FORM 10-Q
For the transition period from to
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 þ 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.
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TABLE OF CONTENTS
INDEX
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PART I. FINANCIAL INFORMATION
Item 1. Consolidated 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)
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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 nine-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:
Inventory Valuation
The Company identifies potentially excess and slow-moving inventory by evaluating turn rates and overall inventory levels. Excess quantities are identified through the application of benchmark turn targets and historical sales experience. Further, exposure to inadequate realization of carrying value is identified through analysis of gross margin achievement and markdown experience, in combination with all merchandising initiatives. The estimated reserve is based on management’s current knowledge with respect to inventory levels, sales trends and historical experience relating to the sale of the excess and/or slow-moving inventory. Management does not believe the Company’s merchandise inventories are subject to significant risk of obsolescence in the near-term, and management has the ability to adjust purchasing practices based on anticipated sales trends and general economic conditions. However, changes in consumer purchasing patterns could result in the need for additional reserves.
Inventory Shrinkage
The Company estimates its expected shrinkage of inventory between physical inventory counts by assessing the chain-wide average shrinkage experience rate, applied to the related periods’ sales volumes. Such assessments are updated on a regular basis for the most recent individual store experiences.
Vendor Funding
The Company receives funding from its vendors for promotion of the Company’s brand as well as the sale of their products. Vendor funding is accounted for as a discount on the purchase price of inventories and is recognized in cost of sales as inventory is sold. The amount of expected funding is estimated based upon initial guaranteed commitments, as well as anticipated purchase levels with applicable vendors. The estimated purchase volume is based on management’s current knowledge with respect to inventory levels, sales trends and expected customer demand, as well as planned new store openings. Although management
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believes it has the ability to reasonably estimate its purchase volume, it is possible that actual results could significantly differ from the estimated amounts.
Sales Returns
The Company generally honors customer refunds within 30 days of the original purchase, with the supporting receipt. The Company estimates its reserve for likely customer returns based on the average refund experience in relation to sales for the related period. Due to the seasonality of the Company’s sales, the refund experience can vary, depending on the fiscal quarter of measurement.
Self-insurance
The Company is self-insured for certain losses relating to workers’ compensation, medical and general liability claims. However, the Company has stop-loss limits and umbrella insurance coverage for certain risk exposures subject to specified limits. Self-insurance claims filed and claims incurred but not reported are accrued based upon management’s estimates of the aggregate liability for uninsured claims incurred using actuarial assumptions followed in the insurance industry and historical experience. Although management believes it has the ability to adequately record estimated losses related to claims, it is possible that actual results could significantly differ from recorded self-insurance liabilities.
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)
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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 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 $5,267,000 higher than reported at December 28, 2002. At September 27, 2003 LIFO and FIFO inventory values were the same. (The reduction in the LIFO reserve is primarily due to the adoption of Emerging Issue Task Force Issue 02-16, (“EITF 02-16”), “Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor,” 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, as required. In accordance with 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
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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 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
The Company accounts 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.” 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 nine months ended September 27, 2003 and September 28, 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 21, 2003 (Note 8).
Reclassifications
Certain amounts in the prior year financial statements presented herein 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 and third fiscal quarter in preparation for a higher volume second and fourth quarter, respectively.
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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 third quarter and the first nine months of 2002, assuming EITF 02-16 had been applied retroactively, would have increased $2,958,000 and $3,847,000 respectively. Basic and diluted income per share for the third fiscal quarter of 2002 would have increased $0.08 and $0.07, respectively, to $0.30 and $0.27, had EITF 02-16 been applied retroactively. Basic and diluted income per share for the first nine months of fiscal 2002 would have increased $0.10 to $0.69 and $0.64, respectively, 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 $201,000 and $279,000 in the third quarter and first nine months of fiscal 2003, respectively, to adjust the carrying value of certain property and equipment related to vacated stores to fair value, less costs to sell. An impairment charge of $558,000 was recorded in the first nine months of 2002. No impairment charge was required during the third quarter of 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 (the “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 (4.00% at September 27, 2003) or the London Inter-Bank Offer Rate (1.12% at September 27, 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 Sept. 27, 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
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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 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 will recognize income of $124,000 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 17, 2003, 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 21, 2003 for each share held as of the record date of August 4, 2003. The par value of the Company’s common stock remains $0.008 per share. 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.
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 a company’s variable interests. The Interpretation is effective immediately for VIEs created after January 31, 2003 and in the first interim period ending after December 15, 2003 for VIEs created prior to February 1, 2003. The Company will adopt FIN 46 in the fourth quarter and does not expect the adoption to impact 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 adopted SFAS 150 in the third quarter of 2003 and the adoption had no impact on its financial position or results of operations.
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Results of Operations" -->
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 nine month periods ended September 27, 2003 and September 28, 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 Issue 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-month and nine-month periods ended September 27, 2003, vendor-provided funding in the amount of $10.1 million and $29.7 million, respectively, has been included as a reduction in cost of sales.
The following pro forma financial information for the three-month and nine-month periods ended September 28, 2002 reflects the impact of EITF 02-16 as if it had been adopted prior to fiscal 2002 (in thousands):
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Results of Operations
Fiscal Three Months (Third Quarter) and Nine Months ended September 27, 2003 and September 28, 2002
Net sales increased 21.9% to $361.2 million for the third quarter of fiscal 2003 from $296.2 million for the third quarter of fiscal 2002. Net sales rose 22.9% to $1,084.4 million for the first nine months of fiscal 2003 from $882.1 million for the first nine months of fiscal 2002. The Company’s sales performance in the third quarter reflects improvement across nearly all product categories and resulted from aggressive merchandising and marketing initiatives, strong third quarter performance in spring seasonal products and sales associated with emergency response to storms (primarily generators and pumps). The Company’s favorable nine month sales performance verses prior year was driven primarily by market share gains in certain markets and improved in-store execution. Importantly, the Company continues to improve its merchandising programs and in-store execution. Comparable store sales increased 13.7% for the third quarter of fiscal 2003 and 6.0% for the first nine months of fiscal 2003. The Company opened four new stores and relocated seven existing stores in the third quarter of fiscal 2003 compared to five new store openings and nine relocations in the prior year period. For the fiscal nine months ended September 27, 2003, the Company opened a total of 29 new stores compared to 111 stores in the prior year period. (The Company substantially expanded its store base during 2002 due to its purchase of property and lease rights from Quality Stores, Inc. in the first quarter of 2002.)
Assuming the provisions of EITF 02-16 has been applied prior to 2002, gross margin decreased 180 basis points to 30.2% for the third fiscal quarter of 2003 and decreased 60 basis points to 30.1% for the first nine months of fiscal 2003 when compared with the corresponding periods in the prior fiscal year. The majority of this third quarter and nine month decline is attributable to a return to a more normal level of vendor funding in fiscal 2003. Specifically, vendors provided additional marketing support funds in fiscal 2002 in connection with the opening of 87 new stores as a result of the purchase of assets from Quality Stores, Inc. Additionally, third quarter gross margin reflects changes in the sales mix associated with increased sales of lower margin spring and seasonal products, as well as emergency response products.
As a percent of sales, selling, general and administrative (“SG&A”) expenses were 23.3% and 22.5% for the third quarter and first nine months of fiscal 2003, respectively. Assuming the provisions of EITF 02-16 had been applied prior to fiscal 2002, SG&A expenses decreased 110 basis points for the third quarter of fiscal 2003 and decreased 190 basis points for the first nine months of fiscal 2003 compared with the corresponding periods in the prior fiscal year. Additionally, excluding the non-recurring expansion costs of $10.7 million for the first nine months of fiscal
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2002, SG&A decreased 80 basis points for the first nine months of fiscal 2003 compared with the corresponding period in the prior fiscal year. This decrease is primarily a result of controlled spending and greater leverage from increased sales.
Depreciation and amortization expense increased 13.3% and 18.7% over the third quarter and the first nine months of fiscal 2002, respectively. The increase is due mainly to costs associated with new and relocated stores, as well as remodeled existing stores. As a percentage of sales, depreciation and amortization expense decreased 10 basis points to 1.4% and 1.3% for the third quarter and first nine months of fiscal 2003 compared to the prior year period. This decrease is due to sales increasing at a greater rate than depreciation and amortization expense.
Net interest expense decreased 36.0% and 20.6% over the third quarter and the first nine 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 was 36.8% and 36.7% for the third quarter and the first nine months of fiscal 2003 compared with 35.3% and 37.0%, respectively, for the same periods of the prior fiscal year. The difference is primarily due to applicable state tax rates.
As a result of the foregoing factors, net income for the third quarter of fiscal 2003 increased 55.1% to $12.1 million, or $0.30 per diluted share, compared to net income of $7.8 million, or $0.20 per diluted share, in the prior year. Exclusive of the cumulative effect of the accounting change, net income for the first nine months of fiscal 2003 was $41.5 million or $1.03 per diluted share compared to net income of $21.1 million, or $0.54 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 third quarter and first nine months of fiscal 2002. The non-recurring store expansion costs referenced above represent costs incurred in the Company’s dramatic and rapid expansion in 2002, which was primarily the result of the purchase of property and lease rights from Quality Stores, Inc. in the first quarter of 2002. The aggressive expansion plan in fiscal 2002 increased the size of the Company by over 25% and was completed in a very compressed time frame. As such, the Company incurred significant incremental costs to achieve the state of readiness required to enable all stores to open within the desired time frame and such costs are not considered by management to be indicative of normal pre-opening or recurring expenses. Management believes that disclosing the effect of the significant 2002 single year store expansion improves the investor’s ability to reasonably evaluate the Company’s longer-term business trends. The following information isolates the expansion costs related to the store expansion resulting from the purchase of property and lease rights from Quality Stores, Inc. (in thousands, except per share amounts) that management believes are nonrecurring:
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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 September 27, 2003, the Company’s inventories had increased $85.5 million to $374.8 million from $289.3 million at December 28, 2002. This increase resulted primarily from additional inventory for new stores and normal increases to prepare for the fourth quarter selling season. Trade credit increased $80.7 million to $195.6 million at September 27, 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 September 27, 2003, the Company had working capital of $179.1 million, which represented a $35.2 million increase from December 28, 2002. This increase resulted primarily from a $17.1 million increase in cash and cash equivalents (due to an increase in sales), a $6.1 million decrease in accrued expenses (due largely to a $6.9 million
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decrease in incentive compensation accruals and timing of payments) and a $4.8 million increase in inventory over the related increase in accounts payable.
Operations provided net cash of $40.2 million and used $3.3 million for the first nine months of fiscal 2003 and 2002, respectively. The increase in net cash provided resulted primarily from inventories increasing at a slower rate than accounts payable in the first nine months of 2003 compared to the first nine months of 2002. Additionally, net income increased $18.5 million compared to the prior year, while being partially offset by a decrease in accrued expenses.
Cash used in investing activities of $36.0 million for the first nine months of fiscal 2003 represented a $19.1 million decrease from cash used in the first nine months fiscal 2002 of $55.1 million. The decrease in cash used in investing activities in the first nine months of fiscal 2003 primarily reflects the addition of 111 new stores in first nine months of fiscal 2002 compared to 29 in the first nine months of fiscal 2003, offset in part by the addition of a distribution center in Waco, Texas.
Financing activities in the first nine months of fiscal 2003 provided $12.9 million in cash, which represented a $50.9 million decrease from the $63.8 million in cash provided in the first nine months of fiscal 2002. This decrease resulted primarily from greater repayments than short term borrowings under the senior credit facility. Net borrowings under the senior credit facility were $9.7 million and $61.8 million for the first nine months of fiscal 2003 and 2002, respectively. This decrease in net borrowings is primarily due to a decrease in capital expenditures (referenced above) in the current period compared to the first fiscal nine months of 2002.
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 $11.5 million at September 27, 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
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agreement. The Company’s interest rate swap agreement is designated as a cash flow hedge. At September 27, 2003, and September 28, 2002, the interest rate agreement hedged cash flows related to variable-rate debt of $43.2 and $77.0 million, respectively. The fair value of the interest rate swap was a liability of $0.2 million at September 27, 2003 and $2.0 million at September 28, 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.
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 6. Exhibits and Reports on Form 8-K
(a) Exhibits
(b) Reports on Form 8-K
The Company filed a report on Form 8-K, dated July 2, 2003 issuing a press release announcing its sales and expected earnings for the second quarter ended June 28, 2003. Notwithstanding the foregoing, information furnished under items 9 and 12 of our Current Reports on Form 8-K, including the related exhibits, is not incorporated by reference in this quarterly report.
The Company filed a report on Form 8-K, dated July 14, 2003 issuing a press release announcing its financial results for the second quarter and six months ended June 28, 2003. Notwithstanding the foregoing, information furnished under items 9 and 12 of our Current Reports on Form 8-K, including the related exhibits, is not incorporated by reference in this quarterly report.
The Company filed a report on Form 8-K, dated July 21, 2003 issuing a press release announcing a two-for-one stock split of the Company’s common stock. Notwithstanding the foregoing, information furnished under items 9 and 12 of our Current Reports on Form 8-K, including the related exhibits, is not incorporated by reference in this quarterly report.
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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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