SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 10-Q
Commission file number 000-23314
TRACTOR SUPPLY COMPANY
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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.
INDEX
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TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
TRACTOR SUPPLY COMPANYCONSOLIDATED BALANCE SHEETS(in thousands, except share and per share amounts)
The accompanying notes are an integral part of this statement.
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TRACTOR SUPPLY COMPANYCONSOLIDATED STATEMENTS OF INCOME(in thousands, except per share amounts)
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TRACTOR SUPPLY COMPANYCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)
The accompanying notes are an integral part of this statement
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1 — Significant Accounting Policies:
Basis of Presentation
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These statements should be read in conjunction with the Company’s annual report on Form 10-K for the fiscal year ended December 28, 2002. The results of operations for the fiscal three-month and six-month periods are not necessarily indicative of results for the full fiscal year.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany accounts and transactions have been eliminated.
Management Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States inherently requires estimates and assumptions by management that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures. Actual results could differ from those estimates.
Significant estimates and assumptions by management primarily impact the following key financial statement areas:
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Revenue Recognition
The Company recognizes revenue when sales transactions occur and customers take possession of the merchandise. A provision for anticipated merchandise returns is provided in the period during which the related sales are recorded.
Store Pre-opening Costs
Non-capital expenditures incurred in connection with start-up activities, including organizational costs, are expensed as incurred.
Store Closing Costs
Beginning in fiscal 2003, the Company recognizes store closing costs in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Prior to the adoption of SFAS 146, the Company recognized store-closing costs (primarily remaining lease obligations and disposals of property and equipment) at the time the plan for the related store closing or relocation was finalized. The adoption of SFAS 146 did not materially impact the Company’s financial position, cash flows, or results of operations.
Cash and Cash Equivalents
The Company considers temporary cash investments, with a maturity of three months or less when purchased, to be cash equivalents.
Fair Value of Financial Instruments
The Company’s financial instruments consist of cash and cash equivalents, short-term trade receivables and payables and long-term debt instruments, including capital leases. The carrying values of cash and cash equivalents, trade receivables and trade payables equal current fair value. The terms of the Company’s revolving credit agreement and term loan agreement include variable interest rates, which approximate current market rates.
Derivative Instruments and Hedging Activities
The Company complies with SFAS Nos. 133, 137, and 138 (collectively “SFAS 133”) pertaining to the accounting for derivatives and hedging activities. SFAS 133 requires the Company to recognize all derivative instruments in the balance sheet at fair value. SFAS 133 impacts the accounting for the Company’s interest rate swap agreement, which is designated as a cash flow hedge. (Note 6)
Inventories
The value of the Company’s inventories was determined using the lower of last-in, first-out (LIFO) cost or market. Inventories are not in excess of market value. The Company receives funding from its vendors for promotion of the Company’s brand as well as the sale of its products. Such funds are recognized as a reduction of the purchase cost of
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inventory. Quarterly inventory determinations under LIFO are based on assumptions as to projected inventory levels at the end of the fiscal year, sales for the year and the rate of inflation/deflation for the year. If the first-in, first-out (FIFO) method of accounting for inventory had been used, inventories would have been approximately $656,000 and $5,267,000 higher than reported at June 28, 2003 and December 28, 2002, respectively. (The reduction in the LIFO reserve is primarily due to the adoption of Emerging Issue Task Force (EITF) issue 02-16, which resulted in a reduction of the carrying value of inventory (Note 3).)
Freight Costs
The Company incurs various types of transportation and delivery costs in connection with inventory purchases and distribution. Such costs are included as a component of the overall cost of merchandise.
Property and Equipment
Property and equipment are carried at cost. Depreciation is recorded using the straight-line method over the estimated useful lives of the assets. Improvements to leased premises are amortized using the straight-line method over the life of the lease or the useful life of the improvement, whichever is shorter. The following estimated useful lives are generally applied:
Impairment of Long-Lived Assets
The Company complies with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” in the recognition of asset impairment. Accordingly, the Company reviews long-lived assets for impairment when circumstances indicate the carrying amount of the asset may not be recoverable. Impairment is recognized on assets classified as held and used when the sum of undiscounted estimated future cash flows expected to result from the use of the asset is less than the carrying value. Impairment on long-lived assets to be disposed of is recognized by writing down the related assets to their fair value (less costs to sell, as appropriate), when the criteria have been met for the asset to be classified as held for sale or disposal (Note 4).
Advertising Costs
Advertising costs consist of expenses incurred in connection with newspaper circulars, television and radio, as well as direct mail, newspaper advertisements and other promotions. Expenses incurred are charged to operations at the time the related advertising first takes place.
Beginning in fiscal 2003, the Company adopted the provisions of EITF No. 02-16 (“EITF 02-16”), “Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor,” as required. Under EITF 02-16, vendor-provided funding is recognized as a reduction of cost of sales as the related vendors’ purchased inventory is sold.
Income Taxes
The Company accounts for income taxes using the liability method, whereby deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to be recovered or settled.
Extinguishment of Debt
In April 2002, the FASB issued SFAS 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections,” which requires gains and losses from extinguishment of debt to no longer be classified as extraordinary items, net of related income tax effect. SFAS 145 requires that extinguishment gains or losses be classified as ordinary gains or losses, and that all such gains or losses in prior periods be reclassified to ordinary gain or loss in comparative financial statements. The Company adopted this Statement in the
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first quarter of fiscal 2003, as required. The adoption of SFAS 145 had no impact on the Company’s financial position, cash flows, or results of operations.
Stock-based Compensation Plans
In December 2002, the FASB issued SFAS 148 “Accounting for Stock-Based Compensation-Transition and Disclosure,” which amends SFAS 123, “Accounting for Stock-Based Compensation.” SFAS 148 provides 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 of SFAS 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. The Company has elected to account for its stock-based compensation plans under the intrinsic value-based method of accounting as permitted by SFAS 123 and as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” However, the Company has adopted the disclosure requirements of SFAS 123 and SFAS 148, as required.
Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with the method prescribed by SFAS 123, the Company’s pro forma net income and net income per share, for the fiscal three months and six months ended June 28, 2003 and June 29, 2002, would have been as follows (in thousands, except per share amounts):
Net Income Per Share
The Company presents both basic and diluted earning per share (“EPS”) on the face of the consolidated income statement. As provided by SFAS 128, “Earnings per Share,” basic EPS is calculated as net income available to common stockholders divided by the weighted average number of shares outstanding during the period. Diluted EPS is calculated using the treasury stock method for options and warrants. All earnings per share data included in the consolidated financial statements and notes thereto has been restated to give effect to a two-for-one stock split that occurred on August 19, 2002 (Note 8). Additionally, on July 17, 2003, the Company’s Board of Directors approved a two-for-one split of the Company’s common stock, which has not been reflected in the accompanying consolidated financial statements (Note 12).
Reclassifications
Certain amounts in previously issued financial statements were reclassified to conform to fiscal 2003 presentations.
Note 2 — Seasonality:
The Company’s business is subject to seasonality and, as a result, a significant portion of its sales and income are realized in the second and fourth fiscal quarter. The Company typically builds inventory in the first fiscal quarter in preparation for a higher volume second quarter.
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Note 3 — Change in Accounting Principle:
EITF 02-16 provides guidance for the accounting treatment and income statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the promotion of sales of the vendor’s products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in prices paid for inventory and recognized in cost of sales as the related inventories are sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of specific, identifiable incremental costs. Prior to adopting this pronouncement, the Company classified all vendor-provided marketing support funds as a reduction in selling, general and administrative expenses.
The effect of applying the consensus of EITF 02-16 on prior-period financial statements resulted in a change to previously reported net income, thus, the Company has reported the adoption of EITF 02-16 as a cumulative effect adjustment in accordance with APB Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements” and as permitted by EITF 02-16. During the first quarter of fiscal 2003, the Company recognized a charge against net income of $3,053,000 ($1,888,000 net of income taxes), that resulted from the cumulative effect on prior years. Net income for the second quarter and the first six months of 2002, assuming EITF 02-16 had been applied retroactively, would have increased $877,000 and $889,000 respectively. Basic and diluted income per share for the second fiscal quarter of 2002 would have increased $0.05 to $1.01 and $0.93, respectively, had EITF 02-16 been applied retroactively. Basic and diluted income per share for the first six months of fiscal 2002 would have increased $0.05 and $0.04, respectively, to $0.79 and $0.73 had EITF 02-16 been applied retroactively.
Note 4 — Assets Held for Sale:
Assets held for sale consists of certain buildings and properties that the Company either acquired through the significant asset purchase as described in Note 9 or that the Company vacated upon relocation of a store.
The Company applies the provisions of SFAS 144 to assets held for sale. SFAS 144 requires assets held for sale to be valued on an asset-by-asset basis at the lower of carrying amount or fair value, less costs to sell. In applying these provisions, recent appraisals, valuations, offers and bids are considered. The Company recorded an impairment charge of $78,000 and $572,000 in the first quarter of fiscal 2003 and 2002, respectively, to adjust the carrying value of certain property and equipment related to vacated stores to fair value, less costs to sell. No impairment charges were required during the second quarter of fiscal 2003 or 2002.
The buildings and properties held for sale are separately presented as assets held for sale in the accompanying consolidated balance sheets. The assets are classified as current, as the Company believes they will be sold within the next twelve months and have met all the criteria for classification as held for sale pursuant to SFAS 144.
Note 5 — Senior Credit Facility:
In August 2002, the Company entered into a replacement unsecured senior revolving credit facility with Bank of America, N.A., as agent for a lender group, expanding the maximum available borrowings from $125.0 million to $155.0 million, extending the maturity to February 2006 and increasing the number of participating banks from seven to ten. The Credit Facility bears interest at either the bank’s prime rate (4.0% at June 28, 2003) or the London Inter-Bank Offer Rate (1.12% at June 28, 2003) plus an additional amount ranging from 0.75% to 1.5% per annum, adjusted quarterly based on the Company’s performance (0.75% at June 28, 2003).
Note 6 — Derivative Financial Instruments:
The Company has entered into an interest rate swap agreement as a means of managing its interest rate exposure. This agreement has the effect of converting certain of the Company’s variable rate obligations to fixed rate obligations.
The Company complies with SFAS 133 and recognizes the fair value of the interest rate swap in its consolidated balance sheet. The Company regularly adjusts the carrying value of the interest rate swap to reflect its current fair value. The related gain or loss on the swap is deferred in stockholders’ equity (as a component of comprehensive income) to the extent that the swap was an effective hedge. The deferred gain or loss is recognized in income in the period in which the related interest rate payments being hedged have been recognized as an expense. However, to the extent that the change in value of an interest rate swap contract does not perfectly offset the change in the interest
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rate payments being hedged, the ineffective portion is immediately recognized as an expense. Net amounts paid or received are reflected as adjustments to interest expense.
The Company expects to recognize income of approximately $409,000 on interest rate swaps from accumulated other comprehensive loss to earnings over the remaining life of the swap agreement. The interest rate swap agreement matures in November 2003.
Note 7 — Comprehensive Income:
Comprehensive income includes the change in the fair value of the Company’s interest rate swap agreement, which qualifies for hedge accounting. Comprehensive income for each period is as follows (in thousands):
Note 8 — Net Income Per Share:
Basic net income per share is based on the weighted average outstanding common shares. Diluted net income per share is based on the weighted average outstanding common shares and reflects basic net income per share reduced by the dilutive effect of stock options.
Net income per share is calculated as follows (in thousands, except per share amounts):
Net income per share before and after the cumulative effect of accounting change is as follows (in thousands, except per share amounts):
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On July 18, 2002, the Company’s Board of Directors approved a two-for-one split of the Company’s common stock. As a result, stockholders received one additional share on August 19, 2002 for each share held as of the record date of August 2, 2002. The par value of the Company’s common stock remains $0.008. All share and per share data included in the consolidated financial statements and notes thereto has been restated to give effect to the stock split. Additionally, on July 17, 2003, the Company’s Board of Directors approved a two-for-one split of the Company’s common stock (Note 12). The accompanying presentation of the consolidated balance sheets and earnings per share do not reflect the effect of this stock split.
Note 9 — Significant Asset Purchase:
On December 31, 2001, the Company, through a joint venture with Great American Group, Gordon Brothers Retail Partners, LLC and DJM Asset Management LLC, was the successful bidder at a liquidation bankruptcy auction for the buildings, improvements, fixtures and lease rights of certain retail stores formerly operated by Quality Stores, Inc., a debtor and debtor in possession under Chapter 11 of the United States Bankruptcy Code. The Company’s share of the bid totaled $34.0 million and was funded entirely through the Senior Credit Facility.
Under its agreement with the other joint venture partners, the Company acquired the buildings for 24 retail stores, assumed the building lease rights for 76 additional retail stores, and acquired the related equipment, furniture and fixtures. The liquidation of the existing inventory by other members of the joint venture was completed in late February 2002, with the Company having conducted hiring, training, refurbishment and merchandising efforts throughout the first fiscal quarter. The transition of these locations, which was completed in the third quarter of fiscal 2002, included the opening of new stores as well as the relocation of existing stores into the newly acquired properties.
Note 10 — Contingencies:
Litigation
The Company is involved in various litigation arising in the ordinary course of business. After consultation with legal counsel, management expects these matters will be resolved without material adverse effect on the Company’s consolidated financial position or results of operations. Any estimated loss has been adequately provided in accrued liabilities to the extent probable and reasonably estimable. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in circumstances relating to these proceedings.
Environmental Matters
In connection with certain contaminated leased properties that the Company relocated from in 2002, the Company has agreed to indemnify property owners with respect to environmental liabilities associated with the use of those properties, as defined in the related lease agreements. During fiscal 2003, the Company has not paid or accrued material amounts related to these properties. Because of the uncertainties associated with environmental assessment and remediation activities, the Company’s future expenses to remediate the currently identified sites could be higher than amounts accrued. Future expenditures for environmental remediation may be affected in the near-term by identification of additional contaminated sites, the level and type of contamination found, and the extent and nature of cleanup activities required.
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Note 11 — Impact of Recently Issued Accounting Standards:
In January, 2003 the Financial Accounting Standards Board issued Interpretation No. 46, “Consolidation of Variable Interest Entities (“VIE”), an Interpretation of Accounting Research Bulletin No. 51” (“FIN 46”). The Interpretation provides guidance for determining whether an entity is a variable interest entity and evaluation for consolidation based on their variable interests. The Interpretation is effective immediately for VIEs created after January 31, 2003 and in the first interim period beginning after June 15, 2003 for VIEs created prior to February 1, 2003. The Company is currently determining the impact of FIN 46 and expects the adoption to have little or no impact on the Company’s financial position or results of operation.
The FASB issued SFAS 150, “Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity”, which is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the Company’s third quarter of 2003. SFAS 150 requires common and preferred stock subject to mandatory redemption to be classified as a liability. The Company will adopt SFAS 150 in the third quarter of 2003 and expects the adoption to have no impact on its financial position or results of operations.
Note 12 — Subsequent Event — Stock Split:
On July 17, 2003, the Company’s Board of Directors approved a two-for-one split of the Company’s common stock. As a result, stockholders will receive one additional share on August 21, 2003 for each share held as of the record date of August 4, 2003. The par value of the Company’s common stock will remain $0.008 per share. The accompanying presentations of the consolidated balance sheets and earnings per share do not reflect the effect of this stock split.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
General
The following discussion and analysis describes certain factors affecting Tractor Supply Company (the “Company”), its results of operations for the fiscal three and six month periods ended June 28, 2003 and June 29, 2002 and significant developments affecting its financial condition since the end of the fiscal year, and should be read in conjunction with the Company’s annual report on Form 10-K for the fiscal year ended December 28, 2002. The following discussion and analysis also contains certain historical and forward-looking information. The forward-looking statements included herein are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (the “Act”). All statements, other than statements of historical facts, which address activities, events or developments that the Company expects or anticipates will or may occur in the future, including such things as future capital expenditures (including their amount and nature), business strategy, expansion and growth of the Company’s business operations and other such matters are forward-looking statements. To take advantage of the safe harbor provided by the Act, the Company is identifying certain factors that could cause actual results to differ materially from those expressed in any forward-looking statements, whether oral or written, made by or on behalf of the Company.
All phases of the Company’s operations are subject to influences outside its control. Any one, or a combination, of these factors could materially affect the results of the Company’s operations. These factors include general economic cycles affecting consumer spending, weather factors, operating factors affecting customer satisfaction, consumer debt levels, pricing and other competitive factors, the ability to attract, train and retain highly qualified employees, the ability to identify suitable locations and negotiate favorable lease agreements on new and relocated stores, the timing and acceptance of new products in the stores, the mix of goods sold, the continued availability of favorable credit sources, capital market conditions in general, threats of war or terrorism, and the seasonality of the Company’s business. Forward-looking statements made by or on behalf of the Company are based on knowledge of its business and the environment in which it operates, but because of the factors listed above, actual results could differ materially from those reflected by any forward-looking statements. Consequently, all of the forward-looking statements made are qualified by these cautionary statements and there can be no assurance that the actual results or developments anticipated by the Company will be realized or, even if substantially realized, that they will have the expected consequences to or effects on the Company or its business and operations.
Change in Accounting Principle
Emerging Issue Task Force item 02-16 (“EITF 02-16”), “Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor” provides guidance for the accounting treatment and income statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the promotion of sales of the vendor’s products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of specific, identifiable incremental costs. Prior to adopting this pronouncement, the Company classified all vendor-provided marketing support funds as a reduction in selling, general and administrative expenses.
The effect of applying EITF 02-16 on prior-period financial statements results in a change to previously reported net income, thus, the Company has reported the adoption of EITF 02-16 as a cumulative effect adjustment in accordance with APB Opinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and as permitted by EITF 02-16. Accordingly, in the first quarter of fiscal 2003, the Company recorded a cumulative effect of accounting change of $3.1 million ($1.9 million net of income taxes) for the impact of this adoption on prior fiscal years. For the three-months and six-months ended June 28, 2003, vendor-provided funding in the amount of $12.4 million and $19.7 million, respectively, has been included as a reduction in inventory costs.
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The following pro forma financial information for the three months and six months ended June 29, 2002 reflects the impact of EITF 02-16 as if it had been adopted prior to fiscal 2002 (in thousands):
Results of Operations
Fiscal Three Months (Second Quarter) and Six Months ended June 28, 2003 and June 29, 2002
Net sales increased 14.6% to $449.4 million for the second quarter of fiscal 2003 from $392.0 million for the second quarter of fiscal 2002. Net sales rose 23.4% to $723.2 for the first six months of fiscal 2003 from $585.9 million for the first six months of fiscal 2002. The net sales increase resulted primarily from the addition of new stores. Comparable store sales increased 1.2% for the second quarter of fiscal 2003 and 2.1% for the first six months of fiscal 2003. The Company opened a total of 13 new stores in the second quarter of fiscal 2003 and 25 new stores during the first six months of fiscal 2003. This compares to 90 openings in the second quarter of fiscal 2002 and 106 new stores in the first six months of fiscal 2002. (The Company substantially expanded its store base during 2002 due largely to its purchase of property and lease rights from Quality Stores, Inc. in the first quarter of 2002.) The Company also relocated three stores and five stores in the second quarter of fiscal 2003 and the first six months of fiscal 2003, respectively, compared to none in the three months ended and one in the six months ended June 29, 2002.
The gross margin rate for the second quarter and first six months of fiscal 2003 was 30.3% and 30.0%, respectively. Assuming the provisions of EITF 02-16 had been applied prior to 2002, gross margin decreased 20 basis points for the second quarter of fiscal 2003 and remained flat for the first six months of fiscal 2003 compared with the corresponding periods in the prior fiscal year. Improved margins as a result of lower merchandise costs and changes in sales mix were more than offset by an increase in freight costs.
As a percent of sales, selling, general and administrative (“SG&A”) expenses were 19.4% and 22.1% for the second quarter and first six months of fiscal 2003, respectively. Assuming the provisions of EITF 02-16 had been applied prior to fiscal 2002, SG&A expenses decreased 220 basis points for the second quarter of fiscal 2003 and decreased 250 basis points for the first six months of fiscal 2003 compared with the corresponding periods in the prior fiscal year. Excluding the non-recurring expansion costs of $4.5 million and $10.7 million for the second quarter and first six months of fiscal 2002, SG&A decreased 100 basis points for the second quarter of fiscal 2003 and 70 basis points for the first six months of fiscal 2003 compared with the corresponding periods in the prior fiscal year. This decrease is primarily a result of controlled spending, greater leverage from increased sales and lower incentive accruals.
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Depreciation and amortization expense increased 6.6% and 21.9% over the second quarter and the first six months of fiscal 2002, respectively. The increase is due mainly to costs associated with new and relocated stores, as well as remodeled existing stores.
Net interest expense decreased 18.0% and 11.9% over the second quarter and the first six months of fiscal 2002, respectively. This decrease reflects stronger cash flow and less cash requirements for store openings, which resulted in reduced average short-term borrowings under the senior credit facility.
The Company’s effective tax rate decreased to 36.7% for the second quarter and the first six months of fiscal 2003 compared with 38.0% for the same periods of the prior fiscal year. This decrease is primarily due to changes in applicable state tax rates.
As a result of the foregoing factors, net income for the second quarter of fiscal 2003 increased 57.9% to $27.4 million, or $1.37 per diluted share, compared to net income of $17.3 million, or $0.88 per diluted share, in the prior year. Net income for the first six months of fiscal 2003 was $27.5 million or $1.38 per diluted share compared to net income of $13.3 million or $0.69 per diluted share, in the prior year. These increases are primarily a result of increased leverage from increased sales and non-recurring store expansion costs experienced in the second quarter and first six months of fiscal 2002 as follows (in thousands, except per share amounts):
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Liquidity and Capital Resources
In addition to normal operating expenses, the Company’s primary ongoing cash requirements are for expansion, remodeling and relocation programs, including inventory purchases and capital expenditures. The Company’s primary ongoing sources of liquidity are funds provided from operations, commitments available under its revolving credit agreement and normal trade credit. The Company’s inventory and accounts payable levels typically build in the first and third fiscal quarters in anticipation of the spring and fall selling seasons.
At June 28, 2003, the Company’s inventories had increased $65.9 million to $355.2 million from $289.3 million at December 28, 2002. This increase resulted primarily from additional inventory for new stores and unplanned inventory increases in seasonal product lines. Trade credit increased $75.1 million to $190.0 million at June 28, 2003 from $114.9 million at December 28, 2002, primarily due to the increase in inventory. Trade credit arises from the Company’s vendors granting payment terms for inventory purchases. Payment terms vary from 30 days to 180 days depending on the inventory product.
At June 28, 2003, the Company had working capital of $148.8 million, which represented a $4.9 million increase from December 28, 2002. This increase resulted primarily from a $10.5 million decrease in accrued expenses (due largely to an $8.6 million decrease in incentive compensation accruals and timing of payments) and a $4.1 million increase in cash and cash equivalents, offset by a $9.2 million increase in accounts payable over the related increase in inventory.
Operations provided net cash of $38.2 million and $69.1 million for the first six months of fiscal 2003 and 2002, respectively. The decrease in net cash provided resulted primarily from inventories increasing at a slower rate than accounts payable in the first six months of 2003 compared to the first six months of 2002, (during the first half of fiscal 2002, many vendors offered special extended payment terms for inventory purchases). Additionally, net income increased $14.2 million compared to the prior year, while being partially offset by a decrease in accrued expenses.
Cash used in investing activities of $14.0 million for the first six months of fiscal 2003 represented a $35.0 million decrease over cash used in the first six months fiscal 2002 of $49.0 million. Cash used in investing activities in the first six months of fiscal 2002 primarily reflects the purchase of buildings, improvements, fixtures and lease rights of certain retail stores formerly operated by Quality Stores, Inc.
Financing activities in the first six-months of fiscal 2003 used $20.2 million in cash, which represented a $6.8 million increase over the $13.4 million in cash used in the first six months of fiscal 2002. This increase in net cash used resulted primarily from greater repayments than short term borrowings under the senior credit facility. Net repayments under the senior credit facility were $23.6 million and $15.1 million for the first six months of fiscal 2003 and 2002, respectively. This increase in net repayments primarily reflects lower borrowing for capital
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expenditures in the current period compared to the first fiscal six months of 2002, offset in part by the favorable accounts payable terms, which required less short term borrowings under the senior credit facility.
The Company believes that its cash flow from operations, borrowings available under credit agreements, and normal trade credit will be sufficient to fund the Company’s operations and its capital expenditure needs, including store openings and renovations, over the next several years.
Off-Balance Sheet Arrangements
The Company’s off-balance sheet arrangements consist of operating leases for buildings and equipment for retail stores, distribution centers and offices. In addition, the Company has outstanding letters of credit totaling $13.4 million at June 28, 2003.
Significant Accounting Policies and Estimates
Management’s discussion and analysis of the Company’s financial position and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make informed estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. The Company’s significant accounting policies, including areas of critical management judgments and estimates, have primary impact on the following financial statement areas:
The Company’s critical accounting policies are subject to judgments and uncertainties, which affect the application of such policies. (See Note 1 of the Unaudited Consolidated Financial Statements.) The Company’s financial position and/or results of operations may be materially different when reported under different conditions or when using different assumptions in the application of such policies. In the event estimates or assumptions prove to be different from actual amounts, adjustments are made in subsequent periods to reflect more current information.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company has entered into an interest rate swap agreement as a means of managing its interest rate exposure. This agreement has the effect of converting certain of the Company’s variable rate obligations to fixed rate obligations. Net amounts paid or received are reflected as an adjustment to interest expense.
The Company applies Statements of Financial Accounting Standards Nos. 133, 137, and 138 (collectively “SFAS 133”) in the accounting for derivatives and hedging activities. SFAS 133 requires the Company to recognize all derivative instruments in the balance sheet at fair value. SFAS 133 impacts the accounting for the Company’s interest rate swap agreement. The Company’s interest rate swap agreement is designated as a cash flow hedge. At June 28, 2003, the interest rate agreement hedged cash flows related to variable-rate debt of $9.9 million. At June 29, 2002 the Company had no outstanding balance of variable rate debt. The fair value of the interest rate swap was a liability of $0.7 million at June 28, 2003 and $2.1 million at June 29, 2002. The interest rate swap agreement expires in November 2003.
The Company is exposed to changes in interest rates primarily from its variable-rate, long-term debt arrangements. Under its current policies, the Company uses the interest rate swap to manage exposure to interest rate changes for a portion of its debt arrangements. Taking into account the effects of the interest rate swap designated as a hedge, a hypothetical 100 basis point adverse move (increase) in interest rates along the entire interest rate yield curve would not materially impact the fair market value of the long-term debt.
Although the Company cannot accurately determine the precise effect of inflation on its operations, it does not believe its sales or results of operations have been materially affected by inflation. The Company has been successful, in many cases, in reducing or mitigating the effects of inflation principally by taking advantage of vendor incentive programs, economies of scale from increased volume of purchases and selective buying from the most competitive vendors without sacrificing quality.
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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the design and operation of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective for gathering, analyzing and disclosing the information the Company is required to disclose in the reports it files under the Securities Exchange Act of 1934, within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Controls
The evaluation referred to above did not identify any change in the Company’s internal control over financial reporting that occurred in the period covered by this report that has materially affected or is reasonably likely to materially affect the Company’s internal controls over financial reporting.
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PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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