Item 1. BUSINESS
THE COMPANY
Factory 2-U Stores, Inc., which was previously named Family Bargain Corporation (the "Company"), at January 30, 1999 operated 168 off-price retail apparel and housewares stores under the names Family Bargain Center and Factory 2-U in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington.
Prior to July 31, 1998, the Company operated through its wholly-owned subsidiaries, General Textiles and Factory 2-U, Inc. The Company acquired General Textiles in 1993, while General Textiles was operating under Chapter 11 of the U.S. Bankruptcy Code and acquired Factory 2-U, Inc. in November 1995.
On July 31, 1998, the Company merged General Textiles and Factory 2-U, Inc. into General Textiles, Inc. On November 23, 1998, the Company merged General Textiles, Inc. into itself in a transaction in which (i) the previous three classes of the Company's stock were converted into a single class of Common Stock and (ii) the Company's name was changed from Family Bargain Corporation to Factory 2-U Stores, Inc. (the "Recapitalization").
The Company's 168 stores average 13,300 total square feet and are located mostly in strip centers. Products include a broad range of family apparel, domestic goods and housewares. Typical customers of the Company are families with below average income, who generally are profiled as discount store shoppers. The Company's merchandising strategy is to offer first quality recognizable national and discount store brands at a substantial discount, generally 20% to 50% below that offered by the national discount chains. The stores are well-lit and present the merchandise primarily on hanging fixtures. In-store signage emphasizing the savings is strategically placed throughout the stores, creating increased customer awareness.
OPERATIONS
OPERATING STRATEGY
The Company seeks to be the leading off-price apparel, domestic goods and housewares retailer to families with below average incomes in the markets it serves. The major elements of its operating strategy include:
Provide Value to Customers on National and Discount Brand Merchandise: The Company emphasizes providing value to its customers by providing merchandise found in national discount chains at savings between 20% and 50% from prices offered by the national discount chains. The Company buys excess supplies of recognized brands at bargain prices and passes along the savings to the customer.
Target Under-Served Market Segments: The Company's stores target customers who are under-served in their markets. Typical customers are young families with below average incomes.
Maximize Inventory Turns: The Company emphasizes inventory turn in its merchandise and marketing strategies. Merchandise presentation, an everyday low price strategy, frequent store deliveries and advertising programs all target rapid inventory turn, which management believes leads to increased profits and efficient use of capital.
EXPANSION PLANS
Opening of New Stores: The Company plans to increase its store count by 20 to 25 stores in the fiscal year ending January 29, 2000 (fiscal 1999). The new stores are planned for markets in which the Company currently operates. During fiscal 1998, the Company opened 7 new stores and closed 5 stores. During the period from January 30, 1999 through April 3, 1999, 3 stores closed and 3 new stores were opened. Average store opening costs for equipment, fixtures, leasehold improvements and preopening expenses are approximately $215,000. Average initial inventory for a new store is approximately $300,000. Generally, during the two to three month grand opening period, a new store achieves sales in excess of sales of an average comparable mature store and, within six months, generates sales consistent with comparable mature store levels.
Renovation and Relocation Program: The Company plans to renovate and relocate stores; relocation will be considered as superior sites become available in their markets. Store renovations generally include installing new fixtures, redesigning layouts and refurbishing floors and walls. The cost to renovate or relocate a store is approximately $50,000 and $175,000, respectively. During fiscal 1998, the Company renovated 51 stores and relocated 1 store. The Company plans to change the name of all stores to Factory 2-U by the end of the first quarter of fiscal 2000.
BUYING AND DISTRIBUTION
The Company purchases merchandise from domestic manufacturers, jobbers, importers and other vendors. Payment terms are typically net 30 days. The Company continually adds new vendors and does not maintain long-term or exclusive purchase commitments or agreements with any vendor. Management believes that there are a substantial number of additional sources of supply of first quality, national and discount brand merchandise that will meet its increased inventory needs as the Company grows.
In-Season Goods. Unlike traditional department stores and discount retailers, which primarily purchase merchandise in advance of the selling season (for example, back-to-school clothing is purchased by March), the Company purchases approximately 70% of its merchandise in-season (i.e., during the selling season). In-season purchases generally represent closeouts of vendors' excess inventories remaining after the traditional wholesale selling season and are often created by other retailers' order cancellations. Sometimes vendors manufacture to meet anticipated demand rather than known demand, knowing the Company is a potential buyer of the excess. Such merchandise is typically available at prices below wholesale. Management believes that such in-season buying practices are well suited to the Company's customers, who tend to make purchases on an as-needed basis later into a season. The Company's in-season buying practice is facilitated by its ability to process and ship merchandise through its distribution center to its stores, usually within two or three days of receipt from the vendor, and to process a large number of relatively small purchase orders. Management believes that the Company is a desirable customer for vendors seeking to liquidate inventory because it can take immediate delivery of large quantities of in-season goods. Furthermore, the Company rarely requests markdown concessions, advertising allowances or special shipping and packing procedures, insisting instead on the lowest possible price. It passes these low prices on to its customers.
Manufacturers ship goods directly to the Company's San Diego distribution center or, in the case of East Coast vendors, to the Company through its East Coast freight consolidator. Goods received at the Company's warehouse are generally shipped to its stores using independent trucking companies within two to three days of their arrival. The Company generally does not store goods from season to season at its warehouse. An auxiliary warehouse is scheduled to go into service in the summer of 1999. That warehouse will be used in conjunction with the current facility to ticket all merchandise prior to
shipment to the stores.Ticketing is now done at each store and the change in ticketing procedure is expected to create greater efficiency.
MERCHANDISING AND MARKETING
The Company's merchandise selection, pricing practices and store formats are designed to reinforce the concept of value and maximize customer enjoyment of the shopping experience. The Company's stores offer their customers a diverse selection of primarily first quality, in-season merchandise at prices which generally are lower than those of competing discount and off-price stores in their local markets. Nearly all of their merchandise carries brand name labels, including nationally recognized brands.
The Company delivers new merchandise to its stores at least once per week to encourage frequent shopping trips by its customers and to maximize the rate of inventory turn. As a result of its purchasing practices, store inventory may not always include a full range of colors, sizes and styles in a particular item. Management believes, however, that price, quality and product mix is more important to the Company's customers than the availability of a specific item at a given time.
The Company emphasizes inventory turn in its merchandising and marketing strategy. Merchandise presentation, pricing below discounters, frequent store deliveries, staggered vendor shipments, promotional advertising, store-tailored distribution and prompt price reductions on slow moving items all target rapid inventory turn. The Company believes that the pace of its inventory turn leads to increased profits, reduced inventory markdowns, efficient use of capital and customer urgency to make purchase decisions.
The Company's administrative headquarters receives daily store sales and inventory information from point-of-sale computers located at each of its stores. This data is reported by stock keeping unit (or "SKU"), permitting management to tailor purchasing and distribution decisions. A chain-wide computer network also facilitates communications between the administrative headquarters and stores, enabling management to provide store management with immediate pricing and distribution information.
The Company's stores are characterized by easily accessible merchandise displayed on hanging fixtures and open shelves in well-lighted stores. Prices are clearly marked, usually displayed in whole dollars. A comparative retail-selling price is often noted on price tags. The Company's major advertising vehicle is the use of a full-color print tab showing actual photos of its merchandise. Print media is delivered to the consumers in newspaper inserts and marriage-mail drops. Other advertising programs include radio and outdoor promotional activities.
The Company's stores emphasize customer satisfaction to develop customer loyalty and generate repeat sales. If a customer is not completely satisfied with any purchase, the Company's stores will make a full refund or exchange. Most sales are for cash, although checks, debit and credit cards are accepted. The Company does not issue its own credit card, but does offer a layaway program. The layaway program is an important means for the Company's customers, many of whom do not possess credit cards, to purchase goods over time.
Approximately 60% of the Company's sales occur in its third and fourth quarters, during the back-to-school (August and September) and Christmas (November and December) seasons. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations -- Seasonality and Quarterly Fluctuations."
THE STORES
As of April 3, 1999 the Company operated 168 stores located in seven western states. Stores are primarily located in rural and lower income suburban communities and, to a lesser extent, in metropolitan areas. Most stores are located in strip shopping centers, where occupancy costs are most favorable. As of January 30, 1999, the number of store locations was as follows:
The stores range in size from 5,000 square feet to 35,000 square feet, averaging 13,300 square feet. Management continually reviews the ability of stores to provide positive contributions to the Company's operating results and may elect to close stores that do not meet performance criteria. Costs associated with closing stores, consisting primarily of the recognition of remaining lease obligations and provisions to re-value assets to net realizable value, are charged to operations during the fiscal year in which the commitment is made to close a store.
The Company's stores typically employ one store manager, two assistant store managers, and seven to ten sales associates, most of whom are part-time employees. New store managers are trained in all aspects of store operations through a management-training program. Other store personnel are trained on site. The Company often promotes experienced assistant store managers to fill open manager positions.
The Company's store management team participates in a bonus plan in which they are awarded bonuses upon achieving plan objectives. The Company believes that the bonus program is an important incentive for its key employees, helps reduce employee turnover and lowers costs.
The Company generally leases previously occupied store sites on terms that it believes are more favorable than those available for newly constructed facilities. After the Company signs a store lease, a store opening team prepares the store for opening by installing fixtures, signs, racks, dressing rooms, checkout counters, cash register systems and other items. The district manager and store manager arrange the merchandise according to the standard store layout and train new personnel before and after the store is opened. The Company selects store sites based on demographic analysis of the market area, sales potential, local competition, occupancy expense, operational fit and proximity to existing store locations. Store opening preparations generally take up to three weeks.
The Company maintains commercial liability, fire, theft, business interruption and other insurance policies.
COMPETITION
The Company operates in a highly competitive marketplace. The Company's stores compete with large discount retail chains such as Wal-Mart, K-Mart, Target and Mervyn's, and with regional off-price chains, such as MacFrugal's, some of which have substantially greater resources than the Company. They also compete with independent and small chain retailers and flea markets (also known as "swap
meets") which serve the same low and low-middle income market as the Company. Management believes that the principal competitive factors in the Company's markets are price, quality and site location and that the Company is well positioned to compete on the basis of these factors.
EMPLOYEES
As of April 3, 1999 the Company employed 3,222 people, of whom 2,916 were store employees and store field management (1,014 of whom were part-time), 228 were executives and administrative employees and 78 were warehouse employees. None of the Company's employees is subject to collective bargaining agreements and management considers its relations with its employees to be good.
TRADEMARKS
Except for the trade names "Family Bargain Center" and "Factory 2-U", which are federally registered trademarks, the Company does not have any material trademarks.
GOVERNMENT REGULATION
The Company's operations are subject to various federal, state and local laws, regulations and administrative practices affecting its business, including laws and regulations relating to equal employment and minimum wages. The Company believes it is in substantial compliance with all federal, state and local laws and regulations governing its operations and has obtained all material licenses and permits required for the operation of its business. The Company believes that the compliance burdens and risks relating to such laws and regulations do not have a material adverse effect on the Company.
ITEM 2.
ITEM 2. PROPERTIES
As of April 3, 1999 the Company operated 168 retail stores located in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington, under various operating leases with third parties. The leases are separately negotiated and are generally not uniform. The store locations include strip centers, downtown business districts, and stand alone sites. Typical lease terms are for five years with renewal options in five year increments. Approximately two-thirds of the leases are "triple net leases" under which the Company is required to reimburse landlords for insurance, real estate taxes and common area maintenance costs. Some leases require the Company to pay a minimum monthly rent and a percentage of sales in excess of a specified sales level. The current annual rent expense for the 168 stores open at January 30, 1999 is approximately $18.2 million.
The Company's headquarters are located in a 269,000 square foot multi-use facility at 4000 Ruffin Road, San Diego, California. This facility consists of 37,000 square feet of office space, an 8,000 square foot retail store and a 224,000 square foot warehouse and distribution center. This facility is leased for a term expiring in September 2005. The lease provides for annual base rent at an average of approximately $1.5 million over the lease term.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is at all times subject to pending and threatened legal actions that arise in the normal course of business. In the opinion of management, based in part on the advice of legal counsel, the
ultimate disposition of these matters will not have a material adverse effect on the financial position or results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a. The Company's Annual Meeting of stockholders was held on November 23, 1998.
b. The directors elected at the meeting were as follows:
Other directors whose terms of office continued after the meeting are as follows: James D. Somerville, John J. Borer III, Ira Neimark, H. Whitney Wagner, and Thomas G. Weld. Mr. Weld resigned as a director effective November 29, 1998.
c. Other matters voted on at the meeting and the results of those votes were as follows:
Approval of the merger of General Textiles, Inc. into Family Bargain Corporation
Approval of the Amended and Restated Family Bargain Corporation 1997 Stock Option Plan
Ratification of Arthur Andersen LLP as independent accountants
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Pursuant to the plan of recapitalization approved by the Company's stockholders on November 23, 1998 (the "Plan of Recapitalization"), the Company's stock was converted into a single class of Common Stock. Each share of common stock prior to the Recapitalization ("Pre-Recapitalization Common Stock") was converted into .30133 shares of Post-Recapitalization Common Stock, each share of Series A Cumulative Convertible Preferred Stock (the "Series A Preferred Stock") was
converted into one share of Post-Recapitalization Common Stock and each share of Series B Junior Convertible, Exchangeable Preferred Stock (the "Series B Preferred Stock") was converted into 173.33 shares of Post-Recapitalization Common Stock. Immediately following the Recapitalization, the Company had 11,306,000 shares of Common Stock outstanding.
Prior to the Recapitalization, the Company's then Common Stock and its Series A Preferred Stock were quoted on the Nasdaq SmallCap Market. The table below sets forth certain information with respect to the high and low closing bid prices (rounded to the nearest hundredth) of the Company's Common Stock and Series A Preferred Stock during the years ended January 31, 1998 (fiscal 1997) and January 30, 1999 (fiscal 1998), and the subsequent interim period, as quoted by Nasdaq. The market prices of the Common Stock have been adjusted to give retroactive effect to the conversion of Pre-Recapitalization Common Stock into Common Stock, i.e., the prices are per share of Post-Recapitalization Common Stock. The market prices after November 23, 1998 are the actual prices of the current Common Stock. The quotations below represent inter-dealer prices without retail markups, markdowns or commissions and may not be representative of actual transactions.
As of January 30, 1999, the number of record holders of Common Stock was approximately 303. This number does not include an indeterminate number of stockholders whose shares are held by financial institutions in "street name." The Company has estimated beneficial holders of its Common Stock to be more than 2000.
Until the Recapitalization, the Company paid quarterly dividends of $0.2375 per share on its Series A Preferred Stock (aggregating $2,593,000 for fiscal 1998). The Company did not pay cash dividends on its Pre-Recapitalization Common Stock and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. The declaration and payment of any cash dividends on its Common Stock in the future will be determined by the Board of Directors in light of conditions then existing, including the Company's earnings, financial condition and cash requirements.
The Company recorded non-cash dividends on the Series B Preferred Stock using the effective interest method to recognize the dividend ratably over the estimated period in which the Series B Preferred
Stock was to be outstanding. For fiscal 1998, such accreted dividends totaled approximately $2,210,000. See Note 11 to Financial Statements.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Set forth below is selected financial data for the Company. All of the selected financial data, except for Operating Data, is derived from audited financial information. The selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Financial Statements and Supplementary Data."
Notes to Selected Financial Data (1) 53 weeks. (2) In December 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share". The statement specifies the computation, presentation, and disclosure requirements for earnings per share (EPS) and diluted earnings per share (DEPS). The statement requires retroactive adoption for all prior periods presented. Additionally, all prior periods presented have been restated giving effect to the reverse stock split that was authorized during the fourth quarter of fiscal 1998.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the information set forth under "Selected Financial Data" and "Financial Statements and Supplementary Data."
GENERAL
During the past three fiscal years, a number of events occurred which have had a significant impact on the financial condition of the Company and its subsidiaries.
On July 31, 1998, the Company's two operating subsidiaries, General Textiles and Factory 2-U, Inc., merged to form General Textiles, Inc.
On November 23, 1998, the Company carried out a Recapitalization in which all of the Company's stock was converted into a single class of Common Stock. Under the Plan of Recapitalization, each share of Pre-Recapitalization Common Stock was converted into .30133 shares of Common Stock, each share of Series A Preferred Stock was converted into one share of Common Stock and each share of Series B Preferred Stock was converted into 173.33 shares of Common Stock. In connection with the Recapitalization, General Textiles, Inc. was merged into Family Bargain Corporation (the "Family Bargain Merger") and the Company's name was changed to Factory 2-U Stores, Inc.
Immediately after the Recapitalization, the Company had 11,306,000 shares of Common Stock outstanding. An investment group (the "TCR Investors") advised by Three Cities Research, Inc. ("TCR") owned approximately 50% of these shares. Immediately after the Recapitalization, the Company undertook a rights offering under which it issued to its stockholders transferable rights to purchase an additional 800,000 shares of Common Stock for $13.00 per share. Three TCR Investors agreed to purchase any shares as to which rights were not exercised. In total, the TCR Investors purchased 798,075 shares as a result of the rights offering, increasing their ownership to 53%.
In January 1997, the TCR Investors advised by TCR purchased a controlling equity interest in the Company by acquiring all of the Common and Series A Preferred Stock held by the former chairman, vice chairman and chief executive officer of the Company (the "Former Executives") and purchasing from the Company 22,000 shares of newly authorized Series B Preferred Stock. Subsequent to the close of fiscal 1996, the Company sold an additional 11,715 shares of the Series B Preferred Stock to TCR Investors, directors and management of the Company.
In connection with the change in control, three former directors resigned from the Board of Directors and three managing directors of TCR were appointed to serve on the Company's Board. The person then serving as President and Chief Executive Officer of the Company's two operating subsidiaries, who was a director of the Company, was appointed President and Chief Executive Officer of the Company. In February 1997, the Company's Board of Directors elected three new directors, one of whom was elected Chairman of the Board of Directors. In August 1997, the President and Chief Executive Officer of the Company resigned from all positions with the Company. In March 1998, the Company appointed a new President and Chief Executive Officer of its operating subsidiaries. He was elected a member of the Board of Directors of the Company in March 1998.
During fiscal 1998 and 1997, the Company's operational focus was on improving the operating performance of existing stores.
RESULTS OF OPERATIONS
The Company defines its fiscal year by the calendar year in which most of the activity occurs (e.g. the year ended January 30, 1999 is referred to as fiscal 1998). The following table sets forth selected statement of operations data expressed as a percentage of net sales for the periods indicated:
FISCAL 1998 COMPARED TO FISCAL 1997
As of January 30, 1999, the Company operated 168 stores compared to 166 as of January 31, 1998.
Net sales were $338.2 million for fiscal 1998 compared to $300.6 million for fiscal 1997, an increase of $37.6 million or 12.5%. Comparable store sales increased 10.9% in fiscal 1998 over the same period of the prior year.
Gross profit was $ 115.9 million for fiscal 1998 compared to $97.1 million for fiscal 1997, an increase of $18.8 million. As a percentage of sales, gross profit was 34.3% in fiscal 1998 compared to 32.3% in fiscal 1997. The increase in gross profit as a percentage of sales was primarily attributable to a lower inventory shrinkage and higher markups, partially offset by higher markdowns in fiscal 1998 compared to fiscal 1997.
Selling and administrative expenses were $99.7 million for fiscal 1998 compared to $88.0 million for fiscal 1997, an increase of $11.7 million. As a percentage of sales, selling and administrative expenses were 29.5% for fiscal 1998 compared to 29.3% in fiscal 1997. The increase in selling and administrative expenses as a percentage of sales was primarily a result of higher store wage rates, due in part to an increase in the minimum wage, and increased administrative support expenses.
Amortization of intangibles was $2.4 million for fiscal 1998 compared to $2.2 million for fiscal 1997, an increase of $0.2 million. The increase is attributable to a non-compete agreement with the former President and CEO. In January 1997, the Company's principal executive officers, who were its largest stockholders, sold their stock interest, resigned from their positions as officers and directors and, among other things, entered into an agreement not to compete with the Company until June 2000 in return for $1.8 million in secured promissory notes, that were paid in January 1998. In August 1997, the former President and CEO entered into an agreement not to compete with the Company until January 2001 in return for payments totaling $970,000.
The special charge of $2.4 million in fiscal 1998 represents various expenses incurred in connection with hiring the current President and CEO of the Company. In fiscal 1997, a charge of $1.8 million was incurred when the Former President and CEO resigned. At the end of fiscal 1998, future payments totaling $1.2 million related to these special charges were included in accrued liabilities.
Interest expense was $4.2 million in fiscal 1998 compared to $5.2 million in fiscal 1997, a decrease of $1.0 million. The decrease was attributable to decreases in the amortization of debt discount related to the exchange of the subordinated and junior subordinated notes for new notes (see Liquidity and Capital Resources).
Federal and state income taxes of $1.3 million were accrued in fiscal 1998, representing the tax provision as calculated in accordance with SFAS No. 109. In 1997, no provision was required due to net operating losses. The Company anticipates that operations in 1999 will also create taxable income.
An extraordinary charge of $2.8 million was incurred in fiscal 1998 because notes payable associated with the General Textiles bankruptcy were extinguished and new notes were issued with terms that the Company believes are more favorable to it which had lower discounts than had previously been recorded (see Liquidity and Capital Resources - Bankruptcy Debt of General Textiles).
Net income before dividends was $2.3 million in fiscal 1998 compared to a net loss before dividends of $0.1 million in fiscal 1997. Total dividends were $4.8 million in fiscal 1998 and $6.1 million in fiscal 1997. That included fiscal 1998 non-cash dividends on the Series B Preferred Stock of $2.2 million compared to $2.6 million in fiscal 1997. Additionally, in fiscal 1998, the Company recognized an inducement charge of $2.8 million in connection with conversion of Series A Preferred Stock to Post-Recapitalization Common Stock. The lower dividends in 1998 were due to the Recapitalization
discussed above (see also Liquidity and Capital Resources). The net loss applicable to common stock was $5.3 million in fiscal 1998 compared to a net loss applicable to common stock of $6.2 million in fiscal 1997.
FISCAL 1997 COMPARED TO FISCAL 1996
Fiscal 1997 was a 52 week year and fiscal 1996 was a 53 week year. For purposes of determining comparable store sales, fiscal 1996 was adjusted to reflect a comparable 52 week year. As of January 31, 1998, the Company operated 166 stores compared to 150 as of February 1, 1997.
Net sales were $300.6 million for fiscal 1997 compared to $252.2 million for fiscal 1996, an increase of $48.4 million. Comparable store sales increased $7.7 million, or 3.4%, in fiscal 1997.
Gross profit was $97.1 million for fiscal 1997 compared to $74.1 million in fiscal 1996, an increase of $23.0 million. The increase in gross profit was due to the opening of new stores, an increase in comparable store sales and an increase in gross profit as a percentage of sales. As a percentage of sales, gross profit was 32.3% in fiscal 1997 compared to 29.4% in fiscal 1996. The increase in gross profit as a percentage of sales was a result of a lower inventory shrinkage and higher initial markups in fiscal 1997 compared to fiscal 1996.
Selling and administrative expenses were $88.0 million for fiscal 1997 compared to $80.6 million for fiscal 1996, an increase of $7.4 million. As a percentage of sales, selling and administrative expenses were 29.3% for fiscal 1997 compared to 32.0% in fiscal 1996. The decrease in selling and administrative expenses as a percentage of sales was primarily attributable to moving the Company's executive offices from New York City to San Diego and economies associated with increased sales volume.
Amortization of intangibles consists of amortization of excess of cost over net assets acquired and agreements not to compete. The noncompete agreements are the result of two transactions discussed in the comparison of fiscal 1998 to fiscal 1997.
The Company recognized special charges to operations in the aggregate amount of $1.8 million in fiscal 1997 and $9.2 million during fiscal 1996. The fiscal 1997 amount pertains to the separation from the Company of the then President and CEO, whereas the fiscal 1996 charges relate to terminating contracts with the former principal executive officers and closure of the former executive offices in New York City in connection with the change in control. At the end of fiscal 1997, future payments totaling $1.6 million related to these special charges were included in accrued liabilities.
Interest expense was $5.2 million in fiscal 1997 compared to $8.6 million for fiscal 1996, a decrease of $3.4 million. The decrease was attributable to decreases in the amortization of debt discount related to the Bankruptcy Debt of General Textiles (see Liquidity and Capital Resources).
There were no discontinued operations in fiscal 1997 compared to a loss from discontinued operations of $0.8 million in fiscal 1996.
The net loss before dividends was $0.1 million in fiscal 1997 compared to a net loss before dividends of $37.4 million in fiscal 1996. Total dividends were $6.1 million in fiscal 1997 and $3.5 million in fiscal 1996. This included non-cash dividends on the Series B Preferred Stock in fiscal 1997 of $2.6 million. There were no Series B Preferred Stock dividends in fiscal 1996. The net loss applicable to common stock was $6.2 million in fiscal 1997 compared to a net loss applicable to common stock of $40.9 million in fiscal 1996.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL
As of January 30, 1999, the Company had outstanding indebtedness in the principal amount of $13.8 million.
The Company finances its operations through credit provided by vendors and other suppliers, amounts borrowed under its $50.0 million revolving credit facility and internally generated cash flow. Credit terms provided by vendors and other suppliers are usually net 30 days. Amounts which may be borrowed under the working capital facility are based on a percentage of eligible inventories, as defined, outstanding from time to time, as more fully described below.
REVOLVING CREDIT FACILITY
In July 1998, the Company and its lender agreed to amend certain terms and conditions of the revolving credit facilities between the lender and General Textiles and Factory 2-U. As a result of the Subsidiary Merger, the covenants and financial ratios were reset to reflect anticipated earnings, capital expenditures and cash flow of the Company during fiscal 1998 and the facilities were combined into one revolving credit facility (the "Facility").
At January 30, 1999 the Company could borrow up to $50,000,000 at the prime rate plus 0.75%, subject to limitations based on inventory levels. At January 30, 1999, the Company owed $1.8 million under the Facility and had $27,700,000 available to borrow under the Facility. The Facility expires in March 2000 but is subject to one year automatic renewal periods, unless terminated by the Company or its lender. The balance owed under the Facility fluctuates based on working capital requirements. Because of the seasonal nature of the Company's business, borrowings are usually greatest between August and December. The Company pays fees of 0.25% on the unused portion of the Facility. The Facility is secured by all the assets of the Company.
The Company was not in compliance with the current ratio covenant in the Facility as of January 30, 1999. The lender has waived that requirement at January 30, 1999.
SUBORDINATED NOTES
At January 31, 1998, the Company had outstanding $22,945,000 face value of Trade Subordinated Notes, Subordinated Reorganization Notes and Junior Subordinated Reorganization Notes. These notes were non-interest bearing, except for certain contingent interest payments and were subject to minimum principal payment requirements based on the annual excess cash flows of General Textiles. Accordingly, they were discounted to carrying values based on estimated future cash flows of General Textiles at discount rates ranging from 6% to 25%.
Effective April 30, 1998, the Company exchanged the Subordinated Reorganization Notes and the Junior Subordinated Reorganization Notes (the "Old Notes") for new notes (the "New Subordinated Notes" and the "New Junior Subordinated Notes", collectively, the "New Notes"). The New Notes removed an estimated excess cash flow calculation previously used to determine the timing and amount of payments. Further, the New Notes provide a fixed schedule for debt principal payments. In accordance with EITF 96-19, the Company recorded the exchange of the Old Notes as an extinguishment of debt, and in connection
therewith, recorded an extraordinary loss, net of taxes, of $2,750,000. This loss represents the amount by which the present value of the New Notes exceeds the present value of the Old Notes for which they were exchanged and fees paid to the lenders. The fees included the issuance of 22,600 shares of pre-Recapitalization common stock and warrants to purchase 82,690 shares of pre-Recapitalization common stock, both stated at fair market value when they were issued.
The New Subordinated Notes totaled $3,250,000 and bore interest at 9.2% per annum through March 31, 1999, after which the interest rate would increase by one percent per annum each year up to a maximum of 13.2%. Principal was due in annual payments ranging from $200,000 to $400,000 with a balloon payment of $2,050,000 due May 28, 2003. The entire balance of $3,250,000 was paid on December 8, 1998.
The New Junior Subordinated Notes have a face value of $17,335,000, are non-interest bearing and are reflected on the accompanying balance sheets at the present value using a discount rate of 10%. The unamortized discount related to the New Junior Subordinated Notes was $6,404,000 at January 30, 1999, resulting in a net carrying value of $10,931,000, as reflected in the January 30, 1999 balance sheet (see Financial Statements). The discount is amortized to interest expense as a non-cash charge until the notes are paid in full. Further, the New Junior Subordinated Notes require principal payments at December 31, 1999 and December 31, 2000 of $1,000,000, at December 31, 2001 and December 31, 2002 of $2,000,000, at December 31, 2003 and December 31, 2004 of $3,000,000 and a final payment at May 28, 2005 of $5,335,000.
Management believes that the Company's sources of cash, including the Facility, will be adequate to finance its operations and meet obligations under its existing indebtedness as they become due for at least the next twelve months.
CAPITAL EXPENDITURES
The Company anticipates spending approximately $15 million on capital expenditures in fiscal 1999 which includes costs to open new stores, to renovate and/or relocate existing stores and to upgrade information systems. Management believes that future expenditures will be financed from internal cash flow and the Facility.
INFLATION
In general, the Company believes that inflation has had no recent material impact on operations and none is anticipated in the next fiscal year.
MINIMUM WAGE INCREASES
The Company employs, both in its stores and in its corporate headquarters, a substantial number of employees who earn hourly wages near or at the minimum wage. Actions by both the federal and certain state governments have increased the hourly wages payable by the Company to such employees. To mitigate the impact of this wage increase, the Company has instituted policies to manage its ratio of wages to sales. Management believes that these measures will be adequate to control the impact of hourly wage increases on the overall profitability of its operations.
SEASONALITY AND QUARTERLY FLUCTUATIONS
The Company historically has realized its highest level of sales and income during the third and fourth quarters of its fiscal year (the quarters ending in October and January) as a result of the "Back to School" (August and September) and Christmas (November and December) seasons. The seasonally
lower sales in the Company's first two quarters (February through July), can result in the Company's incurring losses during those quarters even in years in which it will have full year profits.
YEAR 2000 ISSUE
Many currently installed computer systems and software products are coded to accept only 2 digit entries in the date code field. Beginning in the year 2000, these date code fields will need to accept 4 digit entries to distinguish 21st century dates from 20th century dates. Systems that do not properly recognize such information could generate erroneous data or fail. As a result, computer systems and/or software used by many companies may need to be upgraded to comply with Year 2000 requirements.
The Company is utilizing both internal and external resources as applicable, to identify, correct or reprogram its internal systems for Year 2000 compliance. The effect on the Company's future results of operations is being determined as part of the detailed conversion process. In February 1999, the Company implemented a new integrated software package to support future growth and to address the issues associated with the year 2000. This system implementation substantially completed the Company's internal program to address the Company's Year 2000 issues. The new software installation cost $2.8 million.
The Company is currently seeking to insure that the software and operating systems included in its new integrated software package are Year 2000 compliant. The Company is also in the process of requesting information and assurances from its major vendors, service providers and customers about their state of Year 2000 compliance and readiness. In the event that significant Year 2000 issues are identified with such parties, the Company will develop contingency plans such as the use of alternate vendors or manual systems.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS NO. 133 "Accounting for Derivative Instruments and Hedging Activities." This Statement established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for fiscal quarters beginning after June 15, 1999. The Company anticipates that the adoption of SFAS No. 133 will not have a material impact on the Company's financial position or results of operations.
The Accounting Standards Executive Committee (the "AcSEC") issued AICPA Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities," and SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," in April 1998 and March 1998, respectively. SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs and requires that such costs of start-up activities be expensed as incurred. SOP 98-1 provides guidance on accounting for the costs of computer software developed or obtained for internal use and identifies characteristics to be used in determining when computer software is for internal use. SOP 98-5 and 98-1 are effective for fiscal years beginning after December 15, 1998, with earlier applications permitted. The Company anticipates that the adoption of SOP 98-1 and SOP 98-5 will not have a material impact on the Company's financial position or results of operations.
On February 1, 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which requires reporting certain information about operating segments in condensed financial statements of interim periods issued to shareholders. The Company
did not operate multiple business segments as identified in SFAS No. 131 for the periods presented in the accompanying financial statements.
On February 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which requires companies to report as comprehensive income all changes in equity during a period except those resulting from investments by owners and distributions to owners. The Company had no other comprehensive income as identified in SFAS No. 130 for the periods presented in the accompanying financial statements.
In December 1997, the Company adopted SFAS No. 129, "Disclosure of Information about Capital Structure". This Statement establishes standards for disclosing information about an entity's capital structure. This Statement is effective for financial statements for periods ending after December 15, 1997. The adoption of SFAS No. 129, in fiscal 1997 did not have a material effect on the Company's financial position or results of operations.
CAUTIONARY STATEMENT FOR PURPOSES OF "SAFE HARBOR PROVISIONS" OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations that are not related to historical results are forward-looking statements. Actual results may differ materially from those projected or implied in the forward-looking statements. Risks and uncertainties which could effect the Company include increased competition from large national and regional discount store chains, inability to purchase adequate quantities of merchandise at below wholesale prices and changes in laws and regulations relating to wages, as well as other risks which are more fully described in Part I, Item 1 of this Form 10-K.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
All other schedules are omitted because of the absence of conditions under which they are required or because the required information is set forth in the consolidated financial statements and notes thereto.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated by reference to the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A in connection with the 1999 Annual Meeting of Shareholders (the "Proxy Statement") under the headings "Proposal 1 "Election of Directors" and "Executive Officers."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to the Registrant's Proxy Statement under the heading "Executive Compensation."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference to the Registrant's Proxy Statement under the heading "Security Ownership of Certain Beneficial Owners and Management."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the Registrant's Proxy Statement under the heading "Certain Relationships and Related Transactions."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Documents filed as part of this report:
The following is an index of the financial statements and exhibits included in this report or incorporated herein by reference.
1) Financial Statements; the financial statements filed as part of this report are listed in the index to financial statements on page 18.
2) Exhibits:
(1) Incorporated by reference to the Registrant's Form 10-Q for the 13 weeks ended August 2, 1997.
(2) Incorporated by reference to Registration Statement on Form S-2, No. 333-58797 filed with the Commission on October 14, 1998.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized.
FACTORY 2-U STORES, INC.
By: /s/ Michael M. Searles Michael M. Searles Chairman Dated: April 29, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of this Company and in the capacities and on the date indicated.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Factory 2-U Stores, Inc.:
We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (a Delaware corporation) as of January 30, 1999 and January 31, 1998, and the related statements of operations, stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Factory 2-U Stores, Inc. for the year ended February 1, 1997 were audited by other auditors whose report dated April 11, 1997 expressed an unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Factory 2-U Stores, Inc. as of January 30, 1999 and January 31, 1998, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/ ARTHUR ANDERSEN LLP
San Diego, California March 19, 1999
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Factory 2-U Stores, Inc. (formerly Family Bargain Corporation):
We have audited the accompanying consolidated statements of operations, stockholders' equity, and cash flows of Family Bargain Corporation and subsidiaries for the year ended February 1, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Family Bargain Corporation and subsidiaries for the year ended February 1, 1997, in conformity with generally accepted accounting principles.
KPMG LLP
San Diego, California April 11, 1997
The accompanying notes are an integral part to these financial statements.
FACTORY 2-U STORES, INC. STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part to these financial statements.
FACTORY 2-U STORES, INC. STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
The accompanying notes are an integral part to these financial statements.
FACTORY 2-U STORES, INC. STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part to these financial statements.
FACTORY 2-U STORES, INC. NOTES TO FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Factory 2-U Stores, Inc. ("the Company") operates off-price retail apparel and home goods stores in the western United States. At January 30, 1999, the Company operated 168 stores in seven states under the names Factory 2-U and Family Bargain Center.
PRINCIPLES OF CONSOLIDATION
Fiscal years ending February 1, 1997 and January 31, 1998 reflect consolidated financial statements which include the accounts of Family Bargain Corporation and its wholly-owned subsidiaries, General Textiles and Factory 2-U, Inc. All significant intercompany accounts were eliminated in consolidation. On July 31, 1998, General Textiles and Factory 2-U, Inc. merged to form a new Delaware corporation named General Textiles, Inc. On November 23, 1998, General Textiles, Inc. merged into Family Bargain Corporation which simultaneously changed its name to Factory 2-U Stores, Inc. The financial statements as of and for the period ending January 30, 1999, reflect the mergers (Note 4).
FISCAL YEAR
The Company's fiscal year is based on a 52/53 week year ending on the Saturday nearest January 31. Fiscal years ended January 30, 1999 and January 31, 1998 included 52 weeks and the fiscal year ended February 1, 1997 included 53 weeks. The Company defines its fiscal year by the calendar year in which most of the activity occurs (e.g. the year ended January 30, 1999 is referred to as fiscal 1998).
MERCHANDISE INVENTORY
Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method on a first-in, first-out flow assumption. In addition, consistent with industry practice, the Company capitalizes certain buying, warehousing, storage and transportation costs. At January 30, 1999 and January 31, 1998, such costs included in inventory were approximately $2,408,000 and $1,300,000, respectively.
LEASEHOLD IMPROVEMENTS AND EQUIPMENT
Leasehold improvements and equipment are stated at cost. Equipment under capital leases is stated at the present value of minimum lease payments at the date of acquisition. Depreciation and amortization are calculated using the straight-line method over the shorter of the estimated useful lives of the related asset or the lease term, generally five to seven years.
OTHER ASSETS
Other assets consist principally of rental deposits on leased stores, deferred debt issuance costs and covenants not to compete. Deferred debt issuance costs are amortized using the effective interest method over the terms of the related debt. Noncompete agreements are amortized ratably over the life of the agreements (Note 6).
EXCESS OF COST OVER NET ASSETS ACQUIRED
Excess of cost over net assets acquired (goodwill) is amortized on a straight-line basis over the expected periods to be benefited, generally 25 years. The Company assesses the recoverability of this intangible asset by determining whether the goodwill balance can be recovered from
undiscounted future operating cash flows. The impairment, if any, is measured based on estimated fair values. Goodwill recovery may be impacted if estimated future operating cash flows are not achieved (Note 2).
ASSET IMPAIRMENT
The Company assesses potential asset impairment using Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets (Note 2).
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of all receivables, payables and accrued balances approximate fair value due to the short-term nature of such instruments. The carrying amount of the revolving credit notes approximates fair value due to the floating rate on such instruments. The carrying value of long-term debt with fixed payment terms approximates fair value.
ADVERTISING COSTS
Advertising costs are charged to expense as incurred. Advertising expense for the fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997 was $9,854,000, $9,289,000 and $8,633,000, respectively.
LEASES
Rent expense is recorded on a straight-line basis over the life of the lease. Deferred rent represents the difference between base rentals paid under operating lease agreements and rent expense recognized (Note 10).
STORE PREOPENING AND CLOSING COSTS
Preopening costs (costs of opening new stores including grand opening promotions, training, store set-up and other direct incremental store opening costs) are charged to expense as incurred.
Costs associated with closing stores, consisting primarily of lease obligations and provisions to reduce assets to net realizable value, are charged to operations upon the commitment to close a store.
INCOME TAXES
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date (Note 9).
STOCK BASED COMPENSATION
On January 28, 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock Based Compensation, which permits entities to measure compensation expense related to stock options using either the intrinsic value method or a fair value method. Under the intrinsic value method, compensation expense is recognized only in the event that the exercise price of options granted is less than the market price of the underlying stock on the date of grant. The fair value method generally requires entities to recognize compensation expense over the vesting period of options based on the estimated fair value of the options granted. The Company has elected to apply the intrinsic value method of measuring stock based compensation and provide the pro forma disclosure requirements of SFAS No. 123 (Note 12).
The Company has only issued options with exercise prices above or equivalent to market price on the grant date. Accordingly, the Company has recognized no compensation expense related to stock options in the accompanying financial statements as of the grant date. However, refer to Note 12 regarding potential future compensation expense on certain stock options.
DIVIDEND ACCRETION
The Company's Series B preferred stock had an increasing rate dividend feature (Note 11). Accordingly, dividends on Series B preferred stock were recorded using the effective interest method to recognize the dividends ratably over the estimated period in which the stock would have been outstanding. As of November 23, 1998, the Series B Preferred Stock has been converted to common stock and, therefore, no additional dividends will be accreted (Note 4).
EARNINGS (LOSS) PER COMMON SHARE
In December 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share" (EPS). The statement specifies the computation, presentation, and disclosure requirements for earnings per share and diluted earnings per share. The statement requires retroactive adoption for all prior periods presented.
Some of the changes made to simplify the EPS computations include: (a) eliminating the presentation of primary EPS and replacing it with basic EPS, with the principal difference being that common stock equivalents are not considered in computing basic EPS (1,776,225, 1,030,189, and 237,128 common stock equivalents were excluded from the calculation for the fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997, respectively); (b) eliminating the modified treasury stock method and the three percent materiality provision; and (c) revising the contingent share provisions and the supplemental EPS data requirements.
The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued, except for contingently issuable shares which are omitted from the calculation. In addition, in computing the dilutive effect of convertible securities, the numerator is adjusted to add back (a) any convertible preferred dividends and (b) the after-tax amount of interest recognized in the period associated with any convertible debt.
For fiscal years 1998, 1997 and 1996 potential dilutive securities include certain stock options and warrants, and fiscal years 1997 and 1996 also include convertible preferred stock. Due to the net loss applicable to common shares recorded in each year, had such potential common shares been outstanding, the effect on earnings per share would have been anti-dilutive. Therefore, the exercise or conversion of such securities is not assumed for purposes of calculating diluted earnings per share and basic and diluted are equal in each period presented.
USE OF ESTIMATES
Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform their presentation to fiscal 1998 financial statements.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS NO. 133 "Accounting for Derivative Instruments and Hedging Activities." This Statement established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for fiscal quarters beginning after June 15, 1999. The Company anticipates that the adoption of SFAS No. 133 will not have a material impact on the Company's financial position or results of operations.
The Accounting Standards Executive Committee (the "AcSEC") issued AICPA Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities," and SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," in April 1998 and March 1998, respectively. SOP 98-5 provides guidance on the financial reporting of start-up costs and organization costs and requires that such costs of start-up activities be expensed as incurred. SOP 98-1 provides guidance on accounting for the costs of computer software developed or obtained for internal use and identifies characteristics to be used in determining when computer software is for internal use. SOP 98-5 and 98-1 are effective for fiscal years beginning after December 15, 1998, with earlier applications permitted. The Company anticipates that the adoption of SOP 98-1 and SOP 98-5 will not have a material impact on the Company's financial position or results of operations.
On February 1, 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which requires reporting certain information about operating segments in condensed financial statements of interim periods issued to shareholders. The Company did not operate multiple business segments as identified in SFAS No. 131 for the periods presented in the accompanying financial statements.
On February 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which requires companies to report as comprehensive income all changes in equity during a period except those resulting from investments by owners and distributions to owners. The Company had no other comprehensive income as identified in SFAS No. 130 for the periods presented in the accompanying financial statements.
In December 1997, the Company adopted SFAS No. 129, "Disclosure of Information about Capital Structure". This Statement establishes standards for disclosing information about an entity's capital structure. This Statement is effective for financial statements for periods ending after December 15, 1997. The adoption of SFAS No. 129, in fiscal 1997 did not have a material effect on the Company's financial position or results of operations.
2. SPECIAL CHARGES
During fiscal 1998, the Company recorded charges to operations in the amount of $1,000,000 for costs related to the merger of its wholly-owned subsidiary, General Textiles, Inc. into the Company and the Recapitalization (Note 4).
In fiscal 1998, the Company recorded special charges in the amount of $2,350,000 in connection with hiring the current President and CEO of the Company. In August 1997, the Company recorded special charges to operations in the amount of $1,750,000 pertaining to the separation from the Company of the former President and CEO.
In connection with the sale of a controlling interest in the Company to a new investor group in January 1997 (Note 11), the Company moved its executive offices from New York City to San Diego, CA and entered into a separation agreement with three former executives (the Former Executives). As a result of these actions, the Company recognized special charges in the amount of $9,172,000 in fiscal 1996. The special charges included $7,081,000 to settle the existing employment and benefit agreements of the Former Executives and $2,091,000 to cancel certain contracts and expenses related to the separation of the Former Executives and closure of the New York office.
On November 13, 1995, the Company acquired all of the common stock of Factory 2-U, Inc. The acquisition was accounted for under the purchase method of accounting. The operating results of Factory 2-U during the year after acquisition were significantly below the projections the Company had used when Factory 2-U was acquired. As a result, the Company adjusted its estimate of future cash flows for Factory 2-U. The revised estimated cash flows were insufficient to recover the recorded value of goodwill and accordingly, the Company recorded an asset impairment charge of $8,380,000 to reduce goodwill arising from the Factory 2-U acquisition.
The Company withdrew a securities offering in January 1997. In conjunction with this withdrawal, the Company wrote-off $1,923,000 in deferred offering costs.
3. DISCONTINUED OPERATIONS
The Company divested its distribution business (the "Former Distribution Business"), which was comprised of the operations of MKI Acquisition, Mandel-Kahn, CB/Camelot and CB/Murray, prior to April 30, 1993. The estimation and settlement of the residual net liabilities of the Former Distribution Business have been accounted for as discontinued operations in these financial statements. The Company recognized a loss, net of taxes, on disposal of discontinued operations in the amount of $826,000 in fiscal 1996 to reflect the costs to litigate and settle claims and the cost of consulting services that it does not intend to use. The Company does not anticipate any future expenses related to the Former Distribution Business.
4. RECAPITALIZATION
In fiscal year 1998, the Company initiated a multi-phased plan to restructure its capitalization (the "Recapitalization"), which included restructuring the subordinated and junior subordinated debt in a manner that removed an estimated excess cash flow calculation previously used to determine the timing and amounts of payments and replaced that feature with a fixed schedule for debt payments. The debt restructuring resulted in an extraordinary charge of $2,750,000, net of taxes, in the first quarter ending April 30, 1998 (Note 9).
On July 31, 1998, the Company's two operating subsidiaries, General Textiles and Factory 2-U, Inc., merged to form General Textiles, Inc.
On November 23, 1998, the Company carried out a Recapitalization in which all of the Company's stock was converted into a single class of Common Stock. Under the Plan of Recapitalization, each share of Pre-Recapitalization Common Stock was converted into .30133 shares of Common Stock, each share of Series A Preferred Stock was converted into one share of Common Stock and each share of Series B Preferred Stock was converted into 173.33 shares of Common Stock. In connection with the Recapitalization, General Textiles, Inc. was merged into Family Bargain Corporation (the "Family Bargain Merger") and the Company's name was changed to Factory 2-U Stores, Inc.
The last phase of the Recapitalization was a rights offering in which 800,000 shares of Post-Recapitalization Common Stock were sold to existing shareholders at $13 per share. The Company received proceeds of $10,00,000, net of $400,000 of related expenses.
In November 1998, the Company recorded a reduction to net income available to common stockholders in the amount of $2,804,000 pertaining to the conversion of Series A and Series B Preferred Stock to Common Stock pursuant to the Plan of Recapitalization, in accordance with SFAS No. 84, "Induced Conversions of Convertible Debt." The amount of the reduction represents the fair value of Post-Recapitalization Common Stock transferred in excess of the fair value of common stock issuable pursuant to the original conversion terms of the Preferred Stock.
5. LEASEHOLD IMPROVEMENTS AND EQUIPMENT
Leasehold improvements and equipment consist of the following:
6. OTHER ASSETS
Other assets consist of the following:
In August 1997, the former President and CEO entered into an agreement not to compete with the Company until January 2001 in return for payments totaling $970,000. In January 1997, the Company entered into an agreement not to compete with certain former executives in favor of the Company until June 2000 in return for $1,750,000 in secured promissory notes that were paid in January 1998.
7. ACCRUED EXPENSES
Accrued expenses consist of the following:
8. LONG-TERM DEBT AND REVOLVING CREDIT NOTES
Long-term debt and revolving credit notes consist of the following:
REVOLVING CREDIT FACILITY
In July 1998, the Company and its lender agreed to amend certain terms and conditions of the revolving credit facilities between the lender and General Textiles and Factory 2-U. As a result of the Subsidiary Merger, the covenants and financial ratios were reset to reflect anticipated earnings, capital expenditures and cash flow of the Company during fiscal 1998 and the facilities were combined into one revolving credit facility (the "Facility").
At January 30, 1999 the Company had a revolving credit facility (the "Facility") under which it could borrow up to $50,000,000 under the Facility at the prime rate plus 0.75%, subject to limitations based on inventory levels. At January 30, 1999, the Company owed $1.8 million under the Facility and had $27,700,000 available to borrow under the Facility. The Facility expires in March 2000 but is subject to one year automatic renewal periods, unless terminated by the Company or its lender. The balance owed under the Facility fluctuates based on working capital requirements. Because of the seasonal nature of the Company's business, borrowings are usually greatest between August and December. The Company pays fees of 0.25% on the unused portion of the Facility. The Facility is secured by all the assets of the Company.
The Company was not in compliance with the current ratio covenant in the Facility as of January 30, 1999. The lender has waived that requirement at January 30, 1999.
SUBORDINATED NOTES
At January 31, 1998, the Company had outstanding $22,945,000 face value of subordinated notes issued in settlement of certain pre-bankruptcy claims of General Textiles. In 1997 and previously, the subordinated notes were referred to as the "Sub Notes" and were comprised, in order of seniority, of Trade Subordinated Notes (due no later than April 2003), Subordinated Reorganization Notes (due no later than November 2003) and Junior Subordinated Reorganization Notes (due no later than May 2005). The Sub Notes were non-interest bearing, except for certain contingent interest payments and were subject to minimum principal payment requirements based on the annual excess cash flows of General Textiles. Accordingly, the Sub
Notes were discounted to carrying values based on estimated future cash flows of General Textiles at discount rates ranging from 6% to 25%.
Effective April 30, 1998, the Company entered into agreements to exchange the Subordinated Reorganization Notes and the Junior Subordinated Reorganization Notes (the "Old Notes") for new notes (the "New Subordinated Notes" and the "New Junior Subordinated Notes", collectively, the "New Notes"). The New Notes removed an estimated excess cash flow calculation previously used to determine the timing and amount of payments. Further, the New Notes provide a fixed schedule for debt principal payments. In accordance with EITF 96-19, the Company recorded the exchange of the Old Notes as an extinguishment of debt, and in connection therewith, recorded an extraordinary loss, net of taxes, of $2,750,000. This loss represents increases in the present value of the principal amount of the Old Notes and fees paid to the lenders. The fees included the issuance of 22,600 shares of pre-Recapitalization common stock and warrants to purchase 82,690 shares of pre-Recapitalization common stock, both stated at fair market value when they were issued.
The New Subordinated Notes totaled $3,250,000 and bore interest at 9.2% per annum through March 31, 1999, after which the interest rate would increase by one percent per annum each year up to a maximum of 13.2%. Principal was due in annual payments ranging from $200,000 to $400,000 with a balloon payment of $2,050,000 due May 28, 2003. The entire balance of $3,250,000 was paid on December 8, 1998.
The New Junior Subordinated Notes have a face value of $17,335,000, are non-interest bearing and are reflected on the accompanying balance sheets at the present value using a discount rate of 10%. The unamortized discount related to the New Junior Subordinated Notes was $6,404,000 at January 30, 1999, resulting in a net carrying value of $10,931,000, as reflected in the January 30, 1999 balance sheet (see Financial Statements). The discount is amortized to interest expense as a non-cash charge until the notes are paid in full. Further, the New Junior Subordinated Notes require principal payments at December 31, 1999 and December 31, 2000 of $1,000,000, at December 31, 2001 and December 31, 2002 of $2,000,000, at December 31, 2003 and December 31, 2004 of $3,000,000 and a final payment at May 28, 2005 of $5,335,000.
The Plan required that certain events, such as the Subsidiary Merger of July 31, 1998, result in the acceleration of payment of the Trade Subordinated Notes. Accordingly, the outstanding balance of $1,760,000 of the Trade Subordinated Notes was paid in October 1998.
9. INCOME TAXES
Significant components of the provision (benefit) for income taxes are as follows:
The principal temporary differences that give rise to significant portions of the consolidated deferred tax assets and liabilities are presented below:
The Company has established a valuation allowance due to lack of historical earnings and annual limitations on the usage of net operating loss carryforwards.
The difference between the expected income tax expense (benefit) computed by applying the U.S. federal income tax rate of 34% to net income from continuing operations for fiscal 1998, 1997 and 1996 and actual expense is a result of the following:
At January 30, 1999, the Company had net operating loss carryforwards for federal income tax purposes of approximately $18.2 million that expire starting in 2012.
10. LEASE COMMITMENTS
The Company operates retail stores, warehouse facilities and administrative offices under various operating leases. Total rent expense was $17,977,000, $17,313,000 and $14,987,000, including contingent rent expense of $240,000, $128,000 and $89,000, for fiscal years ended January 30, 1999, January 31, 1998 and February 1, 1997, respectively.
For financial statement purposes, rent expense is recorded on a straight-line basis over the life of the lease. For fiscal year 1998, cash payment requirements exceeded rent expense charged to operations by $362,000, resulting in a decrease to the deferred rent liability for the same amount. For fiscal 1997 and 1996, rent expense charged to operations exceeded cash payment requirements by $153,000 and $452,000, respectively, and resulted in an increase to the deferred rent liability for the same amounts.
The Company is also obligated under various capital leases for leasehold improvements and equipment that expire at various dates during the next three years. Leasehold improvements and equipment and related accumulated amortization recorded under capital leases are as follows:
At January 30, 1999, the future minimum lease payments under capital leases and operating leases with remaining noncancelable terms are as follows:
11. STOCKHOLDERS' EQUITY
Prior to the Recapitalization, the Company was authorized to issue Series A 9-1/2% Cumulative Convertible Preferred Stock (the "Series A Preferred Stock"), Series B Junior Convertible, Exchangeable Preferred Stock (the "Series B Preferred Stock") and Common Stock. As a result of the Plan of Recapitalization approved by the stockholders, the Company converted all shares of its Series A and Series B Preferred Stock into Post-Recapitalization Common Stock and issued a reverse stock split which converted all shares of its Pre-Recapitalization Common Stock into .30133 shares of Post-Recapitalization Common Stock (Note 4).
SERIES A AND SERIES B PREFERRED STOCK
Prior to the Recapitalization, the Company had 7,500,000 shares of preferred stock authorized, of which 4,500,000 were allocated to Series A Preferred Stock and 40,000 were allocated Series B Preferred Stock.
The Series A Preferred Stock ranked senior to the Series B Preferred Stock and the common stock with respect to the payment of dividends and distribution of net assets upon liquidation, dissolution or winding up. Cumulative dividends were payable quarterly at the rate of $.95 per
year on April 30, July 31, October 31, and the last Friday in January if, as and when declared by the Board of Directors. Series A Preferred Stock was convertible, prior to redemption, at the option of the holder, into shares of common stock at a conversion price subject to adjustment under certain circumstances pursuant to anti-dilution provisions.
The Series B Preferred Stock ranked junior to the Series A Preferred Stock and senior to the common stock with respect to the payment of dividends and the distribution of assets upon liquidation, dissolution or winding up. The Series B Preferred Stock was convertible, at the option of the holder, only after all the Series A Preferred Stock was converted or redeemed. The conversion price per share was subject to adjustment under certain circumstances pursuant to anti-dilution provisions. Each share of Series B Preferred Stock was entitled to voting rights equivalent to the number of common shares into which it is convertible. The Series B Preferred Stock was to pay no dividend until January 2002.
During fiscal 1997, the Company placed 11,715 shares of its Series B Preferred Stock for aggregate cash proceeds of $9,600,000 with private investors and notes receivable in the amount of $2,115,000 from management of the Company. Additionally, during fiscal 1998, the Company placed 1,824 shares of its Series B Preferred Stock for notes receivable in the amount of $1,972,000 from management of the Company. The notes receivable from management of the Company for the purchase of Series B Preferred Stock are due in 2002 and 2003, accrue interest at 8% per annum and require annual principal payments equivalent to 16.25% of the annual bonus of each purchaser and a balloon payment of the unpaid principal and accrued interest at maturity. The notes are full-recourse notes and were secured by the Series B Preferred Stock issued in return for the notes. The notes are now secured by the Post-Recapitalization Common Stock into which the underlying Series B Preferred Stock was converted.
In April 1997, concurrent with the Series B issuance, the Company effectively redeemed all rights outstanding under its Shareholders' Rights Agreement. The Company paid each holder of common stock $0.001 per share totaling $4,930.
12. STOCK OPTIONS AND WARRANTS
At January 30, 1999, warrants to purchase 452,459 common shares were outstanding. Of these warrants, 82,690 have an exercise price of $19.91 and expire in May 2005, 320,000 have an exercise price of $16.50 and expire in July 1999, and 49,769 have an exercise price of $6.22 and expire in March 2001 (the "$6.22 Warrants"). The $6.22 Warrants were issued in March 1996 in connection with a private placement of Series A Preferred Stock (Note 11). Had the Company measured the estimated fair value of the warrants issued in March 1996, there would have been no impact on the consolidated financial statements due their being treated as an expense of the private placement.
The Company has one stock option plan, the Amended and Restated Family Bargain Corporation 1997 Stock Option Plan. Options may be granted as incentive or nonqualified stock options. The Company accounts for its stock option plan under APB Opinion No. 25, under which no compensation cost has been recognized in fiscal 1998 and fiscal 1999 respectfully.
FASB Statement No. 123 "Accounting for Stock-Based Compensation" was issued by the FASB in 1995 and, if fully adopted, changes the methods for recognition of cost on plans similar to those of the Company. Adoption of FASB Statement No. 123 is optional, however pro forma disclosures as if the Company had adopted the cost recognition method are required. Had compensation cost for stock options awarded under this plan been determined consistent with FASB Statement No. 123, the Company's net income and earnings per share would have reflected the following pro forma amounts:
The Company may grant up to 1,807,980 options under this Plan. The Company has granted 1,323,766 through January 30, 1999. The options are issued at fair market value with exercise prices equal to Company's stock price at the date of grant. Options vest over three to five years; are exercisable in whole or in installments; and expire from five to ten years from date of grant.
The Company's Board of Directors has granted stock options to members of the Board and to Company management. A summary of the status of the Company's stock option plan at February 1, 1997, January 31, 1998, and January 30, 1999 and changes during the years then ended is presented in the table and narrative below:
* Options for January 31, 1998, February 1, 1997 and January 26, 1996 have been converted at .30133 per option under the Recapitalization.
Of the options outstanding at January 30, 1999, 213,233 have exercises prices of $4.15 to $5.81 with a weighted average exercise price of $5.09, a weighted average remaining contractual life of 3.72 years and 104,895 of these options are exercisable. The remaining 1,110,533 options outstanding at January 30, 1999 have exercise prices of $6.01 to $8.50, a weighted average exercise price of $7.32, a weighted average remaining contractual life of 3.51 years and 247,220 of these options are exercisable.
At January 30, 1999, there were 585,520 options outstanding which, subject to vesting conditions, originally became exercisable in 25% installments when the Common Stock price reaches the following market price hurdles: $19.91, $24.89, $33.19 and $49.78. In December 1998, the Board of Directors removed the first two market price hurdles for employees with options, making one-half of those options granted exercisable, subject to vesting conditions. As a result of the removal of the first two market price hurdles, the Company recorded compensation expense in the amount of $82,000. Assuming all shares are fully vested and all market price hurdles are met, then the Company would be required to record an aggregate non-cash compensation expense in the amount of $9,564,000 in varying amounts as the market price hurdles are achieved.
The weighted-average fair values at date of grant for options granted during fiscal 1998 and 1997 were between $0.90 and $4.14 and were estimated using the Black-Scholes option pricing model
with the following assumptions: (i) weighted average dividend yield of 0.00%, (ii) weighted average volatility of 106.89% and 138.88% for fiscal years 1998 and 1997, respectively, (iii) expected life of three to five years, and (iv) weighted average risk-free interest rate of 5.55% and a range from 5.45% to 6.88%, for fiscal years 1998 and 1997, respectively.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models also require the input of highly subjective assumptions such as expected option life and expected stock price volatility. Because the Company's employee stock-based compensation plan has characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, the Company believes that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from those plans.
13. EMPLOYEE BENEFITS
The Company sponsors a defined contribution plan, qualified under Internal Revenue Code Section 401(k), for the benefit of employees who have completed twelve months of service and who work a minimum of 1,000 hours during that twelve month period. The Company makes a matching contribution equal to 20% of participating employees' voluntary contributions. Participants may contribute from 1% to 15% of their compensation annually, subject to IRS limitations. The Company contributed $134,000, $132,000 and $111,000 in fiscal 1998, 1997 and 1996, respectively.
14. RELATED PARTY TRANSACTIONS
During fiscal 1996, the Company paid $1,100,000 in fees and expense reimbursements related to its withdrawn securities offering and advisory fees related to the private placement of Series B Preferred Stock to an investment banking firm for which a director of the Company served as a managing director (Notes 2 and 11). This same director was appointed to the Board of Directors following the successful completion of the initial public offering of Series A Preferred Stock in July 1994.
The Company also paid a $250,000 finder's fee to a newly appointed director in respect of advisory services rendered to the Company in connection with the private placements of Series B Preferred Stock (Note 11).
In January 1997, the Company paid $96,000 to former directors of the Company pursuant to the cancellation of their stock options and warrants.
In March 1996, a director of the Company was a managing director of the investment-banking firm that served as the placement agent for the Company's private placement of 726,000 shares of Series A Preferred Stock (Note 11).
At January 27, 1996, an accounts receivable balance of approximately $170,000 was outstanding from an affiliate of the Former Executives. This receivable was forgiven in connection with the settlements with the Former Executives and is included in the special charges recorded in fiscal 1996 (Note 2).
15. COMMITMENTS AND CONTINGENCIES
The Company is at all times subject to pending and threatened legal actions that arise out of the normal course of business. In the opinion of management, based in part on the advice of legal counsel, the ultimate disposition of these matters will not have a material adverse effect on the financial position or results of operations of the Company.
The Company has entered into an employment contract with its President and CEO, which defines his duties, compensation and severance in the event of his termination of employment with the Company.
16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The results of operations for fiscal 1998, 1997 and 1996 were as follows:
EXHIBIT INDEX
EXHIBIT NUMBER 11.1 Calculation of per share income (loss) 23 Consents (b) Arthur Andersen LLP (accountants) (c) KPMG Peat Marwick LLP (accountants) 27 Financial Data Schedule (submitted for SEC use only)
EXHIBIT 11.1 FACTORY 2-U STORES, INC. COMPUTATION OF NET INCOME (LOSS) PER COMMON SHARE (BASIC AND DILUTED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
EXHIBIT 23(b)
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statement File No. 333-76011.
ARTHUR ANDERSEN LLP
San Diego, California April 28, 1999
EXHIBIT 23(c)
INDEPENDENT AUDITOR'S CONSENT
The Board of Directors Factory 2-U Stores, Inc. (formerly Family Bargain Corporation)
We consent to the incorporation by reference in the registration statement (No. 333-76011) on Form S-8 of Factory 2-U Stores, Inc. of our report dated April 11, 1997, relating to the consolidated statements of operations, stockholders' equity, and cash flows of Family Bargain Corporation and subsidiaries for the year ended February 1, 1997, which report appears in the January 30, 1999 annual report on Form 10-K of Factory 2-U Stores, Inc.
KPMG LLP
San Diego, California April 28, 1999