the Capital Factors Action or any other civil or criminal action arising from the subject matter thereof up to a maximum of $293,000 (such amount to include fees and expenses advanced prior to the date hereof and fees and expenses advanced pursuant to Section 10.C. below). Such costs shall be advanced by Whitehall only after receipt of copies of appropriate invoices from Jenner & Block LLP or such other legal counsel of national prominence as employee may retain. 4. CONTINUED COOPERATION: Employee agrees to continue to cooperate with Whitehall in connection with the Capital Factors Action, the Government Investigations and Whitehall's internal investigation relating thereto, including by making himself reasonably available for interviews. Nothing in this Section 4 shall obligate Employee to incur any out-of-pocket expense, and Whitehall agrees to pay all reasonable out-of-pocket expenses that Employee incurs in providing any cooperation Whitehall may request. For purposes of clarification, such out-of-pocket expenses shall not include attorneys' fees or expenses, but shall include items such as travel expenses. 5. BENEFIT CONTINUATION: Employee may elect to continue his group health insurance, dental insurance, Exec-U-Care coverage and long-term disability insurance with respect to Employee and his dependents for the greatest of (i) the 12-month period following the - 3 - Termination Date, (ii) the period provided pursuant to the terms of the plan or (iii) if the coverage or insurance is subject to COBRA, the COBRA continuation period. In any case, for the 12-month period immediately following the Termination Date (and only for such period), the costs of such continuation shall be shared by Whitehall and Employee in the same proportion as such costs were shared immediately prior to the Termination Date. 6. DIRECTORS AND OFFICERS LIABILITY INSURANCE; INDEMNIFICATION: Whitehall agrees that, notwithstanding the termination of Employee's employment with Whitehall, Whitehall shall, for at least 3 years after the Date of Termination, use all reasonable efforts to have Employee included as a named insured or otherwise covered for actions or failure to act by Employee in his capacity as a director or officer of Whitehall to at least the same extent as other executive officers or directors, as the case may be, of Whitehall under any directors or officers liability insurance policies maintained by Whitehall; provided that the additional cost of providing coverage with a retroactive date including Employee's period of service or with an extended reporting period or a combination of both does not materially increase the cost of Whitehall's directors and officers insurance. Whitehall agrees that it will not alter the indemnification provisions in the Certificate or By-laws so as to give Employee less protection thereunder with respect to periods during which Employee served Whitehall as an executive officer or other employee as is afforded other executive officers or peer employees, as the case may be, with respect to periods during which they serve Whitehall. 7. OTHER PAYMENTS OR BENEFITS: The parties understand and agree that the Employee is entitled to no payments or benefits of any kind, other than those set forth above. 8. WITHHOLDING TAXES: Whitehall may withhold from all payments due to Employee or to be paid on behalf of Employee hereunder all taxes which, by applicable federal, state, local or other law, Whitehall is required to withhold therefrom. 9. DISCLOSURE: Employee acknowledges that Whitehall may file a copy of this Agreement with the SEC and, therefore, that the terms hereof will be publicly disclosed. Notwithstanding the preceding, Employee and Whitehall agree not to disclose any information with respect to the negotiation of this Agreement to any person other than Employee's spouse, his attorney, officers and directors of Whitehall who have a need to know such information, or as may be otherwise required by law or stock exchange rules. 10. OTHER UNDERTAKINGS: A. Employee agrees that, during his employment with Whitehall, he has had access to and/or has acquired confidential information of Whitehall and its affiliates, including strategic and tactical business, financial, profit, marketing, analytical and sales information, vendor pricing agreements and contract details and internal organizational structure, and trade secrets belonging to Whitehall ("Confidential Information"). Accordingly, Employee agrees that he shall not directly or indirectly use, disclose, or take any action that may result in the use by or disclosure to any person or entity of any Confidential Information of Whitehall, unless such - 4 - information lawfully has become generally available to the public not as a result of a breach of this Agreement by Employee, or except as otherwise required by law. B. Employee shall not take any action, verbal or otherwise, that would be reasonably likely to disparage or damage the reputation or operations of Whitehall or any of the other Whitehall Released Parties. C. Subject to the limitations set forth in Section 3, Whitehall shall reimburse Employee for reasonable legal fees and expenses incurred by Employee for the review and/or negotiation by legal counsel of this Agreement. 11. NON-ADMISSION: The parties agree that this Agreement is not intended to and does not constitute any admission of fault, wrongdoing, responsibility or liability on the part of Whitehall or Employee. 12. ACKNOWLEDGMENTS: Employee hereby acknowledges that he is entering into this Agreement knowingly and voluntarily, and further acknowledges that: A. this Agreement is written in a manner understood by Employee; B. this Agreement refers to and specifically waives claims under the Age Discrimination in Employment Act, as amended, except to the extent that such claims arise after the date of this Agreement; C. Employee has received valuable consideration, to which he would not otherwise have been entitled, in exchange for the waiver and release of claims included in this Agreement; D. Employee has been advised by Whitehall in writing to consult with an attorney prior to executing this Agreement; E. Employee may take up to 21 days from receipt of this Agreement to consider whether to sign the Agreement; and F. Employee shall have seven days following execution to revoke this Agreement (in which case this Agreement shall be null and void and neither Employee nor Whitehall shall any obligations under it), and the Agreement shall not take effect until those seven days have expired. 13. COMPLETE AGREEMENT: The parties agree that this Agreement supersedes and renders null and void all previous agreements of any kind between the parties, except as stated herein. The parties further agree that no promise or inducement has been offered for this Agreement other than as set forth herein. - 5 - 14. APPLICABLE LAW: The provisions of this Agreement shall be governed by the laws of the State of Illinois. WHEREFORE, the parties have affixed their signatures below. /s/ Jon H. Browne Whitehall Jewellers, Inc. - ----------------------------------- Signature of Employee Jon H. Browne By: /s/ Hugh Patinkin - ------------------------------------ -------------------------------- Printed Name of Employee Its: CEO ---------------------------- 3/3/04 3/5/04 - ------------------------------------- ------------------------------------ Dated Dated - 6 - EX-13 4 c84514v2exv13.txt SECTIONS OF 2003 ANNUAL REPORT EXHIBIT 13 SELECTED HISTORICAL FINANCIAL AND OPERATING DATA The following table sets forth certain financial and operating data of the Company. The selected statement of operations data and balance sheet data as of and for the fiscal year ended January 31, 2004 (fiscal 2003) and each of the four prior fiscal years are derived from audited financial statements of the Company. The selected financial information set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's audited financial statements appearing elsewhere herein.
(In thousands, except per share and selected operating data) Fiscal 2003 Fiscal 2002 Fiscal 2001 Fiscal 2000 Fiscal 1999 - ----------------------------------------------------------------------------------------------------------------------- STATEMENT OF OPERATIONS DATA: Net sales $ 344,655 $ 341,037 $ 338,911 $ 355,065 $ 315,406 Cost of sales (including buying and occupancy expenses) 217,622 213,242 207,227 217,344 182,898 - ----------------------------------------------------------------------------------------------------------------------- Gross profit 127,033 127,795 131,684 137,721 132,508 Selling, general and administrative expenses (1) 114,624 104,891 108,481 112,706 91,874 Professional fees and other charges(2) 21,874 2,899 1,494 2,894 3,378 - ----------------------------------------------------------------------------------------------------------------------- (Loss) income from operations (9,465) 20,005 21,709 22,121 37,256 Interest expense 4,110 4,341 6,902 5,757 5,819 - ----------------------------------------------------------------------------------------------------------------------- (Loss) income before income taxes (13,575) 15,664 14,807 16,364 31,437 Income tax (benefit) expense (4,861) 5,970 5,153 6,103 12,103 - ----------------------------------------------------------------------------------------------------------------------- (Loss) income before cumulative effect of accounting change (8,714) 9,694 9,654 10,261 19,334 Cumulative effect of accounting change, net (3) -- -- -- (3,068) -- - ----------------------------------------------------------------------------------------------------------------------- Net (loss) income $ (8,714) $ 9,694 $ 9,654 $ 7,193 $ 19,334 ======================================================================================================================= DILUTED EARNINGS PER SHARE: (Loss) income before cumulative effect of accounting change $ (0.62) $ 0.64 $ 0.66 $ 0.64 $ 1.28 Selected Operating Data: Stores open at end of period 380 370 364 348 290 Average net sales per store (4) $ 925,000 $ 925,000 $ 952,000 $ 1,116,000 $ 1,163,000 Average net sales per gross square foot (5) $ 1,066 $ 1,068 $ 1,093 $ 1,286 $ 1,319 Average merchandise sale $ 285 $ 302 $ 304 $ 319 $ 303 Comparable store sales (decrease) increase (6) (0.6%) (1.9%) (10.7%) (1.7%) 11.0% Balance Sheet Data (at end of period) Merchandise inventories $ 206,146 $ 196,694 $ 173,098 $ 184,185 $ 147,691 Working capital 45,678 57,777 52,658 46,074 31,338 Total assets 286,997 272,479 252,091 261,926 219,363 Total debt 80,980 99,630 45,667 61,860 59,007 Stockholders' equity, net 105,768 117,901 113,145 103,058 71,928
(1) In fiscal 2002, the Company adopted Financial Accounting Standards Board Statement No. 142, "Goodwill and Other Intangible Assets," and has discontinued amortization of goodwill. (See Note 7) (2) Includes legal, accounting and consulting services expenses, litigation charges and severance accruals. (3) Reflects net cumulative effect in the change in accounting for layaway sales. (4) Average net sales per store represents the total net sales for stores open for a full fiscal year divided by the total number of such stores. (5) Average net sales per gross square foot represents total net sales for stores open for a full fiscal year divided by the total square feet of such stores. (6) Comparable store sales are defined as net sales of stores which are operating for the month in the current reporting period as well as open for the same month during the prior year reporting period. Fiscal year 1999 includes sales from the acquired Jewel Box stores from February through July 1999 and from October through January 2000. 1 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the Company's financial statements, including the notes thereto. This section contains statements that constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Forward-Looking Statements disclosure at the end of this section. OVERVIEW The Company is a leading national retailer of fine jewelry (based on number of stores) operating 380 stores in 38 states as of January 31, 2004. The Company offers a selection of merchandise in the following categories: diamond, gold, precious and semi-precious jewelry and watches, an approach oriented toward the Company's target customer base, middle to upper-middle income men and women over 25 years of age. Jewelry purchases are discretionary for consumers and may be particularly affected by adverse trends in the general economy and perceptions of such conditions affecting disposable consumer income. During the first half of fiscal 2003, a lackluster economy, lower consumer confidence and an unstable geopolitical environment resulted in lower comparable store sales than in the prior fiscal year. However, general economic conditions and consumer confidence improved in the second half of fiscal 2003 and along with increased sales generated from new sales focused initiatives and the expansion of the watch lines carried in inventory, comparable store sales in the last six months of fiscal 2003 increased 5.3% over the prior year period. Comparable store sales for the full fiscal year of 2003 decreased $1.9 million, or 0.6%, from the prior year. Notwithstanding the increase in sales during the second half of fiscal 2003, the Company experienced a net loss of $8.7 million for fiscal 2003, versus net income of $9.7 million for fiscal 2002. During fiscal 2003, the Company, among other parties, was named in several lawsuits, which allege that Cosmopolitan Gem Corp. defrauded Capital Factors, Inc. and the Company, among other parties, aided and abetted in the alleged fraud. The Company's fiscal 2003 net loss resulted primarily from a significant increase in expenses in the fourth quarter of fiscal 2003, principally relating to the Capital Factors civil litigation, investigations of the United States Attorney's Office and the Securities and Exchange Commission (the "SEC") of the matters alleged in the Capital Factors litigation and an internal investigation by the Company, through outside counsel and under the direction of the Board of Directors, in connection with these matters. Professional fees increased by approximately $8.6 million in the fourth quarter over the prior year. While the Company expects increased professional fees to continue, such fees have been significantly lower since the end of fiscal 2003. In addition, as previously disclosed in a press release furnished to the SEC under cover of a Current Report on Form 8-K dated March 23, 2004, during the fourth quarter of the fiscal year ended January 31, 2004, the Company accrued a litigation reserve of $6.0 million in connection with the consolidated Capital Factors actions and the United States Attorney and SEC investigations. Since March 23, 2004, the Company has engaged in additional settlement negotiations relating to these matters. In light of developments in the ongoing settlement discussions, the Company has accrued an additional reserve for the fourth quarter of the fiscal year ended January 31, 2004, in the amount of $2.6 million, with respect to these matters. (See Note 16 to the financial statements.) There are no assurances that the Company will be able to reach a settlement with any of the parties to the consolidated Capital Factors actions, or that such a settlement or settlements, as the case may be, will be for the amount recorded as a reserve. However, the Company currently believes that it is more likely than not that it will reach a settlement or settlements, as the case may be, pertaining to the consolidated Capital Factors actions in the near term. The Company is unable at this time to predict the ultimate outcome of the consolidated Capital Factors actions or the United States 2 Attorney and SEC investigations. Lastly, the Company also recorded $1.0 million in the fourth quarter for certain severance related costs that were governed by existing severance agreements. The Board of Directors of the Company has adopted corporate governance guidelines designed to formalize existing Board practices, such as regular meetings of the non-executive directors, and to address other governance matters, such as criteria for Board membership. In addition, the composition of the Board of Directors has been changed, resulting in a higher percentage of independent directors. The Board also is considering additional measures designed to enhance the continued independence of the Board. As a result of the Company's internal investigation described above and the terminations of the Company's Chief Financial Officer and Executive Vice President, Merchandising, arising out of that investigation, the Board and management are undertaking several changes in the Company's management structure. In particular, the Company is in the process of conducting a search for a Chief Operating Officer, a newly created position, who will have significant responsibility for the day-to-day operations of the Company. In addition, the Company plans to hire a new Executive Vice President, Merchandising. The Company also plans to hire a General Counsel, a newly created position, who will oversee all legal matters and serve as the Company's Chief Corporate Compliance Officer. The Company has already hired a Director of Internal Audit who reports directly to the Chairman of the Audit Committee of the Board of Directors. These changes will result in an increase in the Company's personnel costs. During February 2004, the Company was named in several putative class action complaints, as further described in Note 16 to the financial statements. The Company intends to vigorously contest these complaints and exercise all of its rights and remedies. The Company's business is highly seasonal. During fiscal 2003, a significant portion of the Company's sales, and net income of $4.3 million, was generated during the fourth fiscal quarter ending January 31, 2004, as compared to a net loss of $13.0 million experienced in the previous three quarters. Historically, income generated in the fourth fiscal quarter ending each January 31 represents all or a majority of the income generated during the fiscal year. The Company has historically experienced lower net sales in each of its first three fiscal quarters and expects this trend to continue. The Company's quarterly and annual results of operations may fluctuate significantly as a result of factors including, among others: increases or decreases in comparable store sales; the timing of new store openings; net sales contributed by new stores; timing of certain holidays and Company-initiated special events; changes in the Company's merchandise; marketing or credit programs; general economic, industry, weather conditions and disastrous national events that affect consumer spending as well as pricing, merchandising, marketing, credit and other programs of competitors. 3 RESULTS OF OPERATIONS The following table sets forth for the periods indicated certain information derived from the statements of operations of the Company expressed as a percentage of net sales for such periods.
Percentage of net sales Fiscal 2003 Fiscal 2002 Fiscal 2001 - --------------------------------------------------------------------------------------- Net sales 100.0% 100.0% 100.0% Cost of sales (including buying and occupancy expenses) 63.1 62.5 61.1 - --------------------------------------------------------------------------------------- Gross profit 36.9 37.5 38.9 Selling, general and administrative expenses 33.3 30.8 32.0 Professional fees and other charges 6.3 0.8 0.5 - --------------------------------------------------------------------------------------- (Loss) income from operations (2.7) 5.9 6.4 Interest expense 1.2 1.3 2.0 - --------------------------------------------------------------------------------------- (Loss) income before income taxes (3.9) 4.6 4.4 Income tax (benefit) expense (1.4) 1.8 1.5 - --------------------------------------------------------------------------------------- Net (loss) income (2.5%) 2.8% 2.9% =======================================================================================
FISCAL 2003 COMPARED TO FISCAL 2002 NET SALES Net sales increased $3.7 million, or 1.1%, to $344.7 million in fiscal 2003 from $341.0 million in fiscal 2002. Comparable store sales decreased $1.9 million, or 0.6%, in fiscal 2003. The slower economy and lower consumer confidence had a negative impact on sales, which was partially offset by increased sales generated from new promotional initiatives, including semi-annual two-day events and the enhancement of other special promotions and the expansion of the watch lines carried in inventory. These new initiatives were introduced primarily during the first three quarters of fiscal 2003. Comparable store sales in the first six months of fiscal 2003 decreased 7.9% while comparable sales in the last six months of fiscal 2003 increased 5.3%. Additionally, sales were lower by $6.5 million due to store closings and stores closed for remodeling for limited periods and by $1.9 million due to changes in sales returns and allowances, of which, $0.3 million was due to fiscal 2003 reserve activity. The remaining $1.6 million change in the reserve for sales returns and allowances reflects the historical trends in returns which are governed by the Company's return policies and management's initiatives to ensure compliance with those policies which resulted in a reduction in the sales returns and allowances in fiscal 2002. These decreases were offset by sales from new store openings of $14.0 million. The Company plans to significantly reduce new store openings in fiscal 2004. The total number of merchandise units sold increased 7.7% in fiscal 2003 compared to fiscal 2002 while the average price per item sold decreased by approximately 5.7% to $285 in fiscal 2003 from $302 in fiscal 2002. The decline in average price per merchandise sale and the increase in the number of merchandise units sold was primarily due to a significant increase in the number of lower price-point advertised items sold during promotional events during fiscal 2003 compared to fiscal 2002. The Company plans to continue these promotional initiatives in fiscal 2004. The Company opened 21 new stores and closed 11 stores during fiscal 2003, increasing the number of stores operated to 380 as of January 31, 2004 from 370 as of January 31, 2003. 4 GROSS PROFIT Gross profit decreased $0.8 million, or 0.6%, to $127.0 million in fiscal 2003, from $127.8 million in fiscal 2002. As a percentage of net sales, gross profit decreased to 36.9% in fiscal 2003 from 37.5% in fiscal 2002. The gross profit rate was negatively impacted by an increase in the cost of gold and an increase mix in watch sales, which carry a lower margin than other categories, a decrease in the mix of diamond and gold merchandise sales which carry a higher gross margin, as well as the competitive pricing environment. These declines in gross margin were partially offset by lower inventory cost associated with higher vendor discounts and allowances compared to the same period in the prior year. Store occupancy and buying expenses, which increased at a higher rate than the increase in sales, also contributed to the reduction in gross profit percentage. In response to the increased cost of gold, beginning in March 2004, the Company has increased prices of certain items, primarily in gold merchandise categories, which may result in gross profit rate improvements. The Company expects higher watch sales to have a continued negative impact on gross profit rate. EXPENSES Selling, general and administrative expenses, excluding professional fees and other charges, in fiscal 2003 increased $9.7 million, or 9.3%, to $114.6 million from $104.9 million in fiscal 2002. As a percentage of net sales, selling, general and administrative expenses increased to 33.3% in fiscal 2003 from 30.8% in fiscal 2002. Higher personnel expense ($3.6 million), higher other expense ($3.9 million), and higher advertising expense ($2.5 million) were partially offset by lower credit expense ($0.5 million). These dollar increases primarily related to operating costs associated with new store openings. During fiscal 2003, the Company opened 21 new stores, as compared 17 new stores in the prior year. Payroll costs increased primarily due to the increased number of stores and the addition of support office positions and enhancing the hiring requirements and compensation associated with new personnel in fiscal 2003. The increase in other expense is primarily due to the increase in the number of stores, increases in insurance expense ($0.9 million) and increases in accruals for state and local taxes ($0.6 million). Advertising expense increased due to new promotional initiatives in 2003 and the impact of the adoption of Emerging Issues Task Force Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor" ("EITF 02-16") as of the beginning of this fiscal year. To the extent the Company's agreements with merchandise vendors provide credits for co-op advertising, the Company has historically classified such credits as a reduction to advertising expense in selling, general and administrative expenses. EITF 02-16, which was effective for all arrangements entered into after December 31, 2002, requires certain merchandise vendor allowances to be classified as a reduction to inventory cost unless evidence exists supporting an alternative classification. During fiscal year 2003, the Company received $2.7 million of vendor allowances for advertising. Credit expense decreased due to lower historical experience in fiscal 2003 associated with exposures for chargebacks on credit card receivables that have already been collected. The decrease in credit expense was partially offset by higher credit card discounts due to increased credit card sales. Professional fees and other charges increased by $19.0 million to $21.9 million in fiscal 2003 from $2.9 million in fiscal 2002, primarily associated with the Capital Factors matters described in Note 16 in the financial statements. As required by Financial Accounting Standards Board Statement No. 5, "Accounting for Contingencies," the Company determines whether an estimated loss from a loss contingency should be accrued by assessing whether a 5 loss is deemed probable and can be reasonably estimated. As previously disclosed in a press release furnished to the SEC under cover of a Current Report on Form 8-K dated March 23, 2004, during the fourth quarter of the fiscal year ended January 31, 2004, the Company accrued a litigation reserve of $6.0 million for the consolidated Capital Factors actions and the United States Attorney and SEC investigations. Since March 23, 2004, the Company has engaged in additional settlement negotiations relating to these matters. In light of developments in the ongoing settlement discussions, the Company has accrued an additional reserve for the fourth quarter of the fiscal year ended January 31, 2004, of $2.6 million, with respect to these matters. See Note 16 to the financial statements. There are no assurances that the Company will be able to reach a settlement with any of the parties to the consolidated Capital Factors actions or that such a settlement or settlements, as the case may be, will be for the amount recorded as a reserve. However, the Company currently believes that it is more likely than not that it will reach a settlement or settlements, as the case may be, pertaining to the consolidated Capital Factors actions in the near term. Given the amounts sought in the consolidated Capital Factors actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in excess of the amount recorded could occur and could have a material adverse effect on the Company's results of operations, financial condition or liquidity. The Company is unable at this time to predict the ultimate outcome of the consolidated Capital Factors actions or the United States Attorney and SEC investigations. Professional fees of approximately $9.6 million incurred as a result of the consolidated Capital Factors actions, the United States Attorney and SEC investigations, and the Company's internal investigation, have been expensed through January 31, 2004. The Company also recorded approximately $1.0 million for certain severance related costs that were governed by existing severance agreements. (LOSS) INCOME FROM OPERATIONS As a result of the factors discussed above, loss from operations was $9.5 million in fiscal 2003 compared to income from operations of $20.0 million in fiscal 2002. As a percentage of net sales, loss from operations was 2.7% in fiscal 2003 as compared to income from operations in fiscal 2002 of 5.9%. INTEREST EXPENSE Interest expense decreased $0.2 million, or 5.3%, to $4.1 million in fiscal 2003 from $4.3 million in fiscal 2002. The decrease in interest expense resulted from lower average interest rates, which were partially offset by higher average outstanding borrowings and the write-off of deferred loan costs associated with the prior credit facility. INCOME TAX (BENEFIT) EXPENSE Income tax effective rate decreased in fiscal 2003 to 35.8% from 38.1% in fiscal 2002. The income tax benefit associated with the loss in fiscal 2003 was partially offset by a change in the Company's valuation allowance with respect to the Company's current expected ability to use certain state income tax net operating loss carry forwards, resulting in a decrease in the effective tax rate. 6 FISCAL 2002 COMPARED TO FISCAL 2001 NET SALES Net sales increased $2.1 million, or 0.6%, to $341.0 million in fiscal 2002 from $338.9 million in fiscal 2001. Comparable store sales decreased $6.4 million, or 1.9%, in fiscal 2002. Additionally, sales were lower by $5.8 million due to store closings and stores closed for remodeling for limited periods. These decreases were offset by sales from new store openings of $12.5 million and a reduction in the reserve for sales returns and allowances of $1.6 million. The total number of merchandise units sold slightly increased compared to fiscal 2001, while the average price per merchandise item sold decreased by approximately 0.7% to $302 in fiscal 2002 from $304 in fiscal 2001, reflecting a continued reduction in consumer demand for higher priced items. Comparable store sales decreased in fiscal 2002 primarily due to the recession and lower consumer confidence. The reduction in the reserve for sales returns and allowances reflects the historical trends in returns which are governed by the Company's return policies and management's initiatives to ensure compliance with those policies. Credit sales increased to 40.6% in fiscal 2002 from 40.1% in fiscal 2001. Higher third party credit sales resulted from more aggressive promotional credit activities which were partially offset by lower third party finance contract sales. The Company opened 17 new stores and closed 11 stores during fiscal 2002, increasing the number of stores operated to 370 as of January 31, 2003 from 364 as of January 31, 2002. GROSS PROFIT Gross profit decreased $3.9 million, or 3.0%, to $127.8 million in fiscal 2002 from $131.7 in fiscal 2001. As a percentage of net sales, gross profit decreased to 37.5% in fiscal 2002 from 38.9% in fiscal 2001. During fiscal 2002, gross merchandise margin declined by approximately 100 basis points compared to fiscal 2001. This decline resulted from, among other things, an increase in promotional pricing activity and an increase in the mix of sales of lower margin diamond merchandise. Store occupancy and buying expenses which increased at a higher rate than the increase in sales, also contributed to the reduction in gross profit percentage. These declines in gross profit were somewhat offset by better experience associated with sales returns and allowances. In August 2002, the Company delivered gold to its banks extinguishing all existing Company gold consignment obligations under the Credit Agreement. This had the effect of increasing the weighted average cost of gold available for retail sale by the Company, resulting in a higher weighted average cost of sales in future periods. The Company then estimated that future costs of sales would be approximately $1.5 million greater based on the effect of the transaction on the weighted average cost of gold product in its inventory. Approximately $725,000 of this increase in cost of sales is reflected in the year ended January 31, 2003. This purchase increased the Company's inventory by $20.5 million and was funded by revolver loan borrowings. EXPENSES The Company's continued efforts to improve its expense structure resulted in a decrease in selling, general and administrative expenses, excluding professional fees and other charges, of $3.6 million, or 3.3%, to $104.9 million in fiscal 2002 from $108.5 million in fiscal 2001, while opening 17 new stores. As a percentage of net sales, selling, general and administrative expenses decreased 7 to 30.8% in fiscal 2002 from 32.0% in fiscal 2001. The dollar decrease was primarily related to lower personnel expense ($2.0 million), lower other expenses ($2.9 million) and lower advertising costs ($0.5 million), somewhat offset by higher credit expense ($2.3 million). Selling, general and administrative expense attributable to 17 stores opened in fiscal 2002 and 27 stores opened in fiscal 2001 were absorbed in developing the overall reduction in selling, general and administrative expense and were partially offset by greater reductions achieved in existing stores. Payroll costs decreased in fiscal 2002 as compared to fiscal 2001 as a result of continued efforts to reduce store payroll hours and control labor rates. The decrease in other expenses resulted from, among other things, centralized control of the consumption of certain supplies and services along with reductions in negotiated rates for these items. Advertising costs decreased in fiscal 2002, as compared to fiscal 2001, due to the Company's efforts to reduce production costs through a competitive bidding process and increased vendor funding of promotional initiatives. The increase in credit expense relates to, among other things, a significant increase in the use of one year no interest promotions for which the Company pays a higher fee to the third party credit provider, higher credit sales volume, and higher bad debt expense. The increase in bad debt expense versus fiscal 2001 relates to reductions taken in the accounts receivable reserve in fiscal 2001, which are established to address exposures to chargebacks on credit receivables that have already been collected. These reserves were reduced in fiscal 2001 as a result of improved credit practices, reductions in the use of third party finance contract sales and management's belief that the Company's exposure was diminished. The reserve calculation assumptions remained unchanged in fiscal 2002. Professional fees and other charges increased $1.4 million, or 94.0%, to $2.9 million in fiscal 2002 from $1.5 million in fiscal 2001. This increase primarily related to an additional litigation accrual related to the California wage hour class action suit discussed in Note 16 to the financial statements. (LOSS) INCOME FROM OPERATIONS As a result of the factors discussed above, income from operations decreased to $20.0 million in fiscal 2002 from $21.7 million in fiscal 2001. As a percentage of net sales, income from operations decreased to 5.9% in fiscal 2002 from 6.4% in fiscal 2001. INTEREST EXPENSE Interest expense decreased $2.6 million, or 37.1%, to $4.3 million in fiscal 2002 from $6.9 million in 2001. The decrease in interest expense resulted from lower average outstanding borrowings and lower average interest rates. INCOME TAX (BENEFIT) EXPENSE Income tax effective rate increased in fiscal 2002 to 38.1% from 34.8% in fiscal 2001. The Company expects to utilize certain income tax net operating losses over the next fifteen to twenty years. LIQUIDITY AND CAPITAL RESOURCES The Company's cash requirements consist principally of funding inventory for existing stores, capital expenditures and working capital (primarily inventory) associated with the Company's new stores. The Company's primary sources of 8 liquidity have historically been cash flow from operations and bank borrowings under the Company's Second Amended and Restated Revolving Credit and Gold Consignment agreement dated July 29, 2003 (the "Credit Agreement"), as amended effective March 23, 2004. As of January 31, 2004, the calculated revolver borrowing base availability, pursuant to the Credit Agreement, exceeded the maximum availability of $125.0 million. The Company had $80.3 million of outstanding borrowings under the revolving loan facility as of January 31, 2004. FISCAL 2003 The Company's cash flow provided by operating activities was $36.9 million in fiscal 2003 compared to cash flow used in operating activities of $20.1 million in fiscal 2002. Increases in accounts payable ($36.1 million), accrued expenses ($13.1 million) and accrued payroll ($1.2 million) were offset by increases in merchandise inventories ($9.5 million), current income tax benefit ($2.3 million) and accounts receivable ($0.9 million) and decreases in income taxes payable ($3.3 million) and deferred income taxes ($3.1 million). Cash used in investing activities included the funding of capital expenditures of $11.5 million, related primarily to the opening of 21 new stores in fiscal 2003, compared to $8.6 million used for capital expenditures in 2002. The Company utilized cash for financing activities in fiscal 2003 primarily to (i) decrease revolver borrowing ($14.2 million), (ii) make principal payments on the term loan ($4.5 million), (iii) purchase 321,400 shares of common stock at an average price of $11.92 per share under the Stock Repurchase Program ($3.8 million), (iv) pay financing costs ($1.0 million) associated with the second amended and restated credit facility, and (v) decrease outstanding checks ($2.3 million). Cash generated by financing activities included proceeds from the exercise of options ($0.3 million). Stockholders' equity decreased to $105.8 million at January 31, 2004 from $117.9 million at January 31, 2003. FISCAL 2002 The Company's cash flow used in operating activities was $20.1 million in fiscal 2002 compared to cash flow provided by operating activities of $45.2 million in fiscal 2001. Decreases in accounts payable ($34.4 million) in order to gain cash discounts and increases in merchandise inventories ($3.1 million) as compared to a prior year decrease in inventory ($14.1 million) and increase in accounts payable ($7.7 million) were the significant changes in fiscal 2002. Cash used in investing activities included the funding of capital expenditures of $8.6 million, related primarily to the opening of 17 new stores in fiscal 2002 compared to $12.7 million used for capital expenditures in 2001. Cash generated by financing activities included revolver borrowings ($59.2 million) and proceeds from the exercise of options ($1.6 million). The Company utilized cash for financing activities in fiscal 2002 primarily to (i) purchase gold to settle the gold consignment facility ($20.5 million), (ii) make scheduled principal payments on the term loan ($5.3 million) and (iii) repurchase 605,600 shares of common stock under the Stock Repurchase Program announced July 23, 2002 ($6.5 million). Stockholders' equity increased to $117.9 million at January 31, 2003 from $113.1 million at January 31, 2002. OTHER LIQUIDITY AND CAPITAL RESOURCES ELEMENTS During fiscal 2003, the Company amended and restated its $166.5 million credit facility. The Company has a total $125.0 million revolving credit facility through July 28, 2007, which includes a gold consignment facility of up to $40.0 million. Interest rates and commitment fees charged on the unused facility float based on the Company's quarterly performance. Since these interest rates are determined by reference to LIBOR or prime rates, changes in market interest rates can materially affect the Company's interest expense. Borrowings under the revolver are limited to a 9 borrowing base determined based on the levels of the Company's inventory and accounts receivable. Availability under the revolver is based on amounts outstanding thereunder. The Company amended the Credit Agreement effective March 23, 2004 in order to, among other things, (i) add a Layaway Reserve to the Borrowing Base (each as defined in the Credit Agreement), (ii) add and amend certain financial covenants including, amending the Fixed Charge Coverage Ratio (as defined in the Credit Agreement) and adding a covenant to maintain a Net Worth (as defined in the Credit Agreement) of at least $90.0 million at January 31, 2005, (iii) cap the borrowings under the facility to a maximum of $85.0 million for at least thirty consecutive calendar days during the period December 15, 2004 through and including February 15, 2005, (iv) increase the interest rate at which LIBOR based borrowings are available under the Credit Agreement to LIBOR plus 2.5% through April 30, 2005, (v) set the Commitment Fee Rate (as defined in the Credit Agreement) at 0.5% through April 30, 2005, and (vi) set the Standby Letter of Credit Fee Rate (as defined in the Credit Agreement) at 2.0% through April 30, 2005. The Company periodically determines the value of the unused facility based upon a formula the result of which varies with fluctuations in inventory and receivable levels and aggregate borrowings. The peak outstanding borrowing under the Company's revolver during fiscal 2003 and 2002 was $110.4 million and $111.9 million, respectively. The unused facility and availability was $42.6 million as of January 31, 2004. Cash receipts are applied against the outstanding borrowings on a daily basis in accordance with the credit facility provisions. On October 29, 2003, the Company entered into a letter agreement with its lenders which clarified and supplemented the Credit Agreement with respect to the consolidated Capital Factors actions, the SEC investigation and the investigation by the United States Attorney. Pursuant to the letter agreement, the lenders under the Credit Agreement reserved their rights to determine that the consolidated Capital Factors actions, the SEC investigation or the United States Attorney's investigation constituted a breach of the Credit Agreement. As of March 22, 2004, the Company and its lenders entered into a new letter agreement which rescinded the October 29, 2003 letter agreement. Pursuant to the new letter agreement, the lenders under the Credit Agreement have agreed that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC investigation and the United States Attorney's investigation have not resulted in a breach of the Credit Agreement. In addition, the lenders have agreed that none of these matters will give rise to a default or event of default under the Credit Agreement so long as the resolution of such matters does not involve the payment by the Company of Restitution (which is defined below) in an amount in excess of $15.0 million, or does not result in the indictment of the Company or any of its current officers, directors or employees with principal financial or accounting responsibilities. The new letter agreement also states that any settlement involving the payment of Restitution in excess of $15.0 million shall constitute a default under the Credit Agreement or any indictment of the Company or any of the persons described above may constitute a default under the Credit Agreement. "Restitution" is defined as any restitution paid by the Company (whether cash or non-cash or current or deferred consideration) arising from a civil settlement or award and/or criminal penalties paid or payable in connection with the Capital Factors litigation, the SEC investigation and/or the United States Attorney investigation and any other actions or proceedings directly related thereto; excluding, however, (i) amounts paid by the Company for consignment inventory held on behalf of the parties involved in the Capital Factors litigation, (ii) amounts already accrued on the books of the Company for the purchase of merchandise from the parties involved in the Capital Factors litigation and (iii) the value of any consigned inventory returned to parties involved in the Capital Factors litigation. 10 At this time the Company does not expect the payment of Restitution to exceed $15.0 million and, based on the Company's current financial plan, expects to be in compliance with all financial covenants as set forth in the Credit Agreement in 2004. Subject to the contingencies identified in Note 16 to the financial statements and other risks, including those identified in Forward-Looking Statements, management expects that based on our current financial plan the cash flow from operating activities and funds available under the Company's revolving credit facilities should be sufficient to support the Company's current new store expansion program, seasonal working capital needs and liabilities that may arise with respect to the Capital Factors related matters and the investigations of the United States Attorney's Office and the SEC. Additionally, the Company intends to vigorously contest the putative class action complaints and exercise all of its available rights and remedies. Given that these class action cases are in their early stages, and no substantive proceedings have occurred, it is not possible to evaluate the likelihood of an unfavorable outcome in any of these matters, or to estimate any amount or range of potential loss, if any. While there are many potential outcomes, an adverse outcome in these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. It cannot be determined at this stage whether these claims will be resolved in the fiscal year ending January 31, 2005. If the Company were to trigger an event of default pursuant to the March 22, 2004 letter agreement the Company may be required to negotiate relief with its lenders or to seek new financing. There is no assurance that new financing arrangements would be available on acceptable terms or at all. If the existing lenders were to cease funding under the revolving loan facility or require immediate repayment and if the Company were not able to arrange new financing on acceptable terms, this would have a material adverse effect on the Company, which could affect the underlying valuation of its assets and liabilities. In the near term, the Company expects increased professional fees associated with the matters discussed in Note 16 to the financial statements to continue into fiscal 2004, thereby impacting earnings and cash flow. However, such fees have been significantly lower since the end of fiscal 2003. A substantial portion of the merchandise sold by the Company is carried on a consignment basis prior to sale or is otherwise financed by vendors, thereby reducing the Company's direct capital investment in inventory. The peak consigned inventories from merchandise vendors were $99.0 million and $85.7 million during fiscal 2003 and 2002, respectively. The willingness of vendors to enter into such arrangements may vary substantially from time to time based on a number of factors, including the merchandise involved, the financial resources of vendors, interest rates, availability of financing, fluctuations in gem and gold prices, inflation, the financial condition of the Company, the vendors' understanding that the Company bears risk of loss but does not possess title, and a number of economic or competitive conditions in the jewelry business or the general economy. Any change in these relationships could have a material adverse effect on the Company's results of operations or financial condition. On July 23, 2002, the Company announced that the Board of Directors had established a Stock Repurchase Program covering up to $25.0 million of its common stock. During fiscal 2003, the Company repurchased an additional 321,400 shares at a total cost of $3.8 million under the program. As of January 31, 2004, the Company had repurchased a total of 927,000 shares at a total cost of $10.3 million under this program. 11 The Company's inventory levels and working capital requirements have historically been highest in advance of the Christmas season. The Company has funded these seasonal working capital needs through borrowings under the Company's revolver and increases in trade payables and accrued expenses. INTEREST RATE RISK The Company's exposure to changes in interest rates relate primarily to its borrowing activities to fund business operations. The Company principally uses floating rate borrowings under its revolving credit facility. The Company currently does not use derivative financial instruments to protect itself from fluctuations in interest rates. The information below summarizes the Company's interest rate risk associated with debt obligations outstanding as of January 31, 2004. The table presents principal cash flows and related interest rates by fiscal year of maturity or repricing date.
(in thousands) 2004 2005 2006 Total - ---------------------------------------------------------------------------------------------------------- Variable rate (a) $ 80,340 --- --- $ 80,340 Average interest rate 3.25% --- --- 3.25% Fixed rate $ 640 --- --- $ 640 Average interest rate 12.15% --- --- 12.15% - ----------------------------------------------------------------------------------------------------------
(a) All term loans are variable rate, which reprice within 2004. Interest rates charged on the facility float based on the Company's quarterly financial performance. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities" (the effective date of which was amended in September 1999 by FASB Statement No. 137 "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133 -- an amendment of FASB Statement No. 133"). This Statement was further amended in June 2000 by FASB Statement No. 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement No. 137." SFAS 133 and the amendments found in SFAS No. 138 require that entities recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Effective February 1, 2001, the Company adopted SFAS 133, as amended, with no impact on its financial statements. GOLD PRICE RISK The Company does not hedge gold price changes. Current increases in gold prices have had and may have a future negative impact on gross margin to the extent sales prices for such items do not increase commensurately. DIAMOND PRICE RISK Recent increases in diamond prices may have a future negative impact on gross margin to the extent that sales prices for such items do not increase commensurately. INFLATION The Company believes that inflation generally has not had a material effect on the results of its operations. There is no assurance, however, that inflation will not materially affect the Company in the future. 12 CONTRACTUAL OBLIGATIONS The following summarizes the Company's contractual obligations at January 31, 2004: PAYMENTS DUE BY PERIOD
Less than More than (in thousands) Total 1 year 1 - 3 Years 3 - 5 Years 5 years - ----------------------------------------------------------------------------------------------------------------------- Revolver $ 80,340 $ --- $ -- $ 80,340 $ -- Accrued interest 206 206 -- -- -- Subordinated debt 640 640 -- -- -- Purchase obligations 1,547 1,547 -- -- -- Operating leases 217,150 30,065 85,275 66,975 34,835 - ----------------------------------------------------------------------------------------------------------------------- Total contractual obligations $ 299,883 $32,458 $85,275 $147,315 $ 34,835 - -----------------------------------------------------------------------------------------------------------------------
In the normal course of business, the Company issues purchase orders to vendors for purchase of merchandise inventories. The outstanding amount of these purchase orders is not included in the above table, as the purchase orders may be cancelled at the option of the Company without penalty. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company's critical accounting policies and estimates, including the assumptions and judgments underlying them, are disclosed in the Notes to the Financial Statements. These policies have been consistently applied in all material respects and address such matters as revenue recognition, inventory valuation, depreciation methods and asset impairment recognition. While the estimates and judgments associated with the application of these policies may be affected by different assumptions or conditions, the Company believes the estimates and judgments associated with the reported amounts are appropriate in the circumstances. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors. ACCOUNTS RECEIVABLE Accounts receivable consist primarily of customer credit card charges and other non-recourse third party credit arrangements for merchandise delivered to the customer for which the Company has not yet received payment under the terms of the arrangements. Allowance for doubtful accounts represents reserves established to address exposures to chargebacks on credit receivables that have already been collected. The Company accrues an estimate of expected chargebacks based on the Company's historical chargeback experience. MERCHANDISE INVENTORIES Merchandise inventories are stated principally at the lower of weighted average cost or market. Purchase cost is reduced to reflect certain allowances and discounts received from merchandise vendors. Periodic credits or payments from merchandise vendors in the form of consignment buydowns, volume or other purchase discounts and other vendor consideration are reflected in the carrying value of the inventory and recognized as a component of cost of sales as the merchandise is sold. Additionally, to the extent it is not addressed by established vendor return privileges, and if the amount of cash consideration received from the vendor exceeds the estimated fair value of the goods returned, that excess amount is reflected as a reduction in the purchase cost of the inventory acquired. Allowances for inventory shrink, scrap and other provisions are recorded based upon analysis and estimates by the Company. To the extent the Company's agreements with merchandise vendors provide credits for co-op advertising, the Company has historically classified such credits as a reduction to advertising expense in selling, general and 13 administrative expenses. EITF 02-16, which was effective for all arrangements entered into after December 31, 2002, requires certain merchandise vendor allowances to be classified as a reduction to inventory cost unless evidence exists supporting an alternative classification. In prior years, certain vendors reimbursed the Company for certain co-op advertising costs that were incurred. In 2003, the Company changed the terms of its Vendor Trading Agreements to include a vendor allowance for advertising calculated as a percentage of merchandise purchases. During fiscal year 2003, the Company received $2.7 million of vendor allowances for advertising. The Company records such allowances as a reduction of inventory cost and as the inventory is sold, the Company will recognize a lower cost of sales. The Company also obtains merchandise from vendors under various consignment agreements. The consigned inventory and related contingent obligations associated with holding and safekeeping such consigned inventory are not reflected in the Company's financial statements. At the time of sale of consigned merchandise to customers, the Company records the purchase liability and the related consignor cost of such merchandise in cost of sales. LEGAL CONTINGENCIES The Company is involved in certain legal matters and other claims including those discussed in Note 16 to the financial statements. As required by Financial Accounting Standards Board Statement No. 5, "Accounting for Contingencies," the Company determines whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. The Company analyzes its legal matters and other claims based on available information to assess potential liability. The Company consults with outside counsel involved in our legal matters when analyzing potential outcomes. The reserve for these matters totaled $8.6 million at January 31, 2004. Based on the nature of such estimates, it is possible that future results of operations or net cash flows could be materially affected if actual outcomes are significantly different than management's estimates related to these matters. REVENUE RECOGNITION The Company recognizes revenue in accordance with the Securities and Exchange Commission Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". Revenue from merchandise sales is recognized when delivery has occurred and title and risk of loss have transferred to the customer. The Company accrues an estimate of expected returns, which have not yet been presented, based on its historical returns experience, which is governed by the Company's merchandise returns policy. Repair revenues are recognized when the service is complete and the merchandise is delivered to the customer. The Company recognizes revenue, net of cost reimbursed to an unrelated third party service provider, from the sale of an extended warranty and service contract at the time the contract is executed with the customer. The Company records revenue from layaway program sales at the time the customer fulfills the terms of the program, including receipt of full payment and delivery of the merchandise to the customer. The Company charges the customer on a monthly basis to cover the costs of administration of inactive layaways. ACCOUNTING FOR STOCK BASED COMPENSATION The Company follows Accounting Principles Board Opinion No. 25 ("APB No. 25") "Accounting for Stock Issued to Employees" and the related interpretations in accounting for its stock option plans. Since the stock option plans meet certain criteria of APB No. 25, the Company does not recognize any compensation cost in the income statement. Financial Accounting Standards Board Statement No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation" issued subsequent to APB No. 25, defines a "fair value based method" of accounting for employee stock options but allows 14 companies to continue to measure compensation cost for employee stock options using the "intrinsic value based method" prescribed in APB No. 25. The Company believes that applying the intrinsic value based method of accounting for stock options prescribed by APB No. 25 is a critical accounting policy because application of SFAS 123 would require the Company to estimate the fair value of employee stock options at the date of the grant and record an expense in the income statement over the vesting period for the fair value calculated, thus reducing net income and earnings per share. The Company has no immediate plans at this time to voluntarily change its accounting policy to the fair value based method; however, the Company continues to evaluate this alternative. In accordance with SFAS 123, the Company has been disclosing in the Notes to the Financial Statements the impact on net income and earnings per share as if the fair value based method was adopted. ACCOUNTING FOR BUSINESS COMBINATIONS AND GOODWILL AND OTHER TANGIBLES In accordance with the Financial Accounting Standard Board Statement No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets," the Company evaluates goodwill for impairment on an annual basis in the fourth quarter or earlier whenever indicators of impairment exist. SFAS 142 requires that if the carrying value of a reporting unit for which the goodwill relates to exceeds its fair value, an impairment loss is recognized to the extent that the carrying value of the reporting unit goodwill exceeds the "implied fair value" of reporting unit goodwill. As discussed in the notes to the financial statements, the Company evaluated goodwill using discounted cash flow and a market multiple approach for impairment and concluded that no impairment currently exists. The Company believes that the accounting estimate related to determining fair value is a critical accounting estimate because: (1) it is highly susceptible to change from period to period because it requires Company management to make assumptions about the future cash flows over several years in the future and (2) the impact that recognizing an impairment would have on the assets reported on our balance sheet as well as our results of operations could be material. Management's assumptions about future cash flows requires significant judgment and actual cash flows in the future may differ significantly from those forecasted today. NEW ACCOUNTING PRONOUNCEMENTS ACCOUNTING FOR STOCK BASED COMPENSATION The Financial Accounting Standards Board issued Statement No. 148 ("SFAS 148"), "Accounting for Stock-Based Compensation-Transition and Disclosure", during fiscal 2002. This Statement amends SFAS 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and amends the disclosure requirements to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted the disclosure requirements of this statement as of January 31, 2003. ACCOUNTING FOR GUARANTEES The Financial Standards Accounting Board issued FASB Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," and interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34. Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences while the officer or director is serving, or was serving, at its request in such 15 capacity. The maximum potential amount of future payments the Company could be required to make pursuant to indemnification obligations is unlimited; however, the Company has purchased directors and officer liability insurance that, under certain circumstances, enables it to recover a portion of certain future amounts paid. The Company has no liabilities recorded for these obligations as of January 31, 2003 and 2004; however, reference should be made to Note 16 to the financial statements with respect to legal contingencies. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES In the past, the Company provided certain office services to Double P Corporation, PDP Limited Liability Company and CBN Limited Liability Company or other companies, from time to time, which own and operate primarily mall-based snack food stores, and in which Messrs. Hugh Patinkin, John Desjardins and Matthew Patinkin own a 52% equity interest. A substantial portion of the remaining equity interest is owned by the adult children and other family members of Norman Patinkin, a member of the Board of Directors. For these services, Double P Corporation paid the Company $700 per month. Effective February 1, 2004, the Company no longer provides these services. Matthew Patinkin previously served as a director of Double P Corporation and one of Norman Patinkin's adult children is a director and chief executive officer of Double P Corporation. Messrs. Hugh Patinkin, John Desjardins and Matthew Patinkin spend a limited amount of time providing services to Double P Corporation, PDP Limited Liability Company and CBN Limited Liability Company. Such services are provided in accordance with the Company's Code of Ethics. In the case of Hugh Patinkin and John Desjardins, these services are performed solely in their capacities as shareholders of Double P Corporation. In the case of Matthew Patinkin, these services are performed in his capacity as a shareholder of Double P Corporation and were previously performed in his capacities as a director as well as a shareholder of Double P Corporation. Messrs. Hugh Patinkin and John Desjardins receive no remuneration for these services other than reimbursement of expenses incurred. Matthew Patinkin receives no remuneration for these services other than the fee he previously received for his services as a director of Double P Corporation. In several cases, the Company and Double P Corporation agreed to divide and separately lease contiguous mall space. The Company and Double P Corporation concurrently negotiated separately with each landlord ("Simultaneous Negotiations") to reach agreements for their separate locations. Since the Company's initial public offering, its policy had required that the terms of any such leases must be approved by a majority of the Company's outside directors. The Company had conducted such negotiations in less than ten situations, since the Company's initial public offering in 1996. The Company's current policy is that it will no longer enter into such Simultaneous Negotiations. The Company offers health insurance coverage to the members of its Board of Directors. The health insurance policy options and related policy cost available to the Directors are the same as those available to the Company's senior level employees. The Company operates a program under which executive officers and directors, and parties introduced to the Company by its executive officers and directors, are permitted to purchase most Company merchandise at approximately ten percent above the Company's cost. During fiscal 2003, such purchases totaled approximately $174,000. CORPORATE GOVERNANCE INITIATIVES As part of its on going work in connection with the Sarbanes-Oxley Act and the related rules and regulations promulgated by the SEC and listing standards adopted by the New York Stock Exchange, the Board of Directors of the Company has adopted corporate governance guidelines designed to formalize existing Board practices, such as regular meetings of the non-executive directors, and to address other governance matters, such as criteria for Board membership. In addition, the composition of the Board of 16 Directors has been changed, resulting in a higher percentage of independent directors. The Board also is considering additional measures designed to enhance the continued independence of the Board. As a result of the Company's internal investigation described elsewhere in this annual report and the recent terminations of the Company's Chief Financial Officer and Executive Vice President, Merchandising arising out of that investigation, the Board and management are undertaking several changes in the Company's management structure. In particular, the Company is in the process of conducting a search for a Chief Operating Officer, a newly created position, who will have significant responsibility for the day-to-day operations of the Company. In addition, the Company plans to hire a new Executive Vice President, Merchandising. The Company also plans to hire a General Counsel, a newly created position, who will oversee all legal matters and serve as the Company's Chief Corporate Compliance Officer. The Company has already hired a Director of Internal Audit who reports directly to the Chairman of the Audit Committee of the Board of Directors. FORWARD-LOOKING STATEMENTS As used herein, references to the "Company," "Whitehall Jewellers," "we," "us," and "our" refer to Whitehall Jewellers, Inc. This report contains certain forward-looking statements (as such term is defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) and information relating to the Company that are based on the current beliefs of management of the Company as well as assumptions made by and information currently available to management including statements related to the markets for our products, general trends and trends in our operations or financial results, plans, expectations, estimates and beliefs. In addition, when used in this report, the words "anticipate," "believe," "estimate," "expect," "intend," "may," "plan," "predict" and similar expressions and their variants, as they relate to the Company or our management, may identify forward-looking statements. Such statements reflect our judgment as of the date of this report with respect to future events, the outcome of which is subject to certain risks, including the factors described below, which may have a significant impact on our business, operating results or financial condition. Investors are cautioned that these forward-looking statements are inherently uncertain. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results or outcomes may vary materially from those described herein. Whitehall Jewellers undertakes no obligation to update forward-looking statements. The following factors, among others, may impact forward-looking statements contained in this report: (1) a change in economic conditions or the financial markets which negatively impacts the retail sales environment and reduces discretionary spending on goods such as jewelry; (2) reduced levels of mall traffic caused by economic or other factors; (3) our ability to execute our business strategy and the related effects on comparable store sales and other results; (4) the extent and results of our store expansion strategy and associated occupancy costs, and access to funds for new store openings; (5) the high degree of fourth quarter seasonality of our business; (6) the extent and success of our marketing and promotional programs; (7) personnel costs and the extent to which we are able to retain and attract key personnel; (8) the effects of competition; (9) the availability and cost of consumer credit; (10) relationships with suppliers; (11) our ability to maintain adequate information systems capacity and infrastructure; (12) our leverage and cost of funds and changes in interest rates that may increase such costs; (13) our ability to maintain adequate loss prevention measures; (14) fluctuations in raw material prices, including diamond, gem and gold prices; (15) developments relating to the consolidated Capital Factors actions and the related Securities and Exchange Commission ("SEC") and United States Attorney's office investigations, shareholder and other civil litigation, including the impact of such developments on our results of operations and financial condition and relationship with our lenders or with our vendors; (16) regulation affecting the industry generally, including regulation of marketing practices; (17) the successful integration of acquired locations and assets into our existing operations; and (18) the risk factors identified from time to time in our filings with the SEC. 17 Whitehall Jewellers, Inc. Statements of Operations For the Years Ended January 31, 2004, 2003 and 2002
(in thousands, except per share data) 2004 2003 2002 - -------------------------------------------------------------------------------------------------- Net sales $ 344,655 $ 341,037 $ 338,911 Cost of sales (including buying and occupancy expenses) 217,622 213,242 207,227 - -------------------------------------------------------------------------------------------------- Gross profit 127,033 127,795 131,684 Selling, general and administrative expenses 114,624 104,891 108,481 Professional fees and other charges 21,874 2,899 1,494 - -------------------------------------------------------------------------------------------------- (Loss) income from operations (9,465) 20,005 21,709 Interest expense 4,110 4,341 6,902 - -------------------------------------------------------------------------------------------------- (Loss) income before income taxes (13,575) 15,664 14,807 Income tax (benefit) expense (4,861) 5,970 5,153 - -------------------------------------------------------------------------------------------------- Net (loss) income $ (8,714) $ 9,694 $ 9,654 - -------------------------------------------------------------------------------------------------- Basic earnings per share: - -------------------------------------------------------------------------------------------------- Net (loss) income $ (0.62) $ 0.67 $ 0.66 - -------------------------------------------------------------------------------------------------- Weighted average common shares 14,098 14,545 14,584 - -------------------------------------------------------------------------------------------------- Diluted earnings per share: - -------------------------------------------------------------------------------------------------- Net (loss) income $ (0.62) $ 0.64 $ 0.66 - -------------------------------------------------------------------------------------------------- Weighted average common shares and common share equivalents 14,098 15,038 14,685 - --------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements. 18 Whitehall Jewellers, Inc. Balance Sheets As of January 31, 2004 and January 31, 2003
(in thousands, except share data) 2004 2003 - ------------------------------------------------------------------------------------------------------- ASSETS Current assets: Cash $ 1,901 $ 2,048 Accounts receivable, net 2,544 1,621 Merchandise inventories 206,146 196,694 Other current assets 875 1,470 Current income tax benefit 2,294 -- Deferred income taxes, net 5,712 2,627 Deferred financing costs 261 510 - ------------------------------------------------------------------------------------------------------- Total current assets 219,733 204,970 Property and equipment, net 60,948 61,634 Goodwill, net 5,662 5,662 Deferred financing costs 654 213 - ------------------------------------------------------------------------------------------------------- Total assets $ 286,997 $ 272,479 ======================================================================================================= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Revolver loans $ 80,340 $ 94,490 Current portion of long-term debt 640 4,500 Customer deposits 3,601 3,454 Accounts payable 60,538 26,784 Income taxes payable -- 3,303 Accrued payroll 4,457 3,282 Other accrued expenses 24,479 11,380 - ------------------------------------------------------------------------------------------------------- Total current liabilities 174,055 147,193 Long-term debt -- 640 Deferred income taxes, net 3,639 3,607 Other long-term liabilities 3,535 3,138 - ------------------------------------------------------------------------------------------------------- Total liabilities 181,229 154,578 Commitments and contingencies Stockholders' equity: Common Stock, ($.001 par value; 60,000,000 shares authorized; 18,055,008 shares and 18,020,968 shares issued, respectively) 18 18 Class B Common Stock, ($1.00 par value; 26,026 shares authorized; 142 shares issued and outstanding) -- -- Additional paid-in capital 106,091 105,795 Retained earnings 39,311 48,025 Treasury stock, (4,134,143 and 3,822,637 shares, respectively, at cost) (39,652) (35,937) - ------------------------------------------------------------------------------------------------------- Total stockholders' equity, net 105,768 117,901 - ------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 286,997 $ 272,479 =======================================================================================================
The accompanying notes are an integral part of the financial statements. 19 Whitehall Jewellers, Inc. Statements of Stockholders' Equity For the Years Ended January 31, 2004, 2003 and 2002
Class B Additional Common Common Paid-in Retained Treasury (in thousands) Stock Stock Capital Earnings Stock - ----------------------------------------------------------------------------------------------------------------------------------- Balance at January 31, 2001 $ 17 $ -- $103,341 $ 28,677 $(28,977) Net income -- -- -- 9,654 -- Exercise of options -- -- 426 -- -- Stock issued under Employee Stock Purchase Plan -- -- -- -- 7 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at January 31, 2002 17 -- 103,767 38,331 (28,970) Net income -- -- -- 9,694 -- Exercise of options 1 -- 2,028 -- (459) Treasury stock repurchase -- -- -- -- (6,548) Stock issued under Employee Stock Purchase Plan -- -- -- -- 40 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at January 31, 2003 18 -- 105,795 48,025 (35,937) Net loss -- -- -- (8,714) -- Exercise of options -- -- 296 -- 40 Treasury stock repurchase -- -- -- -- (3,831) Stock issued under Employee Stock Purchase Plan -- -- -- -- 76 =================================================================================================================================== Balance at January 31, 2004 $ 18 $ -- $106,091 $ 39,311 $(39,652) ===================================================================================================================================
The accompanying notes are an integral part of the financial statements. 20 Whitehall Jewellers, Inc. Statements of Cash Flows For the Years Ended January 31, 2004, 2003 and 2002
(in thousands) 2004 2003 2002 - -------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net (loss) income $ (8,714) $ 9,694 $ 9,654 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 12,209 11,216 10,715 Store closing impairment charge -- -- 822 Loss on disposition of assets 435 146 74 Write-off of deferred loan cost 516 -- -- Changes in assets and liabilities: (Increase) decrease in accounts receivable, net (923) (432) 217 (Increase) decrease in merchandise inventories, net of gold consignment (9,452) (3,143) 14,098 Decrease (increase) in other current assets 595 (246) (536) (Increase) in current income tax benefit (2,294) -- -- (Decrease) increase in deferred taxes, net (3,053) 1,997 2,327 Increase (decrease) in accounts payable 36,100 (34,381) 7,695 Increase (decrease) customer deposits 147 (509) (251) (Decrease) increase in income taxes payable (3,303) 46 384 Increase (decrease) in accrued payroll 1,175 (2,988) 1,100 Increase (decrease) in other accrued expenses 13,099 (1,944) (1,638) Increase in other long-term liabilities 397 478 532 - -------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 36,934 (20,066) 45,193 - -------------------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Capital expenditures (11,509) (8,571) (12,695) - -------------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (11,509) (8,571) (12,695) - -------------------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Borrowing on revolver loan 1,007,773 1,065,170 1,043,464 Repayment of revolver loan (1,021,923) (1,005,957) (1,055,407) Repayment of term loan (4,500) (5,250) (4,250) Purchase of gold to settle gold consignment -- (20,453) (6,118) Proceeds from gold consignment -- -- 3,107 Financing costs (1,117) -- (348) Proceeds from exercise of stock options 296 1,570 426 Proceeds from stock issued under the Employee Stock Purchase Plan 76 40 7 Purchase of treasury stock (3,831) (6,548) -- (Decrease) in outstanding checks (2,346) (628) (13,564) - -------------------------------------------------------------------------------------------------------------------------- Net cash (used in) provided by financing activities (25,572) 27,944 (32,683) - -------------------------------------------------------------------------------------------------------------------------- Net change in cash and cash equivalents (147) (693) (185) - -------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at beginning of period 2,048 2,741 2,926 - -------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 1,901 $ 2,048 $ 2,741 - -------------------------------------------------------------------------------------------------------------------------- Supplemental disclosures of cash flow information: Interest paid during year $ 2,962 $ 2,515 $ 6,372 Income taxes paid during year $ 3,813 $ 3,809 $ 2,274 - --------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the financial statements. 21 Whitehall Jewellers, Inc. NOTES TO FINANCIAL STATEMENTS (1) Description of operations The financial statements of Whitehall Jewellers, Inc. (the "Company") include the results of the Company's chain of specialty retail fine jewelry stores. The Company operates exclusively in one business segment, specialty retail jewelry. The Company has a national presence with 380 and 370 stores located in 38 states operating in regional or super-regional shopping malls as of January 31, 2004 and January 31, 2003, respectively. The consolidated financial statements include the accounts and transactions of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated. (2) Common stock repurchase program On July 23, 2002, the Company announced that the Board of Directors had established a stock repurchase program covering up to $25.0 million of its common stock. During fiscal 2003, the Company repurchased 321,400 shares of common stock under the stock repurchase program at a total cost of approximately $3.8 million. As of January 31, 2004, the Company had repurchased a total of 927,000 shares of common stock under the stock repurchase program at a total cost of approximately $10.4 million. Shares repurchased by the Company reduce the weighted average number of shares of Common Stock outstanding for basic and diluted earnings per share calculations. (3) Summary of significant accounting policies CASH AND CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers any temporary cash investments purchased with an original maturity of three months or less to be cash equivalents. ACCOUNTS RECEIVABLE Accounts receivable consists primarily of customer credit card charges and other non-recourse third party credit arrangements for merchandise delivered to the customer for which the Company has not yet received payment under the terms of the arrangements. Allowance for doubtful accounts represents reserves established to address exposures to chargebacks on credit receivables that have already been collected. The Company accrues an estimate of expected chargebacks based on the Company's historical chargeback experience. MERCHANDISE INVENTORIES Merchandise inventories are stated principally at the lower of weighted average cost or market. Purchase cost is reduced to reflect certain allowances and discounts received from merchandise vendors. Periodic credits or payments from merchandise vendors in the form of consignment buydowns, volume or other purchase discounts and other vendor consideration are reflected in the carrying value of the inventory and recognized as a component of cost of sales as the merchandise is sold. Additionally, to the extent it is not addressed by established vendor return privileges, and if the amount of cash consideration received from the vendor exceeds the estimated fair value of the goods returned, that excess amount is reflected as a reduction in the purchase cost of the inventory acquired. Allowances for inventory shrink, scrap and other provisions are recorded based upon analysis and estimates by the Company. To the extent the Company's agreements with merchandise vendors provide credits for co-op advertising, the Company has historically classified such 22 credits as a reduction to credits as a reduction to advertising expense in selling, general and administrative expenses. Emerging Issues Task Force Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor" which was effective for all arrangements entered into after December 31, 2002, requires certain merchandise vendor allowances to be classified as a reduction to inventory cost unless evidence exists supporting an alternative classification. In prior years, certain vendors reimbursed the Company for certain co-op advertising costs that were incurred. In 2003, the Company changed the terms of its Vendor Trading Agreements to include a vendor allowance for advertising calculated as a percentage of merchandise purchases. During fiscal year 2003, the Company received $2.7 million of vendor allowances for advertising. The Company records such allowances as a reduction of inventory cost and as the inventory is sold, the Company will recognize a lower cost of sales. The Company also obtains merchandise from vendors under various consignment agreements. The consigned inventory and related contingent obligations associated with holding and safekeeping such consigned inventory are not reflected in the Company's financial statements. At the time of sale of consigned merchandise to customers, the Company records the purchase liability and the related consignor cost of such merchandise in cost of sales. PROPERTY AND EQUIPMENT Property and equipment are carried at cost, less accumulated depreciation and amortization. Furniture and fixtures are depreciated on a straight-line basis over estimated useful lives ranging from five to ten years. Software costs are amortized on a straight-line basis over five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the remaining lease term or ten years. Upon retirement or disposition of property and equipment, the applicable cost and accumulated depreciation are removed from the accounts and any resulting gains or losses are included in the results of operations. LONG-LIVED ASSETS When facts and circumstances indicate potential impairment, the Company evaluates the recoverability of long-lived asset carrying values, using projections of undiscounted future cash flows over remaining asset lives. When impairment is indicated, any impairment loss is measured by the excess of carrying values over fair values. GOODWILL Goodwill represents the excess of cost over the fair value of assets acquired in purchase business combinations. Under the Financial Accounting Standards Board Statement No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", goodwill and indefinite lived intangible assets are reviewed annually in the fourth quarter (or more frequently if impairment indicators arise) for impairment. The Company adopted SFAS 142 on February 1, 2002 and has discontinued the amortization of goodwill. The Company reviewed goodwill for impairment as of January 31, 2004 and determined that no impairment existed. DEFERRED FINANCING COSTS In connection with the Company's financing agreements, the Company incurred various financing costs, which have been deferred on the Company's balance sheet and are amortized over the terms of the agreements and included in interest expense. ACCOUNTS PAYABLE Accounts payable include outstanding checks which were $4,166,000 and $6,512,000 as of January 31, 2004 and 2003, respectively. 23 ADVERTISING AND MARKETING EXPENSE The Company expenses the production costs of advertising the first time the advertising takes place, except for direct-response advertising, which is capitalized and amortized over the expected period of future benefit. Advertising expense was $8.5 million and $6.0 million for fiscal year 2003 and 2002, respectively. Direct-response advertising consists primarily of special offers, fliers and catalogs that include value off coupons for the merchandise. STORE PRE-OPENING EXPENSE Expenses associated with the opening of new store locations are expensed in the period such costs are incurred. LEASE EXPENSE The Company leases the premises for its office facilities and all of its retail stores. Certain leases require increasing annual minimum lease payments over the term of the lease. Minimum lease expense under these agreements is recognized on a straight-line basis over the terms of the respective leases. Virtually all leases covering retail stores provide for additional contingent rentals based on a percentage of sales. These costs are expensed in the period incurred. SELF-INSURANCE The Company self-insures or retains a portion of the exposure for losses related to workers compensation and general liability costs. It is the Company's policy to record self-insurance reserves, as determined actuarially, based upon claims filed and an estimate of claims incurred but not yet reported. REVENUE RECOGNITION The Company recognizes revenue in accordance with the Securities and Exchange Commission Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". Revenue from merchandise sales is recognized when delivery has occurred and title and risk of loss have transferred to the customer. The Company accrues an estimate of expected returns, which have not yet been presented, based on its historical returns experience, which is governed by the Company's merchandise returns policy. Repair revenues are recognized when the service is complete and the merchandise is delivered to the customer. The Company recognizes revenue, net of cost reimbursed to an unrelated third party service provider, from the sale of an extended warranty and service contract at the time the contract is executed with the customer. The Company records revenue from layaway program sales at the time the customer fulfills the terms of the program, including receipt of full payment and delivery of the merchandise to the customer. The Company charges the customer on a monthly basis to cover the costs of administration of inactive layaways. EARNINGS PER SHARE Basic earnings per share are computed by dividing net earnings available to holders of common stock by the weighted average number of shares of common stock outstanding. Diluted earnings per share are computed assuming the exercise of all dilutive stock options. Under these assumptions, the weighted average number of common shares outstanding is increased accordingly. INCOME TAXES Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable earnings. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. STOCK BASED COMPENSATION The Financial Accounting Standards Board issued Statement No. 148 ("SFAS 148"), "Accounting for Stock-Based 24 Compensation-Transition and Disclosure," during 2002. This Statement amends Financial Accounting Standards Board Statement No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and amends the disclosure requirements to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted the disclosure requirements of this statement as of January 31, 2003. The Company accounts for stock-based compensation according to Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", which results in no charge to earnings when options are issued at fair market value. The following table illustrates the effect on net income and earnings per share for the fiscal years ended January 31, 2004, 2003 and 2002 if the Company had applied the fair value recognition provisions of SFAS 123, as amended by SFAS 148, to stock-based employee compensation:
(in thousands, except per share amounts) 2004 2003 2002 - --------------------------------------------------------------------------------------------------------- Net (loss) income, as reported $ (8,714) $ 9,694 $ 9,654 Deduct: Total stock-based employee compensation expense determined under fair value based method, net of related tax effects (921) (1,951) (2,459) - --------------------------------------------------------------------------------------------------------- Pro forma net (loss) income $ (9,635) $ 7,743 $ 7,195 - --------------------------------------------------------------------------------------------------------- Earnings per share: Basic-as reported $ (0.62) $ 0.67 $ 0.66 Basic-pro forma $ (0.68) $ 0.53 $ 0.49 Diluted-as reported $ (0.62) $ 0.64 $ 0.66 Diluted-pro forma $ (0.68) $ 0.51 $ 0.49
For purposes of pro forma net income and earnings per share calculations in accordance with SFAS 123, for each option granted during the years ended January 31, 2004, 2003 and 2002 the fair value is estimated using the Black-Scholes option-pricing model. The assumptions used are as follows:
2004 2003 2002 - ----------------------------------------------------------------------------- Risk-free interest rate 3.3% 4.1% 5.1% Dividend yield 0 0 0 Option life 5.5 years 5.5 years 7 years Volatility 60% 62% 44%
MANAGEMENT ESTIMATES The preparation of financial statements in conjunction 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 disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Valuation reserves for inventory, accounts receivable, sales returns and deferred tax assets are significant examples of the use of such estimates. Actual results could differ from those estimates. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended by Statement of Financial Accounting Standards No. 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of Statement No. 133 - an amendment of FASB Statement No. 133", was required to be adopted by the Company for its fiscal year beginning after December 1, 2000. SFAS 133 requires 25 disclosures of the objectives for holding or issuing derivative instruments, the context to understand the objectives and the strategies for achieving the objectives and disclosures related to the impact of derivatives as reflected in the statement of comprehensive income and requires that all derivative instruments be recognized as either assets or liabilities in the balance sheet and measured at their fair values. SFAS 133 also requires changes in the fair value of derivatives to be recorded in each period in current earnings or comprehensive income, depending on the intended use of the derivatives. The Company adopted SFAS 133, as amended, effective February 1, 2001, which had no impact on its financial statements. ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS In August 2001, the Financial Accounting Standards Board issued Statement No. 144 ("SFAS 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144 establishes accounting requirements for impaired long-lived assets to be held and used, long-lived assets to be disposed of other than by sale and long-lived assets to be disposed of by sale. The Company adopted SFAS 144 effective February 1, 2002, which had no impact on its financial statements. ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES In June 2002, the Financial Accounting Standards Board issued Statement No. 146 ("SFAS 146"), "Accounting for Costs Associated with Exit or Disposal Activities." SFAS 146 requires that costs associated with exit or disposal activities after December 31, 2002 be recorded at fair value in the period in which the liability is incurred. The Company adopted SFAS 146 effective January 1, 2003, which had no impact on its financial statements. ACCOUNTING FOR GUARANTEES The Financial Standards Accounting Board issued FASB Interpretation No. 45 ("FIN 45") "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," and interpretation of FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34. Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences while the officer or director is serving, or was serving, at its request in such capacity. The maximum potential amount of future payments the Company could be required to make pursuant to these indemnification obligations is unlimited; however, the Company has purchased directors and officers liability insurance that, under certain circumstances, enables it to recover a portion of certain future amounts paid. The Company has no liabilities recorded for these obligations as of January 31, 2004, however, reference should be made to Note 16 to the financial statements with respect to legal contingencies. (4) Accounts receivable, net Accounts receivable, net included the following as of January 31:
(in thousands) 2004 2003 - --------------------------------------------------------------------------------------- Accounts receivable $ 3,082 $ 2,165 Less: allowance for doubtful accounts (538) (544) - --------------------------------------------------------------------------------------- Accounts receivable, net $ 2,544 $ 1,621 - ----------------------------------------------------------------------------------------
The Company has charged bad debt expense of $973,000, $1,686,000 and $577,000 for doubtful accounts for the years ended January 31, 2004, 2003 and 2002, respectively. 26 (5) Merchandise inventories Merchandise inventories consisted of the following as of January 31:
(in thousands) 2004 2003 - ------------------------------------------------------------------------------------------------ Raw materials $ 9,827 $ 7,657 Finished goods inventory 196,319 189,037 - ------------------------------------------------------------------------------------------------ Merchandise inventories $ 206,146 $ 196,694 ================================================================================================
Raw materials consist primarily of diamonds, precious gems, semi-precious gems and gold. Included within finished goods inventory are allowances for inventory shrink, scrap and miscellaneous costs of $3,731,000 and $3,567,000 for the years ended January 31, 2004 and 2003, respectively. As of January 31, 2004 and 2003, merchandise consignment inventories held by the Company that are not included in its balance sheets total $91,635,000 and $74,924,000, respectively. Certain merchandise procurement, distribution and warehousing costs are allocated to inventory. As of January 31, 2004 and 2003, these amounts included in inventory are $3,500,000 and $3,364,000, respectively. The amounts comprising the overhead pool of capitalizable costs were $5,521,000, $5,566,000 and $5,211,000 for the years ended January 31, 2004, 2003 and 2002, respectively. (6) Property and equipment, net Property and equipment included the following as of January 31:
(in thousands) 2004 2003 - ------------------------------------------------------------------------------------------------------- Furniture and fixtures, and software $ 86,506 $ 77,614 Leasehold improvements 35,098 36,407 - ------------------------------------------------------------------------------------------------------- Property and equipment 121,604 114,021 Accumulated depreciation and amortization (60,656) (52,387) - ------------------------------------------------------------------------------------------------------- Property and equipment, net $ 60,948 $ 61,634 - -------------------------------------------------------------------------------------------------------
Depreciation expense was $11,760,000, $10,704,000 and $9,955,000 for the years ended January 31, 2004, 2003, and 2002, respectively. The Company has recognized impairment charges included in costs of sales, measured as the excess of net book value of furniture, fixtures and leasehold improvements over their fair values, associated with management's decision to close stores. As of January 31, 2004 the Company has completed the closure of eleven stores without requiring significant adjustment to the originally recorded charges and continues to pursue the closure of the remainder. The Company did not record any impairment charges for the fiscal year ended January 31, 2004 and January 31, 2003. The Company recorded $822,000 in impairment charges for the year ended January 31, 2002. The amount of internally developed software capitalized during the year ending January 31, 2004 and 2003 was $115,000 and $53,000, respectively, and is included in furniture, fixtures and software. Amortization of capitalized software for the year ended January 31, 2004 and 2003, was $50,000 and $69,000, respectively. The remaining unamortized costs of internally developed software included in property and equipment as of January 31, 2004 and 2003 was $229,000 and $164,000, respectively. 27 (7) Goodwill, net On September 10, 1998, the Company acquired substantially all of the assets of 36 jewelry stores operating under the Jewel Box name from Carlyle & Co. Jewelers and its affiliates, headquartered in Greensboro, North Carolina. The Company purchased all associated inventory, accounts receivable and fixed assets for approximately $22 million (including fees and other costs) in cash (the "Acquisition"). The Acquisition has been accounted for using the purchase method of accounting, and, accordingly, the purchase price has been allocated to the assets purchased and the liabilities assumed based upon the fair values at the date of Acquisition. The excess of the purchase price over the fair values of the net assets acquired was $6.6 million and has been recorded as goodwill. The Company adopted the provisions of SFAS 142 effective February 1, 2002 and has discontinued the amortization of goodwill. The Company has no other separately identifiable intangible assets. Pursuant to this standard, the Company has completed an assessment of the categorization of its existing goodwill. In addition, the Company completed an analysis of the fair value using both a discounted cash flow analysis and a market multiple approach and has determined that no impairment of goodwill should be recorded. The carrying amount of goodwill as of January 31, 2004 and January 31, 2003 was $5,662,000. The table below shows income before income taxes, net income and earnings per share for the years ended January 31, 2004, 2003 and 2002, adjusted to add back goodwill amortization and related tax effects.
(in thousands, except per share data) 2004 2003 2002 - ----------------------------------------------------------------------------------------- Reported (loss) income before income taxes $ (13,575) $ 15,664 $ 14,807 Add back: Goodwill amortization -- -- 262 - ----------------------------------------------------------------------------------------- Adjusted (loss) income before income taxes $ (13,575) $ 15,664 $ 15,069 ========================================================================================= Reported net (loss) income $ (8,714) $ 9,694 $ 9,654 Add back: After tax impact of goodwill amortization -- -- 171 - ----------------------------------------------------------------------------------------- Adjusted (loss) net income $ (8,714) $ 9,694 $ 9,825 ========================================================================================= Basic earnings per share: Reported net (loss) income $ (0.62) $ 0.67 $ 0.66 After tax impact of goodwill amortization -- -- 0.01 - ----------------------------------------------------------------------------------------- Adjusted (loss) net income $ (0.62) $ 0.67 $ 0.67 ========================================================================================= Diluted earnings per share: Reported net (loss) income $ (0.62) $ 0.64 $ 0.66 After tax impact of goodwill amortization -- -- 0.01 - ----------------------------------------------------------------------------------------- Adjusted (loss) net income $ (0.62) $ 0.64 $ 0.67 =========================================================================================
(8) Other long-term liabilities Included in long-term liabilities at January 31, 2004 and 2003 are $3,535,000 and $3,138,000 respectively, of deferred lease costs. (9) Financing arrangements Effective July 29, 2003, the Company entered into a Second Amended and Restated Revolving Credit, Term Loan and Gold Consignment Agreement (the "Credit Agreement"), with certain members of its prior bank group to provide for a total facility of $125.0 million through July 28, 2007. Interest rates and the commitment fee charged on the unused portion of the facility float based upon the Company's financial performance as calculated quarterly. The Company amended the Credit Agreement effective March 23, 2004 in order to, among other things, (i) add a Layaway Reserve to the Borrowing Base (each as defined in the Credit 28 Agreement), (ii) add and amend certain financial covenants including, amending the Fixed Charge Coverage Ratio (as defined in the Credit Agreement) and adding a covenant to maintain a Net Worth (as defined in the Credit Agreement) of at least $90.0 million at January 31, 2005, (iii) cap the borrowings under the facility to a maximum of $85.0 million for at least thirty consecutive calendar days during the period December 15, 2004 through and including February 15, 2005, (iv) increase the interest rate at which LIBOR based borrowings are available under the Credit Agreement to LIBOR plus 2.5% through April 30, 2005, (v) set the Commitment Fee Rate (as defined in the Credit Agreement) at 0.5% through April 30, 2005, and (vi) set the Standby Letter of Credit Fee Rate (as defined in the Credit Agreement) at 2.0% through April 30, 2005. Under this Credit Agreement, the banks have a collateral security interest in substantially all of the assets of the Company. The Credit Agreement contains certain restrictions including restrictions on investments, payments of dividends, assumption of additional debt, acquisitions and divestitures. The Credit Agreement also requires the Company to maintain a specified ratio of the sum of earnings before interest, taxes, depreciation and amortization plus minimum store rent to the sum of minimum store rent plus cash interest expense. As of January 31, 2004, the calculated revolver availability, pursuant to the Credit Agreement, exceeded the maximum availability of $125.0 million. The Company had $80.3 million of outstanding borrowings under the revolving loan facility as of January 31, 2004. On October 29, 2003, the Company entered into a letter agreement with its lenders which clarified and supplemented the Credit Agreement with respect to the consolidated Capital Factors actions, the SEC investigation and the investigation by the United States Attorney. Pursuant to the letter agreement, the lenders under the Credit Agreement reserved their rights to determine that the consolidated Capital Factors actions, the SEC investigation or the United States Attorney's investigation constituted a breach of the Credit Agreement. As of March 22, 2004, the Company and its lenders entered into a new letter agreement which rescinded the October 29, 2003 letter agreement. Pursuant to the new letter agreement, the lenders under the Credit Agreement have agreed that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC investigation and the United States Attorney's investigation have not resulted in a breach of the Credit Agreement. In addition, the lenders have agreed that none of these matters will give rise to a default or event of default under the Credit Agreement so long as the resolution of such matters does not involve the payment by the Company of Restitution (which is defined below) in an amount in excess of $15.0 million or does not result in the indictment of the Company or any of its current officers, directors or employees with principal financial or accounting responsibilities. The new letter agreement also states that any settlement involving the payment of Restitution in excess of $15.0 million shall constitute a default under the Credit Agreement or any indictment of the Company or any of the persons described above may constitute a default under the Credit Agreement. "Restitution" is defined as any restitution paid by the Company (whether cash or non-cash or current or deferred consideration) arising from a civil litigation settlement or award and/or criminal penalties paid or payable in connection with the Capital Factors litigation, the SEC investigation, and/or the United States Attorney investigation and any other actions or proceedings directly related thereto; excluding however, (i) amounts paid by the Company for consignment inventory held on behalf of the parties involved in the Capital Factors litigation, (ii) amounts already accrued on the books of the Company for the purchase of merchandise from the parties involved in the Capital Factors litigation and (iii) the value of any consigned inventory returned to parties involved in the Capital Factors litigation. 29 At this time, the Company does not expect the payment of Restitution to exceed $15.0 million and, based on the Company's current financial plan, expects to be in compliance with all financial covenants as set forth in the Credit Agreement in 2004. Subject to the contingencies identified in Note 16 to the financial statements and other risks, including those identified in Forward-Looking statements, management expects that based on our current financial plan the cash flow from operating activities and funds available under the Company's revolving credit facilities should be sufficient to support the Company's current new store expansion program, seasonal working capital needs and liabilities that may arise with respect to the Capital Factors related matters and the investigations of the United States Attorney's Office and the SEC. Additionally, the Company intends to vigorously contest the putative class action complaints and exercise all of its available rights and remedies. Given that these class action cases are in their early stages, and no substantive proceedings have occurred, it is not possible to evaluate the likelihood of an unfavorable outcome in any of these matters, or to estimate any amount or range of potential loss, if any. While there are many potential outcomes, an adverse outcome in these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. It cannot be determined at this stage whether these claims will be resolved in the fiscal year January 31, 2005. If the Company were to trigger an event of default pursuant to the March 22, 2004 letter agreement the Company may be required to negotiate relief with its lenders or to seek new financing. There is no assurance that new financing arrangement would be available on acceptable terms or at all. If the existing lenders were to cease funding under the revolving loan facility or require immediate repayment and if the Company were not able to arrange new financing on acceptable terms, this would have a material adverse effect on the Company, which could affect the underlying valuation of its assets and liabilities. In the near term, the Company expects increased professional fees associated with the matters discussed in Note 16 to the financial statements to continue into fiscal 2004, thereby impacting earnings and cash flow. However, such fees have been significantly lower since the end of fiscal 2003. REVOLVER LOAN The revolving loan facility under the Credit Agreement is available up to a maximum of $125.0 million, including amounts consigned under the gold consignment facility, and is limited by a borrowing base computed based on the value of the Company's inventory and accounts receivables. Availability under the revolver is based on amounts outstanding thereunder, including the value of consigned gold, which fluctuates based on gold prices. Interest rates and commitment fees on the unused facility float based on the Company's quarterly financial performance. The interest rates for borrowings under the Credit Agreement are, at the Company's option, based on LIBOR rates or the United States banks' prime rate. Interest is payable monthly for prime borrowings and upon maturity for LIBOR borrowings. The interest expense under the revolver facility for the years ended January 31, 2004, 2003 and 2002 was $2,900,000, $3,008,000 and $4,650,000, respectively, reflecting a weighted average interest rate of 3.2%, 4.2% and 6.4%, respectively. TERM LOAN In connection with the Credit Agreement, the Company paid the term loan amount due under the prior credit agreement, totaling $4.5 million during fiscal 2003. Interest rates for these borrowings were, at the Company's option, 30 based on LIBOR rates or the United States banks' prime rate. Interest was payable monthly for prime borrowings and upon maturity for LIBOR borrowings. Interest rates and the commitment fee charged on the unused facility float based on the Company's quarterly financial performance. The interest expense under the term loan facility for the years ended January 31, 2004, 2003 and 2002 was $72,000, $353,000 and $841,000, respectively reflecting a weighted average interest rate of 3.9%, 4.4% and 6.7%, respectively. GOLD CONSIGNMENT FACILITY The Company has the opportunity to enter into gold consignments with certain third party financial institutions. At this time the Company has no obligations under the gold consignment facility. In the event of a consignment of gold, the Company provides the third party financial institution with title to a certain number of troy ounces of gold held in the Company's existing merchandise inventory in exchange for cash at the current market price of gold. The Company then consigns the gold from the third party financial institution, pursuant to a gold consignment agreement. This agreement entitles the Company to use the gold in the ordinary course of its business. The gold consignment facility is a transfer of title in specified quantities of the gold content of the Company's inventory (a non-financial asset) to a financial institution in exchange for cash. The Company continues to bear responsibility for damage to the inventory, as is the case in all of its consigned inventory arrangements with its other vendors. The Company has accounted for gold consignment transactions as a reduction in its inventories, as it has transferred title to the gold to the financial institution. Similar to other consigned inventories in the possession of the Company (for which the Company bears risk of loss but does not possess title), the value of the inventory is not included in the assets of the Company. The terms of the gold consignment agreement require the Company to deliver the specified quantities of consigned gold back to the third party financial institution at the end of the facility (which currently expires in 2007). Physical delivery can be made from the Company's inventory or from gold acquired by the Company in the open market. As an alternative to physical delivery of these specific troy ounces of gold, the Company can elect to purchase the consigned quantities at the current market price for gold on that date. In August 2002, the Company delivered gold to its banks extinguishing all existing Company gold consignment obligations under the Credit Agreement. The purchase had the effect of increasing the weighted average cost of gold available for retail sale by the Company and resulted in a higher weighted average cost of sales in subsequent periods. The Company estimated subsequent cost of sales as a result of this transaction to be approximately $1.5 million greater based on the effect of the transaction on the weighted average cost of gold product in its inventory prior to this purchase. Approximately $798,000 and $725,000 of this increase in cost of sales is reflected in the year ended January 31, 2004 and 2003, respectively. This purchase increased the Company's inventory by $20.5 million and was funded by revolver loan borrowings. The Company currently has no gold consignment obligations to the banks under the Credit Agreement. The consignment fees totaled $0, $354,000 and $804,000 for the years ended January 31, 2004, 2003 and 2002, respectively, at a weighted average rate of 0.0%, 3.0% and 3.7%, respectively. 31 SUBORDINATED NOTES As of January 31, 2004 and 2003, the Company had Series C Senior Subordinated Notes due 2004 (the "Series C Notes") totaling $640,000 which bear interest at 12.15% per annum payable in cash, with interest payments due quarterly. Interest expense was $78,000 for each of the years ended January 31, 2004, 2003 and 2002, respectively. As of January 31, 2004 and 2003, the current portion and noncurrent portion of long-term debt consisted of the following:
(in thousands) 2004 2003 - ------------------------------------------------------------- Current portion of long-term debt: Term loan $ -- $4,500 Subordinated debt 640 -- - ------------------------------------------------------------- Sub total $ 640 $4,500 - ------------------------------------------------------------- Long-term debt, net of current portion: Subordinated debt $ -- $ 640 - ------------------------------------------------------------- Total $ 640 $5,140 - -------------------------------------------------------------
The final scheduled maturity of the subordinated notes totaling $640,000 is on October 31, 2004. The carrying amount of the Company's borrowings under the Credit Agreement and other long-term borrowings approximates fair value based on current market rates. (10) Deferred financing costs In conjunction with the Company's refinancing of its prior credit agreement with certain members of its prior bank group, deferred financing costs of $516,000 related to the prior credit facility were written off and included in interest expense in fiscal 2003. Costs associated with the second amended and restated credit facility totaling approximately $1.0 million are being amortized over the term of the Credit Agreement. Amortization expense in the years ended January 31, 2004, 2003 and 2002 was $926,000, $511,000 and $487,000, respectively. 32 (11) Income taxes The temporary differences between the tax basis of assets and liabilities and their financial reporting amounts that give rise to a significant portion of the deferred tax asset and deferred tax liability and their approximate tax effects are as follows, as of January 31:
2004 2003 ------------------------ ------------------------ Temporary Temporary (in thousands) Difference Tax Effect Difference Tax Effect - --------------------------------------------------------------------------------------------- Merchandise inventories $ 1,988 $ 775 $ 1,699 $ 664 Accrued rent 3,798 1,481 3,412 1,331 Accounts receivable 872 340 935 365 Sales returns 920 359 709 276 Vacation pay 1,154 450 1,132 441 Severance 900 351 -- -- Litigation reserve 8,572 3,342 1,000 390 Workers' compensation reserve 774 302 -- -- State and local government fees 1,926 752 937 365 State closing payables 121 47 225 88 Other 4 1 183 72 Net operating loss carryforward 1,971 769 858 334 AMT credit carryforward 53 21 -- -- - --------------------------------------------------------------------------------------------- Total deferred tax asset 23,053 8,990 11,090 4,326 - --------------------------------------------------------------------------------------------- Property and equipment, net 14,181 5,530 12,446 4,854 Goodwill 1,584 618 1,160 452 Valuation allowance 1,971 769 -- -- - --------------------------------------------------------------------------------------------- Total deferred tax liability (17,736) (6,917) (13,606) (5,306) - --------------------------------------------------------------------------------------------- Net deferred tax asset (liability) $ 5,317 $ 2,073 $ (2,516) $ (980) - ---------------------------------------------------------------------------------------------
The net current and non-current components of deferred income taxes recognized in the balance sheet at January 31 are as follows:
(in thousands) 2004 2003 - -------------------------------------------------------------------------------------------------------- Net current assets $ 5,712 $ 2,627 Net non-current (liability) (3,639) (3,607) - -------------------------------------------------------------------------------------------------------- Net deferred tax asset (liability) $ 2,073 $ (980) - --------------------------------------------------------------------------------------------------------
At January 31, 2004, the Company also had a state net operating loss of $21,593,000. This net operating loss will expire in tax years 2006 to 2023. A valuation allowance of $769,000 has been established to reflect management's belief that based on the nature of the net operating losses, the jurisdictions involved and consideration of current tax planning strategies, it is currently unlikely that the deferred tax associated with the net operating loss carryforward will be fully realized prior to expiration. The income tax expense for the years ended January 31, consists of the following:
(in thousands) 2004 2003 2002 - ---------------------------------------------------------------------------------------------------------- Current (benefit) expense $ (1,636) $ 3,795 $ 3,548 Deferred tax (benefit) expense (3,225) 2,175 1,605 - ---------------------------------------------------------------------------------------------------------- Total income tax (benefit) expense $ (4,861) $ 5,970 $ 5,153 - ----------------------------------------------------------------------------------------------------------
33 The provision for income taxes on income differs from the statutory tax expense computed by applying the federal corporate tax rate of 34%, 35% and 34% for the years ended January 31, 2004, 2003 and 2002, respectively.
(in thousands) 2004 2003 - --------------------------------------------------------------------------- Taxes computed at statutory rate $(4,616) $ 5,482 State income tax (benefit) expense, net of federal tax effect (1,032) 499 Valuation expense 769 -- Other 18 (11) - --------------------------------------------------------------------------- Total income tax (benefit) expense $(4,861) $ 5,970 - ---------------------------------------------------------------------------
(12) Common stock Following are the number of shares issued and outstanding for each of the Company's classes of Common Stock as of January 31:
Class B Common Stock Common Stock Treasury (in thousands) (par value $.001) (par value $1.00) Stock - --------------------------------------------------------------------------------------------- Balance at January 31, 2001 17,733,387 148 (3,200,876) Conversion of Class B Common Stock 213 (6) -- Exercise of Options/Restricted Shares 76,230 -- -- Issuance of Stock -- -- 667 - --------------------------------------------------------------------------------------------- Balance at January 31, 2002 17,809,830 142 (3,200,209) Exercise of Options/Restricted Shares 211,138 -- (21,418) Purchase of Treasury Stock -- -- (605,600) Issuance of Stock -- -- 4,590 - --------------------------------------------------------------------------------------------- Balance at January 31, 2003 18,020,968 142 (3,822,637) Exercise of Options/Restricted Shares 34,040 -- -- Purchase of Treasury Stock -- -- (321,400) Issuance of Stock -- -- 9,896 - --------------------------------------------------------------------------------------------- Balance at January 31, 2004 18,055,008 142 (4,134,141) - ---------------------------------------------------------------------------------------------
Each share of Class B Common Stock is exchangeable into common stock on a 35.4 for 1 basis. Each share of Common Stock is entitled to one vote, and each share of Class B Common Stock is entitled to 35.4 votes on each matter submitted to stockholders for vote. (13) Earnings per common share Basic earnings per share are computed by dividing net earnings available to holders of common stock by the weighted average number of shares of common stock outstanding. Diluted earnings per share are computed assuming the exercise of all dilutive stock options. Under these assumptions, the weighted average number of common shares outstanding is increased accordingly. 34 The following table reconciles the numerators and denominators of the basic and diluted earnings per share ("EPS") computations for the years ended January 31:
2004 2003 2002 ------------------------------------------------------------------------- (in thousands, except per share amounts) Basic Diluted Basic Diluted Basic Diluted - -------------------------------------------------------------------------------------------------------------------- EPS Numerator: Net (loss) income $ (8,714) $ (8,714) $ 9,694 $ 9,694 $ 9,654 $ 9,654 EPS Denominator: Average common shares outstanding: 14,098 14,098 14,545 14,545 14,584 14,584 Effect of dilutive securities: Stock options -- -- -- 493 -- 101 - --------------------------------------------------------------------------------------------------------------------- Total shares 14,098 14,098 14,545 15,038 14,584 14,685 - --------------------------------------------------------------------------------------------------------------------- Earnings per share $ (0.62) $ (0.62) $ 0.67 $ 0.64 $ 0.66 $ 0.66 - --------------------------------------------------------------------------------------------------------------------- Stock options excluded from the calculation of diluted earnings per share (due to their antidilutive effect on the calculation) -- 1,240 -- 606 -- 1,133 - ---------------------------------------------------------------------------------------------------------------------
(14) Employee benefit plans Effective October 1, 2001, the Company established an Employee Stock Purchase Plan ("ESPP") for the benefit of substantially all employees. Employees become eligible to participate in the ESPP after six consecutive months of employment and the employee's customary employment is more than 20 hours per week. Through employee contributions to the ESPP, the employee can purchase common stock of the Company at 90% of the market value. Effective October 1, 1997, the Company established a 401(k) Plan (the "Plan") for the benefit of substantially all employees, the assets of which are not commingled with Company funds. Employees become eligible to participate in the Plan after one year of service, which is defined as at least one year of employment and 1,000 hours worked in that year. The Company may make discretionary contributions to the Plan. No such discretionary contributions have been made since inception. In 1988, the Company established an Employee Stock Ownership Plan (the "ESOP"), which is a noncontributory plan established to acquire shares of the Company's Class B Common Stock for the benefit of all employees. In conjunction with completion of the Company's initial public offering and recapitalization of its financing arrangements, the Company restructured the ESOP. As of January 31, 1998, all remaining shares had been released to participants. As long as the stock is publicly traded the Company is not required to repurchase shares from ESOP participants. However, if the Company were to cease being public, the Company's shares held by the ESOP would be subject to redemption at market value. As of January 31, 2004 and 2003, there were approximately 425,000 and 470,000 Company shares with a market value of approximately $3.9 million and $4.7 million held by ESOP, respectively. The only remaining activity of the ESOP is to make distributions to existing participants or beneficiaries. (15) Stock plans In April 1996, the Company approved the 1996 Long-Term Incentive Plan (the "1996 Plan"). Under the 1996 Plan, the Company may grant incentive stock options ("ISOs") within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, or nonqualified stock options. 35 In addition, the Company may grant stock appreciation rights ("SARs"), bonus stock awards which are vested upon grant, stock awards which may be subject to a restriction period and specified performance measures and performance shares. Performance shares are rights, contingent upon the attainment of the performance measures within a specified performance period, to receive one share of common stock, which may be restricted, or the fair market value of such performance share in cash. No compensatory options have been granted under the 1996 Plan during fiscal 2003. A total of 1,156,784 shares of common stock have been reserved for issuance under the 1996 Plan. Grants may be made under the 1996 Plan during the ten years after its effective date. Options granted under the 1996 Plan generally vest in four equal annual installments and expire ten years after the date of grant. Options and shares granted under the plans are subject to forfeiture based on, among other things, the nature and timing of the termination of employment. The Company approved the 1997 Long-Term Incentive Plan (the "1997 Plan") on February 24, 1997 and the stockholders adopted the 1997 Plan on June 5, 1997. On June 8, 1999, June 1, 2000 and June 11, 2002, the stockholders adopted amendments to the 1997 Plan to increase the common stock reserved for issuance under the 1997 Plan. Under the 1997 Plan, the Company may grant ISOs or nonqualified stock options. The 1997 Plan also provides for the grant of SARs, bonus stock awards which are vested upon grant, stock awards which may be subject to a restriction period and specified performance measures, and performance shares. Performance shares are rights, contingent upon the attainment of performance measures within a specified performance period, to receive one share of common stock, which may be restricted, or the fair market value of such performance share in cash. No compensatory options have been granted under the 1997 Plan during fiscal 2003. A total of 2,500,000 shares of Common Stock have been reserved for issuance under the 1997 Plan. Grants may be made under the 1997 Plan during the ten years after its effective date. Options granted under the 1997 Plan generally vest in three or four equal annual installments and expire ten years after the date of grant. In December 1998, the Company adopted the 1998 Non-Employee Director Stock Option Plan (the "1998 Plan"), effective February 1, 1998. Under the 1998 Plan, non-employee directors may elect to receive all or a designated amount of their directors' fee in the form of stock options. A total of 37,500 shares have been reserved for issuance under the 1998 Plan. Grants may be made during the ten years after its effective date. Options granted under the 1998 Plan vest at the end of the quarter in which the date of grant occurs and expire ten years after the date of grant. During fiscal 2003 and fiscal 2002, no options had been granted under the 1998 Plan. 36 Option activity for the years ended January 31, 2002, 2003 and 2004 was as follows:
Weighted-Average Options Shares Exercise Price Exercisable - ---------------------------------------------------------------------------- Balance at January 31, 2001 2,497,417 $12.29 1,460,575 - ---------------------------------------------------------------------------- Options granted 469,849 8.03 Options exercised (76,230) 11.75 Options canceled (120,318) 19.39 - ---------------------------------------------------------------------------- Balance at January 31, 2002 2,770,718 $11.36 1,567,816 - ---------------------------------------------------------------------------- Options granted 423,486 13.50 Options exercised (211,138) 8.87 Options canceled (27,062) 14.16 - ---------------------------------------------------------------------------- Balance at January 31, 2003 2,956,004 $11.81 2,105,510 - ---------------------------------------------------------------------------- Options granted 80,862 10.27 Options exercised (36,806) 8.12 Options canceled (254,462) 11.20 - ---------------------------------------------------------------------------- Balance at January 31, 2004 2,745,598 $11.88 2,338,574 - ----------------------------------------------------------------------------
The weighted-average fair value of 80,862, 423,486 and 469,849 options granted was $5.31, $7.17 and $4.28 for the years ended January 31, 2004, 2003 and 2002, respectively. The following table summarizes the status of outstanding stock options as of January 31, 2004:
Options Outstanding Options Exercisable ------------------------------------------------------------------------------------------ Weighted Number of Average Weighted- Number of Weighted- Options Remaining Average Options Average Range of Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price - ------------------------------------------------------------------------------------------------------------------------------ $6.753 - $8.876 442,849 6.49 $ 7.955 299,113 $ 7.885 $8.915 - $9.333 1,008,466 2.43 9.327 988,483 9.332 $9.525 - $12.360 697,619 5.89 11.142 617,634 11.282 $12.563 - $24.250 596,664 6.82 19.948 433,344 21.656 - ------------------------------------------------------------------------------------------------------------------------------ $6.753 - $24.250 2,745,598 4.92 $ 11.875 2,338,574 $ 11.946 - ------------------------------------------------------------------------------------------------------------------------------
(16) Commitments and contingencies On July 25, 2002, the Company was named a defendant in a wage hour class action suit filed in California by three former store managers. The case was based principally upon the allegation that store managers employed by the Company in California should have been classified as non-exempt for overtime purposes. The parties reached an agreement to settle the matter resulting in a pre-tax charge of $1,000,000, inclusive of the plaintiff's attorneys' fees, interest, penalties, administrative costs and other Company costs, which was approved by the court on December 11, 2003. This settlement covers the period from July 25, 1998 through the date of final settlement approval by the court. The Company has made payments totaling approximately $1,000,000, per the terms of the settlement agreement, as of January 31, 2004. The Company was named a defendant in a wage hour suit filed in California by a former employee on May 6, 2003. The case was based principally upon the allegation that the amount of overtime paid to certain California employees was less than the amount actually earned. The suit asserts a claim for $1,000,000. The parties have reached a settlement of the suit for an amount that is not significant in relation to the Company's financial statements. The Company has been named as one of 14 defendants in a lawsuit originally filed in the United States District Court for the Southern District of New York, now pending in New York State Supreme Court, Commercial Division. The case is brought by Capital Factors, Inc. ("Capital Factors"), which provided 37 financing to defendant Cosmopolitan Gem Corp. ("Cosmopolitan"), an entity with which the Company has certain consignment and other commercial arrangements. The complaint alleges that Cosmopolitan defrauded Capital Factors into advancing funds to Cosmopolitan by misrepresenting Cosmopolitan's finances and the profitability of its operations, and that the Company, along with other persons and entities, including other jewelry retailers, aided and abetted or participated in the alleged fraud. The complaint asserts against the defendants, including the Company, claims under common law and the Racketeer Influenced and Corrupt Organizations Act ("RICO"). Capital Factors seeks aggregate damages from all of the defendants, including the Company, of $30,000,000, plus unspecified punitive damages, interest and fees. Damages, excluding punitive damages, awarded pursuant to claims asserted under RICO as well as interest on such damages are subject to trebling, within the discretion of the court. The Company has also been named as one of 13 defendants in an amended complaint filed on December 2, 2003 by International Diamonds, L.L.C. ("International") and its affiliate, Astra Diamonds Manufacturers, Ltd. ("Astra"). Astra is an Israeli diamond wholesaler that supplied diamonds to Cosmopolitan; International is a joint venture formed by Cosmopolitan and Astra to sell high quality finished diamond jewelry in the United States. The amended complaint, consolidated with the Capital Factors action described above (the "consolidated Capital Factors actions"), alleges that the Company, along with other jewelry retailers and business affiliates of Cosmopolitan, participated in Cosmopolitan's fraudulent scheme to defraud Capital Factors, and thus injured International and Astra. The complaint asserts claims under common law and RICO, seeking aggregate damages from all of the defendants, including the Company, of $6,800,000 plus interest and fees. Damages awarded pursuant to claims asserted under RICO as well as interest on such damages are subject to trebling, within the discretion of the court. In addition, the complaint alleges claims against the Company for breach of contract for approximately $2,520,000 in goods delivered and invoiced to the Company, for which International has not received payment. In connection with the consolidated Capital Factors actions in New York state court, the Company has filed an interpleader action for declaratory relief, asking the Court to determine the proper parties to whom the Company must pay amounts and deliver goods that are not in dispute related to goods received from Cosmopolitan and certain other entities. In its answer to the interpleader, Capital Factors has asserted that the Company owes Cosmopolitan $8,600,000 in accounts receivable on invoices assigned to Capital Factors. This amount is included in the $30,000,000 of losses that Capital Factors seeks in its RICO claims. In addition, Ultimo, Inc. ("Ultimo"), a jewelry supplier, is a defendant in the International action and in the interpleader action. Ultimo provided certain items of jewelry to the Company on a consignment basis and asserts that: (1) the Company has sold approximately $450,000 worth of such items, the proceeds of which it claims remain in the Company's possession; and (2) the Company continues to possess approximately $1,780,000 worth of its consignment goods. Ultimo asserts that it should receive these consignment proceeds and goods. Capital Factors and International also have asserted claims to these proceeds and goods. The Company plans to place the remaining consignment goods into escrow, and the New York State Supreme Court has announced that it will hold a hearing as early as May 2004 to determine the proper distribution of these consignment goods. The consignment proceeds already have been placed in the Company's outside counsel's escrow account pending court determination of the proper recipient. The Company is not currently aware of any accounts payable due and owing to any of the claimants in this action that are not already reflected in the Company's accounts payable and accrued liabilities. 38 In these consolidated Capital Factors actions, document discovery has begun, but depositions have been stayed until April 19, 2004 upon consent of the parties. In addition, the Company has filed motions to dismiss both the Capital Factors and International/Astra complaints. The motions are currently pending before the court. As previously disclosed, the United States Attorney for the Eastern District of New York is conducting a criminal investigation regarding matters that include those alleged in the consolidated Capital Factors actions. The Company, among others, is a subject of this criminal investigation and is cooperating fully with the United States Attorney. In addition, subsequent to the filing of the complaint by Capital Factors and as previously disclosed, the SEC initiated an informal inquiry into matters that are the subject of the consolidated Capital Factors actions. On November 3, 2003, the Company received a subpoena issued by the SEC as a part of a formal investigation by the SEC with respect to the matters that are the subject of the consolidated Capital Factors actions. The Company produced documents to the SEC in response to the SEC's subpoena and information requests. The Company is cooperating fully with the SEC in connection with this formal investigation. In accordance with Financial Accounting Standards Board Statement No. 5, "Accounting for Contingencies," the Company determines whether an estimated loss from a loss contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. As previously disclosed in a press release furnished to the SEC under cover of a Current Report on Form 8-K dated March 23, 2004, during the fourth quarter of the fiscal year ended January 31, 2004, the Company accrued a litigation reserve of $6.0 million for the consolidated Capital Factors actions and the United States Attorney and SEC investigations. Since March 23, 2004, the Company has engaged in additional settlement negotiations relating to these matters. In light of developments in the ongoing settlement discussions, the Company has accrued an additional reserve for the fourth quarter of the fiscal year ended January 31, 2004, in the amount of $2.6 million, with respect to these matters. There are no assurances that the Company will be able to reach a settlement with any of the parties to the consolidated Capital Factors actions or that such a settlement or settlements, as the case may be, will be for the amount recorded as a reserve. However, the Company currently believes that it is more likely than not that it will reach a settlement or settlements, as the case may be, pertaining to the consolidated Capital Factors actions in the near term. Given the amounts sought in the consolidated Capital Factors actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in excess of the amount recorded could occur and these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. The Company is unable at this time to predict the ultimate outcome of the consolidated Capital Factors actions or the United States Attorney and SEC investigations. Professional fees of approximately $9.6 million incurred as a result of the consolidated Capital Factors actions, the United States Attorney and SEC investigations, and the Company's internal investigation, have been expensed through January 31, 2004. On October 29, 2003, the Company entered into a letter agreement with its lenders which clarified and supplemented the Credit Agreement with respect to the consolidated Capital Factors actions, the SEC investigation and the investigation by the United States Attorney. Pursuant to the letter agreement, the lenders under the Credit Agreement reserved their rights to determine that the consolidated Capital Factors actions, the SEC investigation or the United States Attorney's investigation constituted a breach of the Credit Agreement. As of March 22, 2004, the Company and its lenders entered into a new letter agreement which rescinded the October 29, 2003 letter agreement. Pursuant to the new letter agreement, the lenders under the Credit Agreement have agreed that, 39 as of March 23, 2004, the consolidated Capital Factors actions, the SEC investigation and the United States Attorney's investigation have not resulted in a breach of the Credit Agreement. In addition, the lenders have agreed that none of these matters will give rise to a default or event of default under the Credit Agreement so long as the resolution of such matters does not involve the payment by the Company of Restitution (which is defined below) in an amount in excess of $15.0 million, or does not result in the indictment of the Company or any of its current officers, directors or employees with principal financial or accounting responsibilities. The new letter agreement also states that any settlement involving the payment of Restitution in excess of $15.0 million shall constitute a default under the Credit Agreement or any indictment of the Company or any of the persons described above may constitute a default under the Credit Agreement. "Restitution" is defined as any restitution paid by the Company (whether cash or non-cash or current or deferred consideration) arising from a civil settlement or award and/or criminal penalties paid or payable in connection with the Capital Factors litigation, the SEC investigation and/or the United States Attorney investigation and any other actions or proceedings directly related thereto; excluding, however, (i) amounts paid by the Company for consignment inventory held on behalf of the parties involved in the Capital Factors litigation and (ii) amounts already accrued on the books of the Company for the purchase of merchandise from the parties involved in the Capital Factors litigation and (iii) the value of any consigned inventory returned to parties involved in the Capital Factors litigation. At this time the Company does not expect the payment of Restitution to exceed $15.0 million and, based on the Company's current financial plan, expects to be in compliance with all financial covenants as set forth in the Credit Agreement in 2004. On February 12, 2004, a putative class action complaint captioned Greater Pennsylvania Carpenters Pension Fund, et al. v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1007, was filed in the United States District Court for the Northern District of Illinois against the Company and certain of the Company's current and former officers. The complaint makes reference to the litigation filed by Capital Factors Inc. above and to the Company's November 21, 2003 announcement that it had discovered violations of Company policy by the Company's Executive Vice President, Merchandising, with respect to Company documentation regarding the age of certain store inventory. The complaint further makes reference to the Company's December 22, 2003 announcement that it would restate results for certain prior periods. The complaint purports to allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 ("1934 Act") and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue and inventory during the putative class period of November 19, 2001 to December 10, 2003. On February 18, 2004, a putative class action complaint captioned Michael Radigan, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1196, was filed in the United States District Court for the Northern District of Illinois against the Company and certain of the Company's current and former officers, charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue and inventory during the putative class period of November 19, 2001 to December 10, 2003. The factual allegations of this complaint are similar to those made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed above. On February 20, 2004, a putative class action complaint captioned Milton Pfeiffer, et al., v. Whitehall Jewellers, Inc. et al., Case No. 04 C 1285, was filed in the United States District Court for the Northern District of 40 Illinois against the Company and certain of the Company's current and former officers, charging violations of Sections 10(b) and 20(a) officers, charging violations of Sections 10(b) and 20(a) of the 1934 Act and Rule 10b-5 promulgated thereunder, and alleging that the Company and its officers made false and misleading statements and falsely accounted for revenue, accounts payable, inventory, and vendor allowances during the putative class period of November 19, 2001 to December 10, 2003. The factual allegations of this complaint are similar to those made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed above. On April 6, 2004, the District Court in the Greater Pennsylvania Carpenters case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints with the Greater Pennsylvania Carpenters complaint, and on April 14, 2004, granted the plaintiffs up to 60 days to file an amended consolidated complaint. The Company intends to vigorously contest these putative class action complaints and exercise all of its available rights and remedies. Given that these cases are in their early stages, and no substantive proceedings have occurred, it is not possible at this preliminary stage to evaluate the likelihood of an unfavorable outcome in any of these matters, or to estimate any amount or range of potential loss, if any. While there are many potential outcomes, an adverse outcome in any of these actions could have a material adverse effect on the Company's results of operations, financial condition or liquidity. It cannot be determined at this stage whether these claims will be resolved in the fiscal year ending January 31, 2005. On January 16, 2004, the Company was named as a defendant in a copyright infringement lawsuit filed in the United States District Court for the District of Minnesota by Janel Russell Designs, Inc. ("Janel Russell Designs"). Janel Russell Designs asserts that the Company is infringing its copyright in a jewelry design by selling infringing merchandise. Janel Russell Designs seeks unquantified damages. Two of the allegedly infringing pieces are supplied to the Company by Samuel Aaron Inc. and one is supplied by Princess Pride Creations. Each of the suppliers has also been sued by Janel Russell Designs in separate lawsuits. Pursuant to language in certain Vendor Trading Agreements the Company entered into with each supplier, the Company tendered the defense of the cases to Samuel Aaron and Princess Pride and demanded indemnification. Both vendors, through counsel, have indicated they will defend and indemnify the Company. The Company filed its answer on March 3, 2004. The Company is subject to other claims and litigation in the normal course of business. Although there can be no certainty, it is the opinion of management that additional liabilities, if any, resulting from these other claims and litigation are not expected to have a material adverse effect on the Company's financial condition. The Company leases the premises for its office facilities and all of its retail stores, and certain office and computer equipment generally under noncancelable agreements for periods ranging from two to 13 years. Most leases require the payment of taxes, insurance and maintenance costs. Future minimum rentals under noncancelable operating leases as of January 31, 2004 are as follows:
Years ending January 31 (in thousands) Amount - ----------------------------------------------------------------------------------- 2005 $ 30,065 2006 29,614 2007 28,305 2008 27,356 2009 25,757 Thereafter 76,053 - ----------------------------------------------------------------------------------- Total future minimum rent obligations $ 217,150 - -----------------------------------------------------------------------------------
41 Total rental expense for all operating leases for the years ended January 31, is as follows:
(in thousands) 2004 2003 2002 - ----------------------------------------------------------------------------- Rental expense: Minimum $ 29,750 $ 28,437 $ 26,730 Rentals based on sales 761 923 1,137 Other 387 431 592 - ----------------------------------------------------------------------------- Total rental expense $ 30,898 $ 29,791 $ 28,459 - -----------------------------------------------------------------------------
(17) Related party transactions In the past, the Company provided certain office services to Double P Corporation, PDP Limited Liability Company and CBN Limited Liability Company or other companies, from time to time, which own and operate primarily mall-based snack food stores, and in which Messrs. Hugh Patinkin, John Desjardins and Matthew Patinkin own a 52% equity interest. A substantial portion of the remaining equity interest is owned by the adult children and other family members of Norman Patinkin, a member of the Company's Board of Directors. For these services, Double P Corporation paid the Company $700 per month. Effective February 1, 2004, the Company no longer provides these services. Matthew Patinkin previously served as a director of Double P Corporation and one of Norman Patinkin's adult children is a director and chief executive officer of Double P Corporation. Messrs. Hugh Patinkin, John Desjardins and Matthew Patinkin spend a limited amount of time providing services to Double P Corporation, PDP Limited Liability Company and CBN Limited Liability Company. Such services are provided in accordance with the Company's Code of Ethics. In the case of Hugh Patinkin and John Desjardins, these services are performed solely in their capacities as shareholders of Double P Corporation. In the case of Matthew Patinkin, these services are performed in his capacity as a shareholder of Double P Corporation and were previously performed in his capacities as a director and a shareholder of Double P Corporation. Messrs. Hugh Patinkin and John Desjardins receive no remuneration for these services other than reimbursement of expenses incurred. Matthew Patinkin receives no remuneration for these services other than the fee he previously received for his services as a director of Double P Corporation. In several cases, the Company and Double P Corporation agreed to divide and separately lease contiguous mall space. The Company and Double P Corporation concurrently negotiated separately with each landlord ("Simultaneous Negotiations") to reach agreements for their separate locations. Since the Company's initial public offering, its policy had required that the terms of any such leases must be approved by a majority of the Company's outside directors. The Company had conducted such negotiations in less than ten situations, since the Company's initial public offering in 1996. The Company's current policy is that it will no longer enter into such Simultaneous Negotiations. The Company offers health insurance coverage to the members of its Board of Directors. The health insurance policy options and related policy cost available to the Directors are the same as those available to the Company's senior level employees. The Company operates a program under which executive officers and directors, and parties introduced to the Company by its executive officers and directors, are permitted to purchase most Company merchandise at approximately ten percent above the Company's cost. During fiscal 2003, such purchases totaled approximately $174,000. 42 (18) Unaudited quarterly results The Company's results of operations fluctuate on a quarterly basis. The following table sets forth summary unaudited financial information of the Company for each quarter in fiscal 2003 and 2002. In the opinion of management, this quarterly information has been prepared on a basis consistent with the Company's audited financial statements appearing elsewhere in this annual report, and reflects adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such unaudited quarterly results when read in conjunction with the audited financial statements and notes thereto. 2003 Quarters Ended
(in thousands, except per share data) April 30, 2003 July 31, 2003 October 31, 2003 January 31, 2004 - ------------------------------------------------------------------------------------------------------------- Net sales $ 69,149 $ 72,732 $ 66,179 $136,595 Gross profit 23,111 24,192 20,880 58,850 Income (loss) from operations (3,659) (3,031) (9,661) 6,886 Net income (loss) (2,787) (2,803) (7,408) 4,284 Diluted earnings per share: Net income (loss) $ (0.20) $ (0.20) $ (0.53) $ 0.30
In the fourth quarter of fiscal 2003, the Company accrued a litigation reserve of $8.6 million for the consolidated Capital Factors actions and the United States Attorney and SEC investigation, as further discussed in Note 16 to the financial statements. 2002 Quarters Ended
(in thousands, except per share data) April 30, 2002 July 31, 2002 October 31, 2002 January 31, 2003 - ------------------------------------------------------------------------------------------------------------- Net sales $ 74,588 $ 76,243 $ 61,831 $128,375 Gross profit 27,094 26,445 18,762 55,494 Income (loss) from operations 1,467 1,194 (6,791) 24,135 Net income (loss) 293 54 (5,110) 14,457 Diluted earnings per share: Net income (loss) $ 0.02 $ 0.00 $ (0.35) $ 1.00
(19) Reclassifications Certain Balance Sheet amounts from prior periods were reclassified to conform to the current year presentation. These reclassifications had no impact on earnings or equity. (20) Subsequent events The Company amended the Credit Agreement effective March 23, 2004 in order to, among other things, (i) add a Layaway Reserve to the Borrowing Base (as defined in the Agreement), (ii) add and amend certain financial covenants including, amending the Fixed Charge Coverage Ratio (as defined in the Credit Agreement) and adding a covenant to maintain a Net Worth (as defined in the Credit Agreement) of at least $90.0 million at January 31, 2005, (iii) cap the borrowings under the facility to a maximum of $85.0 million for at least thirty consecutive calendar days during the period December 15, 2004 through and including February 15, 2005, (iv) increase the interest rate at which LIBOR based borrowings are available under the Credit Agreement to LIBOR plus 2.5% through April 30, 2005, (v) set the Commitment Fee Rate (as defined in the Credit Agreement) at 0.5% through April 30, 2005, and (vi) set the Standby Letter of Credit Fee Rate (as defined in the Credit Agreement) at 2.0% through April 30, 2005. 43 On October 29, 2003, the Company entered into a letter agreement with its lenders which clarified and supplemented the Credit Agreement with respect to the consolidated Capital Factors actions, the SEC investigation and the investigation by the United States Attorney. Pursuant to the letter agreement, the lenders under the Credit Agreement reserved their rights to determine that the consolidated Capital Factors actions, the SEC investigation or the United States Attorney's investigation constituted a breach of the Credit Agreement. As of March 22, 2004, the Company and its lenders entered into a new letter agreement which rescinded the October 29, 2003 letter agreement. Pursuant to the new letter agreement, the lenders under the Credit Agreement have agreed that, as of March 23, 2004, the consolidated Capital Factors actions, the SEC investigation and the United States Attorney's investigation have not resulted in a breach of the Credit Agreement. In addition, the lenders have agreed that none of these matters will give rise to a default or event of default under the Credit Agreement so long as the resolution of such matters does not involve the payment by the Company of Restitution (which is defined below) in an amount in excess of $15.0 million, or does not result in the indictment of the Company or any of its current officers, directors or employees with principal financial or accounting responsibilities. The new letter agreement also states that any settlement involving the payment of Restitution in excess of $15.0 million shall constitute a default under the Credit Agreement or any indictment of the Company or any of the persons described above may constitute a default under the Credit Agreement. "Restitution" is defined as any restitution paid by the Company (whether cash or non-cash or current or deferred consideration) arising from a civil settlement or award and/or criminal penalties paid or payable in connection with the Capital Factors Lawsuit, the SEC Investigation and/or the United States Attorney Investigation and any other actions or proceedings directly related thereto; excluding, however, (i) amounts paid by the Company for consignment inventory held on behalf of the parties involved in the Capital Factors Lawsuit and (ii) amounts already accrued on the books of the Company for the purchase of merchandise from the parties involved in the Capital Factors Lawsuit and (iii) the value of any consigned inventory returned to parties involved in the Capital Factors Lawsuit. As previously disclosed in a press release furnished to the SEC under cover of a Current Report on Form 8-K dated March 23, 2004, during the fourth quarter of the fiscal year ended January 31, 2004, the Company accrued a litigation reserve of $6.0 million for the consolidated Capital Factors actions and the United States Attorney and SEC investigations. Since March 23, 2004, the Company has engaged in additional settlement negotiations relating to these matters. In light of developments in the ongoing settlement discussions, the Company has accrued an additional reserve for the fourth quarter of the fiscal year ended January 31, 2004, in the amount of $2.6 million, with respect to these matters. There are no assurances that the Company will be able to reach a settlement with any of the parties to the consolidated Capital Factors actions or that such a settlement or settlements, as the case may be, will be for the amount recorded as a reserve. However, the Company currently believes that it is more likely than not that it will reach a settlement or settlements, as the case may be, pertaining to the consolidated Capital Factors actions in the near term. The Company is unable at this time to predict the ultimate outcome of the consolidated Capital Factors actions or the United States Attorney and SEC investigations. 44 Report of Independent Auditors To the Board of Directors and Shareholders of Whitehall Jewellers, Inc. In our opinion, the accompanying balance sheets and the related statements of operations, shareholders' equity, and cash flow present fairly, in all material respects, the financial position of Whitehall Jewellers, Inc. (the "Company") at January 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended January 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 7 to the financial statements, effective February 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." PricewaterhouseCoopers LLP (signed) Chicago, Illinois March 22, 2004, except for the last paragraph of Note 20 as to which the date is April 15, 2004 45 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's stock began trading on the New York Stock Exchange under the symbol "JWL" on January 27, 2000. Prior to that date the Company's stock traded on the NASDAQ National Market System under the symbol "WHJI." At April 1, 2004, there were 103 registered holders of Class B stock and 322 registered holders of Common Stock for a total of 425 registered shareholders.
2004 2003 ----------------------------------------------------- Year ended January 31 High Low High Low - ------------------------------------------------------------------------------------------------------------------ First Quarter $ 10.23 $ 7.90 $ 20.25 $ 13.54 Second Quarter 12.20 8.88 23.00 9.80 Third Quarter 12.60 10.23 12.97 8.00 Fourth Quarter 13.25 8.66 12.35 8.41
The Company has not declared any dividends in fiscal 2003 and 2002, and intends to retain its earnings to finance future growth. Therefore, the Company does not anticipate paying any cash dividends in the foreseeable future. The declaration and payment of dividends, if any, is subject to the discretion of the Board of Directors of the Company and to certain limitations under the General Corporation Law of the State of Delaware. In addition, the Company's Credit Agreement contains restrictions of the Company's ability to pay dividends. The timing, amount and form of dividends, if any, will depend, among other things, on the Company's results of operations, financial condition, cash requirements and other factors deemed relevant by the Board of Directors. 46 EX-21 5 c84514v2exv21.txt SUBSIDIARIES OF THE COMPANY Exhibit 21 Whitehall Jewellers, Inc. - List of Subsidiaries Place of Incorporation WH Inc. of Illinois Illinois WhitehallJewellers.com, LLC Delaware EX-23 6 c84514v2exv23.txt CONSENT OF PRICEWATERHOUSECOOPERS LLP Exhibit 23 CONSENT OF INDEPENDENT AUDITORS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-38958, 333-50159, 333-47601, 333-14895, and 333-70510) of Whitehall Jewellers, Inc. of our report dated March 22, 2004 (except for the last paragraph of Note 20 as to which the date is April 15, 2004) relating to the financial statements, which appears in the Annual Report to Shareholders, which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report dated March 22, 2004 relating to the financial statement schedule, which appears in this Form 10-K. /s/ PricewaterhouseCoopers LLP Chicago, Illinois April 15, 2004 EX-31.1 7 c84514v2exv31w1.txt CERTIFICATE OF PRINCIPAL EXECUTIVE OFFICER Exhibit 31.1 Certificate Pursuant to Rule 13a-14a under the Securities Exchange Act of 1934 of the Principal Executive Officer I, Hugh M. Patinkin certify that: 1. I have reviewed this annual report on Form 10-K of Whitehall Jewellers, Inc.; 2. Based on my knowledge, this 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 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-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: April 15, 2004 /s/Hugh M. Patinkin -------------------------------- Name: Hugh M. Patinkin Title: Chief Executive Officer (Principal Executive Officer) EX-31.2 8 c84514v2exv31w2.txt CERTIFICATE OF PRINCIPAL FINANCIAL OFFICER Exhibit 31.2 Certificate Pursuant to Rule 13a-14a under the Securities Exchange Act of 1934 of the Principal Financial Officer I, John R. Desjardins certify that: 1. I have reviewed this annual report on Form 10-K of Whitehall Jewellers, Inc.; 2. Based on my knowledge, this 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 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-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: April 15, 2004 /s/ John R. Desjardins ------------------------------------- Name: John R. Desjardins Title: Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) EX-32.1 9 c84514v2exv32w1.txt SECTION 906 CERTIFICATE Exhibit 32.1 CERTIFICATE PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Whitehall Jewellers, Inc. (the "Company") on Form 10-K for the period ended January 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), the undersigned, as Chief Executive Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Hugh M. Patinkin --------------------------- Hugh M. Patinkin Chief Executive Officer April 15, 2004 EX-32.2 10 c84514v2exv32w2.txt SECTION 906 CERTIFICATE Exhibit 32.2 CERTIFICATE PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Whitehall Jewellers, Inc. (the "Company") on Form 10-K for the period ended January 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), the undersigned, as Chief Financial Officer of the Company, hereby certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ John R. Desjardins -------------------------------------------------- John R. Desjardins Executive Vice President, Chief Financial Officer, Treasurer and Secretary April 15, 2004 -----END PRIVACY-ENHANCED MESSAGE-----