-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LsR2Zkl3isTB1Msq2zVGJ6FZj/ZZ/U8nzoD0dSXFogRQRoapn/c+u0jdcbgBKYCJ wLa0CdX3KempTvbW0xCyFw== 0000813775-04-000017.txt : 20040430 0000813775-04-000017.hdr.sgml : 20040430 20040430152642 ACCESSION NUMBER: 0000813775-04-000017 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 20040430 FILED AS OF DATE: 20040430 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FACTORY 2 U STORES INC CENTRAL INDEX KEY: 0000813775 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-FAMILY CLOTHING STORES [5651] IRS NUMBER: 510299573 STATE OF INCORPORATION: DE FISCAL YEAR END: 0131 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-10089 FILM NUMBER: 04769608 BUSINESS ADDRESS: STREET 1: 4000 RUFFIN ROAD STREET 2: 6TH FLR CITY: SAN DIEGO STATE: CA ZIP: 92123-1866 MAIL ADDRESS: STREET 1: 4000 RUFFIN ROAD STREET 2: 6TH FLOOR CITY: SAN DIEG STATE: CA ZIP: 92123-1866 FORMER COMPANY: FORMER CONFORMED NAME: FAMILY BARGAIN CORP DATE OF NAME CHANGE: 19940202 FORMER COMPANY: FORMER CONFORMED NAME: DRS INDUSTRIES INC DATE OF NAME CHANGE: 19920703 FORMER COMPANY: FORMER CONFORMED NAME: LONGWOOD GROUP LTD DATE OF NAME CHANGE: 19920527 10-K 1 a10k043004.txt FORM 10-K FILED 043004 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended January 31, 2004 Commission File number 1-10089 FACTORY 2-U STORES, INC. (1) --------------------------- (Exact Name of Registrant as Specified in its Charter) Delaware 51-0299573 -------- ---------- (State or Other Jurisdiction of (I.R.S. Employer Identification Number) Incorporation or Organization) 4000 Ruffin Road San Diego, California 92123 --------------------- ----- (Address of Principal Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (858) 627-1800 -------------- Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- None None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value ----------------------------- (Title of Class) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ X ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES X NO ___ At August 2, 2003, the aggregate market value of the voting and non-voting common equity of the Registrant held by non-affiliates was approximately $83,739,378. At April 23, 2004, the Registrant had outstanding 17,921,178 shares of Common Stock, $0.01 par value per share. (1)Factory 2-U Stores, Inc. has been operating as a Debtor-in-Possession under Chapter 11 of the United States Bankruptcy Code since January 13, 2004. 1 PART I Item 1. Business 4 Item 2. Properties 16 Item 3. Legal Proceedings 17 Item 4. Submission of Matters to a Vote of Security Holders 18 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 18 Item 6. Selected Financial Data 20 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 35 Item 8. Financial Statements and Supplementary Data 36 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 36 Item 9A. Controls and Procedures 36 PART III Item 10. Directors and Executive Officers of the Registrant 38 Item 11. Executive Compensation 40 Item 12. Security Ownership of Certain Beneficial Owners and Management 51 Item 13. Certain Relationships and Related Transactions 55 Item 14. Principal Accounting Fees and Services 56 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 57 2 Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995 In December 1995, Congress enacted the Private Securities Litigation Reform Act of 1995 (the "Act"). The Act contains amendments to the Securities Act of 1933 and the Securities Exchange Act of 1934 which provide protection from liability in private lawsuits for "forward-looking" statements made by specified persons. We desire to take advantage of the "safe harbor" provisions of the Act. Certain statements in this Annual Report on Form 10-K, or in documents incorporated by reference into this Annual Report on Form 10-K, are forward-looking statements, which are within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are not based on historical facts, but rather reflect our current expectation concerning future results and events. These forward-looking statements generally may be identified by the use of phrases such as "believe", "expect", "estimate", "anticipate", "intend", "plan", "foresee", "likely", "will" or other similar words or phrases. Similarly, statements that describe our objectives, plans or goals are or may be forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be different from any future results, performance or achievements expressed or implied by these statements. The following factors, among others, could affect our future results, performance or achievements, causing these results to differ materially from those expressed in any of our forward-looking statements: general economic and business conditions (both nationally and in regions where we operate); trends in our business and consumer preferences, especially as may be impacted by economic weakness on consumer spending; the effect of government regulations and legislation; litigation and other claims that may be asserted against us; the effects of intense competition; our ability to successfully implement business strategies and otherwise execute planned changes in various aspects of the business; the challenges and costs associated with maintaining and improving technology; the costs and difficulties of attracting and retaining qualified personnel; the effects of increasing labor, utility, fuel and other operating costs; our ability to obtain adequate quantities of suitable merchandise at favorable prices and on favorable terms and conditions; our ability to maintain adequate liquidity; the effectiveness of our operating initiatives and advertising and promotional strategies and other factors described in this Annual Report on Form 10-K and in our other filings with the Securities and Exchange Commission. In addition to the above general factors, the following bankruptcy related factors, among others, could also affect our future results, performance or achievements, causing these results to differ materially from those expressed in any of our forward-looking statements: our ability to continue as a going concern; our ability to operate pursuant to the terms of our debtor-in-possession financing facility; our ability to obtain approval from the United States Bankruptcy Court for the District of Delaware (the "Court") with respect to motions in the Chapter 11 case (as that term is defined below) from time to time; our ability to negotiate, confirm and consummate a plan of reorganization in a timely manner; risks associated with third parties seeking and obtaining court approval to terminate or shorten the exclusivity period that we have to propose and confirm one or more plans of reorganization, for the appointment of a Chapter 11 trustee or to convert the Chapter 11 case to a case under Chapter 7 of title 11 of the United States Bankruptcy Code (the "Bankruptcy Code"); our ability to offset the negative effects that the filing for reorganization under Chapter 11 of the Bankruptcy Code has had on our business, including the loss in customer traffic, the impairment of vendor relations and the constraints placed on available capital; our ability to obtain and maintain normal terms with vendors and service providers; the ability of our vendors to obtain satisfactory credit terms from factors and other financing sources; our ability to maintain contracts, including leases, which are critical to our operations; the potential adverse impact of the Chapter 11 case on our liquidity or results of operations; our ability to develop a long-term strategy to revitalize our business and return to profitability; and our ability to fund and execute our business plan. 3 We do not undertake to publicly update or revise any of our forward-looking statements, whether as a result of new information, future events and developments or otherwise, except to the extent that we may be obligated to do so by applicable law. Similarly, these and other factors, including the terms of the final plan of reorganization, if any, ultimately confirmed, can affect the value of our pre-petition liabilities and common stock. Until a plan of reorganization is confirmed by the Court, the recoveries of pre-petition claims holders are subject to change. Accordingly, no assurance can be given as to what values, if any, will be ascribed in the bankruptcy case to each of these constituencies. The final plan of reorganization, if any, confirmed by the Court may result in the cancellation of our existing common stock with holders thereof receiving no distributions under the plan of reorganization. In light of the foregoing, we consider the value of our common stock to be highly speculative and caution equity holders that the stock may ultimately be determined to have no value. Accordingly, we urge that appropriate caution be exercised with respect to existing and future investments in our common stock or any claims relating to pre-petition liabilities. PART I Item 1. Business GENERAL We operate a chain of off-price retail apparel and housewares stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores. Our stores average approximately 15,000 square feet and are located mostly in shopping centers. Our products include a broad range of family apparel, domestic goods and houseware products. Our typical customers are families with more than the average number of children and average household income of approximately $35,000, which generally are profiled as discount store shoppers. Our merchandising strategy is to offer first quality recognizable national and discount store brands at a substantial discount, generally 20% to 50% below prices offered by other discount chains. Our stores are well lit and present the merchandise primarily on hanging fixtures. We also use strategically placed in-store signage to emphasize savings and create increased customer awareness. We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal 2003). We were incorporated in Delaware in March 1987 as BMA Life Care Corp., changed our name later that month to The Longwood Group, Ltd. and changed our name in May 1992 to DRS Industries, Inc. In December 1992, we acquired an interest in General Textiles while it was operating under Chapter 11 of the Bankruptcy Code. General Textiles operated an off-priced apparel retail chain known as Family Bargain Center. In May 1993, we contributed additional equity to General Textiles and thereby increased our ownership of General Textiles to 100%, at which time General Textiles emerged from bankruptcy protection. In January 1994, we changed our name to Family Bargain Corporation. In November 1995, we acquired Capin Mercantile Corporation and changed its name to Factory 2-U, Inc. and began to coordinate the purchasing, warehousing and delivery operations for the Family Bargain Center and Factory 2-U chains. In July 1998, General Textiles and Factory 2-U, Inc. were merged into a new corporate entity, General Textiles, Inc., which was a wholly-owned subsidiary of Family Bargain Corporation. In November 1998, General Textiles, Inc. was merged into Family Bargain Corporation, at which time we converted our previous three classes of stock into a single class of common stock and changed our corporate name from Family Bargain Corporation to Factory 2-U Stores, Inc. 4 Recent Developments We experienced a continuation of declining sales volume in fiscal 2003 with a decrease of 4.4% in comparable store sales for the year. We believe there were a number of factors that contributed to the lower sales in fiscal 2003: (1) lower inventory levels for most of our first quarter due to a tightening of credit by our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor strikes in the southern California region in the third quarter, (4) decrease in retail price points, and (5) a continuation of a very soft retail environment impacted by general price deflation and heavy promotion, particularly in apparel. As a result of our financial results over the past two fiscal years, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after our fiscal 2002 Christmas selling season we experienced a tightening of credit extended to us by our vendors and the credit community for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and, to a lesser extent, March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing. In addition, in response to a very competitive retail environment, we increased our advertising expenditures above originally planned levels and equivalent to the prior year. We also increased our in-store promotional efforts with weekly in-store specials. In an effort to improve our liquidity, obtain more favorable credit terms and provide for a consistent flow of merchandise, we initiated a series of financing transactions and took steps to accelerate the receipt of refunds related to tax loss carry-back benefits. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting the placement fees and other offering expenses. In addition, during March of 2003, we received an $8.2 million federal tax refund as a result of utilizing tax loss carry-back benefits. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note and a $1.0 million term note. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses. Despite our efforts to improve sales and our liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code. PROCEEDINGS UNDER CHAPTER 11 OF THE UNITED STATES BANKRUPTCY CODE On January 13, 2004 (the "Petition Date"), we filed a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code in the Court, which is currently pending as case number 04-10111(PJW) (the "Chapter 11 filing"). As the debtor, we remain in possession of our properties, and continue to operate our business as debtor-in-possession ("DIP") in accordance with the applicable provisions of the Bankruptcy Code. We decided to seek judicial reorganization in order to implement a comprehensive operational and financial restructuring due to the tightening of credit extended by our vendors and the credit community and a decline in our liquidity caused by declining sales volume and deteriorating operating margin in a very soft retail environment. As the debtor, we are authorized to continue to operate as an ongoing business, but may not engage in transactions outside the ordinary course of business without the approval of the Court after notice and an opportunity for a hearing. 5 At hearings held on January 14, 2004 concerning our first day motions, the Court entered orders granting us authority, among other things, to (1) continue our centralized cash management system, (2) pay pre-petition wages and continue our employee benefit plans and other employee programs, (3) continue customer related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers and vendors in full for all goods and services provided on or after the Petition Date and (6) continue ongoing pre-petition "going out of business sales" for four store locations completed by January 31, 2004. In addition, the Court also gave interim approval for a $45.0 million DIP financing facility (DIP financing facility) that was committed by The CIT Group/Business Credit, Inc. and GB Retail Funding, LLC. On February 2, 2004, the Court granted final approval of the $45.0 million DIP financing facility. We intend to utilize this financing, in addition to cash flow from operations, to fulfill business obligations during the Chapter 11 process. A full description of this DIP financing facility is included in Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations. Additionally, on February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of the Great American Group ("Great American") as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. On February 17, 2004, we filed with the Court our schedules of assets and liabilities and statements of financial affairs setting forth, among other things, the assets and liabilities as shown on our books and records as of the Petition Date, subject to the assumptions contained in certain notes filed in connection therewith. The schedules of assets and liabilities and statements of financial affairs remain subject to further amendment or modification. We have mailed notices to all known creditors that the deadline for filing proofs of claim with the Court is June 15, 2004. Differences between amounts we have scheduled and claims by creditors will be investigated and resolved in connection with our claims resolution process. As we are at an early stage of the bankruptcy and we do not yet have a plan of reorganization, the ultimate distribution with respect to allowed claims is not presently ascertainable. The United States Trustee has appointed an unsecured creditors committee and may consider the appointment of an equity committee. There can be no assurance that the unsecured creditors committee or equity committee, if any, will support our positions in the bankruptcy case or the plan of reorganization once proposed, and any disagreements could protract the bankruptcy case, negatively impact our ability to operate during bankruptcy, and/or delay our emergence from bankruptcy. Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well as most other pending litigation, are stayed and other contractual obligations against us generally may not be enforced. Absent an order of the Court, substantially all pre-petition liabilities are subject to compromise under a plan of reorganization to be voted upon and approved by the Court. Although we expect to file a reorganization plan that provides for emergence from bankruptcy, there can be no assurance that a plan of reorganization will be proposed by us or confirmed by the Court, or that any such plan will be consummated. We also may assume or reject executory contracts and unexpired leases, including our store and distribution center leases, subject to the approval of the Court and our satisfaction of certain other requirements. In the event we choose to reject an executory contract or unexpired lease, parties affected by these rejections may file claims with the Court-appointed claims agent as prescribed by the Bankruptcy Code and/or orders of the Court. Unless otherwise agreed, the assumption of an executory contract or unexpired lease will require us to cure all prior defaults under such executory contract or lease, including all pre-petition liabilities, some of which may be significant. In addition, in this regard, we expect that liabilities that will be subject to compromise through the Chapter 11 process will arise in the future as a result of the rejection of additional executory contracts and/or unexpired leases, and from the determination by the Court (or agreement by parties in interest) of allowed claims for items that we now claim as contingent or disputed. Conversely, we would expect that the assumption of additional executory contracts may convert some liabilities shown on our financial statements as subject to compromise to post-petition liabilities. Due to the uncertain nature of many of the potential claims, we are unable to project the magnitude of such claims with any degree of certainty. We have incurred, and will continue to incur, significant costs associated with the reorganization. 6 Under the priority scheme established by the Bankruptcy Code, certain post-petition liabilities and pre-petition liabilities need to be satisfied before shareholders are entitled to receive any distribution. The ultimate recovery to creditors and shareholders, if any, will not be determined until confirmation of a plan of reorganization. We can give no assurance as to what values, if any, will be ascribed in the bankruptcy case to each of these constituencies. A plan of reorganization could also result in holders of our common stock receiving no distribution on account of their interests and cancellation of their interests. In addition, under certain conditions specified in the Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its rejection by an impaired class of equity holders and notwithstanding the fact that equity holders do not receive or retain property on account of their equity interests under the plan. Moreover, as discussed above, there can be no assurance that a plan of reorganization will be confirmed by the Court. In light of the foregoing, we consider, as described above, the value of the common stock to be highly speculative and caution equity holders that the stock may ultimately be determined to have no value. Accordingly, we urge that appropriate caution be exercised with respect to existing and future investments in our common stock or in any claims related to pre-petition liabilities and our other securities. At this time, it is not possible to predict the effect of the Chapter 11 filing on our business, various creditors and shareholders or when we will be able to exit Chapter 11. Our future results are dependent upon our confirming and implementing a plan of reorganization. Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following: - developing and implementing a long-term strategy to revitalize our business and return to profitability; - taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations; - operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants, - generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms; - attracting, motivating and retaining key executives and associates; and - developing, negotiating, and, thereafter, a plan of reorganization confirmed by the Court. These challenges are in addition to other operational and competitive challenges faced by us in connection with our business as an off-price retailer. See the section below titled "Risk Factors" for a discussion of these items. A plan of reorganization could materially change the amounts reported in the financial statements, which do not give effect to all adjustments of the carrying value of assets or liabilities that might be necessary as a consequence of a plan of reorganization. 7 The financial statements contained herein have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business, and in accordance with Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Our ability to continue as a going concern, as described above, is predicated upon, among other things, the development and confirmation of a plan of reorganization, compliance with the provisions of the DIP financing facility and the ability to generate cash flows from operations and obtain financing sources sufficient to satisfy our future obligations. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 2 of the Notes to Financial Statements in Item 8. Financial Statements and Supplementary Data, for additional information. OPERATIONS Operating Strategy Our strategy is to be an off-price casual apparel, domestic goods, and housewares retailer to families with more than the average number of children and whose average household income is approximately $35,000 in the markets we serve. The major element of our operating strategy is to provide value to our customers by selling merchandise offered by national and discount store chains at savings of generally 20 to 50% below their prices. We primarily buy excess in-season inventory of recognized brands at bargain prices and pass along the savings to our customers. We believe we are positioned to help families dress, decorate their homes, and entertain their children at a great value. Buying and Distribution We purchase merchandise from domestic manufacturers, jobbers, importers, and other vendors. Historically, our payment terms have typically been net 30 days, although during the pendency of the Chapter 11 case, many of our vendors have reduced the amount of time in which we must pay for goods. We do not maintain any long-term or exclusive purchase commitments or agreements with any vendors. We believe that there are sufficient sources of supply of first quality, national and discount store branded merchandise that will meet our inventory needs. Unlike traditional department stores and discount retailers (that primarily purchase merchandise in advance of the selling season, for example, back-to-school is purchased by March), we primarily purchase our merchandise in-season (i.e., during the selling season). These 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. We believe that in-season buying practices are well suited to our customers, who tend to make purchases on an as-needed basis during the season. For years, our customers have substantiated this pattern, which has helped shape the way we do business. Our in-season buying practice is facilitated by our ability to efficiently process orders and ship merchandise through our distribution center to our stores. At our administrative headquarters, we receive daily store sales and inventory information from point-of-sale equipment located at each of our stores. This data is reported by stock keeping unit (SKU), permitting us to tailor purchasing and distribution decisions on an as-needed basis. Our chain-wide computer network, recently upgraded with a view to enhanced allocation capabilities, also facilitates communications between store management with timely pricing and distribution information. Generally, manufacturers ship goods directly to our distribution center or freight consolidators who then ship directly to our distribution center. We then deliver merchandise from our distribution center to our stores within ten to 14 days of receipt utilizing the services of independent trucking companies. We do not typically store merchandise at our distribution center from season to season. We believe we are a desirable customer for vendors seeking to liquidate inventory because we can take immediate delivery of large quantities of in-season goods. We rarely request markdown concessions, advertising allowances or special shipping requirements, but insist on the lowest price possible. 8 Merchandising and Marketing Our merchandise selection, pricing strategies and store formats are designed to reinforce the concept of value and maximize customer enjoyment of shopping at our stores. Our stores offer customers a diverse selection of first quality, in-season merchandise at prices that generally are lower than those of competing discount stores in their local markets. Our stores generally carry an assortment of brand name labels, including nationally recognized brands. We attempt to deliver new merchandise to our stores at least weekly to encourage frequent shopping trips by our customers and to maximize our inventory turns. As a result of our purchasing practices and the nature of the off-price retail industry, store inventory may not always include a full range of colors, sizes and styles in a particular item. We believe that price, quality and product mix are more important to our customers than the availability of a specific item at a given time. It is important that we emphasize inventory turns in our merchandising and marketing strategy. Our merchandise presentation, pricing below discounters, weekly store deliveries, staggered vendor shipments, promotional advertising, store-tailored distribution and prompt price reductions on slow-moving items are all designed to increase inventory turns. We believe that the pace of our inventory turns can lead to increased profits, lower markdowns, and efficient use of capital and customer urgency to make purchase decisions. Our stores are characterized by easily accessible merchandise displayed on hanging fixtures and open shelves in well-lit areas. Our prices are clearly marked with the comparative retail-selling price often noted on the price tag. Our major advertising vehicle is the use of full-color advertising circulars showing photos of our merchandise and emphasizing value to customers. Our print media is delivered to consumers through both direct mail and newspaper inserts. We also conduct local promotional activities at various stores throughout our chain from time to time. Seasonality We experience three primary selling seasons: Spring, Back to School and Holiday. We have historically realized our highest levels of sales during the Holiday season, which represents approximately 25% of our sales during the fiscal year. The Back to School season historically has generated our second highest level of sales for the fiscal year, representing approximately 17% of our sales. Competition We operate in a highly competitive marketplace. We compete with large national and discount store retail chains in most of our markets, such as Wal-Mart, K-Mart, Target and Mervyn's. In fiscal 2003, we experienced a decrease in market share due to our store closings and the growth of our major competitors. We expect that this trend will continue due to the 44 stores we have closed in fiscal 2004. While these retail chains offer a larger assortment of merchandise than we do and may provide a higher level of customer service, given our off-price format, our competitive advantage is that we sell our merchandise at prices typically 20% to 50% below the prices of these chains. We also carry national and recognizable brands that may not be carried by these retail chains. We also compete in most of our markets with other off-price retail chains, such as TJ Maxx, Ross Stores, Marshall's, and Big Lots. For the most part, these off-price chains serve the middle and upper-middle income markets offering apparel that is typically found in department store chains (such as Robinsons-May, Nordstrom and Dillard's), whereas we serve the lower and lower-middle income markets and offer apparel that is targeted at a discount store shopper. These national, discount store and off-price chains may have substantially greater resources than we do. We also compete with independent or small chain retailers and flea markets (also known as "swap meets"), which have a similar price strategy as we do, but generally offer lower service levels. In the future, new companies may enter the deep-discount retail industry. 9 Over the past few years, the retail industry has experienced price deflation, primarily due to a soft economy and intense competition. We expect the competition will continue and increase in the future. In addressing this competitive environment, we have initiated new merchandise strategies and a revised print advertising program; all designed to improve store contribution. Our Stores Our stores emphasize value and satisfaction to develop customer loyalty and generate repeat business. Most of our sales are for cash, although we accept checks, debit and credit cards. We also offer layaway and gift card programs. Our layaway program is important to our customers, many of whom do not possess credit cards, because it permits them to pay for purchases over time. In general, our store business hours are from 9:00 am to 9:00 pm. On January 22, 2004, we filed a motion with the Court seeking authorization for closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. We continually review store performance and may close additional stores that do not meet our minimum financial performance criteria. The costs associated with closing stores consist primarily of inventory liquidation costs, provisions to write down assets to net realizable value, teardown costs and the estimated cost with respect to disposition of the lease. As of April 23, 2004, we operated 195 stores located in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington, under various operating leases with third parties. Our stores are generally located in shopping centers in densely populated urban areas, lower to moderate income suburban communities and certain rural locations. Our stores range in size from 6,000 square feet to 35,000 square feet, averaging approximately 15,000 square feet. We generally lease previously occupied store sites on terms that we believe are more favorable than those available for newly constructed facilities. We select store sites based on demographic analysis of the market area, sales potential, local competition, occupancy costs, operational fit and proximity to existing store locations. Our stores typically employ one store manager, two to three assistant store managers and/or store supervisors, and 15 to 20 sales associates, most of whom are part-time employees. We train new store managers and assistant store managers in all aspects of store operations through our management-training program. Our management training program provides for the training of our store management candidates over a two to three week period in one of our training stores. Each of our 20 operating districts has a training store in which the store manager is responsible to train the store management candidates for that district. The training program covers operational procedures, merchandising skills, employee selection and other human resource skills. Our other store personnel are trained on site. We often promote experienced assistant store managers to fill open store manager positions. We maintain customary workers' compensation, commercial liability, fire, theft, business interruption and other insurance policies for all store, distribution and corporate office locations. At January 31, 2004, we operated 239 stores under the name Factory 2-U. The number of stores we operated in each quarter during fiscal year 2003, 2002 and 2001 were as follows: 10
2003 2002 2001 ------ ------ ------ As of the beginning of the first quarter 244 279 243 Opened 1 5 9 Closed (2) (28) (1) ------ ------ ------ As of the end of the first quarter 243 256 251 Opened 1 3 12 Closed (1) (2) - ------ ------ ------ As of the end of the second quarter 243 257 263 Opened - 4 12 Closed - - (2) ------ ------ ------ As of the end of the third quarter 243 261 273 Opened - - 6 Closed (4) (17) - ------ ------ ------ As of the end of the fourth quarter 239 244 279
Subsequent to January 31, 2004, we closed 44 stores in connection with our reorganization efforts as discussed above. As of April 23, 2004, our stores were located as follows:
State Strip Center Downtown Power Center Freestanding Mall Total - ----- ------------ -------- ------------ ------------ ---- ----- Arizona 22 2 2 1 1 28 California 88 7 13 1 2 111 Nevada 6 - 1 - - 7 New Mexico 7 - - - - 7 Oregon 7 - 2 1 - 10 Texas 17 - 2 1 3 23 Washington 6 1 1 - 1 9 ------------ --------- ----------- ------------- ------- ------- Total 153 10 21 4 7 195 ------------ --------- ----------- ------------- ------- -------
Employees As of April 23, 2004, we had 3,550 employees (2,020 of whom were part-time employees). Of that total, 1,301 were store employees and store field management, 155 were executives and administrative employees and 74 were warehouse employees. None of our employees are subject to collective bargaining agreements and we consider relations with our employees to be generally good. Trademarks Except for the trade names "Factory 2-U" and "Family Bargain Center", which are federally registered trademarks, we do not have any material trademarks. Government Regulation Our business operations are subject to federal, state and local laws, regulations and administrative practices. We believe we are in substantial compliance with all federal, state and local laws and regulations governing our business operations and we have obtained all material licenses and permits required to operate our business. We believe that the compliance burdens and risks relating to these laws and regulations do not have a material adverse effect on our business. 11 RISK FACTORS Our High Store Concentration in California Leaves Us Particularly Susceptible to Risks of Doing Business in California As of April 23, 2004, we operated 111 stores in California, representing over half of our total store base. Accordingly, our results of operations and financial condition are significantly more dependent upon trends and events in California than are those of our competitors with more geographically balanced store locations. Operating costs, such as workers' compensation and utilities in California have been significantly higher than other regions in the country where we currently operate. If operating costs continue to increase in California, they could continue to reduce our operating margins. The costs associated with workers' compensation insurance in the state of California have increased significantly over the past few years. These cost increases are related to the average cost per claim and the related state benefits. In California, the average workers' compensation claim is significantly higher than other states where we currently operate. With these continued workers' compensation cost increases, there can be no assurance that we will be able to obtain workers' compensation insurance at favorable rates. Additionally, with the uncertain economy, the continued rise in benefits could reduce our earnings. Utility costs for electricity and natural gas in California have risen significantly. These costs may continue to increase due to the actions of federal and state governments and agencies, as well as other factors beyond our control. We have attempted to mitigate such increases through energy conservation measures and other cost cutting steps. However, we can make no assurances that these measures and other steps taken will be adequate to control the impact of these utility cost increases in the future. In addition, increasing utility and gasoline costs, together with high unemployment, may significantly reduce the disposable income of our target customers. Our sales could be reduced if our target customers have less disposable income. In addition, California historically has been vulnerable to certain natural disasters and other risks, such as earthquakes and fires. At times, these events have disrupted the local economy. These events could also pose physical risks to our properties. We Could Experience Disruptions in Receiving and Distribution Well-organized and managed receiving and shipping schedules and the avoidance of interruptions are vital to our success. From time to time, we may face unexpected demands on our distribution operations that could cause delays in delivery of merchandise from our distribution center to our stores. A fire, earthquake or other disaster at our distribution center that disrupts the flow of merchandise could severely impair our ability to maintain inventory in our stores and thus reduce sales. During fiscal 2003, we closed two distribution centers in San Diego, California and one in Lewisville, Texas and consolidated their operations into a single, new distribution center in San Diego, California. We may face unexpected or unforeseen demands, disruptions or costs, which may result from earthquakes or mechanical breakdowns, that could adversely affect our distribution center operations and delay or interfere with our ability to deliver merchandise from our distribution facility to our stores in connection with this consolidation. Any such delay or interference could lead to a reduction in sales. We Depend Upon, But Do Not Have Long-Term Agreements With, Our Vendors for the Supply of Close-Out and Excess In-Season Merchandise Our success depends in large part on our ability to locate and purchase quality close-out and excess in-season merchandise at attractive prices from our vendors. We cannot be certain that such merchandise will continue to be available in the future. Further, we may not be able to find and purchase merchandise in quantities necessary to accommodate our needs. 12 We do not have long-term agreements with any vendor. As a result, we must continuously seek out buying opportunities from our existing suppliers and from new sources. We compete for these opportunities with other wholesalers and retailers, discount and deep-discount chains, and mass merchandisers. Although we do not depend on any single vendor or group of vendors and believe we can successfully compete in seeking out new vendors, a disruption in the availability of merchandise at attractive prices could result in reductions in sales and gross margins. We Rely on Credit Support From Our Vendors and the Credit Community Our ability to purchase merchandise depends upon our receiving credit support from trade vendors or the credit community that extends financing terms to certain of our vendors. In light of our recent Chapter 11 filing, certain vendors and factors have significantly reduced our credit support. Any improvement in our credit terms will be contingent upon, among other things, our results of operations, liquidity and a plan of reorganization. Any further withdrawal or reduction of the extension of credit from the credit community and our vendors may result in our not being able to purchase merchandise at attractive prices, disrupt product flow, reduce our liquidity and result in a reduction in sales and profit margins. It may also impair our ability to finance our operations, pay our debt obligation, and complete our reorganization efforts over the next twelve months. Our Sales Fluctuate According to Seasonal Buying Patterns, Which Expose Us to Excess Inventory Risk We have historically realized our highest levels of sales and income during the third and fourth quarters of our fiscal year (the quarters ending in October and January) as a result of the Back to School and Holiday seasons. Any adverse events during the third and fourth quarters could therefore reduce sales. In anticipation of the Back to School and Holiday seasons, we may purchase substantial amounts of seasonal merchandise. If for any reason, including periods of sustained inclement weather, our net sales during these seasons were to fall below seasonal norms and/or our expectations, a seasonal merchandise inventory imbalance could result. If such an imbalance were to occur, markdowns are required to clear excess inventory. Our sales, gross margins and net income could be reduced by higher than expected markdowns. We Face Intense Competition We operate in a highly competitive marketplace. We compete with large national and discount store retail chains, such as Wal-Mart, K-Mart, Target and Mervyn's, and other off-price chains, such as TJ Maxx, Ross Stores, Marshall's and Big Lots, some of which have substantially greater resources than ours. We 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. Over the past few years, the retail industry has experienced price deflation, primarily due to a weak economy and intense competition. We compete in the discount retail merchandise business, which is a highly competitive environment that subjects us to the price competition, the potential for lower net sales and decreased operating margins. We expect the competition will continue and increase in the future. In addressing this competitive environment, we have initiated new merchandise strategies and a revised print advertising program; all designed to improve store contribution. However, we can make no assurances that these strategies and other actions taken will be adequate to minimize our exposure to reduced sales and lower gross margins due to competition. We Handle Certain Materials that Could Expose Us to Liability Under Environmental Laws In the ordinary course of our business, we sometimes handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations. We have adopted policies regarding the handling and disposal of these products and we train our employees on how to handle and dispose of them. We cannot assure that our policies and training will successfully help us avoid potential violations of these environmental laws and regulations in the future. 13 Our Anti-Takeover Provisions Could Depress Our Stock Price In addition to some governing provisions in our Certificate of Incorporation and Bylaws, we are also subject to certain Delaware laws and regulations which could delay, discourage and prevent others from initiating a potential merger, takeover or other change in control, even if such actions would benefit our shareholders and us. The Market Price of Our Existing Common Stock is Subject to Substantial Fluctuation and Ultimately May Have No Value The market price of our common stock has fluctuated substantially since our recapitalization occurred in November 1998. In addition, a final plan of reorganization, if any, confirmed by the Court may result in the cancellation of our existing common stock with holders thereof receiving no distributions under the plan of reorganization other than, possibly, for a minor interest in a creditor litigation trust to be established pursuant to the plan of reorganization. In light of the foregoing, we consider the value of our common stock to be highly speculative and caution equity holders that the stock may ultimately be determined to have no value. On January 22, 2004, we were delisted from the Nasdaq national market as we were not in compliance with certain of the Nasdaq National Market continued listing requirements. Our stock is currently trading in an "over-the-counter" market and accordingly trading prices for our common stock could fluctuate significantly due to many factors, including: o the depth of the market for our common stock; o changes in expectations of our future financial performance, including financial estimates by securities analysts and investors; o our ability to reorganize under Chapter 11; o variations in our operating results and financial conditions; o conditions or trends in our industry; o additions or departures of key personnel; and o future issuances of our common stock. We Face Exposure in Lawsuits On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the possible entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations. 14 In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit. We are periodically subject to legal actions that arise in the ordinary course of business that could subject us to substantial money damages or injunctive relief. Our Customers Might Reduce their Houseware and Apparel Purchases as a Result of Downturns in the United States and Local Economy Our typical customers are families with more than the average number of children and with an average annual household income of approximately $35,000. This customer base is particularly vulnerable to economic recessions, depressions and general slowdowns in the overall United States and local economy. During periods of general economic weakness, our customers may choose to reduce their houseware and apparel purchases in favor of housing and food expenditures, which could result in a reduction in our sales. We Face Uncertainties Relating to Our Bankruptcy Case At this time, it is not possible to predict the effect of our Chapter 11 filing on our business, creditors and shareholders or when we will be able to exit Chapter 11. Our ability to continue as a going concern is predicated upon numerous issues, including our ability to develop a long-term strategy to revitalize our business and return to profitability; take appropriate actions to offset the negative impacts that the Chapter 11 filing has had on our business and the impairment of vendor relations; operate within the framework of our DIP financing facility including limitations on capital expenditures and compliance with financial covenants; generate cash flows from operations or seek other sources of financing and the availability of projected vendor credit terms; attract, motivate and retain key executives and associates; and develop, negotiate, confirm and consummate a plan of reorganization in a timely manner. AVAILABLE INFORMATION We make available on our web site, www.factory2-u.com, our filings on Form 10-K, 10-Q, 8-K and amendments thereto, as soon as reasonably practical after we file or furnish such materials with the Securities and Exchange Commission. All such materials are available free of charge. Any information that is included on or linked to our Internet site is not a part of this report or any registration statement that incorporates this report by reference. 15 Item 2. Properties As of April 23, 2004, we operated 195 retail stores located in seven states, under various operating leases with third parties. Our store locations include shopping centers, downtown business districts, malls and freestanding sites. Each store lease is separately negotiated. The lease term for our stores is between five to ten years with renewal options typically in five-year increments. Approximately 98% of our leases are "triple net leases" under which we are required to reimburse landlords for insurance, real estate taxes and common area maintenance costs; however, for many of those leases, we have negotiated reimbursement limitations on common area costs. As well as the monthly minimum base rent, some of our store leases require additional rent, which generally is based on an agreed percentage of sales in excess of a specified sales level. Our store rent expense for the fiscal year ended January 31, 2004 was approximately $36.1 million. Subsequent to January 31, 2004, we closed 44 stores in conjunction with our reorganization efforts. As of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. During fiscal 2003, we completed the consolidation of our two former San Diego distribution centers and our Lewisville, Texas distribution center into one single distribution center, which is located at a new facility in San Diego, California. As part of our bankruptcy case, we have rejected the lease of our San Diego distribution center located at 7130 Miramar Road and the lease of our Lewisville, Texas distribution center at 1875 Waters Ridge Drive. We continue to lease the space at our headquarters, located in a 208,460 square-foot multi-use facility at 4000 Ruffin Road, San Diego, California. This facility consists of 58,460 square feet of office space and 150,000 square feet of distribution space. The lease of our new distribution facility located at 2020 Piper Ranch Road in San Diego, California expires in July 2015 and provides for an annual base rent of approximately $2.6 million. 16 Item 3. Legal Proceedings On January 13, 2004, we filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. We retain control of our assets and are authorized to operate the business as a debtor-in-possession while being subject to the jurisdiction of the Court. As of the Petition Date, most pending litigation is stayed, and absent further order of the Court, substantially all pre-petition liabilitities are subject to settlement under a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 case or its effect on our business. If it is determined that the liabilities subject to compromise in the Chapter 11 case exceed the fair value of the assets, unsecured claims may be satisfied at less than 100% of their fair value and the equity interests of our shareholders may have no value. See Item 1. Business Proceedings Under Chapter 11 of the Bankruptcy Code. On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations. In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit. 17 There are numerous other matters filed with the Court in our reorganization proceedings by creditors, landlords or other third parties related to our business operations or the conduct of our reorganization activities. Although none of these individual matters which have been filed to date have had or are expected to have a material adverse effect on us, our ability to successfully manage the reorganization process and develop an acceptable reorganization plan could be negatively impacted by adverse determinations by the Court on certain of these matters. We are at all times subject to pending and threatened legal actions that arise in the normal course of business. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Market for Factory 2-U Stores, Inc. Common Equity and Related Stockholder Matters Market Information On January 22, 2004 our Common Stock was suspended from trading on the NASDAQ National Market and began trading on the "Over-the-Counter" (OTC) market under the symbol of "FTUSQ.PK." Prior to January 22, 2004, our Common Stock was traded on NASDAQ under the symbol of "FTUS." The following table sets forth the range of high and low trading prices of each of our fiscal quarters in fiscal 2002 and 2003. For Fiscal 2002 and through the 13 weeks ended November 1, 2003 the prices were based on the NASDAQ National Market of the Common Stock, as reported by NASDAQ. Prices for the 13 weeks ended January 31, 2004 were based on prices as reported by NASDAQ and Pinksheets LLC. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.
High Low ------- ------- Fiscal 2002 - ----------- 13 weeks ended May 4, 2002 $ 18.31 $ 11.35 13 weeks ended August 3, 2002 $ 16.49 $ 10.61 13 weeks ended November 2, 2002 $ 10.91 $ 1.11 13 weeks ended February 1, 2003 $ 5.64 $ 1.45 Fiscal 2003 - ----------- 13 weeks ended May 3, 2003 $ 5.35 $ 1.67 13 weeks ended August 2, 2003 $ 8.55 $ 2.85 13 weeks ended November 1, 2003 $ 7.65 $ 1.84 13 weeks ended January 31, 2004 $ 2.89 $ 0.28 Fiscal 2004 ending January 29, 2005 - ----------------------------------- Through April 23, 2004 $ 1.76 $ 0.86
As of April 23, 2004, we had approximately 230 stockholders of record and approximately 2,200 beneficial stockholders. 18 Dividend Policy We have never paid cash dividends on our Common Stock and do not anticipate paying cash dividends in the foreseeable future. The declaration and payment of any cash dividends on our Common Stock in the future will be determined by the Board of Directors in light of conditions then existing, including our earnings, financial condition, cash requirements and contractual, legal and regulatory restrictions relating to the payments of dividends and any other factors that our Board of Directors deems relevant. During the pendency of the Chapter 11 proceedings, any such dividend would be remote and, in any event, subject to the approval of the Court. We are contractually prohibited from paying cash dividends on our Common Stock under the terms of our existing DIP financing facility without the consent of the lenders. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - DIP Financing Facility." Equity Compensation Plan Information The following table sets forth information as of January 31, 2004 with respect to our common stock that may be issued upon the exercise of stock options under our Amended and Restated 1997 Stock Option Plan, together with information relating to our common stock that may be issued under plans not approved by stockholders.
(c) (a) Number of Securities Remaining Available for Number of (b) Future Issuance Under Securities to be Equity Compensation Issued Upon Exercise Weighted Average Exercise Plans (Excluding of Outstanding Price of Outstanding Securities Reflected in Plan Category Options Options Column (a)) - ------------------------------ ----------------------- -------------------------- ------------------------- Equity Compensation 1,514,380 $8.19 1,643,600 Plans Approved by Stockholders - ------------------------------ ----------------------- -------------------------- -------------------------
19 Item 6. Selected Financial Data The selected financial data set forth below, except for Operating Data, is derived from our audited financial information and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our Financial Statements, including the Notes, and Supplementary Data included in this Annual Report on Form 10-K.
Fiscal Year Ended ----------------- January 31, February 1, February 2, February 3, January 29, 2004(1) 2003 (2) 2002 (3) 2001 (4) 2000 (5) ---------- ---------- ---------- ---------- ----------- (in thousands, except per share and operating data) Statement of Operations Data - ---------------------------- Net sales $ 493,297 $ 535,270 $ 580,460 $ 555,670 $ 421,391 Operating income (loss) (26,383) (45,050) (16,786) 31,868 22,753 Reorganization items (31,703) - - - - Income (loss) from continuing operations before income taxes and extraordinary items (61,779) (46,661) (17,746) 30,322 20,481 Net income (loss) applicable to common stock (85,859) (28,509) (10,896) 21,264 12,442 Weighted average shares outstanding Basic 16,187 12,957 12,807 12,589 12,214 Diluted 16,187 12,957 12,807 13,066 12,864 Income (loss) before extraordinary items and discontinued operations applicable to common stock Basic (5.30) (2.20) (0.85) 1.69 1.02 Diluted (5.30) (2.20) (0.85) 1.63 0.97 Net income (loss) per common stock Basic (5.30) (2.20) (0.85) 1.69 1.02 Diluted (5.30) (2.20) (0.85) 1.63 0.97 Operating Data - -------------- Number of stores at fiscal year end 239 244 279 243 187 Total selling square footage at fiscal year end 2,965,000 3,021,000 3,459,000 2,979,000 2,169,000 Sales per average selling square foot $ 164 $ 167 $ 178 $ 211 $ 209 Comparable store sales increase (decrease)(6) (4.4%) (7.7%) (8.7%) 4.4% 10.3% Balance Sheet Data - ------------------ Working capital (deficit) (7) $ 21,521 $ (2,913) $ 14,633 $ 18,896 $ 1 ,241 Total assets 70,708 126,504 155,709 142,265 108,466 Liabilities subject to compromise 63,062 - - - - Long-term debt and revolving credit facility, including current portion (7) 128 15,746 10,376 11,218 11,067 Stockholders' equity (deficit) (24,932) 44,319 70,566 79,737 46,430
(1) Includes the following pre-tax items: (a) $26.3 million adjustment related to the impairment of goodwill (reorganization items), (b) $7.8 million inventory valuation allowance, net of a $0.5 million adjustment for the reserve established at the end of fiscal 2002 for slow moving and aged items (cost of sales), (c) $1.5 million adjustment to reduce the reserves for the fiscal 2002 and 2001 restructuring plans (restructuring charge, net), (d) $2.4 million related to impairment of fixed assets associated with the 44 closing stores, (reorganization items), (e) $1.7 million related to inventory sold below cost at our 44 closing stores (reorganization items), (f) $1.3 million related to professional services and other expenses as a result of the Chapter 11 filing (reorganization items), (g) $1.0 million related to separation with former executives (selling and administrative expenses), and (h) $0.7 million favorable adjustment to the stock subscription notes receivable valuation allowance established at the end of fiscal 2002 (selling and administrative expenses). 20 (2) Included the following pre-tax items: (a) $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance (cost of sales), (b) $2.8 million related to a long-term consulting project, which was terminated in November 2002, (c) $2.1 million related to a litigation settlement, (d) $14.4 million related to fiscal 2002 restructuring efforts, partially offset by a $5.0 million reserve reduction related to the fiscal 2001 restructuring efforts (as a result of favorable experience with lease termination costs), (e) $0.8 million related to the separation agreement of our former Chief Executive Officer, and (f) $2.2 million write-down of shareholders and trade notes receivable. (3) Included pre-tax expenses of $21.2 million related to fiscal 2001 restructuring efforts, $0.5 million non-cash stock option charge, and $1.1 million related to the retirement and replacement of our former General Merchandising Manager. (4) Fiscal year included 53 weeks. Included pre-tax expenses of $4.8 million non-cash charge for performance-based stock options, partially offset by a $1.2 million condemnation award and $2.9 million after-tax reduction to our tax valuation allowance. (5) Included a pre-tax $2.1 million non-cash charge related to performance-based stock options. (6) We averaged 230, 217, 179, 152 and 151 comparable stores for fiscal years 2003, 2002, 2001, 2000 and 1999, respectively. We define comparable stores as follows: o New stores are considered comparable after 18 months from date of opening. o When a store relocates within the same market, it is considered comparable after 6 months of operations. o Store expansion greater than 25% of the original store size is treated like a new store and becomes comparable after 18 months of operations. Store expansion less than 25% of the original store size remains in the comparable store base. (7) As of January 31, 2004, working capital and long term debt and revolving credit facility, including current portion, do not include liabilities classified as subject to compromise. 21 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 We operate a chain of off-price retail apparel and houseware stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores. In fiscal 2002, we continued to experience declining transaction counts, declining purchase size, increased competition, rising operating costs and a slow economy. These factors were exacerbated by the lingering effects of the September 11 terrorist attacks and fear of war in Iraq. In December 2002, we announced the fiscal 2002 restructuring initiatives needed to improve operating results. These initiatives included the closure of 23 under-performing stores and consolidation of our distribution center network and corporate overhead structure. In connection with the fiscal 2002 restructuring, we recorded a pre-tax restructuring charge of approximately $14.4 million. We also announced efforts to liquidate our slow-moving and aged inventory chain-wide. We incurred a pre-tax charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance. We experienced a continuation of declining sales volume in fiscal 2003 with a decrease of 4.4% in comparable store sales for the year. We believe there were a number of factors that contributed to the lower sales in fiscal 2003: (1) lower inventory levels for most of our first quarter due to a tightening of credit by our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor strikes in the southern California region in the third quarter, (4) decrease in retail price points, and (5) a continuation of a very soft retail environment impacted by general price deflation and heavy promotion, particularly in apparel. As a result of our financial results in fiscal 2001 and 2002, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after the fiscal 2002 Christmas selling season we experienced a tightening of credit extended to us by vendors, factors and others for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and to a lesser extent March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing. In an effort to improve our liquidity, obtain more reasonable credit terms and provide for a consistent flow of merchandise, we initiated a series of financing transactions and took steps to accelerate the receipt of refunds related to tax loss carry-back benefits. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deduction the placement fees and other offering expenses. In addition, during March of 2003, we received an $8.2 million federal tax refund as a result of utilizing a tax loss carry-back benefit. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note secured primarily by inventory and a $1.0 million term note secured primarily by equipment and other assets. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses. Despite our efforts to improve sales and our liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code on January 13, 2004. 22 Under Chapter 11, we are operating our business as a debtor-in-possession. As of the Petition Date, actions to collect pre-petition indebtedness as well as most other pending litigation, are stayed and other pre-petition contractual obligations generally may not be enforced against us. In addition, under the Bankruptcy Code, we may assume or reject executory contracts and unexpired leases, subject to approval of the Court and our satisfaction of certain other requirements. Parties affected by these rejections may file claims in accordance with the reorganization process. Absent an order of the Court, substantially all pre-petition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and equity holders and approved by the Court. At hearings held on January 14, 2004 concerning our first day motions, the Court entered orders granting us authority, among other things, to (1) continue our centralized cash management system, (2) pay pre-petition wages and continue our employee benefit plans and other employee programs, (3) continue customer related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers and vendors in full for all goods and services provided on or after the Petition Date and (6) continue ongoing pre-petition "going out of business sales" for four store locations completed by January 31, 2004. In addition, the Court also gave interim approval for a $45.0 million DIP financing facility that was committed by The CIT Group/Business Credit, Inc. and GB Retail Funding, LLC. On February 2, 2004, the Court granted final approval of the $45.0 million DIP financing facility. We intend to utilize this financing, in addition to cash flow from operations, to fulfill business obligations during the Chapter 11 case. Additionally, on February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores. Stores were selected by evaluating their market and financial performance. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at these 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. In connection with our Chapter 11 case, the United States Trustee has appointed an unsecured creditors committee and may consider the appointment of an equity committee. These official committees and their legal representatives often take positions on matters that come before the Court, and are the entities with which we plan to negotiate the terms of our plan of reorganization. There can be no assurance that the unsecured creditors committee or equity committee, if any, will support our positions in the bankruptcy case or the plan of reorganization once proposed, and any disagreements could protract the bankruptcy case, negatively impact our ability to operate during bankruptcy, and/or delay our emergence from bankruptcy. See additional information regarding the Chapter 11 case in Item 1. Business -- Proceedings Under Chapter 11 of the United States Bankruptcy Code, of this Form 10-K. Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following: - developing and implementing a long-term strategy to revitalize our business and return to profitability; - taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations; - operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants; 23 - generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms; - attracting, motivating and retaining key executives and associates; and - developing, negotiating, and, thereafter, having a plan of reorganization confirmed by the Court. These challenges are in addition to those operational and competitive challenges faced by Factory 2-U in connection with our business as an off-price retailer. See " Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995" immediately preceding Item 1 of this Form 10-K. We started fiscal 2004 with numerous issues and tasks that we need to resolve and achieve. The Chapter 11 filing right before the beginning of our fiscal 2004 provides us an opportunity to improve our business operations, reduce our cost structure and restructure our financial affairs. Our primary goal for fiscal 2004 is to improve our cash flows. We have started taking steps and continue to focus on our major management objectives including: - improving store performance - closing 44 non-core underperforming stores (all these stores were closed by March 18, 2004); - improving our gross margin - raising our initial mark up and adjusting our retail price points; - reducing advertising spend - reducing the number of advertising circulars and improving productivity of our advertising circulars; and - reducing our selling, general and administrative expenses - monitoring store payroll and reducing costs at the corporate headquarters. With respect to store openings and closings in fiscal 2004, we have already closed 44 stores as discussed above and we currently plan to open one new store for which the lease was signed before our Chapter 11 filing. We continue to review and monitor our store performance by evaluating each existing store's market and financial performance and we may close additional stores that do not meet our minimum financial performance criteria. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The financial statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business. Based on guidance in SOP 90-7, all pre-petition liabilities subject to compromise have been segregated in the Balance Sheet and are classified as Liabilities subject to compromise, at the estimated amount of allowable claims. Liabilities not subject to compromise are separately classified as current and non-current. Expenses, realized losses, and provision for losses resulting from the reorganization are reported separately as reorganization items. 24 We believe the following represents the areas where the most critical estimates and assumptions are used in the preparation of the financial statements: o Inventory valuation. Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method ("RIM") on a first-in, first-out basis. Under the RIM, the valuation of inventory at cost and the resulting gross margin are calculated by applying a computed cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventory at the lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventory. Inherent in the RIM calculation are certain significant management judgments and estimates regarding markdowns and shrinkage, which may from time to time cause adjustments to the gross margin in the subsequent period. Factors that can lead to distortion in the calculation of the inventory balance include applying the RIM to a group of merchandise items that is not fairly uniform in terms of its cost and selling price relationship and turnover, and applying RIM to transactions over a period of time that includes different rates of gross profit, such as those relating to seasonal merchandise items. To minimize the potential of such distortions in the valuation of inventory from occurring, we utilize 82 sub-departments in which fairly homogeneous classes of merchandise items having similar gross margin are grouped. In addition, failure to take markdowns currently may result in an overstatement of cost under the lower of cost or market principle. As of January 31, 2004, we had an inventory valuation allowance of approximately $9.1 million representing our estimate of the cost in excess of the net realizable value of all clearance items. In addition, we had an allowance of approximately $2.2 million representing additional inventory shrink reserve. We believe that our RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market. o Valuation of goodwill, intangible and other long-lived assets. We use certain assumptionsin establishing the carrying value and estimated lives of our long-lived assets and goodwill. The criteria used for these evaluations include management's estimate of the asset's continuing ability to generate income from operations and positive cash flows. If assets are considered to be impaired, the impairment recognized is measured by the amount that the carrying value of the assets exceeds the fair value of the assets. Useful lives and related depreciation or amortization expense are based on our estimate of the period that the assets will generate revenues or otherwise be used in operations. Factors that would influence the likelihood of a material change in our reported results include a significant decline in our stock price and market capitalization compared to our net book value, significant changes in an asset's ability to generate positive cash flows, significant changes in our strategic business objectives and utilization of the asset. In conjunction with our Chapter 11 filing, we recorded an impairment charge of $26.3 million for our goodwill. Additionally, as a result of the closure of 44 stores, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores. o Accrued restructuring costs. We have estimated amounts for the charges and the related liabilities regarding our fiscal 2002 and fiscal 2001 restructuring initiatives including store closures, realignment of our field organization and workforce reductions in accordance with the Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Depending on our ability to dispose of the remaining lease obligations for the store and distribution center closures, the actual costs to complete the restructuring initiatives may be different from our estimated costs. As of January 31, 2004, we evaluated our accrued restructuring costs and recorded a favorable adjustment of $1.5 million primarily related to the adjustment of lease termination costs, which is based on the maximum amount allowed by the Bankruptcy Code. 25 o Litigation reserves. Based in part on the advice of our legal counsel, estimated amounts for litigation and claims that are probable and can be reasonably estimated are recorded as liabilities in the balance sheet. The likelihood of a material change in these estimated reserves would be dependent on new claims as they may arise and the favorable or unfavorable outcome of the particular litigation. We continuously evaluate the adequacy of these reserves and, as new facts come to light, adjust these reserves when necessary. o Workers' compensation accrual. At the beginning of fiscal 2001, we transitioned to a partially self-insured workers' compensation program. The program for the policy year ended January 31, 2002 had both a specific and aggregate stop loss amount of $250,000 and $3.2 million, respectively. The program for the policy years ended January 31, 2004 and January 31, 2003 had a specific stop loss amount of $250,000 with no aggregate stop loss limit. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy year ended January 31, 2004, 2003 and 2002 were estimated to be approximately $3.6 million, $4.7 million and $4.3 million ($3.2 million aggregate stop loss), respectively. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above. o Valuation of deferred income taxes. Valuation allowances are established, if deemed necessary, to reduce deferred tax assets to the amount expected to be realized. The likelihood of a material change in our expected realization of these assets is dependent on future taxable income, our ability to use the net operating loss carryforwards, the effectiveness of our tax planning and strategies among the various tax jurisdictions that we operate in, and any significant changes in the tax treatment we currently receive. In light of our significant net operating losses and our Chapter 11 filing, we provided for a 100% valuation allowance on our deferred tax assets as of January 31, 2004. Results of Operations The financial statements contained herein have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business, and in accordance with SOP 90-7. Upon emergence from bankruptcy, the amounts reported in subsequent financial statements may materially change, due to the restructuring of our assets and liabilities as a result of the plan of reorganization, if any, and the application of "Fresh Start" accounting. We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal 2003). The following table sets forth operating data expressed as a percentage of net sales for the fiscal years indicated. Due to operational and strategic changes, year-to-year comparisons of financial results may not be meaningful and the historical results of our operations may not be indicative of our future results. 26
Fiscal Year ----------- 2003 2002 2001 ---- ---- ---- (percentage of net sales) Net sales 100.0 100.0 100.0 Cost of sales 68.9 69.7 66.4 ------ ------ ------ Gross profit 31.1 30.3 33.6 Selling and administrative expenses 36.7 36.6 32.4 Pre-opening and closing expenses 0.1 0.2 0.5 Amortization of intangibles - - 0.3 Restructuring charge, net (0.3) 1.9 3.2 Stock-based compensation expense - - 0.1 ------- ------ ------ Operating loss (5.4) (8.4) (2.9) Interest expense, net 0.7 0.3 0.2 ------- ------- ------ Loss before reorganization items and income taxes (benefit) (6.1) (8.7) (3.1) Reorganization items 6.4 - - ------- ------- ------ Loss before income taxes (benefit) (12.5) (8.7) (3.1) Income taxes (benefit) 4.9 (3.4) (1.2) ------- ------- ------ Net loss (17.4) (5.3) (1.9) ------- ------- ------
We operated 239 stores, 244 stores and 279 stores as of January 31, 2004, February 1, 2003 and February 2, 2002, respectively. The average number of stores in operation in fiscal 2003 was 243 versus 259 in fiscal 2002 and 252 in fiscal 2001. In addition, we averaged 230, 217 and 179 comparable stores for fiscal 2003, 2002 and 2001, respectively. We define comparable stores as follows: o New stores are considered comparable after 18 months from date of opening. o When a store relocates within the same market, it is considered comparable after 6 months of operations. o Store expansion greater than 25% of the original store size is treated like a new store and becomes comparable after 18 months of operations. Store expansion less than 25% of the original store size remains in the comparable store base. Fiscal 2003 Compared to Fiscal 2002 Net sales were $493.3 million for fiscal 2003 compared to $535.3 million for fiscal 2002, a decrease of $42.0 million or 7.8%. Comparable store sales decreased 4.4% in fiscal 2003 versus a decrease of 7.7% in fiscal 2002. The decrease in net sales was due to negative comparable store sales as well as fewer stores in operation as a result of our fiscal 2002 restructuring. Gross profit was $153.2 million for fiscal 2003 compared to $162.4 million for fiscal 2002, a decrease of $9.2 million or 5.6%. As a percentage of net sales, gross profit was 31.1% in fiscal 2003 compared to 30.3% in fiscal 2002, or an 80 basis-point improvement versus fiscal 2002. Included in fiscal 2003 cost of sales were a non-cash inventory valuation allowance charge of $7.8 million, net and a non-cash adjustment of $217,000 to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2002 and 2001 restructuring plans. Of the $7.8 million, $6.1 million represented a "lower of cost or market" adjustment related to approximately $19.2 million of aged and slow-moving items that we decided to liquidate during the first quarter of fiscal 2004, $2.2 million represented additional shrink reserve based on unfavorable shrink results we experienced during physical inventory taken at our 27 stores in February 2004, and an adjustment of $523,000 to reduce excess inventory reserve established at the end of fiscal 2002. As previously reported, included in fiscal 2002 cost of sales were (1) a non-cash charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance, (2) a non-cash charge of $1.1 million related to the expected inventory liquidation cost for store closings identified in the previously mentioned fiscal 2002 restructuring, and (3) a non-cash adjustment of $1.3 million to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2001 restructuring plan. The inventory valuation allowance represented a "lower of cost or market" adjustment related to approximately $16.3 million of aged and slow-moving items that we decided to liquidate in the first quarter of fiscal 2003. Selling and administrative expenses were $180.9 million for fiscal 2003 compared to $196.4 million for fiscal 2002, a decrease of $15.5 million or 7.9%. Included in fiscal 2003 selling and administrative expenses were $1.0 million charge in connection with separation of two former executives and an income of approximately $708,000 to adjust the valuation allowance established at the end of fiscal 2002 related to certain of our stock subscription notes receivable. Included in fiscal 2002 selling and administrative expenses were: (1) consulting fees of $2.8 million in connection with a consulting agreement, which was terminated in November 2002; (2) a charge of $2.1 million recorded during the second quarter in conjunction with the settlement of litigation; (3) a non-cash charge of $1.2 million to adjust the value of certain shareholders' notes receivable; and (4) a non-cash valuation allowance of $1.0 million for an uncollectible note receivable due from one of our vendors. Excluding these special items in fiscal 2003 and 2002, the selling and administrative expenses for fiscal 2003 was $180.5 million or 36.6 % of net sales compared to $189.3 million or 35.4% of net sales for fiscal 2002. The decrease of $8.8 million or 4.7% was primarily due to fewer stores in operation. The average number of stores in operation for fiscal 2003 was 243, 6.2% lower than fiscal 2002. The increase in selling and administrative expenses as a percentage of net sales was primarily due to the loss of sales volume. In fiscal 2003, we recorded pre-opening and closing expenses of $292,000, which primarily consisted of start-up expenses for our new distribution center. The decrease of $794,000, or 73.1% from fiscal 2002 was primarily due to the opening of ten fewer new stores in fiscal 2003. In addition, fiscal 2002's pre-opening and closing expenses also included a $250,000 lease termination fee for a store we decided not to open. Restructuring charge for fiscal 2003 was a favorable adjustment of approximately $1.5 million to reduce the reserves for the fiscal 2002 and 2001 restructuring plans. This favorable adjustment was primarily related to the lease termination reserve adjustment in accordance with the maximum claim for rejected leases as allowed by the Bankruptcy Code. During the fourth quarter of fiscal 2002, we recorded a charge of $14.4 million in relation to our fiscal 2002 restructuring efforts. The charge of $14.4 million included a non-cash inventory liquidation cost of $1.1 million, which was included in cost of sales. In addition, as a result of favorable experience related to the costs of closing the 28 stores included in our fiscal 2001 restructuring plan, we recorded a favorable adjustment of approximately $5.0 million to reduce the reserve established for the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3 million related to inventory liquidation cost, which was reported as part of cost of sales. As such, the total amount reported as a restructuring charge for fiscal 2002 was $9.9 million. Reorganization items for fiscal 2003 were $31.7 million and consisted of: (1) a non-cash goodwill impairment charge of $26.3 million; (2) a non-cash impairment charge of $2.4 million for fixed assets associated with the 44 stores closed subsequent to January 31, 2004 as part of our reorganization efforts; (3) a non-cash inventory valuation reserve of $1.7 million related to the sale inventory at the 44 stores below cost; and (4) $1.3 million of professional fees and other expenses related to the bankruptcy case and reorganization efforts. Interest expense, net was $3.7 million in fiscal 2003 versus $1.6 million in fiscal 2002, an increase of $2.1 million or 131.3%. The increase in interest expense from fiscal 2002 is due to increased borrowings at higher interest rates and the write-off of remaining unamortized debt issuance costs of approximately $353,000 as a result of the Chapter 11 filing. 28 Income tax expense increased from a credit for income taxes of $18.2 million in fiscal 2002 to an expense for income taxes of $24.1 million in fiscal 2003. The credit for income taxes recorded during fiscal 2002 reflected the recognition of a tax benefit associated with our net operating losses. Fiscal 2003 results reflected the establishment of a valuation reserve against certain previously recorded deferred tax assets. Due to our significant net operating losses and our Chapter 11 filing, we now beleive that our ability to recover previously recorded deferred tax assets in the near term has diminished and that it is appropriate to establish a valuation allowance to fully reserve our previously recorded deferred tax assets. Fiscal 2002 Compared to Fiscal 2001 Net sales were $535.3 million for fiscal 2002 compared to $580.5 million for fiscal 2001, a decrease of $45.2 million or 7.8%. Comparable store sales decreased 7.7% in fiscal 2002 versus a decrease of 8.7% in fiscal 2001. The decrease in net sales was due to fewer stores in operation as well as negative comparable store sales. Comparable store sales decreased primarily as a result of continuing slow economy, threat of terrorist attacks, threat of war with Iraq, increased price competition, and to a lesser extent, increased utilities and fuel costs in California, our largest market. As a result of these factors, we experienced fewer transactions and a reduced purchase size. Compounding this, apparel is considered a deferrable purchase for our core customers who have limited discretionary income. Apparel and houseware purchases may be reduced and deferred in favor of more current needs such as food, housing, utilities and transportation. Gross profit was $162.4 million for fiscal 2002 compared to $195.1 million for fiscal 2001, a decrease of $32.7 million or 16.8%. As a percentage of net sales, gross profit was 30.3% in fiscal 2002 compared to 33.6% in fiscal 2001, or a 330 basis-point decline versus fiscal 2001. Included in fiscal 2002 cost of sales were: (1) a non-cash charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance; (2) a non-cash charge of $1.1 million related to the expected inventory liquidation cost for store closings identified in the previously mentioned fiscal 2002 restructuring; and (3) a non-cash adjustment of $1.3 million to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2001 restructuring plan. The inventory valuation allowance represented a "lower of cost or market" adjustment related to approximately $16.3 million of aged and slow-moving items that we decided to liquidate by April 2003. As previously reported, the fiscal 2001 gross margin reflected a non-cash charge of $2.9 million related to the estimated inventory liquidation cost for the closing of 28 under-performing stores identified in the fiscal 2001 restructuring plan. After giving effect to restructuring charges in both years, gross profit margin declined primarily due to higher markdown volume (260 basis points). The higher markdown volume was related to a very heavy promotional environment and clearance of slow-moving and aged merchandise. Selling and administrative expenses were $196.4 million for fiscal 2002 compared to $188.3 million for fiscal 2001, an increase of $8.1 million or 4.3%. As a percentage of net sales, selling and administrative expenses were 36.6% for fiscal 2002 compared to 32.4% for fiscal 2001. The increase in selling and administrative spending as a percentage of net sales was both spending related and sales volume related. Included in fiscal 2002 selling and administrative expenses were: (1) consulting fees of $2.8 million in connection with a consulting agreement, which was terminated in November 2002; (2) a charge of $2.1 million recorded during the second quarter in conjunction with the settlement of litigation; (3) a non-cash charge of $1.2 million to adjust the value of certain shareholders' notes receivable; and (4) a non-cash valuation allowance of $1.0 million for an uncollectible note receivable due from one of our vendors. In addition to these items, we experienced an increase of approximately $3.5 million in advertising expense. The higher advertising expense was due to increased advertising circulars in response to a very competitive promotional environment. Other store selling expenses, which included store labor and store occupancy, were lower than fiscal 2001 primarily due to the lower average number of stores in operation. Pre-opening expenses were $1.1 million for fiscal 2002 compared to $3.1 million for fiscal 2001, a decrease of $2.0 million, or 64.8%. The decrease in pre-opening expenses was primarily related to 12 new store openings this year versus 39 new store openings last year. Current year pre-opening expenses included a $250,000 lease termination fee for a store we decided not to open. 29 Amortization of intangibles was not recorded for fiscal 2002 compared to $1.7 million for fiscal 2001. The change was due to the elimination of goodwill amortization in conjunction with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 142 and cessation of amortization associated with prior business acquisitions. During the fourth quarter of this year, we recorded a charge of $14.4 million in relation to our previously announced fiscal 2002 restructuring efforts. The charge of $14.4 million included a non-cash inventory liquidation cost of $1.1 million, which was included in cost of sales. In addition, as a result of favorable experience related to the costs of closing the 28 stores included in our fiscal 2001 restructuring plan, we recorded a favorable adjustment of approximately $5.0 million to reduce the reserve established for the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3 million related to inventory liquidation cost, which was reported as part of cost of sales. As such, the total amount reported as a restructuring charge for fiscal 2002 was $9.9 million versus $18.3 million for fiscal 2001. The restructuring charge of $18.3 million in fiscal 2001 was part of the $21.2 million charge related to our restructuring initiatives, as previously discussed. We recorded $2.9 million of the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which was included in cost of sales. We recorded non-cash stock-based compensation expense related to certain performance-based stock options during fiscal 2001 in the amount of $456,000. During the second quarter of fiscal 2001, we removed the market price hurdle of $49.78 for 19,361 stock options held by a former Executive Vice President who retired in August 2001. As a result of the removal of the market price hurdle, we incurred a non-cash charge of $456,000. There was no stock-based compensation expense incurred in fiscal 2002. Interest expense, net was $1.6 million in fiscal 2002 versus $960,000 in fiscal 2001, an increase of $651,000 or 67.8%. The increase was due to higher average outstanding borrowings on the revolving credit facility. We recorded a federal and state income tax benefit of $18.2 million in fiscal 2002 versus $6.9 million in fiscal 2001, an increase of $11.3 million or 165.0%. The increase was due to an increased pre-tax loss incurred in the current year compared to the prior year. Liquidity and Capital Resources General We finance our operations through credit provided by vendors and other suppliers, amounts borrowed under our revolving credit facilities, internally generated cash flow, and other financing resources. Credit terms provided by vendors and other suppliers have historically been approximately 30 days net, although during the pendency of the Chapter 11 case, many of our vendors have reduced the amount of time in which we must pay for goods. Amounts that may be borrowed under the DIP financing facility are based on a percentage of eligible inventory and accounts receivable, as defined. During fiscal 2003, we completed a series of financing transactions designed to improve liquidity and strengthen our financial position. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting the placement fees and other offering expenses. On April 10, 2003, we completed a $7.5 million debt financing transaction, which consists of a $6.5 million junior term note and a $1.0 million term note. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting the placement fees and other offering expenses. In addition to these financing transactions, we also received a federal tax refund of $8.2 million in March 2003. After the completion of our private equity offerings, debt financing transaction and receipt of the federal tax refund, the vendor and credit community provided support and extended credit terms for merchandise shipments. However, despite our efforts to improve sales and liquidity, we were unable to improve comparable sales growth and operating margin at a rate that could generate sufficient cash flow to sustain ongoing operations. Accordingly, we elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy Code on January 13, 2004. 30 DIP Financing Facility In conjunction with our Chapter 11 filing, we entered into a financing agreement with The CIT Group/Business Credit, Inc. (the Tranche A Lender) and GB Retail Funding, LLC (the Tranche B Lender), (collectively the "Lenders") in which the Lenders provide us a $45.0 million revolving credit facility for working capital needs and other general corporate purposes while we operate as a debtor-in-possession (the "DIP financing facility"). This DIP financing facility with a maturity date of January 14, 2005 has since been amended twice, the first amendment on January 30, 2004 and the second amendment on March 10, 2004. The DIP financing facility has a superpriority claim status in our Chapter 11 case and is collateralized by first liens on substantially all of our assets, subject to valid and unavoidable pre-petition liens and certain other permitted liens. Under the terms of the DIP financing facility, we may borrow up to 85% of our eligible accounts receivable and up to 70% of our eligible inventory, as defined. However, the DIP financing facility provides for a $5.0 million availability block against our availability calculation, as defined. The DIP financing facility also includes a $20.0 million sub-facility for letters of credit. Interest on the outstanding borrowings under the DIP financing facility is payable monthly and accrues at the rate equal to, at our option, either the prime rate (as announced by JP Morgan Chase Bank) plus 1.50% per annum or LIBOR plus 3.5% per annum. The Tranche B Lender will fully fund $4.0 million within five business days after demand by the Tranche A Lender when the outstanding borrowing provided by the Tranche A Lender first equals or exceeds $6.5 million for three consecutive business days. In the event that there is any outstanding borrowing provided by the Tranche B Lender, such borrowing bears interest at 14.5% per annum payable monthly. We are also obligated to pay a monthly fee equal to 0.375% per annum on the unused available line of credit and a fee equal to 2.5% per annum on the outstanding letters of credit. Under the terms of the DIP financing facility, capital expenditure for fiscal 2004 is restricted to $2.0 million. In addition, we are required to be in compliance with financial covenants and other customary covenants. The financial covenants include average minimum availability, cumulative four-week rolling average of cash receipts from store sales and cumulative rolling four-week average of inventory receipts, as defined. The customary covenants include certain reporting requirements and covenants that restrict our ability to incur or create liens, indebtedness and guarantees, make dividend payments, sell or dispose of assets, change the nature of our business and enter into affiliate transactions, mergers and consolidations. Failure to satisfy these covenants would (in some cases, after the expiration of a grace period) result in an event of default that could cause, absent the receipt of appropriate waivers, the funds necessary to maintain our operations to become unavailable. The DIP financing facility contains other customary events of default including certain ERISA events, a change of control and the occurrence of certain specified events in the Chapter 11 case. In addition, during the period from December 28, 2004 through January 11, 2005, we are not allowed to have any outstanding borrowings under the revolving credit facility and our outstanding letters of credit cannot exceed $11.0 million. As of January 31, 2004, we were in compliance with our covenants and had no borrowings outstanding under the revolving credit facility and outstanding letters of credit of $10.1 million under the sub-facility for letters for credit. As of January 31, 2004, based on our eligible inventory and accounts receivable, we were eligible to borrow $33.8 million under the revolving credit facility and had $17.6 million available after giving effect for the availability block, as defined. Cash Flows Net cash provided by operating activities was $225,000 in fiscal 2003 as compared to $8.1 million used in operating activities in fiscal 2002. Net cash generated by operating activities in fiscal 2003 was primarily due to our obligations to pay for liabilities incurred prior to the Petition Date were suspended in conjunction with the Chapter 11 filing. 31 Net cash used for investing activities was $3.5 million in fiscal 2003 compared to $11.0 million in fiscal 2002. Fiscal 2003 investing activities were primarily related to the final stage of capital improvement at our new Otay Mesa distribution center and the installation of a new information system for our planning and allocation department. Fiscal 2002's investing activities were primarily related to capital expenditures for the Otay Mesa distribution center, new store development, replacement capital for existing stores, information system hardware upgrades and replacements, and other general corporate purposes. Net cash provided by financing activities was $9.8 million in fiscal 2003 compared to $5.2 million in fiscal 2002. In fiscal 2003, our financing activities included $17.1 million of net proceeds from private offerings, offset by $6.3 million of net payments on our revolving credit facility and $1.1 million of payments of debt issuance costs. In fiscal 2002, our financing activities included $6.3 million of net borrowings on our revolving credit facility, $918,000 in proceeds from the exercise of stock options, partially offset by $2.0 million in repayments of our junior subordinated notes and capital lease obligations. Due to the seasonal nature of our business, where merchandise sales and cash flows from operations are historically higher in the fourth quarter than any other period, a disproportionate amount of operating income and cash flows from operations are earned in the fourth quarter. Our results of operations and cash flows are primarily dependent upon the large sales volume generated during the fourth quarter of our fiscal year. Fourth quarter sales represented 29.1% of total net sales in fiscal 2003. As a result, operating performance for the interim periods is not necessarily indicative of operating performance for the entire year. To support generally higher seasonal sales volume we experience a seasonal inventory build in October and November and therefore our usage of credit facilities is higher during this period of the year. We believe that our DIP financing facility will be adequate to support our projected seasonal borrowing needs. Our cash needs are satisfied through working capital generated by our business and funds available under our DIP financing facility. The level of cash generated by our business is dependent, to a great extent, on our level of sales and the credit extended by our vendors and the factor community. If we experience a significant disruption of terms with our vendors and factors, the DIP financing facility for any reason becomes unavailable, or actual results differ materially from those projected, our compliance with financial covenants and our cash resources could be adversely affected. Pre-petition Revolving Credit Facility Prior to the Petition Date, we had a $50.0 million revolving credit facility agreement (the "Financing Agreement") with a financial institution expiring in March 2006. Under this Financing Agreement, we could borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The revolving credit facility provided for a $7.5 million availability block against our availability calculation, as defined. The Financing Agreement also included a $15.0 million sub-facility for letters of credit. Under the terms of the Financing Agreement, the interest rate could increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. We were obligated to pay fees equal to 0.125% per annum on the unused amount of the revolving credit facility. We were contractually prohibited from paying cash dividends on our common stock under the terms of the Financing Agreement without consent of the lender. As amended on April 10, 2003, the facility was secured by a first lien on all company assets excluding furniture, fixtures, machinery and equipment. On February 14, 2003, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which was secured by a junior lien on the Collateral, as defined. On April 10, 2003, we amended the terms of our Financing Agreement (the "Amended and Restated Financing Agreement") to add $7.5 million of term loans, to add financial covenants, and to amend certain reporting provisions and other terms. The term loans consisted of a $6.5 million junior term note secured by all company assets excluding furniture, fixtures, machinery and equipment and a $1.0 million junior term note secured by furniture, fixtures, machinery and equipment. These notes bore interest at the rate of 14.5% per annum on the then current outstanding balance and a maturity date of April 10, 2004. 32 On December 22, 2003, we amended the terms of our Amended and Restated Financing Agreement ("First Amendment") to shorten the period that we were required to have zero borrowings, or "clean-up", under the revolving credit facility from 15 consecutive days beginning December 22, 2003 to eight consecutive days beginning December 29, 2003. The First Amendment also required us to pay the full unpaid balance of $600,000 under the Tranche B Loan II on or before December 23, 2003, and we paid it accordingly. On January 12, 2004 we amended the terms of our Amended and Restated Financing Agreement ("Second Amendment") in which we were required to pay the full unpaid balance of $6.5 million on or before January 12, 2004, and we paid it accordingly. Junior Subordinated Notes The Junior Subordinated Notes (the "Notes") are non-interest bearing and were reflected on our balance sheets at the present value using a discount rate of 10%. We are prohibited from paying cash dividends on our common stock under the terms of the Notes without the consent of the note holders. As of January 31, 2004, we were in default under the terms of our Notes and have included the net carrying value of $10.3 million (face value of $11.3 million net of a related unamortized discount of $1.0 million) in the line Liabilities subject to compromise. On the Petition Date, we stopped amortizing debt discount related to the Notes, in accordance with SOP 90-7. Under the Bankruptcy Code, the claims of holders of the Notes are subject to disallowance to the extent they represent a claim for unmatured interest, i.e., the portion of face value representing unamortized discount. The amount so disallowed may differ from the unamortized discount maintained on our books and records. Capital Expenditure We anticipate capital expenditure of approximately $1.0 million in fiscal 2004, which includes necessary costs for replacement capital at existing stores. Store Closures As of April 23, 2004, we had closed 20 of the 23 stores identified in our Fiscal 2002 restructuring efforts and completed the consolidation of our distribution network and corporate overhead structure. The remaining three stores have not been closed at this time due to lease concessions agreed to by the landlords. We have completed the consolidation of our two former San Diego distribution centers and our Lewisville, Distribution center into one distribution center, which is also located in San Diego, California. In conjunction with our Chapter 11 filing, we have ceased to make cash payments for any remaining obligations regarding our Fiscal 2002 restructuring plan except the lease obligation of one of our former San Diego distribution centers (located in the same building as our corporate headquarters) and certain satellite communication service fee obligations. We estimate the cash requirement for these obligations for fiscal 2004 will be approximately $1.2 million, which we intend to fund from our sources of cash, including the DIP financing facility. With respect to our Fiscal 2001 restructuring efforts, we closed all 28 stores during fiscal 2002. In conjunction with our Chapter 11 filing, we have ceased to make cash payments for any remaining obligations regarding our Fiscal 2001 restructuring plan except certain satellite communication service fee obligations. The cash requirement for such obligations for fiscal 2004 will be minimal and we intend to fund them from our sources of cash, including the DIP financing facility. On February 2, 2004, the Court authorized the closure of 44 stores, or approximately 18% of our 239 stores open as of January 31, 2004. On February 11, 2004, the Court approved our appointment of Great American as exclusive agent to conduct store closing sales at the 44 store locations. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. 33 Reorganization Efforts In connection with our bankruptcy case and reorganization efforts, we project to incur approximately $5.3 million of professional fees and other related expenses for fiscal 2004. We believe that our sources of cash, including the DIP financing facility, should be adequate to fund the cash requirement for our reorganization efforts. Contractual Obligations and Commitments The following table summarizes, as of January 31, 2004, certain of our contractual obligations, as well as estimated cash requirements related to our fiscal 2002 and 2001 restructuring initiatives. This table should be read in conjunction with "Note 4 Fiscal 2002 Restructuring Charge", "Note 5 Fiscal 2001 Restructuring Charge", "Note 10 Long-Term Debt and Revolving Credit Facilities" and "Note 12 Lease Commitments" in the accompanying financial statements.
Operating Restructuring Notes Leases Charges Payable Total ----------------- ----------------- ---------- ----------- Fiscal Year: 2004 $ 32,781 $ 1,321 $ 43 $ 34,145 2005 27,079 1,009 43 28,131 2006 20,605 - 43 20,648 2007 15,459 - 14 15,473 2008 12,060 - - 12,060 Thereafter 34,811 - - 34,811 ----------------- ----------------- ----------- ----------- Total $ 142,795 $ 2,330 $ 143 $ 145,268 ----------------- ----------------- ----------- -----------
Certain amounts included in the above table are related to executory contracts or lease obligations, which we have neither assumed nor rejected as of January 31, 2004. Under the Bankruptcy Code, we may assume or reject executory contracts, including lease obligations. Therefore, the commitments shown in the above table may not reflect actual cash outlays in the future periods. Reorganization Items Reorganization items represent amounts we incurred as a result of the Chapter 11 proceedings in accordance with SOP 90-7. The amounts for Reorganization items in the Statements of Operations include: (1) a $26.3 million impairment of goodwill; (2) a $2.4 million charge to accelerate depreciation on the remaining fixed assets associated with the 44 closing stores; (3) a $1.7 million charge for inventory sold below cost at our 44 closing stores; and (4) $1.3 million of professional fees related to the bankruptcy case. Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (the "FASB") issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations. 34 In April 2003, the FASB issued Statement of Financial Accounting Standard (the "SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement provides clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The adoption of this statement did not have a material impact on our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity and is effective for financial instruments entered into or modified after May 31, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Currently, our exposure to market risks results primarily from changes in interest rates, principally with respect to the DIP financing facility, which is a variable rate financing agreement. We do not use swaps or other interest rate protection agreements to hedge this risk. As of January 31, 2004, we had no borrowings outstanding under our DIP financing facility. 35 Item 8. Financial Statements and Supplementary Data INDEX TO FINANCIAL STATEMENTS FACTORY 2-U STORES, INC. Page - ------------------------ ---- Report of Independent Public Accountants F-1 Report of Independent Public Accountants (Arthur Andersen LLP) F-3 Balance Sheets as of January 31, 2004 and February 1, 2003 F-4 Statements of Operations for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002 F-6 Statements of Stockholders' Equity (Deficit) for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002 F-7 Statements of Cash Flows for Fiscal Years Ended January 31, 2004, February 1, 2003 and February 2, 2002 F-8 Notes to Financial Statements F-10 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On April 24, 2002, our Board of Directors, on the recommendation of the Audit Committee, determined not to renew the engagement of its independent public accountants, Arthur Andersen LLP ("Andersen"), for the fiscal year ended February 1, 2003. During our fiscal years ended February 2, 2002 and February 3, 2001, and the subsequent interim period through April 24, 2002, there were no disagreements between us and Andersen on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Andersen, would have caused Andersen to make reference to the matter of the disagreement in connection with their reports. Andersen's reports on our financial statements for each fiscal year ended February 2, 2002 and February 3, 2001 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles. Andersen's report on our financial statements for the fiscal year ended February 2, 2002, dated February 27, 2002, was issued on an unqualified basis in conjunction with the filing of our Annual Report on Form 10-K for the fiscal year ended February 2, 2002 filed on April 19, 2002 with the Securities and Exchange Commission. None of the reportable events described under Item 304 (a) (1) (v) of Regulation S-K occurred within our two most recent fiscal years and subsequent interim period through April 24, 2002. Item 9A. Controls and Procedures Evaluation. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. This evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). 36 Conclusions. Based upon our evaluation, our CEO and CFO have concluded that our disclosure controls and procedures are effective to ensure that material information relating to the Company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of our last evaluation of such internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. 37 PART III Item 10. Directors and Executive Officers of the Registrant Directors The following table sets forth, as of April 23, 2004, certain information concerning our directors.
Served on the Expiration of Term Name Age Position Board Since as Director ---- --- -------- ------------- ------------------- Peter V. Handal 61 Director 1997 2004 Ronald Rashkow 63 Lead Director 1997 2004 Wm. Robert Wright II 36 Director 1998 2004 Willem F.P. de Vogel 53 Director 2000 2006 Norman G. Plotkin 50 Director and Chief Executive Officer 2004 2005
Peter V. Handal has been a director since February 1997. Mr. Handal is President and Chief Executive Officer of Dale Carnegie & Associates. Since 1990, he has been President of COWI International Group (a management consulting firm). Mr. Handal is also Chief Executive Officer of J4P Associates LP (a real estate developer). He serves on the Board of Directors of Dale Carnegie & Associates and Cole National Corporation. Ronald Rashkow was appointed by the Board of Directors to the position of Lead Director in November 2002. Mr. Rashkow has been a director since February 1997. He has been a principal of RPMS, Inc., an investment banking firm, since January 2004. Prior to that, he was a principal of Chapman Partners, L.L.C., an investment banking firm, from September 1995 to December 2003. For more than five years prior to that, he served as Chief Executive Officer and Chairman of the Board of Directors of Handy Andy Home Improvement Centers, Inc. (a building supply retailer started by his family in 1946). Wm. Robert Wright II has been a director since November 1998. He has been a managing partner of Grey Mountain Partners, LLC, a private equity firm that invests in middle market companies, since its founding in January 2003. Prior to that, he was employed by Three Cities Research, Inc., a firm engaged in the investment and management of private capital, from 1992 through 2002, except for a period from July 1993 to August 1995 when he was in a graduate program at Harvard University. His last position with Three Cities Research, Inc. was "managing partner", a title he held from 1999 to 2002. Willem F.P. de Vogel has been a director since December 2000. Mr. de Vogel has served as President of Three Cities Research, Inc. since 1982. Norman G. Plotkin has been a director since March 2004 and has been Chief Executive Officer since December 2003. Prior to his appointment as Chief Executive Officer, Mr. Plotkin was our Executive Vice President, Store Development, Human Resources and General Counsel. He also assumed responsibility over our Store Operations for a period during 2002. Mr. Plotkin joined us in July 1998 in the position of Senior Vice President, Store Development and General Counsel. Prior to joining us, Mr. Plotkin was the President of Normark Real Estate Services, Ltd., a commercial real estate firm based in Des Plaines, Illinois. Prior to that, from 1988 until 1996, Mr. Plotkin was the Senior Vice President of Finance and Administration and General Counsel of Handy Andy Home Improvement Centers, Inc. Additionally, Mr. Plotkin was engaged in the private practice of law from 1980 to 1988. 38 Executive Officers The following table sets forth certain information concerning our executive officers who are not directors.
Name Age Position Officer Since ---- --- -------- ------------- A.J. Nepa 52 Executive Vice President and 2003 General Merchandise Manager Norman Dowling 41 Executive Vice President and 2004 Chief Financial Officer
A.J. Nepa is Executive Vice President and General Merchandise Manager. Mr. Nepa joined us in November 2003. Prior to joining us, Mr. Nepa was the General Merchandise Manager for Forman Mills, a privately held off-price retail chain headquartered in Pennsylvania. He previously served as Senior Vice President and General Merchandise Manager of One Price Clothing Stores from 1998 to 2000 and General Merchandise Manger for It's Fashion, a division of Cato Stores, from 1992 to 1998. Norman Dowling is Executive Vice President and Chief Financial Officer. Mr. Dowling joined us in March 2004. Prior to joining us, Mr. Dowling served as Vice President, Finance of PETCO Animal Supplies, Inc., from November 1999 to March 2004. Prior to joining PETCO, he served as Chief Financial Officer and Secretary of CinemaStar Luxury Theaters, Inc. from 1997 to 1999. CinemaStar Luxury Theaters, Inc. filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in January 2001. Previously, Mr. Dowling was Director of Finance at Advanced Marketing Services, Inc. from 1993 to 1997. From 1990 to 1993, Mr. Dowling was Controller and then Director of Mergers & Acquisitions at Medical Imaging Centers of America, Inc. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934, as amended requires the Company's directors, executive officers and beneficial owners of more than ten percent (10%) of the Common Stock to file with the SEC initial reports of ownership and reports of changes in ownership of Common Stock of the Company. SEC regulations also require such persons to furnish the Company with copies of all such reports. Based solely upon its review of the copies of such reports furnished to it, or written representations from the reporting persons that no forms were required to be filed, the Company believes that during the fiscal year ended January 31, 2004 all section 16(a) filing requirements applicable to its executive officers, directors and greater than ten percent beneficial owners were complied with. Audit Committee The Company's Board of Directors has identified Wm. Robert Wright II as its Audit Committee Financial Expert, as defined by Item 401 of Regulation S-K. Mr. Wright is an independent Board member, as defined by Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act. Code of Ethics We have adopted the Factory 2-U Stores, Inc. Standards of Business Conduct, which is applicable to all of our employees, including our chief executive officer, chief financial officer, controller and all vice presidents. Our Standards of Business Conduct complies with the requirements of the Sarbanes-Oxley Act of 2002 and the regulations promulgated by the Securities and Exchange Commission thereunder. We have filed a copy of our Standards of Business Conduct as an exhibit to this annual report. 39 Item 11. Executive Compensation Compensation of Directors We pay each director who is not a Lead Director or an employee of ours an annual fee of $12,000 plus $1,250 for attendance at each meeting of the Board of Directors ($250 for a telephonic meeting). Additionally, prior to our Chapter 11 filing, at the end of each fiscal quarter, we granted each director who was not an employee 250 shares of common stock and awarded a cash payment equal to the closing market price of our common stock on such date times 500 shares. Since the Petition Date, we have discontinued such equity-related grants and awards. We also reimburse all directors for any out-of-pocket travel expenses incurred in attending meetings. Ronald Rashkow Lead Director Agreement On November 4, 2002, Mr. Rashkow was appointed to the newly created position of Lead Director by our Board of Directors under the terms of an agreement. We have neither assumed nor rejected the agreement under the federal bankruptcy laws. Mr. Rashkow's service as Lead Director will continue at the pleasure of the Board of Directors for up to three years. Under the terms of his agreement, Mr. Rashkow receives monthly compensation of $12,500, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director. He is also entitled to receive $3,500 per day, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director, for each day of service in excess of six days per quarter. As an inducement to secure his services as Lead Director, Mr. Rashkow also received options to purchase 50,000 shares of our common stock on November 4, 2002 at an exercise price of $1.61, the fair market value of our common stock on the date of grant. The options vested immediately and are exercisable for five years from the date of grant. As a further inducement to secure his services, Mr. Rashkow also received 25,000 shares of restricted common stock, subject to his completion of 12 months of service as Lead Director. Mr. Rashkow has a target grant of 25,000 similar shares of restricted common stock, subject to his completion of 24 months of service, and another 25,000 shares subject to his completion of 36 months of service. His receipt of these restricted shares, in addition to the length of service requirement, will be commensurate with our Chief Executive Officer's achievement of his performance goals for the applicable year. If the goals are not attained, the shares will not be granted. Compensation of Executive Officers Employment Contracts with Named Executive Officers The following employment agreements and other arrangements with respect to our named executive officers are described as in effect as of January 31, 2004. We have neither assumed nor rejected the employment agreements under the federal bankruptcy laws. Norman Plotkin Employment Agreement Prior to Mr. Plotkin's appointment as Chief Executive Officer on December 10, 2003, we employed Mr. Plotkin as Executive Vice President - Store Development, Human Resources and General Counsel, pursuant to a one-year employment agreement dated May 20, 2003 that was entered into prior to the Petition Date. His employment agreement was automatically extended under its terms for an additional one-year period, and will continue to be extended on each anniversary thereafter, unless either Mr. Plotkin or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended. 40 Under the employment agreement, Mr. Plotkin's base salary was $285,000 annually. After his appointment as Chief Executive Officer, his base salary was increased to $400,000 annually. Mr. Plotkin's target bonus for the fiscal year ended January 31, 2004 was 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year Mr. Plotkin's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. Also, the employment agreement provides that if the performance objectives accepted by the Compensation Committee are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Plotkin will not be entitled to any bonus. On May 20 2003, we granted Mr. Plotkin non-qualified options to purchase 50,000 shares of our common stock at an exercise price of $3.26 per share, the fair market value of our stock on the date of grant. These options vest in tranches of 3,125 shares on each March, June, September and December 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche. In addition, on September 17, 2003, we granted Mr. Plotkin 50,000 restricted shares of our common stock for $500. These restricted shares will vest in installments as follows: 16,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 16,666.7 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 16,666.7 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Plotkin's right to receive any shares of restricted stock that has not vested prior to April 10, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Plotkin will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. Melvin Redman Employment Agreement Mr. Redman resigned his position with us as of April 27, 2004. Prior to his appointment as Executive Vice President and Chief Operating Officer on January 13, 2004, we employed Mr. Redman as Executive Vice President - Store Operations and Distribution, pursuant to a one-year employment agreement dated January 6, 2003 that was entered into prior to the Petition Date. His employment agreement was automatically extended under its terms for an additional one-year period, and would have continued to be extended on each anniversary thereafter. Under the employment agreement, Mr. Redman's base salary was $500,000 annually. Mr. Redman received a signing bonus in the amount of $100,000 upon beginning his employment. Mr. Redman's target bonus for the fiscal year ended January 31, 2004 was 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year, Mr. Redman's target bonus would have been based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer had been exceeded in any year, the annual bonus would have increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. Mr. Redman would have received no bonus if the performance objectives were not met. As an inducement necessary to secure his services, on January 6, 2003, we granted Mr. Redman non-qualified options to purchase 125,000 shares of our common stock at an exercise price per share of $3.13, the fair market value of our stock on the date of grant. These options vested in tranches of 7,812.5 shares on each March 30, 2003, June 30, 2003, September 30, 2003 and December 30, 2003, and would have vested in tranches of 7,812.5 shares on the 30th of each December, March, June and September during the next three years of his employment term. The non-qualified options in each tranche would have been exercisable for a period of five years after the vesting of that tranche. 41 As a further inducement necessary to secure his services, we also granted Mr. Redman on January 6, 2003, 125,000 restricted shares of our common stock for $1,250. These restricted shares would have vested in installments as follows: 41,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 41,666.7 shares when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 41,666.7 shares would have vested when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Redman's right to receive any shares of restricted stock that has not vested terminated as a result of his resignation, and all of such restricted shares were forfeited. A.J. Nepa Employment Agreement We employed A.J. Nepa, Executive Vice President - General Merchandise Manager, pursuant to a one-year employment agreement dated November 10, 2003 that expires on November 9, 2004, provided that at the scheduled end of the initial employment term, and on each anniversary thereafter, his employment term will be automatically extended for an additional one-year period unless either Mr. Nepa or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended. Under the employment agreement, Mr. Nepa's base salary is $250,000 annually. Mr. Nepa's target bonus for the fiscal year ending January 29, 2005 is 50% of his annual base salary for that year. Under the employment agreement, for each subsequent fiscal year, Mr. Nepa's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Nepa will not be entitled to any bonus. As an inducement to secure his services, on November 10, 2003 we granted Mr. Nepa non-qualified options to purchase 50,000 shares of our common stock at an exercise price per share of $2.56, the fair market value of our stock on the date of grant. These options vest in tranches of 3,125 shares on each March, June, September and December 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche. As a further inducement to secure his services, we also granted Mr. Nepa on November 10, 2003, 50,000 restricted shares of our common stock for $500. These restricted shares will vest in installments as follows: 16,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 16,666.7 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 16,666.7 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Nepa's right to receive any shares of restricted stock that has not vested prior to November 10, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Nepa will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. Severance Agreements On December 10, 2003, William R. Fields' employment with us was terminated. Under the terms of his employment agreement with us, he was entitled to twelve months of his base salary, all accrued but unpaid compensation, vacation pay and reimbursable business expenses through his termination date, payable in a lump sum in the amount of approximately $1.0 million. In addition, he was entitled to the amounts or benefits owing under benefit plans and policies, exclusive of cash severance policies and up to three years of COBRA premiums. We have neither assumed nor rejected Mr. Fields' employment agreement under the federal bankruptcy laws. As a result of the Chapter 11 filing on January 13, 2004, Mr. Fields' severance payments have not been made. 42 On January 5, 2004, Douglas C. Felderman's employment with us was terminated. Under the terms of his employment agreement with us, he was entitled to twelve months of his base salary in the total amount of $285,000, of which $50,000 was paid. We have neither assumed nor rejected Mr. Felderman's employment agreement under the federal bankruptcy laws. As a result of the Chapter 11 filing on January 13, 2004, no further severance payments have been made to Mr. Felderman. Compensation Committee Report on Executive Compensation The discussion below describes our compensation practices and principles for fiscal 2003 prior to the Petition Date. During the pendency of our bankruptcy case, our compensation practices and principles are subject to the jurisdiction of the Court. We have submitted to the Court a proposed key employee retention plan with respect to which the Court has yet to act. The Compensation Committee of the Board of Directors is composed entirely of outside directors. The Compensation Committee is responsible for establishing and administering the compensation policies applicable to our executive officers. All decisions by the Compensation Committee are subject to review and approval by the full Board of Directors. Our executive compensation philosophy and specific compensation plans tie a significant portion of executive compensation to our success in meeting specific profit, growth and performance goals. Our compensation objectives include attracting and retaining the best possible executive talent, motivating executive officers to achieve our performance objectives, rewarding individual performance and contributions, and linking executives' and stockholders' interests through equity based plans. Our executive compensation consists of three key components: base salary, annual incentive compensation and stock options, each of which is intended to complement the others and, taken together, to satisfy our compensation objectives. The Compensation Committee's policies with respect to each of the three components are discussed below. Base Salary. In the early part of each fiscal year, the Compensation Committee reviews the base salary of the Chief Executive Officer (subject to requirements of his employment agreement) and the recommendations of the Chief Executive Officer with regard to the base salary of all other executive officers, and approves, with any modifications it deems appropriate, annual base salaries for each of our executive officers. We base the recommended base salaries of the executive officers on an evaluation of the individual performance of the executive officer, including satisfaction of annual objectives. The recommended base salary of the Chief Executive Officer is based on achievement of our annual goals relating to financial objectives, including earnings growth and return on capital employed, and an evaluation of individual performance. Recommended base salaries of the executive officers are also based in part upon an evaluation of the salaries of executives who hold comparable positions at comparable companies. Annual Incentive Compensation. Our executive officers participate in a discretionary incentive bonus plan which provides for the payment of annual bonuses in cash or stock (or both), based on our success in attaining financial objectives, and subjective factors established from time to time by the Compensation Committee or the Board of Directors. With the exception of those executives who have separate employment agreements with us, the Compensation Committee normally considers aggregate incentive cash and stock bonus payments to the executive officers, as a group, of up to 50% of their base salaries, and any bonus payments in excess of 50% of the aggregate base salaries, may be paid in cash or stock, at the discretion of the Compensation Committee. The Compensation Committee did not award annual incentive bonus payments to any of our executive officers for fiscal 2003. Compensation of the Chief Executive Officer. Mr. Plotkin was appointed Chief Executive Officer on December 10, 2003 and elected as a director on our Board of Directors in March 2004. Mr. Plotkin's base salary is $400,000 annually. The Compensation Committee determined Mr. Plotkin's compensation by considering his prior experience, expertise and compensation paid to other executives with similar experience in comparable companies. In determining Mr. Plotkin's compensation, the Compensation Committee took into account Mr. Plotkin's extensive prior experience. Mr. Plotkin has been with us since July 1998 and has held the positions of Executive Vice President of Store Development, Human Resources and General Counsel and for a period in 2002 he assumed responsibility over Store Operations. The Compensation Committee concluded that Mr. Plotkin's compensation was commensurate with the compensation paid to other executives with similar experience in comparable companies. 43 Compensation of the former Chief Executive Officer. Mr. Fields joined the Company in November 2002 as Chairman of our Board of Directors and Chief Executive Officer. Under the terms of his employment agreement, Mr. Fields' base salary was $750,000 annually. For the first year of his employment term, Mr. Fields received a guaranteed bonus of $375,000, that was payable in 12 monthly installments. The Compensation Committee determined Mr. Fields' compensation by considering his prior experience and expertise, compensation paid to other executives with similar experience in comparable companies, and what would be required in order to induce Mr. Fields to join the Company. In determining Mr. Fields' compensation, the Compensation Committee took into account Mr. Fields' extensive prior experience, including his 24 years of experience with Wal-Mart, culminating in his serving as Chief Executive Officer and President of Wal-Mart Stores Division during 1993 through 1996, as well as his experience as Chairman and Chief Executive Officer of Blockbuster Entertainment Group during 1996 and 1997 and as Chief Executive Officer and President of Hudson's Bay Company during 1997 though 1999. The Compensation Committee concluded that Mr. Fields' compensation was required in order to induce him to join the Company and that it was commensurate with the compensation paid to other executives with similar experience in comparable companies. Stock Options. The primary objective of the stock option program is to link our interests and those of our executive officers and other selected employees to those of the stockholders through significant grants of stock options. The Compensation Committee bases the aggregate number of options it recommends on practices of comparable companies, while grants of stock options to specific employees reflect their expected long-term contribution to our success. As a result of the Chapter 11 filing, the Company is not currently granting stock options to its employees. Compensation Committee: Willem F.P. de Vogel, Chairman Peter V. Handal Compensation Committee Interlocks and Insider Participation No member of the Compensation Committee of the Board of Directors was, during fiscal 2003 or at any other time, one of our officers or employees. 44 Summary of Cash and Other Compensation The following table contains information about the compensation during fiscal 2003 of our former principal executive officer; current principal executive officer; our two other most highly paid executive officers who served as executive officers at the end of fiscal 2003 and received salary and bonus in excess of $100,000 during fiscal 2003; and two other named executive officers who were not serving as executive officers at the end of fiscal 2003:
SUMMARY COMPENSATION TABLE Annual Compensation Long-Term Compensation ------------------- ---------------------- Fiscal All Other Name and Principal Year Securities Underlying Compensation Position (1) Salary ($) Bonus ($) Options ($) (2) -------- --- ---------- --------- --------------------- ------------ William R. Fields (3) 2003 $663,461 $ 312,500 - $326,944 Former Chief Executive 2002 158,754 62,500 250,000 40,328 Officer and Chairman of - - - - - the Board Norman G. Plotkin (4) 2003 290,308 - 50,000 2,071 Chief Executive Officer 2002 285,000 112,468 - 2,200 and Director 2001 282,500 - - 15,689 Douglas C. Felderman (5) 2003 270,750 - 50,000 87,102 Former Executive Vice 2002 285,000 94,271 - 987 President and 2001 283,250 - - 66,195 Chief Financial Officer Melvin C. Redman (6) 2003 480,769 - - 123,694 Former Executive Vice - - - - - President - Chief - - - - - Operating Officer John W. Swygert (7) 2003 146,442 - 25,000 881 Former Senior Vice - - - - - President - Chief - - - - - Financial Officer Larry I. Kelley (8) 2003 216,923 58,333 - 42,242 Former Executive Vice - - - - - President - Merchandising - - - - - and Marketing - ---------------------------------------------------------------------------------------------------------
Note:The aggregate amount of any other annual compensation is less than the lesser of $50,000 or 10% of such person's total annual salary and bonus. (1) We refer to a fiscal year by the year in which most of the activity occurred (for example, we refer to fiscal year ended January 31, 2004 as fiscal 2003). (2) "All Other Compensation" for fiscal 2003 includes (i) matching contributions under our 401(k) Savings Plan of $1,973 for Mr. Felderman, $2,071 for Mr. Plotkin and $881 for Mr. Swygert; (ii) payment of moving expenses of $326,944 for Mr. Fields and $123,694 for Mr. Redman; (iii) final vacation pay of $35,129 for Mr. Felderman and $8,695 for Mr. Wong; and (iv) severance payments of $50,000 for Mr. Felderman and $41,538 for Mr. Wong. (3) Mr. Fields was Chief Executive Officer and Chairman of the Board until his termination of employment on December 10, 2003. Mr. Fields received $312,500 during fiscal 2003 and $62,500 during fiscal 2002, of his guaranteed first year bonus of $375,000 under the terms of his employment agreement. 45 (4) Mr. Plotkin was appointed Chief Executive Officer effective December 10, 2003 and a member of the Board of Directors effective March 16, 2004. (5) As of January 5, 2004, Mr. Felderman was no longer an employee. (6) As of April 27, 2004, Mr. Redman was no longer an employee. (7) As of February 20, 2004, Mr. Swygert was no longer an employee. (8) As of August 11, 2003, Mr. Kelley was no longer an employee. 46 Grants of Stock Options The following table sets forth information concerning the award of stock options during fiscal 2003. We have never granted stock appreciation rights.
% of Total Potential Realizable Number of Options Value at Assumed Securities Granted to Exercise Annual Rates of Underlying Employees or Base Stock Price Appreciation Options in Fiscal Price Expiration For Option Term (1) Granted (#) Year ($/Share) Date 5% ($) 10%($) Name ---------- --------- -------- ----------- ------ ------ ---- William R. Fields (2) - - $ - - $ - $ - Norman G. Plotkin 50,000 7.54% 3.26 3/30/2012 89,866 221,345 Douglas C. Felderman (3) 50,000 7.54% 3.26 3/30/2012 89,866 221,345 Melvin C. Redman (4) - - - - - - John W. Swygert (5) 25,000 3.77% 4.26 9/17/2013 66,977 169,734 Larry I. Kelley (6) - - - - - -
(1) Amounts shown represent the potential value of granted options if the assumed annual rates of stock appreciation are maintained over the terms of the granted options. The assumed rates of appreciation are established by regulation and are not intended to be a forecast of our performance or to represent our expectations with respect to the appreciation, if any, of the common stock. Any value of our common stock underlying the options will depend on the value, if any, ascribed to our common stock in any plan of reorganization which may be confirmed. As described earlier, we believe that, in light of the Chapter 11 filing, the value of our common stock is highly speculative. Accordingly, we are not presently ascribing any value to the above options. Nevertheless, in order to comply with SEC rules, this column sets forth the estimated present value of the options granted during fiscal year 2003. (2) As of December 10, 2003, Mr. Fields was no longer an employee. All such options expired unexercised 3 months after that date. (3) As of January 5, 2004, Mr. Felderman was no longer an employee. All such options expired unexercised 3 months after that date. (4) As of April 27, 2004, Mr. Redman was no longer an employee. (5) As of February 20, 2004, Mr. Swygert was no longer an employee. All such options expired unexercised 60 days after that date. (6) As of August 11, 2003, Mr. Kelley was no longer an employee. All such options expired unexercised on that date. 47 Exercise of Stock Options and Holdings The following table sets forth information concerning exercises of stock options during fiscal 2003 and the fiscal year-end value of unexercised options. We have never granted stock appreciation rights.
Aggregated Option Exercises in Fiscal 2003 Fiscal 2003 Year-End Option Values Shares Number of Securities Acquired Value Underlying Unexercised Value of Unexercised On Realized Options at Fiscal Year End (#) In-the-Money Options at Name Exercise ($) Fiscal Year End ($) ---- -------- --------- Exercisable Unexercisable Exercisable Unexercisable ----------- ------------- ----------- ------------- William R. Fields (1) - $ - 78,125 171,875 $ - $ - Norman G. Plotkin - - 72,523 56,131 - - Douglas C. Felderman (2) - - 89,585 60,415 - - Melvin C. Redman (3) - - 31,250 93,750 - - John W. Swygert (4) - - 9,080 35,920 - - Larry I. Kelley (5) - - - - - -
(1) As of December 10, 2003, Mr. Fields was no longer an employee. All such options expired unexercised 3 months after that date. (2) As of January 5, 2004, Mr. Felderman was no longer an employee. All such options expired unexercised 3 months after that date. (3) As of April 27, 2004, Mr. Redman was no longer an employee. All such options will expire 3 months after that date. (4) As of February 20, 2004, Mr. Swygert was no longer an employee. All such options expired unexercised 60 days after that date. (5) As of August 11, 2003, Mr. Kelley was no longer an employee. All such options expired unexercised on that date. 48 Long-Term Incentive Plans - Awards in Last Fiscal Year
Number of Shares, Units or Other Name Rights (#) Performance or Other Period Until Maturation or Payout ---- ---------- ------------------------------------------------------ William R. Fields - Former Chief Executive Officer and Chairman of the Board Norman G. Plotkin 50,000 (1) Restricted stock shares potentially vest in three increments of Chief Executive Officer 16,666.7 shares each. The first increment vests when the closing and Director market price of our common stock equals or exceeds $10 for 20 consecutive trading days in any three-month period. The second increment vests when the closing market price of our common stock equals or exceeds $20 for 20 consecutive trading days in any three-month period. The third increment vests when the closing market price of our common stock equals or exceeds $20 for 20 consecutive trading days in any three-month period. Douglas C. Felderman (2) 50,000 Restricted stock shares would have vested in three increments of Former Executive Vice 16,666.7 shares each. The first increment would have vested when President and the closing market price of our common stock equals or exceeds $10 Chief Financial Officer for 20 consecutive trading days in any three-month period. The second increment would have vested when the closing market price of our common stock equals or exceeds $20 for 20 consecutive trading days in any three-month period. The third increment would have vested when the closing market price of our common stock equals or exceeds $20 for 20 consecutive trading days in any three-month period. Melvin C. Redman (3) - Executive Vice President - - Chief Operating Officer John W. Swygert (4) - Former Executive Vice President - Chief Financial Officer Larry I. Kelley (5) - Former Executive Vice President - Merchandising and Marketing - ---------------------------------------------------------------------------------------------------------
(1) Mr. Plotkin received a restricted stock grant of 50,000 shares of common stock on September 17, 2003 when the closing market price of our common stock was $4.26 per share. Mr. Plotkin's right to receive any shares of restricted stock that have not vested prior to September 17, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Plotkin will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the date of grant. Mr. Plotkin is entitled to receive dividends that are paid on common stock and he has the right to vote his restricted shares. (2) As of January 5, 2004, Mr. Felderman was no longer an employee. Mr. Felderman received a restricted stock grant of 50,000 shares of common stock on September 17, 2003 when the closing market price of our common stock was $4.26 per share. Mr. Felderman's right to receive any shares of restricted stock terminated as a result of the termination of his employment and the restricted stock has been returned to us. (3) As of April 27, 2004, Mr. Redman was no longer an employee. (4) As of February 20, 2004, Mr. Swygert was no longer an employee. (5) As of August 11, 2003, Mr. Kelley was no longer an employee. 49 PERFORMANCE CHART The following chart compares the five-year cumulative total return (change in stock price plus reinvested dividends) on our common stock with the total returns of the Nasdaq Composite Index, a broad market index covering stocks listed on the Nasdaq National Market, the Dow Jones Retailers Broadline Index ("Industry Index") which currently encompasses 22 companies, and the companies in the Family Clothing Retail industry (SIC Code 5651), a group currently encompassing 23 companies (the "SIC Index"). This information is provided through January 31, 2004, the end of fiscal 2003. COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN AMONG FACTORY 2-U STORES, INC., NASDAQ MARKET INDEX, INDUSTRY INDEX AND SIC INDEX 50
FISCAL YEAR 2003 (1998 = 100) Measurement Period Factory 2-U Nasdaq (Fiscal Year Covered) Stores, Inc. Composite Index Industry Index SIC Index 1998 100.00 100.00 100.00 100.00 1999 198.48 149.59 115.13 91.88 2000 351.57 107.10 117.80 81.28 2001 149.58 75.46 130.15 53.91 2002 22.67 52.09 98.62 49.80 2003 3.67 81.75 121.70 72.59
The composition of the Industry Index is as follows: BJ's Wholesale Club, Inc., Bon-Ton Stores, Inc., Coles Myer Ltd., Controladora Comer Mex, Cost-U-Less, Inc., Costco Wholesale Corp., Daiei Inc ADR, Dillard's, Inc., Dollar General Corp., Duckwall-Alco Stores, Inc., Family Dollar Stores, Inc., Federated Dept. Stores, Fred's, Inc., Ltd., J.C. Penney Holding Co., May Department Stores, Overstock.com Inc., Pricesmart, Inc., Retail Ventures, Inc., Sears, Roebuck & Co., Shopko Stores Inc., Target Corporation and Wal-Mart Stores, Inc. The composition of the SIC Index is as follows: Abercrombie & Fitch Co., Aeropostale, Inc., American Eagle Outfitter, Big Dog Holdings, Inc., Buckle, Inc., Burlington Coat Factory Warehouse, Casual Male Retail Group, Chico's FAS, Inc., Children's Place Retail Stores, Factory 2-U Stores, Inc., Freestar Technologies, Gadzooks, Inc., Gap, Inc., Goody's Family Clothing, Gymboree Corp., Harold's Stores, Inc., Nordstrom, Inc., Ross Stores, Inc., Stage Stores, Inc., Stein Mart, Inc., Syms Corp., Urban Outfitters, Inc., and Wilsons the Leather Expert. Source: Media General Financial Services Item 12. Security Ownership of Certain Beneficial Owners and Management Principal Stockholders The following persons are known by us, based solely upon information filed by such persons with the Securities Exchange Commission, to have owned beneficially more than 5% of any class of our voting securities as of April 23, 2004:
Name and Address Common Stock of Beneficial Owner Number Percent of Class ------------------- ------ ---------------- Lonestar Partners, L.P. (1) 1,584,000 8.8% Gryphon Master Fund, L.P. (2) 1,205,269 6.7% Couchman Partners, L.P. (3) 1,192,200 6.6% Conus Partners, Inc. (4) 1,011,450 5.6% Cannell Capital LLC (5) 900,000 5.0% - -------------------------------------------------------------------------------
51 (1) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is One Maritime Plaza, 11th Floor, San Francisco, CA 94111. Lonestar Partners, L.P. ("Lonestar") filed its 13G with the SEC on January 23, 2004 and claimed beneficial ownership of 1,584,000 shares, or 8.8% of our common stock. The statement was filed by Lonestar a Delaware limited partnership, with respect to Shares owned by it, Lonestar Capital Management LLC, a Delaware limited liability company ("LCM"), the investment adviser to and general partner of Lonestar, with respect to the Shares held by Lonestar, and Jerome L. Simon ("Simon"), the manager and sole member of LCM, with respect to Shares held by Lonestar. The Shares reported hereby for Lonestar are owned directly by Lonestar. LCM, as general partner and investment adviser to Lonestar, may be deemed to be the beneficial owner of all such Shares owned by Lonestar. Simon, as the manager and sole member of LCM, may be deemed to be the beneficial owner of all such Shares held by Lonestar. Each of LCM and Simon hereby disclaim any beneficial ownership of any such Shares. (2) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 100 Crescent Court, Suite 490, Dallas, Texas 75201. Gryphon Master Fund, L.P. ("Master Fund") filed its 13G with the SEC on January 27, 2004 and claimed beneficial ownership of 1,205,269 shares, or 6.7% of our common stock. The statement was filed by Master Fund, Gryphon Partners L.P. ("Gryphon Partners"), Gryphon Management Partners, L.P. ("GMP"), Gryphon Advisors, LLC ("Gryphon Advisors"), and E.B. Lyon, IV ("Lyon"). The shares of our common stock are owned directly by Master Fund. The General Partner of Master Fund is Gryphon Partners, L.P., which may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. The General Partner of Gryphon Partners is GMP, which may be deemed to be the beneficial owner of all such shares of our common stock owned by Mater Fund. The General Partner of GMP is Gryphon Advisors, which may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. Lyon controls Gryphon Advisors and may be deemed to be the beneficial owner of all such shares of our common stock owned by Master Fund. Each of Gryphon Partners, GMP, Gryphon Advisors and Lyon disclaims any beneficial ownership of any such shares of our common stock owned by Master Fund. (3) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The statement filed on March 29, 2004 was jointly filed by Couchman Partners, L.P. ("CP"), Capital LLC ("CC"), and Jonathan Couchman (together with CP and CC, the "Reporting Persons"). Because Jonathan Couchman is the sole member of the Management Board of CC, which in turn is the partner of CP, the Reporting Persons may be deemed, pursuant to Rule 13d-3 of the Securities Exchange Act of 1934, as amended (the "Act"), to be the beneficial owners of all shares of our common stock held by CP. The Reporting Persons are filing this joint statement, as they may be considered a "group" under Section 13(d)(3) of the Act. However, neither the fact of this filing nor anything contained herein shall be deemed to be an admission by the Reporting Persons that such a group exists. The principal business address of CP is c/o Hedge Fund Services (BVI) Limited, James Frett Building, PO Box 761, Wickhams Cay 1, Road Town, Tortola, British Virgin Islands. The principal business of CC and Mr. Couchman is 800 Third Avenue, 31st Floor, New York, New York 10022. (4) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is One Rockefeller Plaza, 19th Floor, New York, New York 10020. Conus Partners, Inc. filed its Schedule 13G with the SEC on January 22, 2004 and claimed beneficial ownership of 1,011,450 shares, or 5.6% of our common stock. (5) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 150 California Street, Fifth Floor, San Francisco, CA 94111. Cannell Capital LLC filed its Schedule 13G with the SEC on November 5, 2003 and claimed beneficial ownership of 900,000 shares, or 5.0% of our common stock. This statement was filed by (i) Cannell Capital, LLC, a California limited liability company and California licensed investment adviser ("IA"), (ii) J. Carlo Cannell ("Managing Member"), (iii) The Anegada Fund Limited ("Anegada"), (iv) The Cuttyhunk Fund Limited ("Cuttyhunk"), (v) Tonga Partners, L.P. ("Tonga"), (vi) GS Cannell Portfolio, LLC ("GS Cannell") and (vii) Pleiades Investment Partners, LP ("Pleiades") (collectively, the Reporting Persons). Managing Member controls IA by virtue of Managing Member's position as 52 managing member and majority owner of IA. IA's beneficial ownership of the Common Stock is direct as a result of IA's discretionary authority to buy, sell, and vote shares of such Common Stock for its investment advisory clients. Managing Member's ownership of Common Stock is indirect as a result of Managing Member's ownership and management of IA. The beneficial ownership of Managing Member is reported solely because Rules 13d-1(a) and (b) under the Securities Exchange Act of 1934, as amended, require any person who is "directly or indirectly" the beneficial owner of more than five percent of any equity security of a specified class to file a Schedule 13G. The answers in blocks 6, 8, 9 and 11 above and the response to item 4 by Managing Member are given on the basis of the "indirect" beneficial ownership referred to in such Rule, based on the direct beneficial ownership of Common Stock by IA and the relationship of Managing Member to IA referred to above. On April 23, 2004, The Depository Trust Company owned of record 17,003,657 shares of common stock, constituting 94.88% of our outstanding common stock. We understand these shares were held beneficially for members of the New York Stock Exchange, some of whom may in turn have been holding shares beneficially for customers. Management Stockholders As of April 23, 2004, our directors and executive officers beneficially owned the following amounts of our voting securities:
Amount and Nature of Beneficial Percent of Name of Beneficial Owner Ownership (1) Class - ------------------------ ------------- ---------- Willem F.P. de Vogel 22,847 * Norman Dowling - - Peter V. Handal 92,267 * A.J. Nepa (2) 56,250 * Norman G. Plotkin (2) 160,791 * Ronald Rashkow (3) 320,704 1.8% Melvin C. Redman (2)(4) 164,063 * Wm. Robert Wright II 13,617 * Directors and Officers as a Group (8 persons) 830,539 4.6% - ------------------------------------------------------------------------------- * Less than 1%.
(1) Includes shares which may be acquired within 60 days through the exercise of stock options or warrants, as follows: Mr. de Vogel, 3,000 shares; Mr. Handal, 6,500 shares; Mr. Nepa, 6,250 shares; Mr. Plotkin, 86,902 shares; Mr. Rashkow, 56,500 shares; Mr. Redman, 39,063 shares; and Mr. Wright, 6,500 shares; all officers and directors as a group, 204,715 shares. (2) Includes shares considered beneficially owned under SEC rules, but that are subject to restrictions on disposition, as follows: Mr. Nepa, 50,000 shares; Mr. Plotkin, 50,000 shares; and Mr. Redman, 125,000 shares. (3) Includes 45,525 shares of common stock held by Mr. Rashkow's spouse, 2,340 shares of common stock held by a limited partnership of which Mr. Rashkow is the general partner and 56,500 shares, which Mr. Rashkow may acquire within 60 days through the exercise of stock options. 53 (4) As of April 27, 2004, Mr. Redman was no longer an employee. His right to receive any shares of restricted stock that has not vested terminated, and all of such restricted shares were forfeited. In addition, his options will expire 3 months after that date. 54 Item 13. Certain Relationships and Related Transactions Transactions with Management and Others In March 1997, we entered into an agreement with Three Cities Research, Inc. ("TCR") engaging TCR to act as financial advisors to us. Under this agreement, we paid TCR an annual fee of $50,000 and reimbursed TCR all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. As of January 31, 2004, we no longer engage TCR as our financial advisors. We reimbursed TCR for out-of-pocket expenses in the amounts of $46,000, $47,000 and $34,000 during fiscal 2003, 2002 and 2001, respectively. In addition, we paid legal fees in the amount of $24,000 to TCR in connection with our private equity placements during fiscal 2003. As of January 31, 2004, TCR did not own any of our outstanding common stock, however a principal of TCR is still a member of our Board of Directors. On March 6, 2003, Three Cities Fund II L.P. purchased 240,793 shares of our common stock and Three Cities Offshore II C.V. purchased 407,207 shares of our common stock in a private placement at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000. Also on March 6, 2003, Mr. Rashkow purchased 72,700 shares of our common stock in the private placement at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925. Indebtedness of Management During fiscal years 1997 and 1998, we sold to our executive management shares of our Series B Preferred Stock, which were subsequently converted to common stock. With the exception of Michael M. Searles, our former Chief Executive Officer, and Johnathan W. Spatz, our Former Chief Financial Officer, each of the executives paid for his or her shares by giving us a full-recourse promissory note secured by the purchased stock. Each note accrues interest at 8% per annum and requires principal payments equivalent to 16.25% of the annual bonus paid to the purchaser (if such bonus is actually paid in a given year) and a balloon payment of the unpaid principal and interest at maturity. Each of the notes matures five years after the date it was made. Mr. Searles' promissory note in the principal amount of $1,400,000 was partial-recourse and was due on April 29, 2003. Mr. Searles was liable for the payment of principal and accrued but unpaid interest on his note up to $600,000 (including the value of the shares of our stock securing the note) and we had the right to retain the stock securing his note with respect to the balance of any principal and accrued interest on his note to the extent such stock had a value in excess of $600,000 (but not in excess of the outstanding balance of principal and accrued interest). We had forgiven interest payments aggregating $157,808 through November 7, 2002, but Mr. Searles' note accrued interest from November 7, 2002 to April 29, 2003. On April 29, 2003, the principal and accrued interest due on Mr. Searles' note was $1,458,608 and we foreclosed on the collateral which had a market value of $1,198,750, resulting in a deficiency of $259,858, for which Mr. Searles does not have personal liability under the terms of the note. Mr. Plotkin's promissory note was outstanding during fiscal 2002, but as of March 21, 2003, Mr. Plotkin had repaid his promissory note in full in the amount of $101,008. On April 29, 2003, the principal and accrued interest on two notes due from Mr. Spatz, were $688,197 and the collateral's market value on that date was $376,744, resulting in a deficiency of $311,453, for which Mr. Spatz is personally liable for $136,614 of the deficiency under the terms of his notes. Based on Mr. Spatz's current financial condition, we have elected, at this time, to forbear our collection efforts regarding the amount for which he is personally liable. Additionally, on April 29, 2003, the principal and accrued interest on the notes due from Tracy W. Parks, our former Executive Vice President and Chief Operating Officer, was $117,042. On that date, we foreclosed on the collateral which had a market value of $82,197, resulting in a deficiency of $34,845, for which Mr. Parks was personally liable under the terms of his notes. In August 2003, we received payment in full from Mr. Parks to repay the outstanding principal balance of his note plus interest. 55 Item 14. Principal Accounting Fees and Services The following table shows the aggregate fees billed to us by Ernst & Young LLP for fiscal years ended January 31, 2004 and February 1, 2003.
Fiscal Year Ended ----------------------------- January 31, Februaray 1, 2004 2003 ----------------------------- Fees Fees ----------------------------- Audit Fees(1) $ 50,600 $144,468 Audit-Related Fees (2) 27,396 - Tax Fees - - All Other Fees - - -------- -------- Total Fees $ 77,996 $144,468 ======== ========
(1) Includes fees for professional services provided in conjunction with the audit of our financial statements and review of our quarterly financial statements; (2) Includes fees for assurance and related professional services primarily related to services provided in connection with our registration statements on Form S-3 filed with respect to the resale of securities sold in the private offerings in March 2003 and August 2003. Our Audit Committee's policy is to pre-approve all audit and permissible audit-related services provided by the independent auditors. Our Audit Committee considers annually for pre-approval a list of specific services and categories of services, including audit and audit-related services, for the upcoming or current fiscal year. All non-audit services are approved by our Audit Committee in advance on a case-by-case basis. Any service that is not included in the approved list of services or that does not fit within the definition of a pre-approved service is required to be presented separately to our Audit Committee for consideration at its next regular meeting or, if earlier consideration is required, by other means of communication. All fees were pre-approved in accordance with our Audit Committee pre-approval policy. Our Audit Committee considered and concluded that the provision of those services provided by Ernest & Young LLP was compatible with the maintenance of the auditor's independence in conducting auditing functions. 56 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. See Index to Financial Statements contained in Item 8. 2. Financial Statement Schedules. Schedule II Valuation and Qualifying Accounts contained on page 59. 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 financial statements and notes thereto. 3. Exhibits. See Item 15(c). (b) Reports on Form 8-K. On December 24, 2003, we filed a report on Form 8-K regarding an amendment to our Amended and Restated Financing Agreement, announcing an agreement in principle with holders of our Junior Subordinated Notes to amend the scheduled payment dates and announcing revised expectations for sales and operating results for the fourth quarter ended January 31, 2004. The full text of our press release dated December 23, 2003 was attached as an exhibit to the Form 8-K. On January 7, 2004, we filed a report on Form 8-K regarding the termination of Douglas C. Felderman as Chief Financial Officer effective January 5, 2004, and the appointment of John Swygert as Chief Financial Officer on an interim basis. The full text of our press release dated January 6, 2004 was attached as an exhibit to the Form 8-K. On January 16, 2004, we filed a report on Form 8-K regarding the following: (1) our filing of a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code on January 13, 2004, (2) our receipt of a commitment for a $45 million DIP financing facility from the CIT Group/Business Credit, Inc. and GB Retail Funding, LLC, (3) our appointment of Norman G. Plotkin as Chief Executive Officer and John W. Swygert as Chief Financial Officer, (4) the discontinuation of our mid-month sales updates and monthly sales press releases, and (5) the notice from Nasdaq of its determination to delist us and our intention not to appeal. The full text of the press releases dated January 13, 2004 and January 15, 2004 related to items (1), (2) and (3) above were furnished and attached as an exhibit to the Form 8-K. The full text of the press release dated January 16, 2004 related to item (5) above was furnished and attached as an exhibit to the Form 8-K. In addition, the full text of our DIP financing facility agreement was filed and attached as an exhibit to the Form 8-K. On January 22, 2004, we furnished a report on Form 8-K regarding our filing of a motion with the Court seeking authorization to close 44 stores. The full text of our press release dated January 22, 2004 was furnished and attached as an exhibit to the Form 8-K. On February 3, 2004, we furnished a report on Form 8-K regarding the decision by the Court to grant final approval for the use of the entire $45 million debtor-in-possession financing agreement. The full text of our press release dated February 2, 2004 was furnished and attached as an exhibit to the Form 8-K. 57 On February 17, 2004, we filed a report on Form 8-K regarding the resignation of John W. Swygert as Chief Financial Officer, effective February 20, 2004. On March 22, 2004, we filed a report on Form 8-K regarding the appointment of Norman Dowling as Executive Vice President and Chief Financial Officer effective March 22, 2004 and the election of Norman G. Plotkin to our Board of Directors effective March16, 2004. The full text of our press release dated March 22, 2004 was furnished and attached as an exhibit to the Form 8-K. (c) Exhibits. Reference is made to the Index to Exhibits immediately preceding the exhibits thereto. 58
Schedule II Factory 2-U Stores, Inc. Valuation and Qualifying Accounts Fiscal Year Ended January 31, 2004, February 1, 2003 and February 2, 2002 (in thousands) Additions Balance at Charged to Charged to Balance at Beginning Costs and Other End of Description of Period Expenses Accounts Deductions Period ----------- ---------- ---------- ---------- ---------- ---------- As of January 31, 2004 Notes Receivable Allowance $ 2,340 $ 60 $ - $ (1,109) $ 1,291 Inventory Valuation Allowance 8,362 10,155 - (7,100) 11,417 FY02 Restructuring Reserve 12,411 (471) - (7,125) 4,815 FY01 Restructuring Reserve 4,774 (1,076) - (2,329) 1,369 As of February 1, 2003 Notes Receivable Allowance $ - $ 2,340 $ - $ - $ 2,340 Inventory Valuation Allowance 1,152 7,210 - - 8,362 FY02 Restructuring Reserve - 14,398 - (1,987) 12,411 FY01 Restructuring Reserve 21,154 (4,969) - (11,411) 4,774 As of February 2, 2002 Inventory Valuation Allowance $ 1,265 $ - $ - $ (113) $ 1,152 FY01 Restructuring reserve - 21,231 - (77) 21,154
59 Index to Exhibits Exhibit Number Document - -------------------------------------------------------------------------------- 2.1 (1) Plan and Agreement of Merger dated June 18, 1998 between Family Bargain Corporation and General Textiles, Inc. 3.1 (2) (i) Restated Certificate of Incorporation (ii) Bylaws 4.1 (1) Junior Subordinated Note Agreement dated April 30, 1998 among General Textiles, American Endeavour Fund Limited and London Pacific Life & Annuity Company 4.2 (1) Form of Warrant dated April 30, 1998 10.1 (3) Factory 2-U Stores, Inc. Employee Stock Purchase Plan 10.2 (4) Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan 10.3 (5) Factory 2-U Stores, Inc. Employee Compensation Agreements 10.4 (6) Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 2000 10.5 (6) First Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 2000 10.6 (6) Amended Employment Agreement between Factory 2-U Stores, Inc. and Michael M. Searles 10.7 (7) Second Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 10, 2001 10.8 (7) Third Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 9, 2002 10.9 (8) Fourth Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of September 16, 2002 10.10 (10) Fifth Amendment to the Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of February 14, 2003 10.11 (10) Sixth Amendment to the Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated as April 10, 2003 10.12 (9) Employment Agreement, dated as of November 7, 2002, by and between Factory 2-U Stores, Inc. and William R. Fields 10.13 (9) Letter Agreement, dated as of November 4, 2002, by and between Factory 2-U Stores, Inc. and Ronald Rashkow 10.14 (10) Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Melvin Redman 10.15 (10) Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Larry I. Kelley 10.16 (10) Industrial/Commercial Single-Tenant Lease as of March 8, 2002, by and between Factory 2-U Stores, Inc. (as Tenant) and ORIX Otay, LLC (as Landlord) 10.17 (11) Employment Agreement, dated as of May 20, 2003, by and between Factory 2-U Stores, Inc. and Douglas C. Felderman 10.18 (11) Employment Agreement, dated as of May 20, 2003, by and between Factory 2-U Stores, Inc. and Norman G. Plotkin 10.19 (12) Employment Agreement, dated as of November 10, 2003, by and between Factory 2-U Stores, Inc. and A.J. Nepa 10.20 (13) First Amendment to Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated December 23, 2003 10.21 (14) Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated January 12, 2004 10.22 * Second Amendment to Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated January 12, 2004 60 10.23 * First Amendment to the Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower) , and GB Retail Funding LLC (a Lender), dated January 30, 2004 10.24 * Agency Agreement, dated as of February 10, 2004, by and between The Great American Group and Factory 2-U Stores, Inc. 10.25 * Second Amendment to the Second Amended and Restated Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower) , and GB Retail Funding LLC (a Lender), dated March 10, 2004 14.1 * Standards of Business Conduct 23.1 * Consent of Ernst & Young LLP, Independent Auditors 23.2 * Information regarding consent of Arthur Andersen LLP 31.1 * Certification of the Chief Executive Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 * Certification of the Chief Financial Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Norman G. Plotkin, Chief Executive Officer 32.2 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Norman Dowling, Executive Vice President and Chief Financial Officer 61 (1) Incorporated by reference to Registration Statement on Form S-2, No. 333-58797 filed with the SEC on October 14, 1998. (2) Incorporated by reference to Registration Statement on Form S-1, No. 33-77448 filed with the SEC on April 7, 1994. (3) Incorporated by reference to Registration Statement on Form S-8 No. 333-94123 filed with the SEC on January 5, 2000. (4) Incorporated by reference to Registration Statement on Form S-8 No. 333-40682 filed with the SEC on June 30, 2000. (5) Incorporated by reference to Registration Statement on Form S-8 No. 333-89267 filed with the SEC on October 19, 1999. (6) Incorporated by reference to Form 10-K for the fiscal year ended January 29, 2000 filed with the SEC on April 24, 2000. (7) Incorporated by reference to Form 10-K for the fiscal year ended February 2, 2002 filed with the SEC on April 19, 2002. (8) Incorporated by reference to Form 10-Q for the quarterly period ended August 3, 2002 filed with the SEC on September 17, 2002. (9) Incorporated by reference to Form 8-K for report dated November 7, 2002 filed with the SEC on November 19, 2002. (10) Incorporated by reference to Form 10-K for the fiscal year ended February 1, 2003 filed with the SEC on May 2, 2003. (11) Incorporated by reference to Form 10-Q for the quarterly period ended May 3, 2003 filed with the SEC on June 17, 2003. (12) Incorporated by reference to Form 10-Q for the quarterly period ended November 1, 2003 filed with the Sec on December 16, 2003. (13) Incorporated by reference to Form 8-K for report dated December 22, 2003 filed with the SEC on December 24, 2003. (14) Incorporated by reference to Form 8-K for report dated January 13, 2004 filed with the SEC on January 16, 2004. * Filed herewith. ** Furnished herewith. 62 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/ Norman G. Plotkin ---------------------------- Norman G. Plotkin Chief Executive Officer Dated: April 30, 2004 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. Signature Title Date --------- ----- ---- /s/ Norman G. Plotkin Director and Chief --------------------- Executive Officer April 30, 2004 Norman G. Plotkin /s/ Norman Dowling Executive Vice President, April 30, 2004 --------------------- Chief Financial Officer Norman Dowling (Principal Financial and Accounting Officer) /s/ Ronald Rashkow Lead Director April 30, 2004 ------------------ Ronald Rashkow /S/ Willem de Vogel Director April 30, 2004 -------------------- Willem de Vogel /s/ Peter V. Handal Director April 30, 2004 ------------------- Peter V. Handal /s/ Wm. Robert Wright II Director April 30, 2004 ------------------------ Wm. Robert Wright II 63 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS To the Shareholders and the Board of Directors of Factory 2-U Stores, Inc. We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (the "Company") as of January 31, 2004 and February 1, 2003 and the related statements of operations, stockholders' equity (deficit) and cash flows for the years ended January 31, 2004 ("fiscal 2003") and February 1, 2003 ("fiscal 2002'). Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. The financial statements and financial statement schedule of the Company for the fiscal year ended February 2, 2002 ("fiscal 2001"), were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those statements in their report dated February 27, 2002. We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 fiscal 2003 and fiscal 2002 financial statements referred to above present fairly, in all material respects, the financial position of the Company as of January 31, 2004 and February 1, 2003 and the results of its operations and its cash flows for the years ended January 31, 2004 and February 1, 2003 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related fiscal 2003 and fiscal 2002 financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 8 to the financial statements, the Company changed its method of accounting for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards ("Statement") No.142 during the first quarter of fiscal 2002. As discussed above, the financial statements of the Company as of February 2, 2002, and for the year then ended were audited by other auditors who have ceased operations. As described in Note 8, these financial statements have been updated to include the transitional disclosures required by Statement No. 142, "Goodwill and Other Intangible Assets," which was adopted by the Company as of February 3, 2002. Our audit procedures with respect to the disclosures in Note 8 for fiscal 2001 included (i) agreeing the previously reported net income (loss) to the previously issued financial statements and the adjustments to reported net income (loss) representing amortization expense (including any related tax effects) recognized in those periods related to goodwill that are no longer being amortized to the Company's underlying records obtained from management, and (ii) testing the mathematical accuracy of the reconciliation of adjusted net income (loss) to reported net income (loss), and the related net income (loss)-per-share amounts. In our opinion, the disclosures for fiscal 2001 in Note 8 related to the transitional disclosures of Statement 142 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the Company's financial statements for fiscal 2001 other than with respect to such disclosures and, accordingly, we do not express an opinion or any other form of assurance on the Company's fiscal 2001 financial statements taken as a whole. F-1 The accompanying financial statements have been prepared assuming that Factory 2-U Stores, Inc. will continue as a going concern, which contemplates continuity of the Company's operations and realization of its assets and payments of its liabilities in the ordinary course of business. As more fully described in the notes to the financial statements, on January 13, 2004 Factory 2-U Stores, Inc. filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The uncertainties inherent in the bankruptcy process and the Company's recurring losses from operations raise substantial doubt about Factory 2-U Stores, Inc.'s ability to continue as a going concern. The Company is currently operating its business as a Debtor-in-Possession under the jurisdiction of the Bankruptcy Court, and continuation of the Company as a going concern is contingent upon, among other things, the confirmation of a Plan of Reorganization, the Company's ability to comply with all debt covenants under the existing debtor-in-possession financing agreement, and the Company's ability to generate sufficient cash from operations and obtain financing sources to meet its future obligations. If no reorganization plan is approved, it is possible that the Company's assets may be liquidated. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amount and classification of liabilities that may result from the outcome of these uncertainties. /s/ ERNST & YOUNG LLP San Diego, California April 19, 2004 F-2 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH FACTORY 2-U STORES, INC.'S FILING ON FORM 10-K FOR THE YEAR ENDED FEBRUARY 2, 2002. THIS AUDIT REPORT HAS NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH THIS FILING ON FORM 10-K. SEE EXHIBIT 23.2 FOR FURTHER DISCUSSION. THE BALANCE SHEET AS OF FEBRUARY 3, 2001, REFERRED TO IN THIS REPORT HAS NOT BEEN INCLUDED IN THE ACCOMPANYING FINANCIAL STATEMENTS. To Factory 2-U Stores, Inc.: We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (a Delaware corporation) as of February 2, 2002 and February 3, 2001, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended February 2, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 February 2, 2002 and February 3, 2001 and the results of its operations and its cash flows for each of the three years in the period ended February 2, 2002 in conformity with accounting principles generally accepted in the United States. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements and supplementary data is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material aspects in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP San Diego, California February 27, 2002 F-3
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Balance Sheets (in thousands) January 31, February 1, 2004 2003 ---------- ----------- ASSETS Current assets: Cash and cash equivalents $ 9,963 $ 3,465 Merchandise inventory 38,168 32,171 Accounts receivable, net 618 884 Income taxes receivable - 8,200 Prepaid expenses 2,740 5,436 Deferred income taxes - 9,732 -------- -------- Total current assets 51,489 59,888 Leasehold improvements and equipment, net 18,186 28,602 Deferred income taxes - 10,750 Other assets 1,033 963 Goodwill - 26,301 -------- -------- $ 70,708 $126,504 ======== ========
The accompanying notes are an integral part of these financial statements. (continued) F-4
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Balance Sheets (in thousands) January 31, February 1, 2004 2003 ----------- ----------- LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: DIP financing facility $ - $ - Current maturities of long-term debt 36 3,000 Accounts payable 8,257 27,961 Income tax payable 3,500 - Sales tax payable 5,615 5,840 Accrued expenses 12,560 27,831 ---------- --------- Total current liabilities 29,968 64,632 Revolving credit facility - 6,300 Long-term debt 92 6,445 Accrued restructuring charges - 1,747 Deferred rent and other liabilities 2,518 3,061 ---------- --------- Total liabilities not subject to compromise 32,578 82,185 ---------- --------- Liabilities subject to compromise 63,062 - Stockholders' equity (deficit): Common stock, $0.01 par value; 35,000 shares authorized and 17,921 shares and 13,476 shares issued and outstanding, respectively 179 135 Stock subscription notes receivable - (1,116) Additional paid-in capital 137,964 122,516 Accumulated deficit (163,075) (77,216) --------- --------- Total stockholders' equity (deficit) (24,932) 44,319 --------- --------- $ 70,708 $126,504 ========== ========= Commitments and contingencies
The accompanying notes are an integral part of these financial statements. F-5
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Statements of Operations (in thousands, except per share data) Fiscal Year Ended ------------------------------------------------- January 31, February 1, February 2, 2004 2003 2002 ------------------------------------------------- Net sales $ 493,297 $ 535,270 $ 580,460 Cost of sales 340,069 372,885 385,390 ---------- ---------- ---------- Gross profit 153,228 162,385 195,070 Selling and administrative expenses (exclusive of non-cash stock-based compensation expense shown below) 180,866 196,435 188,272 Pre-opening and closing expenses 292 1,086 3,086 Amortization of intangibles - - 1,682 Restructuring charge, net (1,547) 9,914 18,360 Stock-based compensation expense - - 456 ---------- ---------- ---------- Operating loss (26,383) (45,050) (16,786) Interest expense, net 3,693 1,611 960 ---------- ---------- ---------- Loss before reorgranization items and income taxes (benefit) (30,076) (46,661) (17,746) Reorganization items 31,703 - - ---------- ---------- ---------- Loss before income taxes (benefit) (61,779) (46,661) (17,746) Income taxes (benefit) 24,080 (18,152) (6,850) ---------- ---------- ---------- Net loss $ (85,859) $ (28,509) $ (10,896) ========== ========== ========== Net loss per share, basic and diluted $ (5.30) $ (2.20) $ (0.85) Weighted average common shares outstanding, basic and diluted 16,187 12,957 12,807
The accompanying notes are an integral part of these financial statements. F-6
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Statements of Stockholders' Equity (Deficit) (in thousands, except share data) Stock Common Stock Subscription Additional --------------------- Notes Paid-in Accumulated Shares Amount Receivable Capital Deficit Total ---------- -------- ------------ ----------- ------------ ----------- Balance at February 3, 2001 12,759,304 $ 127 $ (2,225) $ 119,646 $ (37,811) $ 79,737 ---------- ------ ---------- ---------- ------------ ----------- Issuance of common stock for exercise of stock options 66,456 1 - 522 - 523 Compensation expense related to the removal of price hurdle for performance- based stock options - - - 456 - 456 Tax effect related to non-qualified stock options - - - 389 - 389 Issuance of common stock to Board members as compensation 4,000 - - 106 - 106 Issuance of common stock under employee stock purchase plan 12,386 - - 251 - 251 Net loss - - - - (10,896) (10,896) ---------- ------ ----------- ---------- ------------- ----------- Balance at February 2, 2002 12,842,146 128 (2,225) 121,370 (48,707) 70,566 ---------- ------ ----------- ---------- ------------- ----------- Issuance of common stock for exercise of stock options 124,764 1 - 917 - 918 Issuance of common stock to Board Members and management as compensation 478,000 5 - 78 - 83 Issuance of common stock under employee stock purchase plan 30,795 1 - 151 - 152 Payments of notes receivable - - 76 - - 76 Write-down of stock subscription notes receivable to fair value - - 1,033 - - 1,033 Net loss - - - - (28,509) (28,509) ---------- ------ ---------- --------- ------------ ---------- Balance at February 1, 2003 13,475,705 135 (1,116) 122,516 (77,216) 44,319 ---------- ------ ---------- --------- ------------ ---------- Issuance of common stock in private placements 4,965,379 50 - 17,019 - 17,069 Issuance of common stock to Board members and management as compensation 154,250 1 - 14 - 15 Issuance of common stock under employee stock purchase plan 36,410 - - 63 - 63 Forfeiture of common stock issued to former management (375,000) (4) - 4 - - Payments of notes receivable - - 143 - - 143 Forfeiture of common stock in connection with default on stock subscription notes receivable (335,566) (3) 973 (1,652) - (682) Net loss - - - - (85,859) (85,859) ----------- ------ --------- ------------ ----------- ----------- Balance at January 31, 2004 17,921,178 $ 179 $ - $ 137,964 $ (163,075) $ (24,932) ----------- ------ --------- ------------ ----------- -----------
The accompanying notes are an integral part of these financial statements. F-7
FACTORY 2-U STORES, INC. (Debtor-in-Possiession) Statements of Cash Flows (in thousands) Fiscal Year Ended ----------------------------------------- January 31, February 1, February 2, 2004 2003 2002 ----------------------------------------- Cash flows from operating activities Net loss $ (85,859) $ (28,509) $ (10,896) Adjustments to reconcile net loss to net cash provided by (used in) operating activities Depreciation and amortization 13,602 15,160 14,773 Loss on disposal of equipment 81 76 205 Deferred income tax 20,482 (9,748) (3,240) Deferred rent (571) (550) 264 Reorganization items 31,164 - - Restructuring charge, net (1,547) 4,734 4,922 Stock-based compensation expense 15 78 562 Stock subscription notes receivable valuation adjustment (708) 1,033 - Vendor note receivable valuation reserve - 1,106 - Other - 171 - Changes in operating assets and liabilities Merchandise inventory (7,519) 22,454 (5,286) Income taxes - net 11,700 (9,311) (4,347) Prepaid expenses and other assets 3,141 3,430 (369) Advances to vendor (51) (3,118) - Repayments from vendor 116 789 - Accounts payable 22,030 (8,310) 11,077 Accrued expenses and other liabilities (5,851) 2,432 19,208 ------- ------- -------- Net cash provided by (used in) operating activities 225 (8,083) 26,873 ------- ------- -------- Cash flows from investing activities Purchase of leasehold improvements and equipment (3,493) (11,001) (12,694) ------- -------- -------- Net cash used in investing activities (3,493) (11,001) (12,694) ------- -------- --------
(continued) The accompanying notes are an integral part of these financial statements. F-8
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Statements of Cash Flows (in thousands) Fiscal Year Ended ---------------------------------------------------- January 31, February 1, February 2, 2004 2003 2002 ---------------------------------------------------- Cash flows from financing activities Borrowings on revolving credit facility 148,097 94,794 88,044 Payments on revolving credit facility (154,397) (88,494) (88,044) Payments on long-term debt and capital lease obligations (7,523) (2,019) (2,171) Proceeds from debt financing 7,500 - - Payments of debt issuance costs (1,123) (121) (40) Proceeds from issuance of common stock, net 17,069 5 160 Proceeds from exercise of stock options - 918 523 Payments of stock subscription notes receivable 143 76 - --------- --------- -------- Net cash provided by (used in) financing activities 9,766 5,159 (1,528) --------- --------- -------- Net increase (decrease) in cash and cash equivalents 6,498 (13,925) 12,651 Cash and cash equivalents at the beginning of the period 3,465 17,390 4,739 --------- --------- --------- Cash and cash equivalents at the end of the period $ 9,963 $ 3,465 $ 17,390 ========= ========= ========= Supplemental disclosure of cash flow information Cash paid during the period for Interest $ 1,947 $ 613 $ 387 Income taxes $ 94 $ 1,328 $ 5,698 Supplemental disclosures of non-cash investing and financing activities Acquisition of equipment under notes payable $ 151 $ - $ - Foreclosure of collateral on stock subscription notes receivable $ 1,681 $ - $ - Tax effect related to non-qualified stock options $ - $ - $ 389
The accompanying notes are an integral part of these financial statements. F-9 FACTORY 2-U STORES, INC. (Debtor-in-Possession) Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Our Company and Business We operate a chain of off-price retail apparel and houseware stores in Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestics and household merchandise at prices, which generally are significantly lower than other discount stores. On January 13, 2004 (the "Petition Date"), we filed a voluntary petition to reorganize under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the District of Delaware (the "Court"), which is currently pending as case number 04-10111(PJW) (the "Chapter 11 filing"). We remain in possession of our properties and continue to operate our business as debtor-in-possession ("DIP") in accordance with the applicable provisions of the Bankruptcy Code. At January 31, 2004, we operated 239 stores under the name Factory 2-U. Subsequently, we closed 44 stores located in states listed above as well as Arkansas, Idaho and Oklahoma. Fiscal Year Our fiscal year is based on a 52/53 week year ending on the Saturday nearest January 31. Fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 included 52 weeks. We define our fiscal year by the calendar year in which most of the activity occurs (e.g. the fiscal year ended January 31, 2004 is referred to as fiscal 2003). Basis of Presentation The accompanying Financial Statements are prepared on a going concern basis, which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business. In accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"), all pre-petition liabilities subject to compromise have been segregated in the Balance Sheet as of January 31, 2004 and classified as Liabilities subject to compromise, at the estimated amount of allowable claims. Liabilities not subject to compromise are separately classified as current and non-current. Expenses, realized gains and losses, and provisions for losses resulting from the reorganization are reported separately as Reorganization items in the Statement of Operations for fiscal year ended January 31, 2004. Cash used for reorganization items is disclosed separately in the Statement of Cash Flows for fiscal year ended January 31, 2004. Our ability to continue as a going concern is predicated upon numerous issues, including our ability to achieve the following: - developing and implementing a long-term strategy to revitalize our business and return to profitability; - taking appropriate actions to offset the negative impact the Chapter 11 filing has had on our business and the impairment of vendor relations; - operating within the framework of our DIP financing facility, including limitations on capital expenditures and compliance with financial covenants, F-10 - generating cash flows from operations or seeking other sources of financing and the availability of projected vendor credit terms; - attracting, motivating and retaining key executives and associates; and - developing, negotiating, and, thereafter, having a plan of reorganization confirmed by the Court. These challenges are in addition to other operational and competitive challenges faced by us in connection with our business as an off-price retailer. Bankruptcy Accounting Since the Chapter 11 filing, we have applied the provisions of SOP 90-7, which does not significantly change the application of accounting principles generally accepted in the United States; however, it requires the financial statements for periods including and subsequent to filing Chapter 11 petition distinguish transactions and events that are directly associated with the reorganization from the ongoing operations of the business. Cash Equivalents We consider all liquid investments with original maturities of three months or less to be cash equivalents. 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 basis. In addition, consistent with industry practice, we capitalize direct buying (primarily salaries and wages of buyers and their traveling expenses), warehousing, storage and transportation costs. Such costs are thereafter expensed as cost of sales upon the sale of the merchandise. At January 31, 2004 and February 1, 2003, such costs included in inventory were $4.3 million and $3.4 million, respectively. As of January 31, 2004 and February 1, 2003, we had an inventory valuation allowance of $11.6 million and $8.4 million, respectively, which represented our estimate of the cost in excess of the net realizable value of all clearance and slow-moving items. The inventory valuation allowance of $11.6 million as of January 31, 2004 also included a $2.2 million shrink reserve and a $1.7 million allowance related to the sale of inventory at the 44 stores to be closed. Leasehold Improvements and Equipment Leasehold improvements and equipment are stated at original cost less accumulated depreciation and amortization. Tenant improvement allowances, offered by landlords from time to time, are recorded as a reduction to the original cost of leasehold improvements. Equipment under capital leases is stated at the present value of minimum lease payments at the date of acquisition. Depreciation expense for the fiscal year ended January 31, 2004, February 1, 2003 and February 2, 2002 was $11.9 million, $14.0 million and $14.0 million, respectively. We calculate depreciation and amortization using the straight-line method over the estimated useful lives as follows: Leasehold improvements the shorter of the asset's useful life or thelease term,generally five years Furniture, fixtures and other equipment three to five years F-11 Goodwill At the beginning of fiscal 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets", which ceases goodwill amortization and instead, requires us to evaluate goodwill for impairment at least annually using a fair value test. In conjunction with our Chapter 11 filing on January 13, 2004, our annual impairment test indicated that goodwill was impaired and we recorded a goodwill impairment charge of $26.3 million. At February 1, 2003, we concluded that our goodwill was not impaired. Prior to fiscal 2002, goodwill was amortized on a straight-line basis over 25 years. Goodwill amortization was $1.6 million for the fiscal year ended February 2, 2002. We do not have any other intangible assets recorded in our books as of January 31, 2004 and February 1, 2003. Comprehensive Loss Comprehensive loss for the fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 did not differ from net loss. Asset Impairment We assess potential asset impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which establishes an accounting model to be used for long-lived assets to be disposed of by sale or held for use and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and the accounting and reporting provisions of Accounting Principles Board ("APB") No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for the disposal of a segment of a business (as previously defined in that Opinion). 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 an asset to be held and used is measured by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount that the carrying value of the asset exceeds the fair value of the asset. In conjunction with our closure of 44 stores soon after January 31, 2004, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores. Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, receivables, payables and accrued expenses approximate fair value due to the short-term nature of such instruments. The carrying amount of the DIP financing facility approximates fair value due to the floating rate on such instrument. The carrying value of long-term debt with fixed payment terms approximates fair value. Self-Insurance We self-insure or retain a portion of the exposure for losses related to workers' compensation and general liability costs. The self-insured policies provide for both specific and aggregate stop-loss limits. The workers' compensation program for the policy years ended January 31, 2004 and 2003 have a specific stop loss amount of $250,000 with no aggregate stop loss limit. The program for the policy year ended January 31, 2002 had both a specific and aggregate stop loss amount of $250,000 and $3.2 million, respectively. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy years ended January 31, 2004, 2003 and 2002 were estimated to be approximately $3.6 million, $4.7 million and $4.3 million ($3.2 million aggregate stop loss), respectively. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above. F-12 For general liability insurance, our program for fiscal 2003 provided for a specific stop loss of $35,000 per claim with no aggregate stop loss limit. Revenue Recognition We recognize sales revenue at the time the merchandise is sold to the customer, except for layaway and gift card sale transactions. The recognition of layaway sales and the related cost of sales are deferred until the merchandise is fully paid for and delivered to our customer. Cash received for the layaway transaction in advance is recorded as a liability, which is included in Accounts payable in the accompanying Balance Sheets. Cash received for the sale of gift cards is recorded as a liability, which is included in Accounts payable in the accompanying Balance Sheets. The related liability is reduced and revenue is recognized upon delivery of the layaway merchandise to the customer or upon redemption of the gift card. As of January 31, 2004 and February 1, 2003, the balances of the liability recorded in relation to layaway and gift card programs were approximately $300,000. Costs of Sales Costs of sales include merchandise cost, transportation cost, markdowns, shrink, direct distribution and processing costs, and inventory capitalization cost. Selling and Administrative Expenses Selling and administrative expenses primarily consist of salaries and wages, workers compensation, employee benefits, advertising costs, occupancy costs (primarily rent), utilities, professional fees and other direct and indirect selling expenses. Advertising Costs Advertising costs are expensed as incurred. Advertising costs for the fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 were approximately $23.5 million, $24.7 million and $20.9 million, respectively. Deferred Rent Rent expense under non-cancelable operating lease agreements is recorded on a straight-line basis over the life of the respective leases. The excess rent expense over rent paid is accounted for as deferred rent. Store Pre-opening and Closing Costs Store pre-opening costs (costs of opening new stores, including grand opening promotions, training and store set-up costs) are expensed as incurred. Costs associated with closing stores consist primarily of inventory liquidation costs which are recognized as incurred, fixed asset impairments as recognized in accordance with SFAS No. 144, and future lease obligations subsequent to the cease use date. Closing costs related to exit or disposal activities initiated prior to December 31, 2002 were recognized as operating expenses at the date of a commitment to an exit or disposal plan. F-13 Debt Issuance Costs Debt issuance costs are amortized to interest expense evenly over the life of the related debt. For fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, amortization for debt issuance costs was $833,000, $118,000 and $132,000, respectively. Debt issuance costs for the fiscal year ended January 31, 2004 included the write-off of remaining unamortized debt issuance costs of approximately $353,000 as a result of the Chapter 11 filing. Income Taxes Income taxes are accounted for under the asset and liability method required by SFAS No. 109, "Accounting for Income Taxes." 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. In evaluating exposure associated with various tax filing positions, we often accrue charges for probable exposures. The Internal Revenue Service ("IRS") is currently conducting an examination of our consolidated tax returns for the fiscal years 1998 through 2002. We expect the IRS examination to be completed within the next two years. We believe that adjustments, if any, are adequately provided for in the accrued income taxes account in the accompanying financial statements. To the extent we prevail in matters for which accruals have been established or are required to pay amounts in excess of these accruals, our effective tax rate in a given financial statement period could be materially affected. Stock-based Compensation We have elected under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" to continue using the intrinsic value method of accounting for employee stock- based compensation in accordance with APB No. 25, "Accounting for Stock Issued to Employees." 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. We have disclosed the pro forma effect of using the fair value based method to account for our stock-based compensation as required by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." The following table illustrates the effect on net loss and net loss per common share if we had applied the fair value recognition provisions of SFAS No. 148.
(in thousands, except per share data) 2003 2002 2001 ---------- ---------- ---------- Net loss before stock-based compensation, as reported $ (85,859) $ (28,509) $ (10,896) Stock based compensation using the fair value method, net of tax (1,901) (3,159) (5,877) ---------- ---------- ----------- Pro-forma net loss $ (87,760) $ (31,668) $ (16,773) ========== ========== =========== Pro-forma net loss per share, basic and diluted $ (5.42) $ (2.44) $ (1.31)
F-14 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 our 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, we believe that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from those plans. The weighted-average fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the following weighted-average assumptions:
2003 2002 2001 ---- ---- ---- (i) Expected dividend yield 0.00% 0.00% 0.00% (ii) Expected volatility 107.73% 104.00% 96.86% (iii) Expected life 7 years 8 years 9 years (iv) Risk-free interest rate 3.68% 3.55% 5.71%
Loss per Share We compute loss per share in accordance with SFAS No. 128, "Earnings Per Share." Under the provisions of SFAS No. 128, basic earnings (loss) per share is computed based on the weighted average shares outstanding. Diluted income (loss) per share is computed based on the weighted average shares outstanding and potentially dilutive common stock equivalent shares. Common stock equivalent shares totaling 144,616, 127,242 and 147,000 for fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively, are not included in the computation of diluted loss per share because the effect would have been anti-dilutive. Use of Estimates Our management 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 in the United States. Actual results could differ from these estimates. Reclassifications Certain prior period amounts have been reclassified to conform their presentation to the fiscal 2003 Financial Statements. Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (the "FASB") issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations. F-15 In April 2003, the FASB issued Statement of Financial Accounting Standard (the "SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement provides clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The adoption of this statement did not have a material impact on our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity and is effective for financial instruments entered into or modified after May 31, 2003. The adoption of this statement did not have a material impact on our financial position or results of operations. 2. REORGANIZATION ITEMS Reorganization items represent amounts we incurred as a result of the Chapter 11 filing, and are recorded and presented in accordance with SOP 90-7. Reorganization items for the fiscal year ended January 31, 2004 were $31.7 million and consisted of: (1) a non-cash goodwill impairment charge of $26.3 million; (2) a non-cash impairment charge of $2.4 million for fixed assets associated with the 44 stores closed subsequent to January 31, 2004 as part of our reorganization efforts; (3) a non-cash inventory valuation reserve of $1.7 million related to the sale inventory at the 44 stores below cost; and (4) $1.3 million of professional fees and other expenses incurred in our bankruptcy case and reorganization efforts. Cash payments resulting from reorganization through January 31, 2004 was approximately $1.2 million. 3. LIABILITIES SUBJECT TO COMPROMISE Under the Bankruptcy Code, actions by creditors to collect indebtedness we owe prior to the Petition Date are stayed and certain other pre-petition contractual obligations may not be enforced against us. We have received approval from the Court to pay certain pre-petition liabilities including employee salaries and wages, benefits and other employee obligations. Except for secured debt, employee payroll and benefits, sales, use and other taxes, and capital lease obligations, all pre-petition liabilities have been classified as Liabilities subject to compromise in the Balance Sheet as of January 31, 2004. Adjustments to pre-petition liabilities may result from negotiations, payments authorized by Court order, additional rejection of executory contracts including leases, or other events. Therefore, the amounts below in total may vary significantly from the stated amounts of proofs of claim that will be filed with the Court. F-16 The following table summarizes the components of Liabilities subject to compromise in our Balance Sheet as of January 31, 2004.
(in thousands) January 31, 2004 ------------------------------------------------------------------------ Trade and other accounts payable $ 41,734 Junior subordinated notes, net of discount 10,349 Restructuring costs, primarily lease termination claims 6,044 General liability and workers compensation claims 2,283 Severance claims 1,385 Other 1,267 --------- Liabilities subject to compromise $ 63,062 ---------
4. FISCAL 2002 RESTRUCTURING CHARGE In December 2002, we recorded a restructuring charge of $14.4 million in conjunction with the decision to close 23 stores as well as to consolidate both our distribution center network and corporate overhead structure. The purpose of these restructuring initiatives was to improve store profitability, reduce costs and improve efficiency. In fiscal 2002, the charge and the related liability were recognized in accordance with the Emerging Issues Task Force ("EITF") No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF No. 94-3 provides specific requirements as to the appropriate recognition of costs associated with employee termination and other exit costs. As of April 23, 2004, we have closed 20 of these 23 stores and terminated the lease obligations of 14 of these closed stores. In conjunction with our Chapter 11 filing, we rejected 6 leases and recorded a non-cash reduction of $296,000 to adjust the lease termination reserve to the allowed claim amount under the Bankruptcy Code. The three remaining stores have not been closed at this time due to lease concessions agreed to by the landlords. In addition, we have completed the consolidation of our two former San Diego distribution centers and our Lewisville, Texas distribution center into one distribution center, which is located at a new facility in San Diego, California. As a result of our Chapter 11 filing, we have rejected the lease of one of our former San Diego, CA distribution centers and the lease of our Lewisville, Texas distribution center. In conjunction with these two lease rejections, we recorded a non-cash adjustment of $355,000 to increase the related lease termination reserve to the allowed claim amount under the Bankruptcy Code. We continue to pay the rent of the other former San Diego distribution center, which is also the location of our corporate headquarters. F-17 The balance of the liability $4.7 million (included in "Liabilities subject to compromise" in the accompanying Balance Sheet as of January 31, 2004) related to this fiscal 2002 restructuring charge was as follows:
Non-cash Balance at Restructuring Cash Charges and January 31, (in thousands) Charge Payments Adjustments 2004 ------------- -------- ----------- ------------ Lease termination costs* $ 6,513 $ (2,605) $ 555 $ 4,463 Employee termination costs 1,027 (723) (239) 65 Other costs 807 (354) (306) 147 ------------- --------- ----------- ----------- $ 8,347 $ (3,682) $ 10 $ 4,675 ============= ========= =========== =========== * The non-cash charge portion consists primarily of the write-off of deferred rent and adjustment of estimated lease termination costs to the maximum amount allowed by the Bankruptcy Code.
The balances of non-cash inventory liquidation costs and fixed asset write-downs related to this fiscal 2002 restructuring charge at January 31, 2004 were as follows:
Balance at Restructuring Usage/ January 31, (in thousands) Charge Adjustments 2004 --------------------------------------------------- Inventory liquidation costs* $ 1,082 $ (942) $ 140 Fixed asset write-downs $ 4,969 $ (4,969) $ - * The balance of inventory liquidation costs of approximately $140,000 was recorded as a valuation allowance for merchandise inventory for two stores that were closed subsequent to January 31, 2004.
5. FISCAL 2001 RESTRUCTURING CHARGE In January 2002, we recorded a restructuring charge of $21.2 million in conjunction with the decision to close 28 under-performing stores as well as the realignment of our field organization and workforce reductions. The purpose of the restructuring was to improve store profitability, streamline field operations, reduce costs and improve efficiency. In light of the favorable experience related to the costs of closing these stores, we recorded a non-cash adjustment to reduce the reserve for the fiscal 2001 restructuring initiatives by approximately $5.0 million during the fourth quarter of fiscal 2002. The adjustment included (1) reduction of reserve for lease termination costs by $3.8 million, (2) reduction of reserve for inventory liquidation costs by $1.3 million, offset by (3) an additional reserve for fixed asset write-downs of $94,000. We closed all 28 stores during fiscal 2002. As of April 23 2004, we had terminated the lease obligations of 23 of these stores and rejected the remaining 5 leases. As a result of rejecting these leases, we recorded a non-cash adjustment of $161,000 to reduce the reserve to the allowed claim amount under the Bankruptcy Code. In addition, we recorded a non-cash adjustment of $832,000 to reduce the reserve for lease termination costs as a result of favorable experience related to several lease terminations. F-18 The balance of liability $1.4 million (included in "Liabilities subject to compromise" in the accompanying Balance Sheet as of January 31, 2004) related to the fiscal 2001 restructuring charge was as follows:
Non-cash Balance at Restructuring Cash Charges and January 31, (in thousands) Charge Payments Adjustments 2004 ------------- -------- ----------- ------------ Lease termination costs $ 13,724 $ (7,986) $ (4,489) $ 1,249 Employee termination costs 1,206 (1,152) (54) - Other costs 1,379 (1,244) (15) 120 ----------- --------- ---------- ----------- $ 16,309 $(10,382) $ (4,558) $ 1,369 ============ ========= ========== =========== *The non-cash charge portion consists primarily of adjustments made during fiscal 2002 and fiscal 2003 as a result of favorable experience related to lease termination costs.
As of January 31, 2004, the non-cash inventory liquidation costs and fixed asset write-downs related to this fiscal 2001 restructuring charge were zero.
Balance at Restructuring Usage/ January 31, (in thousands) Charge Adjustments 2004 --------------------------------------------------- Inventory liquidation costs $ 2,870 $ (2,870) $ - Fixed asset write-downs $ 2,052 $ (2,052) $ -
6. NOTE RECEIVABLE In July 2002, we entered into a temporary bridge financing agreement (the "Agreement") with one of our trade vendors (the "Borrower") in which we, subject to the terms and conditions of the Agreement, agreed to provide a $4.0 million revolving line of credit facility to the Borrower. Advances made to the Borrower under this Agreement are secured by the Borrower's accounts receivable, inventory, personal property and other assets including cash. Borrowings under this facility are also secured by personal guarantees from the principals of the Borrower. This Agreement expired on October 11, 2002, and we have not made any direct advances to the Borrower thereafter. Through May 27, 2003, we made cash advances in the aggregate of approximately $3.1 million to the Borrower and received cash repayments in the aggregate of approximately $811,000. We also received approximately $1.5 million of inventory from the Borrower to partially offset the advances. On May 27, 2003, we filed a lawsuit against the Borrower and the two guarantors seeking the remaining balance plus interest of approximately $1.1 million due under the agreement. As of January 31, 2004, this amount was fully reserved. On September 17, 2003, we entered into a settlement agreement with the Borrower in which the Borrower agreed to make payments in the amount of $500,000 with interest at the rate of 7.5% per annum as full payment for the balance due under the Agreement. Under the settlement agreement, the first payment of $50,000 became due on September 30, 2003. Through January 31, 2004, we have received $50,000 from the Borrower, however the amount was received through several smaller payments, the last payment of $9,000 having been received on January 20, 2004. As a result of this default, under the settlement agreement, we reserve the right to reinstate the original amount due under the Agreement. F-19 Subsequent to January 31, 2004, we received $70,000 from the Borrower for payment under the settlement agreement. 7. LEASEHOLD IMPROVEMENTS AND EQUIPMENT Leasehold improvements and equipment consist of the following (in thousands):
January 31, February 1, 2004 2003 ---------- --------- Furniture, fixtures and equipment $ 47,810 $ 55,843 Leasehold improvements 12,687 14,090 Automobiles 965 890 Equipment under capital leases* 1,830 2,549 -------- --------- 63,292 73,372 Less: accumulated depreciation and amortization (45,106) (44,770) --------- --------- $ 18,186 $ 28,602 --------- --------- *All obligations related to capital leases were fully paid prior to February 1, 2003.
We assess potential asset impairment in accordance with SFAS 144. Recoverability of an asset to be held and used is measured by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount that the carrying value of the asset exceeds the fair value of the asset. In conjunction with our closure of 44 stores soon after January 31, 2004, we recorded an impairment charge of $2.4 million regarding fixed assets located at these stores. As of February 1, 2003, we had asset impairment valuation allowances related to the fiscal 2002 and 2001 restructuring activities totaling $3.8 million. These allowances were recorded as direct reductions of the related assets. 8. GOODWILL As required, we adopted SFAS 142 on February 3, 2002 and ceased the amortization of goodwill accordingly and instead evaluate the carrying value of goodwill for impairment at least annually using a fair value test. In conjunction with our Chapter 11 filing on January 13, 2004, our annual impairment test indicated that goodwill was impaired and we recorded a goodwill impairment charge of $26.3 million. At February 1, 2003, we concluded that our goodwill was not impaired. Prior to fiscal 2002, goodwill was amortized on a straight-line basis over 25 years. Goodwill amortization was $1.6 million for the fiscal year ended February 2, 2002. F-20 The following table presents the reconciliation of net income and per share data to what would have been reported had the new rules been in effect during the fiscal year ended February 2, 2002 (in thousands, except per share data):
2001 ------------ Reported net loss $ (10,896) Add back goodwill amortization, net of tax 984 ------------ Adjusted net loss $ (9,912) ------------ Basic net loss per common share Reported net loss $ (0.85) Goodwill amortization, net of tax 0.08 ------------ Adjusted net loss $ (0.77) ------------
We do not have any other intangible assets recorded in our books as of January 31, 2004 or February 1, 2003. 9. ACCRUED EXPENSES Accrued expenses consist of the following:
(in thousands) -------------- January 31, February 1, 2004 2003 ----------- ----------- Accrued compensation and related costs $ 2,983 $ 4,070 Accrued occupancy 1,469 693 Accrued restructuring charges - 11,117 Accrued workers compensation 5,132 4,741 Other accrued expenses 2,976 7,210 ----------- ----------- $ 12,560 $ 27,831 ----------- -----------
10. DIP FINANCING FACILITY, LONG-TERM DEBT AND PRE-PETITON REVOLVING CREDIT FACILITY Long-term debt and revolving credit facilities consist of the following:
(in thousands) -------------- January 31, February 1, 2004 2003 ----------- ----------- Junior subordinated notes, $ 10,349 $ 9,445 non-interest bearing, discounted at a rate of 10%, principal payments in annual installments of $3.0 million and final balloon payment of $5.3 million due May 2005 Less amount subject to compromise (10,349) - Notes payable 128 - Less current maturities (36) (3,000) ------------ ---------- Long-term debt, net of current maturities $ 92 $ 6,445 ------------ ---------- Debtor-in-possession financing facility $ - $ - Pre-petition revolving credit facility $ - $ 6,300
F-21 DIP Financing Facility In conjunction with our Chapter 11 filing, we entered into a financing agreement with The CIT Group/Business Credit, Inc. (the Tranche A Lender) and GB Retail Funding, LLC (the Tranche B Lender), (collectively the "Lenders") in which the Lenders provide us a $45.0 million revolving credit facility for working capital needs and other general corporate purposes while we operate as a debtor-in-possession (the "DIP financing facility"). This DIP financing facility with a maturity date of January 14, 2005 has since been amended twice, the first amendment on January 30, 2004 and the second amendment on March 10, 2004. The DIP financing facility has a superpriority claim status in our Chapter 11 case and is collateralized by first liens on substantially all of our assets, subject to valid and unavoidable pre-petition liens and certain other permitted liens. Under the terms of the DIP financing facility, we may borrow up to 85% of our eligible accounts receivable and up to 70% of our eligible inventory, as defined. However, the DIP financing facility provides for a $5.0 million availability block against our availability calculation, as defined. The DIP financing facility also includes a $20.0 million sub-facility for letters of credit. Interest on the outstanding borrowings under the DIP financing facility is payable monthly and accrues at the rate equal to, at our option, either the prime rate (as announced by JP Morgan Chase Bank) plus 1.50% per annum or LIBOR plus 3.5% per annum. The Tranche B Lender will fully fund $4.0 million within five business days after demand by the Tranche A Lender when the outstanding borrowing provided by the Tranche A Lender first equals or exceeds $6.5 million for three consecutive business days. In the event that there is any outstanding borrowing provided by the Tranche B Lender, such borrowing bears interest at 14.5% per annum payable monthly. We are also obligated to pay a monthly fee equal to 0.375% per annum on the unused available line of credit and a fee equal to 2.5% per annum on the outstanding letters of credit. Under the terms of the DIP financing facility, capital expenditures for fiscal 2004 is restricted to $2.0 million. In addition, we are required to be in compliance with financial covenants and other customary covenants. The financial covenants include average minimum availability, cumulative four-week rolling average of cash receipts from store sales and cumulative rolling four-week average of inventory receipts, as defined. The customary covenants include certain reporting requirements and covenants that restrict our ability to incur or create liens, indebtedness and guarantees, make dividend payments, sell or dispose of assets, change the nature of our business and enter into affiliate transactions, mergers and consolidations. Failure to satisfy these covenants would (in some cases, after the expiration of a grace period) result in an event of default that could cause, absent the receipt of appropriate waivers, the funds necessary to maintain our operations to become unavailable. The DIP financing facility contains other customary events of default including certain ERISA events, a change of control and the occurrence of certain specified events in the Chapter 11 case. In addition, during the period from December 28, 2004 through January 11, 2005, we are not allowed to have any outstanding borrowings under the revolving credit facility and our outstanding letters of credit cannot exceed $11.0 million. As of January 31, 2004, we were in compliance with our covenants and had no borrowings outstanding under the revolving credit facility and outstanding letters of credit of $10.1 million under the sub-facility for letters for credit. As of January 31, 2004, based on our eligible inventory and accounts receivable, we were eligible to borrow $33.8 million under the revolving credit facility and had $17.6 million available after giving effect for the availability block, as defined. F-22 Pre-petition Revolving Credit Facility Prior to the Petition Date, we had a $50.0 million revolving credit facility agreement (the "Financing Agreement") with a financial institution expiring in March 2006. Under this Financing Agreement, we could borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The revolving credit facility provided for a $7.5 million availability block against our availability calculation, as defined. The Financing Agreement also included a $15.0 million sub-facility for letters of credit. Under the terms of the Financing Agreement, the interest rate could increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. We were obligated to pay fees equal to 0.125% per annum on the unused amount of the revolving credit facility. We were contractually prohibited from paying cash dividends on our common stock under the terms of the Financing Agreement without consent of the lender. As amended on April 10, 2003, the facility was secured by a first lien on all company assets excluding furniture, fixtures, machinery and equipment. On February 14, 2003, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which was secured by a junior lien on the Collateral, as defined. On April 10, 2003, we amended the terms of our Financing Agreement (the "Amended and Restated Financing Agreement") to add $7.5 million of term loans, to add financial covenants, and to amend certain reporting provisions and other terms. The term loans consisted of a $6.5 million junior term note secured by all company assets excluding furniture, fixtures, machinery and equipment and a $1.0 million junior term note secured by furniture, fixtures, machinery and equipment. These notes bore interest at the rate of 14.5% per annum on the then current outstanding balance and a maturity date of April 10, 2004. On December 22, 2003, we amended the terms of our Amended and Restated Financing Agreement ("First Amendment") to shorten the period that we were required to have zero borrowings, or "clean-up", under the revolving credit facility from 15 consecutive days beginning December 22, 2003 to eight consecutive days beginning December 29, 2003. The First Amendment also required us to pay the full unpaid balance of $600,000 under the Tranche B Loan II on or before December 23, 2003, and we paid it accordingly. On January 12, 2004, we amended the terms of our Amended and Restated Financing Agreement ("Second Amendment") in which we were required to pay the full unpaid balance of $6.5 million on or before January 12, 2004, and we paid it accordingly. Junior Subordinated Notes The Junior Subordinated Notes (the "Notes") are non-interest bearing and were reflected on our balance sheets at the present value using a discount rate of 10%. We are prohibited from paying cash dividends on our common stock under the terms of the Notes without the consent of the note holders. As of January 31, 2004 we were in default under the terms of our Notes and have included the net carrying value of $10.3 million (face value of $11.3 million net of a related unamortized discount of $1.0 million) in the line Liabilities subject to compromise. On the Petition Date, we stopped amortizing debt discount related to the Notes, in accordance with SOP 90-7. Under the Bankruptcy Code, the claims of holders of the Notes are subject to disallowance to the extent they represent a claim for unmatured interest, i.e., the portion of face value representing unamortized discount. The amount so disallowed may differ from the unamortized discount maintained on our books and records. F-23 11. INCOME TAXES Significant components of income tax expense/(benefit) are as follows:
(in thousands) ----------------------------------------- 2003 2002 2001 --------- --------- ---------- Federal income tax expense (benefit) Current $ 3,298 $ (8,200) $ (3,069) Deferred 13,696 (8,321) (2,754) --------- --------- --------- 16,994 (16,521) (5,823) --------- --------- --------- State income tax expense (benefit) Current 300 (204) (541) Deferred 6,786 (1,427) (486) --------- --------- --------- 7,086 (1,631) (1,027) --------- --------- --------- $ 24,080 $(18,152) $ (6,850) --------- --------- ---------
The principal temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below:
(in thousands) ------------------------------ January 31, February 1, 2004 2003 ------------- ------------- Deferred tax assets Net operating loss carryforwards $ 23,438 $ 10,483 Compensated absences and bonuses 3,122 3,002 Deferred rent 1,296 1,325 Closed store accrual - 101 Excess of tax over book inventory 4,738 3,648 Accrued expenses 7,992 12,255 Fixed assets 2,196 490 Other 2,445 1,174 ---------- ---------- Total gross deferred tax assets 45,227 32,478 Less: valuation allowance (45,227) (7,647) ---------- ---------- Net deferred tax assets - 24,831 ---------- ---------- Deferred tax liabilities Tax basis difference - 4,349 ---------- ---------- Deferred tax liabilities - 4,349 ---------- ---------- Net deferred tax asset $ - $ 20,482 ---------- ----------
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Accordingly, a valuation allowance has been recognized to offset deferred tax assets because management cannot conclude that it is more likely than not that the deferred tax assets will be realized in the foreseeable future. A portion of the valuation allowance for deferred tax assets relates to stock option deductions which, when recognized, will be allocated directly to additional paid-in-capital. F-24 In evaluating exposure associated with various tax filing positions, we often accrue charges for probable exposures. The IRS is currently conducting an examination of our consolidated tax returns for the fiscal years 1998 through 2002. We expect the IRS examination to be completed within the next two years. We believe that adjustments, if any, are adequately provided for in the accrued income taxes account in the accompanying financial statements. To the extent we prevail in matters for which accruals have been established or are required to pay amounts in excess of these accruals, our effective tax rate in a given financial statement period could be materially affected. The difference between the expected income tax expense (benefit) computed by applying the U.S. federal income tax rate of 35% to net loss from continuing operations for each of the fiscal years 2003, 2002 and 2001, and the actual tax expense (benefit) is a result of the following:
(in thousands) 2003 2002 2001 ------------- ---------- --------- Computed "expected" tax benefit $(21,622) $(16,331) $ (6,211) Impairment/Amortization of goodwill 10,100 - 656 Change in valuation allowance 37,581 - - Business credits (325) (195) (238) State income taxes, net of federal income tax credit (2,101) (1,586) (1,064) Release of tax contingency reserve 849 - - Other, net (402) (40) 7 --------- --------- -------- $ 24,080 $(18,152) $ (6,850) --------- --------- ---------
At January 31, 2004, we had net operating loss carryforwards for federal income tax purposes of approximately $61.2 million that expire starting in fiscal 2005. At January 31, 2004, we had general business credit carryforwards for federal income tax purposes of approximately $2.1 million that expire starting in fiscal year 2014. At January 31, 2004, we had net operating loss carryforwards for state income tax purposes of approximately $24.7 million that expire starting in fiscal 2012. A portion of our federal net operating loss carryforwards are subject to annual usage limitations under Section 382 of the Internal Revenue Code, annual use of our net operating loss carry-forwards will be limited due to prior cumulative ownership changes of more than 50% within a three-year period. 12. LEASE COMMITMENTS We operate retail stores, a distribution center and administrative offices under various operating leases. Total rent expense was approximately $40.5 million, $42.5 million and $40.7 million, including contingent rent expense of approximately $95,000, $98,000 and $228,000, for fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively. Rent expense is recorded on a straight-line basis over the life of the lease. For fiscal 2003 and 2001, rent expense charged to operations exceeded cash payment requirements by approximately $202,000 and $264,000, respectively, and resulted in an increase to the deferred rent liability for the same amount. For fiscal 2002, cash payment requirements exceeded rent expense by $414,000. F-25 At January 31, 2004, the future minimum lease payments under operating leases with remaining non-cancelable terms are as follows:
(in thousands) -------------- Fiscal year: 2004 $ 32,781 2005 27,079 2006 20,605 2007 15,459 2008 12,060 Thereafter 34,811 -------- Total minimum lease payments $142,795 --------
Amounts included in the above table are related to lease agreements, which we have neither assumed nor rejected as of January 31, 2004. Under the Bankruptcy Code, we may assume or reject executory contracts, including lease obligations. Therefore, the commitments shown in the above table may not reflect actual cash outlays in the future periods. 13. STOCKHOLDERS' EQUITY We have 35,000,000 shares of common stock authorized for issuance at a par value of $0.01 per share. At January 31, 2004, we have reserved 3,157,980 shares of common stock for issuance in connection with our stock option plan. We have also reserved 263,102 shares for issuance under the employee stock purchase plan and 270,190 shares for issuance related to outstanding warrants. On March 6, 2003, we completed a private offering of 2,515,379 shares of our common stock for net proceeds of approximately $5.7 million, after deducting placement fees and other offering expenses. In addition to the placement fees, the placement agent received warrants to purchase 75,000 shares of our common stock at an exercise price of $3.50 per share, a 30% premium over the closing price of $2.68 on March 6, 2003. These warrants will expire in March 2006. On August 20, 2003, we completed another private offering of 2,450,000 shares of our common stock for net proceeds of approximately $11.4 million, after deducting placement fees and other offering expenses. This transaction also provides for warrants to purchase 490,000 shares at the same price as the initial shares purchased, which expired on December 23, 2003. In addition to the placement fees, the placement agent received warrants to purchase 112,500 shares of our common stock at an exercise price of $6.00 per share, a 7% premium over the closing price of $5.62 on August 20, 2003. These warrants will expire in August 2006. We used the net proceeds of these two private offerings primarily for working capital purposes. In fiscal 2002, we issued a total of 450,000 restricted shares of common stock to certain of our new senior management members as an inducement to accept employment at the time they were hired. In fiscal 2003, we issued an additional 150,000 restricted shares of common stock to existing and new management members. Of these 600,000 restricted shares, 375,000 shares were forfeited in fiscal 2003 as a result of employment terminations. The remaining 225,000 restricted shares shall vest in installments; 75,000 shares at such time as the closing market price of our common stock equals or exceeds $10.00 per share for 20 consecutive trading days in any three-month period, 75,000 shares at such time as the closing market price of our common stock equals or exceeds $20.00 per share for 20 consecutive trading days in any three-month period, and the final 75,000 shares at such time as the closing market price of our common stock equals or exceeds $30.00 per share for 20 consecutive trading days in any three-month period. In the event that the closing market price of our common stock equals or exceeds $10.00, $20.00 and $30.00 per share for 20 consecutive trading days in any three-month period, at a minimum we may incur non-cash charges of approximately $750,000, $1.5 million, and $2.3 million, respectively. F-26 We have never paid cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future. During the pendency of the Chapter 11 proceedings, any such dividend would be remote and, in any event, subject to the approval of the Court. We are contractually prohibited from paying cash dividends on our common stock under the terms of our DIP financing facility without the consent of the lenders. 14. STOCK SUBSCRIPTION NOTES RECEIVABLE At February 1, 2003, the outstanding stock subscription notes receivable balance was $1.1 million, net of a valuation allowance. All outstanding stock subscription notes receivable, which were secured by the underlying common stock of the Company, at that time were due from either current or former members of management with a five-year term and had maturity dates ranging from April 29, 2003 to July 29, 2003 and an interest rate of 8.0% per annum. On March 21, 2003, two stock subscription notes in the principal amount of $92,642 and $50,000, respectively, plus accrued interest, were paid in full by current members of management. On April 29, 2003, the remaining stock subscription notes matured and we foreclosed on the shares of our common stock that served as collateral as of the close of business. The principal and accrued interest on the note due from Michael M. Searles, our former President and Chief Executive Officer, was $1,458,608 and the collateral's market value on April 29, 2003 was $1,198,750, resulting in a deficiency of $259,858, for which Mr. Searles was not personally liable under the terms of the note. In addition, the principal and accrued interest on two notes due from Jonathan W. Spatz, our former Chief Financial Officer, were $688,197 and the collateral's market value on April 29, 2003 was $376,744, resulting in a deficiency of $311,453, for which Mr. Spatz is personally liable for $136,614 of the deficiency under the terms of his notes. Additionally, on April 29, 2003, the principal and accrued interest on the notes due from Tracy W. Parks, our former Chief Operating Officer, was $117,042 and the collateral had a market value of $82,197, resulting in a deficiency of $34,845, for which he is personally liable under the terms of his notes. In conjunction with the foreclosures as discussed above, we recorded income of approximately $708,000 to adjust the valuation allowance established as of February 1, 2003 as a result of the increase in the market value of our common stock on April 29, 2003 as compared to February 1, 2003. In August 2003, we received payment in full from Mr. Parks to repay the outstanding principal balance of his note plus interest. Based on Mr. Spatz's current financial condition, we have elected, at this time, to forbear our collection efforts regarding the amount for which he is personally liable. The outstanding amount of $136,614 plus accrued interest was fully reserved as of January 31, 2004. 15. WARRANTS AND STOCK OPTIONS At January 31, 2004, warrants to purchase 270,190 common shares were outstanding. These warrants have an exercise prices in the range of $3.50 to $19.91 (weighted average exercise price of $9.56) and expire on various dates between May 2005 and August 2006. We have a stock option plan, the Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan (the "Plan") that provides for the granting of incentive or nonqualified stock options. Under the Plan, we may grant up to 3,157,980 options. The options are issued at fair market value with exercise prices equal to our stock price on 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 the date of grant. F-27 Our Board of Directors has granted stock options to members of the Board and to our management. A summary of our stock option activity and related information is as follows:
Number of Weighted average options exercise price ------------- --------------- Balance at February 3, 2001 1,285,432 $ 15.52 Granted 238,323 20.64 Exercised (66,456) 7.90 Canceled (41,141) 24.38 -------------- -------- Balance at February 2, 2002 1,416,158 16.49 Granted 807,556 5.34 Exercised (124,764) 7.36 Canceled (375,546) 20.09 -------------- --------- Balance at February 1, 2003 1,723,404 11.14 Granted 662,720 3.76 Exercised - - Canceled (871,744) 10.64 -------------- --------- Balance at January 31, 2004 1,514,380 $ 8.19 Exercisable at January 31, 2004 478,319 $ 13.56
The following table summarizes information about the stock options outstanding at January 31, 2004:
Weighted - average Weighted- Weighted- Number of contractual average Number of average Range of options life exercise options exercise exercise prices outstanding (Years) price exercisable price - --------------------------------------------------------------------------------------- $0.00 - $4.23 725,156 6.9 $ 2.52 184,723 $ 2.11 $4.23 - $8.45 339,670 9.6 4.26 - - $8.45 - $12.68 79,404 5.1 12.10 62,046 12.10 $12.68 - $16.90 133,410 6.7 14.76 69,432 14.98 $16.90 - $21.13 47,260 7.1 20.62 24,004 20.38 $21.13 - $25.35 56,660 6.3 24.88 33,296 24.84 $25.35 - $29.58 103,887 5.8 26.55 83,459 26.39 $29.58 - $33.80 7,933 6.7 32.43 5,559 32.31 $33.80 - $38.03 14,500 5.5 37.55 10,500 37.55 $38.03 - $42.25 6,500 3.9 40.22 5,300 40.64 ------------------------------------------------------------ 1,514,380 7.3 $ 8.19 478,319 $ 13.56 -------------------------------------------------------------
In fiscal 2001, we recorded non-cash stock-based compensation expense of $456,000 as a result of the removal of the market price hurdle of 19,361 stock options held by former Executive Vice President who retired in August 2001. In fiscal 2003 and 2002, there was no event related to our stock options triggered by the market price hurdle; and therefore, we did not record any non-cash stock-based compensation expense. F-28 16. EMPLOYEE BENEFITS We sponsor 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. We make 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. We contributed approximately $184,000, $238,000 and $232,000 in fiscal 2003, 2002 and 2001, respectively. We also sponsor the Factory 2-U Stores, Inc. Employee Stock Purchase Plan (the "ESPP") which allows eligible employees to acquire shares of our Common Stock at a discount from market price, at periodic intervals, paid for with accumulated payroll deductions. The discount is 15% of the lower of the market price per share as quoted on the NASDAQ National Market on the first and last day of an offering period. The ESPP will terminate when all 350,000 shares available for issuance are sold although the ESPP may be terminated earlier by us at any time. At December 31, 2003 the ESPP was temporarily suspended. As of January 31, 2004, eligible employees had purchased 86,898 shares of our common stock under the ESPP. 17. LEGAL MATTERS, COMMITMENTS AND CONTINGENCIES On January 13, 2004, we filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. We retain control of our assets and are authorized to operate the business as a debtor-in-possession while being subject to the jurisdiction of the Court. As of the Petition Date, most pending litigation is stayed, and absent further order of the Court, substantially all pre-petition liabilitities are subject to settlement under a plan of reorganization. At this time, it is not possible to predict the outcome of the Chapter 11 case or its effect on our business. If it is determined that the liabilities subject to compromise in the Chapter 11 case exceed the fair value of the assets, unsecured claims may be satisfied at less than 100% of their fair value and the equity interests of our shareholders may have no value. See Item 1. Business Proceedings Under Chapter 11 of the Bankruptcy Code. On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No. RCV071918, in the Superior Court of the State of California for the County of San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False Advertising." The thrust of plaintiffs' claim is that the Company failed to pay wages and overtime for all hours worked, failed to document all hours worked, and failed to inform prospective or new employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of the California stores at anytime after April 25, 2003. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided adversely, the potential exposure could be material to our results of operations. F-29 In November 2003, Virginia Camarena, a current employee in one of our California stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior Court of the State of California for the County of Los Angeles - Central District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the California Wage Orders, California Labor Code, California Business and Profession Code and the Federal Fair Labor Standards Act by failing to pay her wages and overtime for all hours worked, by failing to provide her with statements showing the proper amount of hours worked, and by wrongfully converting her property by failing to pay overtime wages owed on the next payday after they were earned. The plaintiff purports to bring this as an action on behalf of all persons who were employed in one of our California stores or outside the state of California. Plaintiffs seek compensatory, punitive and liquidated damages, restitution, interest, penalties and attorneys' fees. In December 2003, we filed an answer to the complaint and removed the Camarena Lawsuit to the United States District Court for the Central District of California, Case No. CV-03-8880 RGK (SHx), where it is currently pending. Although at this stage of the litigation it is difficult to predict the outcome of the case with certainty, we believe that we have meritorious defenses to the Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject to the entry of an order by the Court lifting the automatic stay. In the event the Court enters an order lifting the automatic stay, we will continue to vigorously defend against the Camarena Lawsuit. There are numerous other matters filed with the Court in our reorganization proceedings by creditors, landlords or other third parties related to our business operations or the conduct of our reorganization activities. Although none of these individual matters which have been filed to date have had or are expected to have a material adverse effect on us, our ability to successfully manage the reorganization process and develop an acceptable reorganization plan could be negatively impacted by adverse determinations by the Court on certain of these matters. We are at all times subject to pending and threatened legal actions that arise in the normal course of business. 18. RELATED PARTY TRANSACTIONS In March 1997, we entered into an agreement with Three Cities Research, Inc. ("TCR") engaging TCR to act as financial advisor to us. Under this agreement, we paid TCR an annual fee of $50,000 and reimburse TCR for all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. As of January 31, 2004, we no longer engage TCR as our financial advisors. We reimbursed TCR for out-of-pocket expenses in the approximate amounts of $46,000, $47,000 and $34,000 during fiscal 2003, 2002 and 2001, respectively. In addition, we paid legal fees in the amount of $24,000 to TCR in connection with our private equity placements during fiscal 2003. As of January 31, 2004, TCR did not own any of our outstanding common stock, however a principal of TCR is still a member of our Board of Directors. On November 4, 2002, with the approval of the Board of Directors, we appointed Ronald Rashkow to a newly-created position as the Lead Director to our Board for three years. In connection with his Lead Director duties, we granted 50,000 options at an exercise price of $1.68 per share, the fair market value of our common stock on the date of grant. These options are fully vested and are exercisable for five years from the date of grant. We also issued 25,000 shares of restricted common shares to Mr. Rashkow at a price of $0.01 per share. These options vested on November 4, 2003, after his completion of 12 months of service as Lead Director. In addition to this equity compensation, we are also required to pay Mr. Rashkow a monthly fee of $12,500 plus reimbursement of all reasonable out-of-pocket expenses. F-30 On March 6, 2003, two individual investment entities controlled by TCR, Three Cities Offshore II, C.V. and Three Cities Fund II, L.P., participated in our private offering transaction and acquired 407,207 shares and 240,793 shares of our common stock, respectively, at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000. Mr. Rashkow, our Lead Director, also participated in this private offering transaction and acquired 72,700 shares of our common stock at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925. Including these 72,700 shares, Mr. Rashkow's total current direct and indirect ownership of our outstanding common stock is approximately 1.8%. 19. SUBSEQUENT EVENT On February 2, 2004, the Court authorized the closure of 44 stores. On February 11, 2004, the Court approved the agreement between the Great American Group ("Great American") and us in which Great American acts as an exclusive agent to conduct store closing sales at the 44 stores location. The store closing sales started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total of 13 leases with these stores and rejected the remaining 31 leases. Under the terms of the agreement with Great American, we receive a percentage of the aggregate retail price of the merchandise at the 44 stores as of February 11, 2004, as defined. In addition, we receive reimbursement of sale expenses, as defined, incurred during the store closing sales. Sales proceeds, net of sales tax, received during the store closing sales goes to Great American. As of April 23, 2004, we have received $3.4 million as partial payment for the sale of inventory to Great American. In addition, we have received approximately $1.5 million sale expenses reimbursement. These amounts are subject to final agreed upon reconciliation. 20. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The results of operations for fiscal 2003 and 2002 were as follows:
(in thousands, except per share data) ------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------------- --------------- ------------- -------------- Fiscal 2003 - ----------- Net sales $ 104,347 $ 123,659 $ 121,925 $ 143,367 Gross profit 37,635 38,569 41,656 35,369 Operating loss (3,758) (7,762) (3,923) (10,940) Net loss (2,721) (5,390) (3,008) (74,740) Loss per share basic & diluted $ (0.19) $ (0.35) $ (0.17) $ (4.23) Fiscal 2002 - ----------- Net sales $ 116,951 $ 128,088 $ 134,506 $ 155,725 Gross profit 41,158 41,029 44,652 35,546 Operating loss (4,977) (9,418) (4,771) (25,884) Net loss (3,141) (5,837) (3,516) (16,015) Loss per share basic & diluted $ (0.24) $ (0.45) $ (0.27) $ (1.23)
As a result of rounding differences, total amounts disclosed in the Statements of Operations may not agree to the sum of the amounts disclosed above for the four quarters. F-31 EX-10 2 ex1022043004.txt SECOND AMENDMENT TO THE AMENDED AND RESTATED Exhibit 10.22 SECOND AMENDMENT TO AMENDED AND RESTATED FINANCING AGREEMENT This Second Amendment to Amended and Restated Financing Agreement ("Amendment") is entered into as of January 12, 2004, by and among FACTORY 2-U STORES, INC., a Delaware corporation ("Company"), THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation ("CITBC"), in its capacity as Agent for the Lenders under the Financing Agreement ("Agent"); CITBC in its capacity as the Tranche A Lender (together with any other Persons who may subsequently become a Tranche A Lender, the "Tranche A Lenders"); and GB RETAIL FUNDING, LLC, a Massachusetts limited liability company in its capacity as the Tranche B Lender (together with any other Persons who may subsequently become a Tranche B Lender, the "Tranche B Lenders" and together with the Tranche A Lenders, the "Lenders"). A. Agent, Company and Lenders have previously entered into that certain Amended and Restated Financing Agreement dated as of April 10, 2003 (as amended and restated by that certain First Amendment to Amended and Restated Financing Agreement dated as of December 22, 2003, the "Financing Agreement"), pursuant to which the Lenders have provided Company with certain loans and other financial accommodations. B. Company has requested that Agent and Lenders amend the Financing Agreement pursuant to the terms and subject to the conditions set forth in this Amendment. C. Agent and Lenders are willing to amend the Financing Agreement on the terms and subject to the conditions set forth in this Amendment. NOW THEREFORE, in consideration of the foregoing and the terms and conditions hereof, the parties do hereto agree as follows, effective as of the date set forth above: 1. Definitions. Terms used herein, unless otherwise defined herein, shall have the meanings set forth in the Financing Agreement. 2. Amendments to Financing Agreement. (a) Section 1 of the Financing Agreement is hereby amended by deleting the definition of "Overall Borrowing Base" in such Section in its entirety and replacing it with the following: "Overall Borrowing Base shall mean the Tranche A Borrowing Base." ---------------------- (b) Section 1 of the Financing Agreement is hereby amended by deleting the definition of "Overall Inventory Advance Percentage" in such Section without replacement. (c) Section 1 of the Financing Agreement is hereby amended by deleting the definition of "Tranche B Early Termination Fee" in such Section and replacing it with the following: "Tranche B Early Termination Fee" shall mean $75,000; provided, however, that Tranche B Lender agrees that it shall pay $25,000 in outstanding legal fees due to its counsel for services rendered through January 12, 2004; and provided further, however, that Tranche B Lender's agreement to pay such legal fees shall not relieve Borrower from the obligation under the Financing Agreement to pay Tranche B Lender's legal fees and expenses for services rendered from and after January 13, 2004. (d) Section 1 of the Financing Agreement is hereby amended by deleting the definition of "Tranche B Fees" in such Section without replacement. (e) Section 8.14 of the Financing Agreement is hereby amended by deleting all language after the word "termination" in the fourth line thereof. (f) Section 8.15 of the Financing Agreement is hereby amended by deleting the first sentence of such Section in its entirety and replacing with the following: "8.15 Notwithstanding anything to the contrary as may be contained in this Agreement or any of the other Loan Documents, the full unpaid balance of Tranche B Loan I shall be due and payable on or before January 12, 2004, and the Company and the Tranche A Lenders hereby agree that, so long as no Event of Default shall have occurred and be continuing or shall result therefrom, up to $4,000,000 of such amount shall be paid on or before such date by the Tranche A Lenders on behalf of the Company as a Revolving Loan." 3. Conditions Precedent. The effectiveness of the foregoing amendment shall be, and hereby is, subject to the fulfillment to Agent's satisfaction of the Conditions Precedent. The "Conditions Precedent" shall mean each of the following: (a) Receipt by Agent of this Amendment duly executed by each of the parties hereto; and (b) Receipt by Agent of that certain letter agreement by and among Tranche A Lender and Tranche B Lender, in form and substance satisfactory to Agent. 5. Miscellaneous. (a) Reference to and Effect on the Financing Agreement. (i) Except as specifically amended by this Amendment and the documents executed and delivered in connection herewith, the Financing Agreement shall remain in full force and effect and is hereby ratified and confirmed. (ii) The execution and delivery of this Amendment shall not, except as expressly provided herein, constitute a waiver of any provision of, or operate as a waiver of any right, power or remedy of Agent or any Lender under the Financing Agreement or any agreement or document executed in connection therewith. (iii) Upon the Conditions Precedent being satisfied, this Amendment shall be construed as one with the existing Financing Agreement, and the existing Financing Agreement shall, where the context requires, be read and construed throughout so as to incorporate this Amendment. (b) Headings. Section and subsection headings in this Amendment are included for convenience of reference only and shall not constitute a part of this Amendment for any other purpose or be given any substantive effect. (d) Counterparts. This Amendment may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one and the same instrument. (e) Governing Law. This Amendment shall be governed by and construed according to the laws of the State of California. [Remainder of page intentionally left blank.] IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. Company: FACTORY 2-U STORES, INC. By: /s/Norman G. Plotkin ------------------------------------ Name: Norman G. Plotkin ------------------------------------ Title: Chief Executive Officer ------------------------------------ Agent and Tranche A Lender: THE CIT GROUP/BUSINESS CREDIT, INC. By: /s/ Mike Richman ------------------------------------- Name: Mike Richman ------------------------------------- Title: Vice President ------------------------------------- Tranche B Lender: GB RETAIL FUNDING, LLC By:/s/ Larry Klaff ------------------------------------ Name: Larry Klaff ------------------------------------- Title: Managing Director ------------------------------------- EX-10 3 ex1023043004.txt FIRST AMENDMENT TO THE AMENDED AND RESTATED Exhibit 10.23 FIRST AMENDMENT TO SECOND AMENDED AND RESTATED FINANCING AGREEMENT This First Amendment to Second Amended and Restated Financing Agreement ("Amendment") is entered into as of January 30, 2004, by and among FACTORY 2-U STORES, INC., a Delaware corporation, the debtor and debtor in possession in the Bankruptcy Case ("Company"), THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation ("CITBC"), in its capacity as Agent for Lenders under the Financing Agreement ("Agent"); CITBC in its capacity as Tranche A Lender (together with any other Persons who may subsequently become a Tranche A Lender, "Tranche A Lenders"); and GB RETAIL FUNDING, LLC, a Massachusetts limited liability company in its capacity as Tranche B Lender (together with any other Persons who may subsequently become a Tranche B Lender, "Tranche B Lenders" and together with the Tranche A Lenders, "Lenders"). A. Agent, Company and Lenders have previously entered into that certain Second Amended and Restated Financing Agreement dated as of January 12, 2004 (the "Financing Agreement"), pursuant to which Lenders have provided Company with certain loans and other financial accommodations. B. Company has requested that Agent and Lenders amend the Financing Agreement pursuant to the terms and subject to the conditions set forth in this Amendment. C. Agent and Lenders are willing to amend the Financing Agreement on the terms and subject to the conditions set forth in this Amendment. NOW THEREFORE, in consideration of the foregoing and the terms and conditions hereof, the parties do hereto agree as follows, effective as of the date set forth above: 1. Definitions. Terms used herein, unless otherwise defined herein, shall have the meanings set forth in the Financing Agreement. 2. Amendments to Financing Agreement. (a) Section 1 of the Financing Agreement is hereby amended by adding the following definition in such Section: "Springing Junior Liens shall have the meaning given to such term in the Final Financing Order." (b) Section 1 of the Financing Agreement is hereby amended by deleting each of the following definitions in such Section in each of their entirety and replacing such definition in such Section with the following: "Permitted Encumbrances shall mean: (a) liens existing on the date hereof on specific items of Equipment and listed on Schedule 1 hereto and other liens expressly permitted, or consented to, by the Agent; (b) Permitted Purchase Money Liens; (c) Customarily Permitted Liens; (d) liens created in connection with sale leasebacks or loans secured by the Company's equipment to the extent that such transactions constitute Permitted Indebtedness hereunder; (e) liens granted the Agent by the Company; (f) liens of judgment creditors provided such liens do not exceed, in the aggregate, at any time, Two Hundred Thousand Dollars ($200,000) (other than liens bonded or insured to the reasonable satisfaction of the Agent); (g) Springing Junior Liens; (h) liens for taxes not yet due and payable or which are being diligently contested in good faith by the Company by appropriate proceedings for which the Company has posted a bond in the required amount or otherwise has taken action necessary to stay enforcement of such lien. In no event shall any Collateral be subject to foreclosure proceedings or, in the Agent's discretion, subject to any loss of perfection or priority in favor of the Agent and/or the Lenders; and (i) liens to secure indebtedness that would (1) result in the indefeasible and permanent satisfaction of the Obligations in full in cash, and (2) being effective, arising and existing only upon such indefeasible and permanent satisfaction of the Obligations in full in cash." "Permitted Indebtedness shall mean (a) current indebtedness maturing in less than one (1) year and incurred in the ordinary course of business for raw materials, supplies, equipment, services, taxes or labor; (b) the indebtedness secured by the Permitted Purchase Money Liens; (c) indebtedness arising under the Letters of Credit, this Financing Agreement, and the Loan Documents; (d) deferred taxes and other expenses incurred in the ordinary course of business; (e) Subordinated Debt, if unsecured and subject to a subordination agreement in form and substance satisfactory to the Agent; (f) indebtedness arising from sale leaseback transactions or loans secured by the Company's equipment, but only if (i) the Company gives prior written notice to the Agent of each such transaction, (ii) an Event of Default has not occurred and is continuing at the time any such transaction is entered into, (iii) such indebtedness does not exceed the cost of the Company's equipment being given as collateral for such indebtedness, (iv) the transaction does not involve the Company's intangible assets (including, but not limited to, trademarks, trade names and trade styles), and (v) the net cash proceeds from such sale/leaseback or loan transaction shall be paid to the Agent for distribution to the Lenders to the extent required under Section 8.15 of the Financing Agreement; (g) other indebtedness existing on the Petition Date or otherwise disclosed to the Agent in writing; (h) indebtedness secured by liens on real estate acquired after the date of the Prior Agreement, provided that (i) each such lien shall attach only to the real estate acquired, (ii) the aggregate amount of such real estate debt shall not, at any time, exceed Ten Million Dollars ($10,000,000), (iii) the Company shall give the Agent prior written notice before incurring any such real estate indebtedness, and (iv) no Event of Default shall have occurred and be continuing at the time the Company incurs any such indebtedness; (i) all indebtedness secured by a Permitted Encumbrance; and (j) indebtedness that would (1) result in the indefeasible and permanent satisfaction of the Obligations in full in cash, and (2) being effective, arising and existing only upon such indefeasible and permanent satisfaction of the Obligations in full in cash." (c) 7.21(i) of the Financing Agreement is hereby amended by deleting such Section in its entirety and replacing such Section with the following: "(i) as of the Petition Date the Prepetition Obligations were due and outstanding pursuant to the Prepetition Loan Documents in the principal amount of not more than $17,000,000 in the aggregate, all of which Prepetition Obligations are unconditionally owing by the Company to the Prepetition Lender Parties, without offset, defense or counterclaim of any kind nature and description whatsoever;" (d) Section 10.1(o) of the Financing Agreement is hereby amended by deleting such Section in its entirety and replacing such Section with the following: "(o) any challenge by the Company or any guarantor of the Obligation to the validity of any Loan Document or the applicability or enforceability of any Loan Document strictly in accordance with the subject Loan Document's terms or which seeks to void, avoid, limit, or otherwise adversely affect any security interest created by or in any Loan Document or any payment made pursuant thereto;" (e) Section 10.1(r)(1) of the Financing Agreement is hereby amended by deleting such Section in its entirety and replacing such Section with the following: "(1) authorizing the Company in the Bankruptcy Case to obtain additional financing under section 364(c) or (d) of the Bankruptcy Code unless such relief shall result in the Obligations owed to Lenders being indefeasibly satisfied in full;" (f) Section 10.1(r)(3) of the Financing Agreement is hereby amended by deleting such Section in its entirety and replacing such Section with the following: "(1) authorizing the use of cash collateral without each Lender's prior written consent under section 363(c) of the Bankruptcy Code unless such relief shall result in the Obligations owed to Lenders being indefeasibly satisfied in full (except as provided in the Interim Financing Order or the Final Financing Order);" 3. Conditions Precedent. The effectiveness of this Amendment shall be, and hereby is, subject to the fulfillment to Agent's satisfaction of the Conditions Precedent. The "Conditions Precedent" shall mean each of the following: (a) No objection to this Amendment is filed or served pursuant to Section 1.3.3 of the Interim Financing Order or the Final Financing Order; and (b) As of the date hereof, the representations and warranties contained in Section 7 of the Financing Agreement are (before and after giving effect to this Amendment) true and correct in all material respects (except to the extent any such representation and warranty is expressly stated to have been made as of a specific date, in which case it shall be true and correct as of such specific date) and no Default or Event of Default shall be existing or have occurred and be continuing. 5. Miscellaneous. (a) Reference to and Effect on the Financing Agreement. (i) Except as specifically amended by this Amendment and the documents executed and delivered in connection herewith, the Financing Agreement shall remain in full force and effect and is hereby ratified and confirmed. (ii) The execution and delivery of this Amendment shall not, except as expressly provided herein, constitute a waiver of any provision of, or operate as a waiver of any right, power or remedy of Agent or any Lender under the Financing Agreement or any agreement or document executed in connection therewith. (iii) Upon the Conditions Precedent being satisfied, this Amendment shall be construed as one with the existing Financing Agreement, and the existing Financing Agreement shall, where the context requires, be read and construed throughout so as to incorporate this Amendment. (b) Fees and Expenses. Company acknowledges that all costs, fees and expenses incurred in connection with this Amendment will be paid in accordance with Section 8.5 of the Financing Agreement and the Final Financing Order. (c) Headings. Section and subsection headings in this Amendment are included for convenience of reference only and shall not constitute a part of this Amendment for any other purpose or be given any substantive effect. (d) Counterparts. This Amendment may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one and the same instrument. (e) Governing Law. This Amendment shall be governed by and construed according to the laws of the State of California. IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. Company: -------- FACTORY 2-U STORES, INC. By:/s/Norman G. Plotkin ------------------------------------------------- Name:Norman G. Plotkin ------------------------------------------------- Title: Chief Executive Officer ------------------------------------------------- Agent and Tranche A Lender: THE CIT GROUP/BUSINESS CREDIT, INC. By: /s/Mike Richman -------------------------------------------------- Name: Mike Richman -------------------------------------------------- Title: Vice President -------------------------------------------------- Tranche B Lender: GB RETAIL FUNDING, LLC By:/s/Larry Klaff ---------------------------------------------------- Name: Larry Klaff ---------------------------------------------------- Title: Managing Director -------------------------------------------------- EX-10 4 ex1024043004.txt AGENCY AGREEMENT FILED ON 043004 Exhibit 10.24 AGENCY AGREEMENT This Agency Agreement is made as of this 10th day of February, 2004, by and between Garcel, Inc. d/b/a The Great American Group, a California corporation, with a principal place of business at 6330 Variel Avenue, Woodland Hills, California 91367 (the "Agent") and Factory 2-U Stores, Inc., a Delaware corporation with a principal place of business at 4000 Ruffin Road, San Diego, CA 92123 (the "Merchant"). RECITALS WHEREAS, the Merchant is a debtor and debtor-in-possession under Chapter 11 of the United States Bankruptcy Code, 11 U.S.C. Sections 101-1330 (the "Bankruptcy Code"), pursuant to Chapter 11 Case No. 04-10111 (PJW), filed with the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") on January 13, 2004 (the "Petition Date"), and WHEREAS, Merchant desires that Agent act as Merchant's exclusive agent for the limited purpose of selling all of the Merchandise (as hereinafter defined) located in Merchant's forty-four (44) retail store location(s) (each individually a "Store," and collectively the "Stores") set forth on Exhibit "A" attached hereto and made a part hereof, by means of a store closing, going out of business or similar theme sale at the Stores (as further described below, the "Sale"). NOW THEREFORE, in consideration of the mutual covenants and agreements set forth herein, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, Agent and Merchant hereby agree as follows: Section 1. Defined Terms. The terms set forth below are defined in the Sections referenced of this Agreement: Defined Term Section Reference Agency Accounts Section 7.2 Agency Documents Section 11.1(b) Agent Preamble Agent Claim Section 12.5 Agent Indemnified Parties Section 13.1 Approval Order Section 2 Bankruptcy Code Recitals Bankruptcy Court Recitals Benefits Cap Section 4.1 Central Service Expenses Section 4.1 Clearance Merchandise Section 5.2(b) Defective Merchandise Section 5.2(b) Excluded Benefits Section 4.1 FF&E Section 5.2(a) Guaranteed Amount Section 3.1(a) Gross Rings Section 6.3 Inventory Date Section 5.1 Inventory Taking Section 5.1 Layaway, Repair and Special Order Merchandise Section 5.2(b) Letter of Credit Section 3.4 Merchandise Section 5.2(a) Merchant Preamble Merchant Consignment Goods Section 5.4 Occupancy Expenses Section 4.1 On-Order Merchandise Section 5.2(b) Out of Season Merchandise Section 5.2(b) Proceeds Section 7.1 Petition Date Recitals Retail Price Section 5.3 Retained Employee Section 9.1 Retention Bonus Section 9.4 Returned Merchandise Section 8.5 Sale Recitals Sale Expenses Section 4.1 Sale Commencement Date Section 6.1 Sale Guidelines Section 2 Sale Term Section 6.1 Sale Termination Date Section 6.1 Sales Taxes Section 8.3 Store(s) Recitals Supplies Section 8.4 WARN Act Section 9.1 Section 2. Appointment of Agent; Bankruptcy Court Approval. The Merchant hereby appoints the Agent, and the Agent hereby agrees to serve, as the Merchant's exclusive agent for the limited purpose of conducting the Sale in accordance with the terms and conditions of this Agreement. Merchant's and Agent's obligations hereunder are subject to approval of the Bankruptcy Court and shall be of no force and effect in the event that it is not so approved. As soon as practicable after Merchant's execution of this Agreement, Merchant shall obtain an order of the Bankruptcy Court approving this Agreement in its entirety (the "Approval Order"). The Approval Order shall be in a form satisfactory to the Agent. Attached hereto as Exhibit "B" are Sale Guidelines setting forth the Agent's conduct at the Sale (the "Sale Guidelines"). Section 3. Payments to Merchant and Agent. 3.1 Payments to Merchant. (a) (i) As a guaranty of Agent's performance hereunder, Merchant shall receive from Agent the sum of 45.55% of the aggregate Retail Price of the Merchandise, less any credits provided for Returned Merchandise under Section 8.5 hereof ("Guaranteed Amount"), plus the payment of all Sale Expenses. (ii) Agent shall pay to Merchant the Guaranteed Amount in the manner and at the times specified in Section 3.3 below. The Guaranteed Amount will be calculated based upon (A) the final report of the Merchandise by the inventory taking service after verification thereof by Agent and Merchant, and (B) the aggregate amount of Gross Rings (as defined herein), adjusted for shrinkage as provided in Section 6.3 hereof. (iii) The Guaranteed Amount has been calculated and agreed upon based upon Merchant's representation that the aggregate Retail Price (as defined in section 5.3 hereof) of the Merchandise as of the Sale Commencement Date (as defined herein) will not be less than $12 million (the "Merchandise Threshold"), that all such Merchandise will conform to Merchant's representations and warranties contained herein, and that no material representations, warranties or covenants of Merchant hereunder have been or shall be breached. Merchant and Agent agree that in the event that the final report of the inventory taking service indicates that the aggregate Retail Price of the Merchandise is less than the Merchandise Threshold, then the Guaranteed Amount shall be reduced pro rata as follows: for every $100,000 of Merchandise or pro rata portion thereof (at Retail Price) by which the aggregate Retail Price of the Merchandise falls below the Merchandise Threshold, the Guaranteed Amount shall be reduced by two-tenths of one percent (.2%) or pro rata portion thereof; provided, however, in no event shall the aggregate Retail Price of the Merchandise be less than $9 million. 3.2 Payments to Agent. Agent shall receive as its compensation for services rendered to Merchant all remaining Proceeds (as defined herein) of the Sale after payment of (i) the Guaranteed Amount, and (ii) all Sale Expenses (as defined herein). Provided all payments are made to Merchant as required hereunder, all Merchandise remaining, if any, at the Sale Termination Date shall become the property of Agent, free and clear of all liens, claims and encumbrances, provided that Agent shall use its best efforts to sell any such remaining Merchandise in a commercially reasonable manner and any proceeds generated from the sale of such remaining Merchandise shall be considered Proceeds under this Agreement. 3.3 Time of Payments. The Agent shall pay to Merchant via wire transfer eighty percent (80%) of the estimated Guaranteed Amount attributable to Merchandise in the Stores as of the Sale Commencement Date within one business day after issuance of the Approval Order, which amount shall be calculated based upon the net book value of such Merchandise as of such date as set forth in Merchant's books and records. Thereafter, on the earlier of (i) one (1) business day after the reconciliation by Merchant and Agent of the final inventory report by the inventory taking service, and (ii) thirty (30) days after the Sale Commencement Date, Agent shall pay to Merchant via wire transfer the unpaid balance of the Guaranteed Amount or, to the extent that Agent's payment on account of the estimated Guaranteed Amount exceeds the actual Guaranteed Amount, Merchant shall reimburse such excess to Agent; provided, however, that the Inventory Taking shall be reconciled within seven (7) days after its completion (and the Agent and Merchant shall use their reasonable best efforts to accomplish such reconciliation); provided further however, that in the event of a dispute with respect to the final inventory report, Agent shall pay that portion of the unpaid balance of the Guaranteed Amount not in dispute. All payments by Merchant to Agent hereunder shall be made by wire transfer of immediately available funds. Merchant agrees that any amounts due by Agent to Merchant pursuant to this Section 3 may in Agent's discretion be offset by the amount of Proceeds collected by Merchant for Agent's account (if any) which have not, as of the applicable date, been transferred by Merchant to Agent in accordance with Sections 7.2 and 7.3 hereof. 3.4 Security. To secure Agent's obligations to pay Expenses, Agent shall deliver to Merchant an irrevocable standby letter of credit in the original face amount equal to four (4) weeks estimated Expenses, naming Merchant as beneficiary, substantially in the form of Exhibit 3.4 attached hereto (the "Letter of Credit"). The Letter of Credit shall be delivered no later than one (1) business day following the Sale Commencement Date, shall be issued by a bank selected by Agent and reasonably acceptable to Agent and Merchant. In the event that Agent shall fail to pay any Expenses, Merchant shall be entitled to draw on the Letter of Credit to fund such amount following five (5) days written notice to Agent of Merchant's intention to do so, provided that no material default or Event of Default has then occurred on the part of the Merchant hereunder. The Letter of Credit shall expire on May 31, 2004, provided that in the event that Agent shall have paid all Expenses prior to such date, Merchant agrees to surrender the original Letter of Credit to the issuer thereof together with written notification that the Letter of Credit may be terminated; and provide further, in the event there remain outstanding or unpaid Expenses as of such date, Agent shall cause the term of the Letter of Credit to be extended for a period mutually acceptable to Merchant and Agent. Section 4. Expenses of the Sale. 4.1 Expenses. Agent shall be responsible for all Sale Expenses incurred in conducting the Sale. As used herein, "Sale Expenses" shall mean Store-level operating expenses of the Sale which arise during the Sale Term at the Stores limited to the following: (a) base payroll for Retained Employees for actual days/hours worked in the conduct of the Sale; (b) amounts actually payable in respect of FICA, unemployment taxes, worker's compensation and health care insurance benefits for Retained Employees, in an amount not to exceed 27% of base payroll for each Retained Employee (the "Benefits Cap"); (c) 50% of the fees and costs of the inventory taking service to conduct the Inventory Taking; (d) Agent's supervision fees, expenses, and bonuses; (e) advertising and signage expenses (at Merchant's contract rates, if available, and excluding any allocation of Agent's overhead); (f) telephone expenses, including tie lines, monthly access charges and local and long distance telephone expenses incurred in the conduct of the Sale; (g) utilities at the Stores, including but not limited to gas, electric, water and sewer charges; (h) credit card and bank card fees, chargebacks and discounts, and check guaranty fees, including bank service charges; (i) costs of security personnel/loss prevention in the Stores and armored car services; (j) a pro-rata portion of Merchant's insurance premiums attributable to the Merchandise and a pro-rata portion of comprehensive public liability insurance attributable to the Stores; (k) all costs of transfers of Merchandise, including transfers of Merchandise from the Warehouse, during the Sale Term; (l) Retention Bonuses as described in Section 9.4 below; (m) Occupancy Expenses, limited on a per diem per Store basis and limited to those amounts and categories as described in Exhibit 4.1 attached hereto; (n) housekeeping and cleaning expenses at the Stores during the Sale Term, and expenses to leave the Stores in "broom clean condition" pursuant to section 6.2 hereof; (o) Cash overage, cash shortages and theft; (p) Store trash removal; (q) Agent's cost of capital and letter of credit expenses; (r) Intentionally omitted (s) Cost of additional supplies; (t) Bad checks; (u) the costs and expenses of providing such additional goods and services which the Agent deems appropriate and to which Merchant shall consent; (v) costs of any music contracts for the Stores; (w) postage, courier and overnight mail charges to and from or among the Stores and central office (solely to the extent relating to the Sales) or otherwise relating to the Sale; (x) Central Service Expenses equal to $3,000 per week during the Sale Term; and (y) Agent and/or employee travel in connection with the Sale (including supervisor travel during the Sale); provided, however, that supervisor travel to and from a Store at the commencement and/or conclusion of the Sale shall be excluded from Sale Expenses. "Sale Expenses" shall not include: (i) Excluded Benefits; (ii) Occupancy Expenses in excess of the amount referred to above; (iii) Central Service Expenses in excess of the amount referred to above; and (iv) any other costs, expenses or liabilities payable by Merchant, all of which shall be paid by Merchant promptly when due for and during the Sale Term. As used herein, the following terms have the following respective meanings: "Central Service Expenses" means costs and expenses for Merchant's central administrative services necessary for the Sale, including, but not limited to, MIS and POS services, payroll processing, cash reconciliation, inventory processing and handling, and data processing and reporting. "Excluded Benefits" means vacation days or vacation pay, sick days or sick leave, maternity leave or other leaves of absence, Warn Act termination or severance pay, pension benefits, ERISA coverage and similar contributions, and payroll taxes, worker's compensation and health insurance benefits in excess of the Benefits Cap. "Occupancy Expenses" means Merchant's actually incurred Store-level expenses limited to those per diem per Store amounts set forth on Exhibit 4.1. 4.2 Payment of Sale Expenses. All Sale Expenses incurred during each week of the Sale (i.e. Sunday through Saturday) shall be paid by Agent to or on behalf of Merchant, or offset from Proceeds held by Merchant, immediately following the weekly Sale reconciliation by Merchant and Agent pursuant to Section 8.7 below, based upon invoices and other documentation reasonably satisfactory to Agent. Section 5. Inventory Valuation; Merchandise. 5.1 Inventory Taking. Merchant and Agent shall cause to be taken a Retail Price physical inventory and SKU inventory of the Merchandise (the "Inventory Taking") commencing at the close of business at each of the Stores on a date mutually agreed upon by Agent and Merchant, but in no event later than two (2) days after entry of the Approval Order (the date of the Inventory Taking at each Store being the "Inventory Date" for such Store). Merchant and Agent shall jointly employ Washington Inventory Service and/or another mutually acceptable inventory taking service to conduct the Inventory Taking. Agent shall be responsible for 50% of the costs and fees of the inventory taking service as an Expense hereunder, and the balance of such costs and fees shall be paid by Merchant. Except as provided in the immediately preceding sentence, Merchant and Agent shall bear their respective costs and expenses relative to the Inventory Taking. Merchant and Agent shall each have representatives present during the Inventory Taking, and shall each have the right to review and verify the listing and tabulation of the inventory taking service. Merchant agrees that during the conduct of the Inventory Taking at each Store such Store shall be closed to the public and no sales or other transactions shall be conducted. The procedures to be used in the conduct of the Inventory Taking and its verifications are set forth on Exhibit 5.1 to be mutually agreed upon and attached hereto. In order to facilitate the Inventory Taking, Merchant agrees to make its SKU data files, including retail, UPC to SKU cross-reference, and merchandising rollup data, and related computer hardware and software available to Agent and the inventory taking service commencing prior to the Inventory Date. 5.2 Merchandise Subject to this Agreement. (a) For purposes of this Agreement, "Merchandise" shall mean: (i) all finished goods inventory of first quality, consistent with Merchant's past practices, that is owned by Merchant and located at the Stores as of the Sale Commencement Date, including: (A) Defective Merchandise; (B) clearance merchandise, (C) Out of Season Merchandise, and (D) Merchandise subject to Gross Rings, as adjusted for shrinkage as provided in Section 6.3 hereof. Notwithstanding the foregoing, "Merchandise" shall not include: (1) goods which belong to sublessees, licensees or concessionaires of Merchant; (2) goods held by Merchant on memo, on consignment, or as bailee; (3) Layaway, Repair and Special Order Merchandise; (4) Defective Merchandise for which Merchant and Agent cannot agree upon a Retail Price; (5) equipment, furnishings, trade fixtures (the "FF&E") and improvements to real property which are located in the Stores; and (6) Merchant Consignment Goods; (b) As used in this Agreement, the following terms have the respective meanings set forth below: "Defective Merchandise" means Merchandise that is damaged, defective or otherwise not salable at Merchant's full retail in the ordinary course because it or its packaging is damaged, dented, ripped, soiled, worn, scratched, broken, faded, torn, mismatched, or affected with defects rendering it not first quality. Defective Merchandise shall not include Merchandise that has minor dents in product packaging that do not affect the ability to sell the product contained inside the package. Sample Merchandise and Merchandise on display shall not per se be deemed to be Defective Merchandise. "Out of Season Merchandise" means items of Merchandise specifically relating to holidays falling outside the Sale Term (e.g., Christmas and Thanksgiving). "Layaway, Repair, and Special Order Merchandise" means all items of Merchandise held at the Stores on layaway or for repair, or customer-specific special orders, in each case pursuant to binding agreements, invoices or other legal documentation, where (A) the documentation is clear as to the name, address, telephone number, date of last payment and balance due from the customer, and (B) the goods subject to layaway are fully described in the documentation. "On-Order Merchandise" means merchandise currently ordered by Merchant but which has not been received in the Stores prior to the Sale Commencement Date. Nothing herein shall obligate Merchant to purchase or include any On-Order Merchandise in the Sale. 5.3 Valuation. For purposes of this Agreement, "Retail Price" shall mean for each item of Merchandise the lower of (a) the lowest ticketed price and (b) Merchant's PLU, file or scan price (the "Retail Price"), except for: (i) Out of Season Merchandise, where the Retail Price shall mean the lower of (x) the lowest ticketed price for such Merchandise and (y) the lowest price offered by Merchant for such Merchandise by POS promotion or otherwise at any time during the period 30 days prior to the Sale Commencement Date; (ii) Defective Merchandise, where the Retail Price shall mean such value as to which Agent and Merchant shall mutually agree; and (iii) Returned Merchandise where the Retail Price shall be determined in Section 8.5 hereof. In the event On-Order Merchandise is received in the Stores after the Sale Commencement Date but less than fourteen (14) days after the Commencement Date, the Retail Price shall be as set forth in this section. If the On-Order Merchandise is received after 14 days from the Sale Commencement Date, then the Retail Price shall mean the lower of (i) lowest ticketed price of such item as of the Sale Commencement Date and (ii) the lowest marked, SKU, or PLU file price for such item of Merchandise multiplied, in either the case of (i) or (ii), by the inverse of the prevailing discount in place on the date such On-Order Merchandise is received. Except in the case of Out of Season Merchandise, it is the intent of the parties that in determining the Retail Price of any item of Merchandise the parties shall exclude all temporary promotional activity, including, without limitation, point-of-sale discounting and temporary promoting or discounts advertised by any and all methods, and all Sales Taxes, and Merchant represents that the ticketed prices of items of Merchandise at the Stores do not and shall not include any Sales Taxes. If, at the time of the Inventory Taking, an item of Merchandise has more than one Retail Price, or if multiple items of the same SKU are marked at different prices, the lowest Retail Price on any such item shall prevail for such item or for all such items within the same SKU, as the case may be, unless it is clear that the Retail Price was mismarked. 5.4 Excluded Goods. Merchant shall retain all responsibility for any goods not included as "Merchandise" hereunder. If Merchant elects at the beginning of the Sale Term, Agent shall accept defective goods not included as "Merchandise" hereunder for sale as "Merchant Consignment Goods" at prices established by the Agent. The Agent shall retain 20% of the sale price for all sales of Merchant Consignment Goods, and Merchant shall receive 80% of the receipts in respect of such sales. Merchant shall receive its share of the receipts of sales of Merchant Consignment Goods on a weekly basis, immediately following the weekly Sale reconciliation by Merchant and Agent pursuant to Section 8.7 below. If Merchant does not elect to have Agent sell such goods not included as Merchandise, then all such items will be removed by Merchant from the Stores at its expense as soon as practicable after the date hereof. Except as expressly provided in this Section 5.4, Agent shall have no cost, expense or responsibility in connection with any goods not included in Merchandise. Section 6. Sale Term. 6.1 Term. Subject to satisfaction of the conditions precedent set forth in Section 10 hereof, the Sale shall commence at each Store on the date following issuance of the Approval Order by the Bankruptcy Court (such date with respect to each Store being the "Sale Commencement Date"). The Agent shall complete the Sale at each Store no later than March 31, 2004, unless the Sale is extended by mutual written agreement of Agent and Merchant (the "Sale Termination Date"), the period from the Sale Commencement Date to the Sale Termination Date as to each Store being the "Sale Term"). Notwithstanding the foregoing, the Agent may, in its discretion, terminate the Sale at any Store at any time within the Sale Term (i) upon the occurrence of an Event of Default by Merchant, or (ii) upon not less than seven (7) days' prior written notice to Merchant. 6.2 Vacating the Stores. Agent shall vacate the Stores on or before the Sale Termination Date, at which time Agent shall surrender and deliver the Store premises and Store keys to Merchant. Agent agrees to leave the Stores in "broom clean" condition, ordinary wear and tear excepted. All assets of Merchant used by Agent in the conduct of the Sale (e.g. FF&E, supplies, etc.) shall be returned by Agent to Merchant at the end of the Sale Term to the extent the same have not been used in the conduct of the Sale or have not been otherwise disposed of hereunder or through no fault of Agent by leaving such items in place at the Stores. 6.3 Gross Rings. In the event that the Sale commences prior to the completion of the Inventory Taking at any Store, then for the period from the Sale Commencement Date until the Inventory Date for such Store, Agent and Merchant shall jointly keep (i) a strict count of gross register receipts less applicable Sales Taxes ("Gross Rings"), and (ii) cash reports of sales within such Stores. Register receipts shall show for each item sold the Retail Price for such item and the markdown or discount, if any, specifically granted by Agent in connection with such Sale. All such records and reports shall be made available to Agent and Merchant during regular business hours upon reasonable notice. Agent shall pay that portion of the Guaranteed Amount calculated on the Gross Rings basis, to account for shrinkage, on the basis of 102% of the aggregate Retail Price of Merchandise sold during the Gross Rings period (without taking into account any point of sale discounts or point of sale markdowns taken by the Agent. Section 7. Sale Proceeds 7.1 Proceeds. For purposes of this Agreement, "Proceeds" shall mean the aggregate of: (a) the total amount (in United States dollars) of all sales of Merchandise made under this Agreement, exclusive of (i) Sales Taxes, and (ii) returns, allowances and customer credits; and (b) all proceeds of Merchant's insurance for loss or damage to Merchandise or loss of cash arising from events occurring during the Sale Term. Until 80% of the Guaranteed Amount is paid in full, Merchant shall retain the Proceeds of the Sale from the prior week (which amount shall be applied to the Guaranteed Amount). Following the payment in full of the Guaranteed Amount, Agent may, in its discretion, elect to control the Sale Proceeds in the manner provided below in this Section 7. 7.2 Deposit of Proceeds. Following payment of 80% of the Guaranteed Amount in full, all cash Proceeds shall be deposited in agency accounts established by Agent (the "Agency Accounts"). Agent may, in its discretion, designate new or existing accounts of Agent or Merchant as the Agency Accounts, provided that such accounts are dedicated solely to the deposit of Proceeds and the disbursement of amounts payable by Agent hereunder. Agent shall exercise sole signatory authority and control with respect to the Agency Accounts. Merchant shall promptly upon Agent's request execute and deliver all necessary documents to open and maintain the Agency Accounts. To the extent that following full payment of the Guaranteed Amount, Agent shall elect to use existing accounts of Merchant as the Agency Accounts, (i) commencing on the first business day following the Sale Commencement Date, and on each business day thereafter, Merchant shall pay to Agent by wire funds transfer all collected funds constituting Proceeds deposited in such accounts, and (ii) upon request, Merchant shall deliver to Agent copies of all bank statements and other information relating to such accounts. Merchant shall not be responsible for and Agent shall pay as an Expense hereunder, all bank fees and charges, including wire transfer charges, related to the Agency Accounts, whether received during or after the Sale Term. 7.3 Credit Card Proceeds. Agent shall have the right (but not the obligation) to use Merchant's credit card facilities (including Merchant's credit card terminals and processors, credit card processor coding, Merchant identification numbers and existing bank accounts) for credit card Proceeds. In the event that Agent elects so to use Merchant's credit card facilities, Merchant shall process credit card transactions on behalf of Agent and for Agent's account, applying customary practices and procedures. Without limiting the foregoing, Merchant shall cooperate with Agent to down-load data from all credit card terminals each day during the Sale Term and to effect settlement with Merchant's credit card processors, and shall take such other actions necessary to process credit card transactions on behalf of Agent under Merchant's Merchant identification numbers. Following payment in full of the Guaranteed Amount, all credit card Proceeds will constitute the property of the Agent and shall be held by Merchant in trust for Agent. Merchant shall deposit all credit card Proceeds into a designated account and shall transfer such Proceeds to Agent daily (on the date received by Merchant if received prior to 12:00 noon, or otherwise within one business day) by wire transfer of immediately available funds. At Agent's request, Merchant shall cooperate with Agent to establish Merchant identification numbers under Agent's name to enable Agent to process all credit card Proceeds for Agent's account. Merchant shall not be responsible for and Agent shall pay as an Expense hereunder, all credit card fees, charges, and chargebacks related to the Sale, whether received during or after the Sale Term. Merchant makes no representation that the credit card processors shall permit the use of Merchant's credit card facilities on the same terms and conditions as they did prior to the date hereof and Merchant shall not be obligated to assure the availability of such credit card facilities. Notwithstanding anything herein to the contrary, if Agent elects to use Merchant's credit card facilities during the Sale, Agent shall be required to make all arrangements necessary with Merchant's credit card processors regarding the establishment of reserves for credit cards sales during the Sale Term, and no funds of Merchant shall be used to establish any such reserves. Section 8. Conduct of the Sale. 8.1 Rights of Agent. Agent shall be permitted to, in its sole discretion, conduct the Sale, as a "store closing," or similar sale throughout the Sale Term, but not a "going out of business" sale. Agent shall conduct the Sale in the name of and on behalf of Merchant in a commercially reasonable manner and in compliance with the terms of this Agreement and the Sale Guidelines. In addition to any other rights granted to Agent hereunder, in conducting the Sale, Agent, in the exercise of its sole discretion, shall have the right (subject to compliance with the Sale Guidelines): (a) to establish and implement advertising and promotion programs consistent with a "store closing" theme sale, including hanging interior and exterior signs and banners, provided, however, that Agent shall deliver copies of all advertising materials for the Sale to Merchant, in addition to the notice required in Section 18.1 hereof, via facsimile to Merchant to the attention of Mel Redman at (858) 637-4180, who shall have the right, within one (1) business day of such delivery, to approve such materials (which approval shall not be unreasonably withheld or delayed); and provided further that the failure of the Merchant to reasonably respond to any request for approval within twenty-four (24) hours shall be deemed to be approval of the subject materials; (b) to establish Sale prices and Store hours which are consistent with the terms of applicable leases; (c) to use without charge during the Sale Term all FF&E, advertising materials, bank accounts (consistent with Section 7.2), Store-level customer lists and mailing lists, computer hardware and software, existing supplies located at the Stores, intangible assets (including Merchant's name, logo and tax identification numbers), Store keys, case keys, security codes, and safe and lock combinations required to gain access to and operate the Stores, and any other assets of Merchant located at the Stores or used in the ordinary course of business at the Stores (whether owned, leased, or licensed); (d) subject to applicable law, to transfer Merchandise between Stores; (e) subject to Agent's obligation to pay for Central Service Expenses as provided above, to use without charge during the Sale Term (i) Merchant `s central office facilities, central administrative services and personnel to process payroll, perform MIS and provide other central office services necessary for the Sale, provided that in no event shall Merchant be required to provide services in excess of those it historically provided to support sales in the Stores, and (ii) one (1) office located at Merchant's central office facility. 8.2 Terms of Sales to Customers. (a) All sales of Merchandise will be "final sales" and "as is," and all advertisements and sales receipts will reflect the same. Agent shall not warrant the Merchandise in any manner, but will, to the extent legally permissible, pass on all manufacturers' warranties to customers. Subject to Section 8.2(b) below, all sales will be made only for cash and by nationally recognized bank credit cards. (b) For the first twenty-eight(28) days of the Sale Term, Agent shall accept Merchant's gift certificates and cards issued by Merchant prior to the Sale Commencement Date. Merchant shall reimburse Agent in cash in the aggregate amount of any such gift certificates and cards during the weekly sale reconciliation provided for in Section 8.7 hereof. 8.3 Sales Taxes. During the Sale Term, all sales, excise, gross receipts and other taxes attributable to sales of Merchandise and Merchant Consignment Goods (other than taxes on income) payable to any taxing authority having jurisdiction (collectively, "Sales Taxes") shall be added to the sales price of Merchandise and Merchant Consignment Goods and collected by Agent at the time of sale. To the extent that Agent shall control the Sale Proceeds as provided in Section 7 above, the Agent shall, at such times and in such manner as directed by the Merchant, transfer immediately available funds from the Agency Accounts to the Merchant, the applicable taxing authorities or the applicable escrow account established by the Merchant's existing secured lender, as directed by the Merchant, in the amount so collected in respect of such taxes, together with the accompanying schedules, for payment of taxes when due. Merchant shall promptly pay all Sales Taxes and file all applicable reports and documents required by the applicable taxing authorities. Merchant will be given access to the computation of gross receipts for verification of all such tax collections. 8.4 Supplies. Agent shall have the right to use, without charge, all existing supplies located at the Stores including, without limitation, boxes, bags, paper, twine and similar sales materials (collectively, "Supplies"). In the event that additional Supplies are required in any of the Stores during the Sale, Merchant agrees to promptly provide the same to Agent, if available, for which Agent shall reimburse Merchant at Merchant's cost therefor. Merchant does not warrant that the existing Supplies in the Stores as of the Sale Commencement Date are adequate for the purposes of the Sale. Supplies shall not be prior to the Sale Commencement Date, transferred by Merchant between or among the Stores so as to alter the mix or quantity of Supplies at the Stores from that existing on such date, other than in the ordinary course of business. 8.5 Returns of Merchandise. During the first twenty eight (28) days of the Sale Term, Agent shall accept returns of Merchandise sold by Merchant prior to the Sale Commencement Date; provided that (i) such item was purchased within thirty (30) days prior to the date of such return; (ii) the customer has the original register receipt; (iii) such return is not being made in contemplation of such customer repurchasing the item at the sale price being offered by Agent, and (iv) such return is consistent with Merchant's prior practices (all Merchandise meeting the foregoing criteria, the "Returned Merchandise") provided that any credits for such Returned Merchandise may be used only for the purchase of Merchandise and Agent shall not be required to provide any cash refund on account of any such credits. Returned Merchandise shall be included in Merchandise and valued at the Retail Price applicable to such item less the prevailing Sale discount at the time of the return and the Guaranteed Amount shall be reduced in the amount of any credits provided by Agent in respect of the Returned Merchandise. Merchant shall provide Agent with the name and contact information for a Merchant representative to coordinate with any customers regarding any Returned Merchandise not accepted by Agent. 8.6 Layaway, Repair and Special Order Merchandise. Promptly after the execution of this Agreement, Merchant shall notify each customer for whom Merchant holds Layaway, Repair and Special Order Merchandise of the Sale and request such customers to pick up and pay for the applicable item(s) on or before February 7, 2004. Any Layaway, Repair and Special Order Merchandise unclaimed by customers by such date shall be returned to the Store's sale floor for sale by Agent. To the extent that any such Layaway Repair and Special Order Merchandise is salable as first-quality Merchandise, it shall be included in Merchandise and valued at the Retail Price applicable to such item at the time of the return. If such Layaway, Repair and Special Order Merchandise constitutes Defective Merchandise it shall be included in Merchandise and assigned a Retail Price in accordance with the applicable provisions of Section 5.3 above. The aggregate Retail Price of the Merchandise shall be increased by the Retail Price of any Layaway, Repair and Special Order Merchandise included in Merchandise (determined in accordance with this Section 8.6), and the Guaranteed Amount shall be adjusted accordingly. To the extent that Agent is required to issue refunds to customers in respect of any Layaway, Repair and Special Order Merchandise, Merchant shall reimburse Agent in cash for any such amounts. Layaway, Repair and Special Order Merchandise not included in Merchandise shall be disposed of by Agent in accordance with instructions received from Merchant or, in the absence of such instructions, returned to Merchant at the end of the Sale Term. Any increases in the Guaranteed Amount in connection with Layaway, Repair and Special Order Merchandise shall be accounted for and paid by Agent on a weekly basis. 8.7 Sale Reconciliation. On each Wednesday during the Sale Term (for the previous week ending Saturday), commencing on the second Wednesday after the Sale Commencement Date, Agent and Merchant shall cooperate to reconcile Sale Expenses, Gross Rings, if still applicable, Returned Merchandise, and such other Sale related items as either party shall reasonably request, in each case for the prior week or partial week (i.e. Sunday through Saturday), all pursuant to procedures agreed upon by Merchant and Agent. Within thirty (30) days after the end of the Sale Term, Agent and Merchant shall complete a final reconciliation of the Sale Expenses and the sale of Merchandise, the written results of which shall be certified by representations of each of Merchant and Agent as a final settlement of accounts between Merchant and Agent. 8.8 Force Majeure. If any casualty or act of God prevents or substantially inhibits the conduct of the Sale at any Store, such Store and the Merchandise located at such Store shall be eliminated from the Sale and considered to be deleted from this Agreement as of the date of such event, and Agent and Merchant shall have no further rights or obligations hereunder with respect thereto; provided, however, that (i) the proceeds of any insurance attributable to such Merchandise or business interruption shall constitute Proceeds hereunder, and (ii) the Guaranteed Amount shall be reduced to account for any Merchandise eliminated from the Sale which is not the subject of insurance proceeds, and Merchant shall reimburse Agent for the amount the Guaranteed Amount is so reduced prior to the end of the Sale Term. 8.9 Petty Cash, Etc. All petty cash funds, register funds, unprocessed checks and credit card media (including proceeds of sales of goods) relating to periods prior to the Sale Commencement Date shall constitute property of the Merchant, and Agent shall have no rights or claims with respect thereto. Agent shall purchase from Merchant, on a dollar for dollar basis, all petty cash funds and register funds in the Stores as of the Inventory Date for each Store. Section 9. Employee Matters. 9.1 Merchant's Employees. Merchant shall permit all of its employees at the Stores to be available to Agent for the Sale. Agent may use Merchant's store-level employees in the conduct of the Sale to the extent Agent in its sole discretion deems expedient, and Agent may select and schedule the number and type of Merchant's employees required for the Sale. Agent shall identify any such store-level employees to be used in connection with the Sale (each such employee, a "Retained Employee") and shall notify Merchant of the identity of all Retained Employees prior to the Sale Commencement Date. Retained Employees shall at all times remain employees of Merchant, and shall not be considered or deemed to be employees of Agent. Merchant and Agent agree that, except to the extent that wages and benefits of Retained Employees constitute Sale Expenses hereunder, nothing contained in this Agreement and none of Agent's actions taken in respect of the Sale shall be deemed to constitute an assumption by Agent of any of Merchant's obligations relating to any of Merchant's employees including, without limitation, Excluded Benefits, Worker Adjustment Retraining Notification Act ("WARN Act") claims and other termination type claims and obligations, or any other amounts required to be paid by statute or law; nor shall Agent become liable under any collective bargaining or employment agreement or be deemed a joint or successor employer with respect to such employees. Merchant shall not, without Agent's prior written consent, raise the salary or wages or increase the benefits for, or pay any bonuses or make any other extraordinary payments to, any of its employees in anticipation of the Sale or prior to the Sale Termination Date, provided that Merchant may provide health insurance benefits to newly eligible employees pursuant to Merchant's health insurance plan and may implement scheduled raises in the ordinary course of business. Merchant has not terminated and shall use its reasonable best efforts to continue all employee benefits and benefit programs during the Sale Term. 9.2 Termination of Employees. Agent may in its discretion stop using any Retained Employee at any time during the Sale. Agent shall so notify a representative designated by Merchant at least five (5) days prior thereto, except "for cause" (such as dishonesty, fraud or breach of employee duties), in which event Agent may stop using such employee immediately provided however that Agent shall immediately notify Merchant of the basis for such "cause" so that Merchant can arrange for termination of such employee. Upon the expiration of the applicable notice period, all costs associated with the employee shall not be considered a Sale Expense and Agent shall have no further responsibility or liability for such employees whatsoever. Merchant shall not transfer or dismiss employees of the Stores without Agent's prior consent, which shall not be unreasonably withheld, conditioned or delayed, but shall retain the right to dismiss the employee "for cause." 9.3 Payroll Matters. During the Sale Term Merchant shall process the base payroll for all Retained Employees. Beginning on Wednesday, February 25, 2004, and every other Wednesday thereafter during the Sale Term, Agent shall transfer from the Agency Accounts to Merchant's payroll accounts an amount equal to the base payroll for Retained Employees plus related payroll taxes, worker's compensation and benefits for such week which constitute Sale Expenses hereunder. 9.4 Employee Retention Bonuses. In Agent's reasonable discretion Proceeds may be used to pay, as a Sale Expense, retention bonuses ("Retention Bonuses") (which bonuses shall be inclusive of payroll taxes and workers' compensation taxes to the extent assessable but as to which no benefits shall be payable) to Retained Employees who do not voluntarily leave employment and are not terminated "for cause". Such Retention Bonuses shall be payable within thirty (30) days after the Sale Termination Date, and shall be processed through Merchant's payroll system. Section 10. Conditions Precedent. The willingness of Agent and Merchant to enter into the transactions contemplated under this Agreement are directly conditioned upon the satisfaction of the following conditions at the time or during the time periods indicated, unless specifically waived in writing by the applicable party: (a) All representations and warranties of Merchant and Agent hereunder shall be true and correct in all material respects and no Event of Default shall have occurred and be continuing at and as of the date hereof and as of the Sale Commencement Date. (b) The Approval Order shall be entered on or before February 13, 2004. (c) Merchant shall have provided Agent reasonable access to all pricing and cost files, computer hardware, software and data files, inter-Store transfer logs, markdown schedules, invoices, style runs and all other documents relative to the price, mix and quantities of inventory located at the Stores. Section 11. Representations, Warranties and Covenants. 11.1 Merchant's Representations, Warranties and Covenants. Merchant hereby represents, warrants and covenants in favor of Agent as follows: (a) Merchant: (i) is a corporation duly organized, validly existing and in good standing under the laws of the state of Delaware; (ii) has all requisite corporate power and authority to own, lease and operate its assets and properties and to carry on its business as presently conducted; and (iii) is and during the Sale Term will continue to be duly authorized and qualified as a foreign corporation to do business and in good standing in each jurisdiction where the nature of its business or properties requires such qualification, including all jurisdictions in which the Stores are located. (b) Subject to the issuance of the Approval Order, (i) Merchant has the right, power and authority to execute and deliver this Agreement and each other document and agreement contemplated hereby (collectively, together with this Agreement, the "Agency Documents") and to perform fully its obligations thereunder; (ii) Merchant has taken all necessary actions required to authorize the execution, delivery and performance of the Agency Documents, and no further consent or approval is required for Merchant to enter into and deliver the Agency Documents, to perform its obligations thereunder, and to consummate the Sale; (iii) each of the Agency Documents has been duly executed and delivered by Merchant and constitutes the legal, valid and binding obligation of Merchant enforceable in accordance with its terms; (iv) no court order or decree of any federal, state or local governmental authority or regulatory body is in effect that would prevent or impair, or is required for Merchant's consummation of, the transactions contemplated by this Agreement, and no consent of any third party which has not been obtained is required therefor; and (v) no contract or other agreement to which Merchant is a party or by which the Merchant is otherwise bound will prevent or impair the consummation of the Sale and the other transactions contemplated by this Agreement. (c) Except as set forth in Sections 11.1(j) and 11.1(l), since January1, 2004, Merchant has operated the Stores, and shall continue to operate the Stores, in the ordinary course of business consistent with historical operations and consistent in terms of pricing and operations in the manner in which Merchant has operated the other stores in its chain that are not closing; provided, however, Merchant has not and shall not prior to the Sale Commencement Date increase the level of promotions or discounts at the Stores from the levels currently in place. (d) Merchant owns and will own at all times during the Sale Term, good and marketable title to all of the Merchandise free and clear of all liens, claims and encumbrances of any nature except existing liens, which, shall be released and attached to the Guaranteed Amount and amounts reimbursed to Merchant on account of Sale Expenses or any other amounts due Merchant hereunder. (e) Merchant has maintained its pricing files in the ordinary course of business, and prices charged to the public for goods (whether in-Store, by advertisement or otherwise) are the same in all material respects as set forth in such pricing files for the periods indicated therein. All pricing files and records relative to the Merchandise have been made available to Agent. All such pricing files and records are true and accurate in all material respects as to the actual cost to Merchant for purchasing the goods referred to therein and as to the selling price to the public for such goods as of the dates and for the periods indicated therein. (f) As of the date hereof, the levels of goods (as to quantity) and the mix of goods (as to type, category, style, brand and description) at the Stores are as set forth in the information provided by Merchant to Agent. (g) As of the Sale Commencement Date, all normal course permanent markdowns on goods located at the Stores will have been taken on a basis consistent with Merchant's historical practices and policies. (h) Merchant has not since January 1, 2004, and shall not up to the Sale Commencement Date, marked up or raised the price of any items of Merchandise, or removed or altered any tickets or any indicia of clearance merchandise, except in the ordinary course of business or as previously disclosed to Agent. (i) Merchant shall ticket or mark all items of inventory received at the Stores prior to the Sale Commencement Date, in a manner consistent with similar inventory located at the Stores and in accordance with Merchant's historic practices and policies relative to pricing and marking inventory. (j) Merchant has not replenished the inventory in the Stores since December 31, 2003. In addition, Merchant has not and shall not purchase or transfer to or from the Stores any inventory outside the ordinary course in anticipation of the Sale or of the Inventory Taking. (k) To the best of Merchant's knowledge, except for Merchant's Chapter 11 bankruptcy case pending before the Bankruptcy Court, no action, arbitration, suit, notice, or legal, administrative or other proceeding before any court or governmental body has been instituted by or against Merchant, or has been settled or resolved, or to Merchant's knowledge, is threatened against or affects Merchant, relative to Merchant's business or properties, or which questions the validity of this Agreement, or that if adversely determined, would adversely affect the conduct of the Sale. (l) Merchant covenants to continue to operate the Stores in the ordinary course of business prior to the Sale Commencement Date. (m) To the best of Merchant's knowledge, all Merchandise is in compliance with all applicable federal, state, or local product safety laws, rules and standards. (n) Throughout the Sale Term, Agent shall have the right to the uninterrupted use and occupancy of, and peaceful and quiet possession of, each of the Stores, the assets currently located at the Stores, and the services provided at the Stores in order to conduct the Sale as contemplated herein. (o) Except as otherwise set forth herein, Merchant has paid and will use its reasonable best efforts to continue to pay throughout the Sale Term, (i) all post-petition self-insured or Merchant funded employee benefit programs for employees, including health and medical benefits and insurance and all proper claims made or to be made in accordance with such programs, (ii) all casualty, liability, workers' compensation and other similar insurance premiums, and (iii) all applicable taxes. (p) Merchant has not and shall not throughout the Sale Term take any actions the result of which is to materially increase the cost of operating the Sale, including, without limitation, increasing salaries or other amounts payable to employees. (q) Merchant is not a party to any collective bargaining agreements with its employees at the Stores and, to the best of Merchant's knowledge, no labor unions represent Merchant's employees at the Stores. (r) To the best of Merchant's knowledge, all information provided by Merchant to Agent in the course of Agent's due diligence and preparation and negotiation of this Agreement (including information as to the Store inventories and operating expenses) is as of the date hereof true and accurate in all material respects. (s) As of the date of this Agreement, Merchant is current in the payment of all post-petition telephone, utilities, taxes and insurance. 11.2 Agent's Representations, Warranties and Covenants. The Agent hereby warrants and covenants in favor of Merchant as follows: (a) The Agent (i) is a corporation validly existing and in good standing in its State of incorporation; (ii) has all requisite power and authority to consummate the transactions contemplated hereby; and (iii) is and during the Sale Term will continue to be, duly authorized and qualified to do business and in good standing in each jurisdiction where the nature of its business or properties requires such qualification. (b) Agent has the right, power and authority to execute and deliver each of the Agency Documents to which it is a party and to perform fully its obligations thereunder. Agent has taken all necessary actions required to authorize the execution, delivery, and performance of the Agency Documents, and no further consent or approval is required on the part of Agent for Agent to enter into and deliver the Agency Documents and to perform its obligations thereunder. Each of the Agency Documents has been duly executed and delivered by the Agent and constitutes the legal, valid and binding obligation of Agent enforceable in accordance with its terms. No court order or decree of any federal, state or local governmental authority or regulatory body is in effect that would prevent or impair or is required for Agent's consummation of the transactions contemplated by this Agreement, and no consent of any third party which has not been obtained is required therefor. No contract or other agreement to which Agent is a party or by which Agent is otherwise bound will prevent or impair the consummation of the transactions contemplated by this Agreement. (c) No action, arbitration, suit, notice, or legal administrative or other proceeding before any court or governmental body has been instituted by or against Agent, or has been settled or resolved, or to Agent's knowledge, has been threatened against or affects Agent, which questions the validity of this Agreement or any action taken or to be taken by Agent in connection with this Agreement, or which if adversely determined, would have a material adverse effect upon Agent's ability to perform its obligations under this Agreement. Section 12. Insurance. 12.1 Merchant's Liability Insurance. Merchant shall continue at its cost and expense (subject to Agent's payment of a pro rata portion as a Sale Expense) until the Sale Termination Date, in such amounts as it currently has in effect, all of its liability insurance policies including, but not limited to, products liability, comprehensive public liability, auto liability and umbrella liability insurance, covering injuries to persons and property in, or in connection with Merchant's operation of the Stores, and shall cause Agent to be named an additional insured with respect to all such policies. Prior to the Sale Commencement Date, Merchant shall deliver to Agent certificates evidencing such insurance setting forth the duration thereof and naming Agent as an additional insured, in form reasonably satisfactory to Agent. All such policies shall require at least thirty (30) days prior notice to Agent of cancellation, non-renewal or material change. In the event of a claim under any such policies Merchant shall be responsible for the payment of all deductibles, retention's or self-insured amounts thereunder, unless it is determined that liability arose by reason of the wrongful acts or omissions or negligence of Agent, or Agent's employees, independent contractors or agents (other than Merchant's employees). 12.2 Merchant's Casualty Insurance. Except for flood insurance, Merchant will provide throughout the Sale Term, at Agent's sole cost and expense, fire, theft and extended coverage casualty insurance covering the Merchandise in a total amount as it currently has in effect equal to no less than the Retail Price thereof. From and after the date of this Agreement until the Sale Termination Date, all such policies will name Agent as loss payee. In the event of a loss to the Merchandise on or after the entry of the Approval Order, the proceeds of such insurance attributable to the Merchandise plus any self insurance amounts and the amount of any deductible (which amounts shall be paid by Merchant), shall constitute Proceeds hereunder and shall be paid to Agent. Following the full payment of the Guaranteed Amount, and so long as the applicable Merchandise is not eliminated from the Sale pursuant to Section 8.8, in the event of such a loss Agent shall have the sole right to adjust the loss with the insurer. Prior to the Sale Commencement Date, Merchant shall deliver to Agent certificates evidencing such insurance setting forth the duration thereof and naming Agent as loss payee, in form and substance reasonably satisfactory to Agent. All such policies shall require at least thirty (30) days prior notice to Agent of cancellation, non-renewal or material change. Merchant shall not make any change in the amount of any deductibles or self insurance amounts prior to the Sale Termination Date without Agent's prior written consent. 12.3 Agent's Insurance. Agent shall maintain at Agent's cost and expense throughout the Sale Term, in such amounts as it currently has in effect, comprehensive public liability and automobile liability insurance policies covering injuries to persons and property in or in connection with Agent `s agency at the Stores, and shall cause Merchant to be named an additional insured with respect to such policies. Prior to the Sale Commencement Date, Agent shall deliver to Merchant certificates evidencing such insurance policies setting forth the duration thereof and naming Merchant as an additional insured, in form and substance reasonably satisfactory to Merchant. In the event of a claim under any such policies Agent shall be responsible for the payment of all deductibles, retention's or self-insured amounts thereunder, unless it is determined that liability arose by reason of the wrongful acts or omissions or negligence of Merchant or Merchant's employees, independent contractors or agents (other than Agent or Agent's employees, agents or independent contractors). 12.4 Worker's Compensation Insurance. Merchant shall at all times during the Sale Term maintain in full force and effect worker's compensation insurance covering all Retained Employees in compliance with all statutory requirements. Prior to the Sale Commencement Date, Merchant shall deliver to Agent a certificate of its insurance broker or carrier evidencing such insurance. 12.5 Risk of Loss. Without limiting any other provision of this Agreement, Merchant acknowledges that Agent is conducting the Sale on behalf of Merchant solely in the capacity of an agent, and that in such capacity (i) Agent shall not be deemed to be in possession or control of the Stores or the assets located therein or associated therewith, or of Merchant's employees located at the Stores, and (ii) except as expressly provided in this Agreement, Agent does not assume any of Merchant's obligations or liabilities with respect to any of the foregoing. Merchant and Agent agree that Merchant shall bear all responsibility for liability claims of customers, employees and other persons arising from events occurring at the Stores during and after the Sale Term, except to the extent any such claim arises from the acts or omissions of Agent, or its supervisors or employees located at the Stores (an " Agent Claim"). In the event of any such liability claim other than an Agent Claim, Merchant shall administer such claim and shall present such claim to Merchant's liability insurance carrier in accordance with Merchant's historic policies and procedures, and shall provide a copy of the initial documentation relating to such claim to Agent. To the extent that Merchant and Agent agree that a claim constitutes an Agent Claim, Agent shall administer such claim and shall present such claim to its liability insurance carrier, and shall provide a copy of the initial documentation relating to such claim to Merchant. In the event that Merchant and Agent cannot agree whether a claim constitutes an Agent Claim, each party shall present the claim to its own liability insurance carrier, and a copy of the initial claim documentation shall be delivered to the other party. Section 13. Indemnification. 13.1 Merchant Indemnification. Merchant shall indemnify and hold Agent and its officers, directors, employees, agents and independent contractors (collectively, "Agent Indemnified Parties") harmless from and against all claims, demands, penalties, losses, liability or damage, including, without limitation, reasonable attorneys' fees and expenses, directly or indirectly asserted against, resulting from, or related to: (i) Merchant's material breach of or failure to comply with any of its agreements, covenants, representations or warranties contained in any Agency Document; (ii) Subject to Agent's compliance with its obligations under Section 9.3 hereof, any failure of Merchant to pay to its employees any wages, salaries or benefits due to such employees during the Sale Term; (iii) Subject to Agent's compliance with its obligations under Section 8.3 hereof, any failure by Merchant to pay any Sales Taxes to the proper taxing authorities or to properly file with any taxing authorities any reports or documents required by applicable law to be filed in respect thereof; (iv) any consumer warranty or products liability claims relating to Merchandise; (v) any liability or other claims asserted by customers, any of Merchant's employees, or any other person against any Agent Indemnified Party (including, without limitation, claims by employees arising under collective bargaining agreements, worker's compensation or under the WARN Act), except for Agent Claims; and (vi) the gross negligence or willful misconduct of Merchant or any of its officers, directors, employees, agents or representatives. 13.2 Agent Indemnification. Agent shall indemnify and hold Merchant and its officers, directors, employees, agents and representatives harmless from and against all claims, demands, penalties, losses, liability or damage, including, without limitation, reasonable attorneys' fees and expenses, directly or indirectly asserted against, resulting from, or related to: (i) Agent's material breach of or failure to comply with any of its agreements, covenants, representations or warranties contained in any Agency Document; (ii) any harassment or any other unlawful, tortuous or otherwise actionable treatment of any employees or agents of Merchant by Agent or any of its representatives; (iii) any claims by any party engaged by Agent as an employee or independent contractor arising out of such employment and any governmental claims related thereto; (iv) any Agent Claims; and (v) the gross negligence or willful misconduct of Agent or any of its officer, directors, employees, agents or representatives. (vi) Agent's failure to pay to Merchant any Sales Taxes when due under Section 8.3 hereof and any payroll when due under Section 9.3 hereof. Section 14. Defaults. The following shall constitute "Events of Default" hereunder: (a) Merchant's or Agent's failure to perform any of their respective material obligations hereunder, which failure shall continue uncured seven (7) days after written notice thereof to the defaulting party; or (b) Any representation or warranty made by Merchant or Agent proves untrue in any material respect as of the date made; or (c) The Sale is terminated or materially interrupted at more than four (4) Stores for any reason other than (i) an Event of Default by Agent, or (ii) any other breach or action by Agent not authorized hereunder, or (iii) any event administered pursuant to Section 8.8 above. Section 15. Security Interest. In consideration of Agent's payment of the Guaranteed Amount and the Sale Expenses, and the provision of services hereunder to Merchant, effective upon the later of (i) payment by Agent of the initial eighty percent (80%) of the Guaranteed Amount as provided in Section 3.3 hereof, and (ii) Agent's delivery of the Letter of Credit as provided in Section 3.4 hereof, Merchant hereby grants to Agent a first priority security interest in and lien upon the Merchandise and the Proceeds to secure all obligations of Merchant to Agent hereunder, junior only to the lien of Lender to the extent of any unpaid balance of the Guaranteed Amount or the Expenses, and any and all valid and perfected pre-petition liens. Merchant shall execute all such documents and take all such other actions as are reasonably required to perfect and maintain such security interest as a valid and perfected first priority security interest. Section 16. Furniture, Fixtures and Equipment. At Merchant's option, Agent shall sell the FF&E and be entitled to receive a commission equal to twenty (20%) of the proceeds from the sale of such FF&E, net of sales taxes and expenses incurred in connection with the disposition of the FF&E in accordance with a budget to be mutually agreed upon between Merchant and Agent; provided further however, Merchant may elect to receive (the "FF&E Election"), in lieu of proceeds net of expenses and Agent's commission, a lump sum payment, on a per Store basis, in an amount to be agreed upon between Merchant and Agent, in which case all costs and expenses associated with the disposition thereof shall be borne by Agent. In either event, as of the Sale Termination Date, Agent may abandon, to Merchant, in place in a neat and orderly manner any unsold FF&E at the Stores. In the event that Merchant elects to have someone other than the Agent dispose of the FF&E, Agent agrees that it shall cooperate with such party, provided however, it is understood that such third party's efforts shall not unreasonably interfere with Agent's conduct of the Sale, and removal of any FF&E shall be done in coordination with, and the consent of, the Agent, which consent shall not be unreasonably withheld. As to any unsold FF&E, Agent shall have the right to leave such FF&E at the Stores without liability or costs; provided, however, the Stores are left in broom clean condition. Section 17. Intentionally Omitted. Section 18. Miscellaneous. 18.1 Notices. All notices and communications provided for pursuant to this Agreement shall be in writing, and sent by hand, by facsimile, or a recognized overnight delivery service, as follows: If to the Agent: Garcel, Inc. d/b/a The Great American Group One Parkway North Suite 520 Deerfield, Illinois 60015 Attn: Mark Naughton Telecopy No. (847) 444-1401 If to Merchant: Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, CA 92123 Attn: Susan M. Skrokov Secretary Telecopy No. (858)-637-4180 With a copy to: Hennigan, Bennett & Dorman LLP 601 South Figueroa Street Suite 3300 Los Angeles, CA 90017 Attn: Bennett J. Murphy, Esq. Telecopy No. (213) 694-1234 18.2 Governing Law; Consent to Jurisdiction. This Agreement shall be governed and construed in accordance with the laws of the State of California without regard to conflicts of laws principles thereof, except where governed by the Bankruptcy Code. Agent and Merchant agree that the Bankruptcy Court shall retain jurisdiction to resolve any and all disputes arising under this Agreement and accepts and submits to the jurisdiction of the Bankruptcy Court. 18.3 Entire Agreement. This Agreement contains the entire agreement between the parties hereto with respect to the transactions contemplated hereby and supersedes and cancels all prior agreements, including, but not limited to, all proposals, letters of intent or representations, written or oral, with respect thereto. 18.4 Amendments. This Agreement may not be modified except in a written instrument executed by each of the parties hereto. 18.5 No Waiver. No consent or waiver by any party, express or implied, to or of any breach or default by the other in the performance of its obligations hereunder shall be deemed or construed to be a consent or waiver to or of any other breach or default in the performance by such other party of the same or any other obligation of such party. Failure on the part of any party to complain of any act or failure to act by the other party or to declare the other party in default, irrespective of how long such failure continues, shall not constitute a waiver by such party of its rights hereunder. 18.6 Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon Agent and Merchant, and their respective successors and assigns; provided, however, that this Agreement may not be assigned by Merchant or Agent without the prior written consent of the Court. 18.7 Execution in Counterparts. This Agreement may be executed in two (2) or more counterparts, each of which shall be deemed an original and all of which together shall constitute but one agreement. This Agreement may be executed by facsimile, and such facsimile signature shall be treated as an original signature hereunder. 18.8 Section Headings. The headings of sections of this Agreement are inserted for convenience only and shall not be considered for the purpose of determining the meaning or legal effect of any provisions hereof. 18.9 Survival. All representations, warranties, covenants and agreements made by the parties hereto shall be continuing, shall be considered to have been relied upon by the parties and shall survive the execution, delivery, performance and/or termination of this Agreement. IN WITNESS WHEREOF, Agent and Merchant hereby execute this Agreement by their duly authorized representatives as of the day and year first written above. Factory 2-U Stores, Inc. By: /s/Norman G. Plotkin ------------------------------------------------ Norman G. Plotkin Chief Executive Officer Garcel, Inc. d/b/a The Great American Group By: /s/ Mark Naughton ------------------------------------------------ Mark Naughton Vice President and General Counsel EX-10 5 ex1025043004.txt SEOND AMENDMENT TO AMENDED AND RESTATED Exhibit 10.25 SECOND AMENDMENT TO SECOND AMENDED AND RESTATED FINANCING AGREEMENT This Second Amendment to Second Amended and Restated Financing Agreement ("Amendment") is entered into as of March 10, 2004, by and among FACTORY 2-U STORES, INC., a Delaware corporation, the debtor and debtor in possession in the Bankruptcy Case ("Company"), THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation ("CITBC"), in its capacity as Agent for Lenders under the Financing Agreement ("Agent"); CITBC in its capacity as Tranche A Lender (together with any other Persons who may subsequently become a Tranche A Lender, "Tranche A Lenders"); and GB RETAIL FUNDING, LLC, a Massachusetts limited liability company in its capacity as Tranche B Lender (together with any other Persons who may subsequently become a Tranche B Lender, "Tranche B Lenders" and together with the Tranche A Lenders, "Lenders"). A.Agent, Company and Lenders have previously entered into that certain Second Amended and Restated Financing Agreement dated as of January 12, 2004 (the "Financing Agreement"), pursuant to which Lenders have provided Company with certain loans and other financial accommodations. B.Company has requested that Agent and Lenders amend the Financing Agreement pursuant to the terms and subject to the conditions set forth in this Amendment. C.Agent and Lenders are willing to amend the Financing Agreement on the terms and subject to the conditions set forth in this Amendment. NOW THEREFORE, in consideration of the foregoing and the terms and conditions hereof, the parties hereto agree as follows, effective as of the date set forth above: 1. Definitions. Terms used herein, unless otherwise defined herein, shall have the meanings set forth in the Financing Agreement. 2. Amendments to Financing Agreement. a. Section 1 of the Financing Agreement is hereby amended by deleting the definition of Factor Letters of Credit and Guaranties in its entirety and replacing such definition with the following: Factor Letter(s) of Credit shall mean any and all Letters of Credit issued by an Issuing Bank, as guaranteed by the Agent, on behalf of the Lenders, and any and all Letter of Credit Guaranties of such Letters of Credit, in either case in favor of the Company's suppliers' factor or factors to secure performance by the Company of certain of its accounts payable. b. Section 1 of the Financing Agreement is hereby amended by deleting the definition of Factor Letters of Credit and Guaranties Reserve in its entirety. c. Section 1 of the Financing Agreement is hereby amended by adding the following definition: Factor Letter of Credit Sub-Line shall mean up to Four Million Dollars ($4,000,000) in the aggregate. d. Section 1 of the Financing Agreement is hereby amended by deleting the definition of Letter of Credit Sub-Line in its entirety and replacing such definition with the following: Letter of Credit Sub-Line shall mean up to Twenty Million Dollars ($20,000,000) in the aggregate, which shall include the Factor Letter of Credit Sub-Line. d. Section 5.9 of the Financing Agreement is hereby amended by deleting such Section in its entirety and replacing such Section with the following: 5.9 Tranche A Lenders agree that Agent, on behalf of Tranche A Lenders, shall facilitate the issuance of Factor Letters of Credit in amounts that, notwithstanding any other term herein, shall not exceed the Factor Letter of Credit Sub-Line. 3. Conditions Precedent. The effectiveness of this Amendment shall be, and hereby is, subject to the fulfillment to Agent's satisfaction of the Conditions Precedent. The "Conditions Precedent" shall mean each of the following: a. No objection to this Amendment is filed or served pursuant to Section 1.3.3 of the Interim Financing Order or the Final Financing Order; and b. As of the date hereof, the representations and warranties contained in Section 7 of the Financing Agreement are (before and after giving effect to this Amendment) true and correct in all material respects (except to the extent any such representation and warranty is expressly stated to have been made as of a specific date, in which case it shall be true and correct as of such specific date) and no Default or Event of Default shall be existing or have occurred and be continuing. 5. Miscellaneous. a. Reference to and Effect on the Financing Agreement. (i) Except as specifically amended by this Amendment and the documents executed and delivered in connection herewith, the Financing Agreement shall remain in full force and effect and is hereby ratified and confirmed. (ii) The execution and delivery of this Amendment shall not, except as expressly provided herein, constitute a waiver of any provision of, or operate as a waiver of any right, power or remedy of Agent or any Lender under the Financing Agreement or any agreement or document executed in connection therewith. (iii) Upon the Conditions Precedent being satisfied, this Amendment shall be construed as one with the existing Financing Agreement, and the existing Financing Agreement shall, where the context requires, be read and construed throughout so as to incorporate this Amendment. b. Fees and Expenses. Company acknowledges that all costs, fees and expenses incurred in connection with this Amendment will be paid in accordance with Section 8.5 of the Financing Agreement and the Final Financing Order. c. Headings. Section and subsection headings in this Amendment are included for convenience of reference only and shall not constitute a part of this Amendment for any other purpose or be given any substantive effect. d. Counterparts. This Amendment may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one and the same instrument. e. Governing Law. This Amendment shall be governed by and construed according to the laws of the State of California. IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. Company: FACTORY 2-U STORES, INC. By:/s/Norman G. Plotkin -------------------------------------------------- Name: Norman G. Plotkin ---------------------------------------------------- Title:Chief Executive Officer --------------------------------------------------- Agent and Tranche A Lender: THE CIT GROUP/BUSINESS CREDIT, INC. By:/s/Mike Richman --------------------------------------------------- Name:Mike Richman -------------------------------------------------- Title: Vice President -------------------------------------------------- Tranche B Lender: GB RETAIL FUNDING, LLC By:/s/ Larry Klaff --------------------------------------------------- Name: Larry Klaff --------------------------------------------------- Title: Managing Director -------------------------------------------------- EX-14 6 ex14043004.txt CODE OF ETHICS FILED ON 043004 Exhibit 14.1 STANDARDS OF BUSINESS CONDUCT I. INTRODUCTION ================================================================================ Factory 2-U Stores, Inc. (the "Company") has a firmly established policy of conducting its affairs in compliance with all applicable laws and regulations and observing the highest standards of business ethics. Integrity, honesty, forthrightness and fairness are of primary importance in all business relationships involving the Company. The Company expects each director, officer and associate (each, an "associate") to perform his or her duties in such a manner as to preserve the Company's good name and reputation. The Company intends that every associate shall follow the letter, as well as the spirit, of these Standards of Business Conduct. These Standards have been adopted by the Board of Directors of the Company and apply to the Company and its associates. These Standards are not intended to be all encompassing. Situations may arise that are not expressly covered or where the proper course of action is unclear. Associates should consult with their supervisors if any questions as to interpretation of these Standards arise. Any associate may bring problems to the attention of higher management, such as the Chief Executive Officer or the Executive Vice President of Human Resources, for review and the Company maintains an open door policy in that regard. The Company may modify or supplement these Standards from time to time, to comply with evolving corporate governance standards, to comply with applicable requirements adopted by Congress, the SEC or the Nasdaq Stock Market and otherwise as it deems appropriate. Accordingly, all associates must review these Standards at least once every year. Any associate of the Company having information or knowledge regarding a violation, or potential violation, of these Standards should immediately report the same to his or her supervisor, functional Executive Vice President or to the Company's General Counsel. If an associate has reason to believe that it would be inappropriate to report the relevant information to his or her supervisor, then the information should be reported in confidence directly to another high-level authority within the Company. Retaliation or reprisal of any kind against an associate who reports a violation (or, in good faith, potential violation) of these Standards is strictly prohibited. The Company may regard any associate's acts in violation of these Standards to be outside the course and scope of that associate's employment. Any associate found to have violated these Standards may be subject to immediate disciplinary action, up to and including termination of employment. Legal proceedings may also be commenced against such individual to recover the amount of any improper expenditures, any other losses which the Company may have incurred or other appropriate relief. II. CORPORATE ASSETS AND INFORMATION ================================================================================ A. COMPANY FUNDS AND PROPERTY Associates of the Company are responsible and accountable for the proper expenditure of funds and use of Company assets under their control, including all funds and assets entrusted to the Company's custody by customers and others. The Company's assets are to be used only for legitimate business purposes both during and following employment with the Company. Examples of improper uses include unauthorized taking or use of corporate property or other resources, and the disbursement of corporate funds, directly or indirectly, for any form of payment that is illegal, for personal gain or otherwise not in accordance with Company policy. Unless authorized by the Company's Chief Executive Officer or Chief Financial Officer, the sale, loan or gift of Company assets to Company associates, customers or suppliers is prohibited. B. CORPORATE RECORDS AND ACCOUNTING Data, Records and Reports It is the Company's policy to maintain the highest level of integrity and accountability with respect to all financial reporting, including reports to regulatory authorities, auditors and the Company's stockholders. All Company data, records and reports must be accurate and truthful and prepared in a proper manner. The integrity of the Company's accounting, technical, personnel, financial and other records is based on their validity, accuracy and completeness. Disclosures in periodic reports required to be filed by the Company will be full, fair, accurate, timely and understandable and in compliance with applicable governmental rules and regulations. Anyone preparing the type of information described above must be diligent in assuring its integrity and anyone representing or certifying the accuracy of such information should make an inquiry or review adequate to establish a good faith belief in the accuracy of the information. Custodians of the Company's data, records and reports must be sure that such information is released, whether internally or outside the Company, only if adequately protected and only for authorized purposes. C. CONFIDENTIAL AND PROPRIETARY INFORMATION Attached as Exhibit A is the Company's Employee Agreement Concerning Confidentiality, Trade Secrets and Outside Employment. D. INSIDER TRADING Attached as Exhibit B is the Company's Insider Trading Policy, which is distributed to the Company's directors, executive officers, corporate management personnel, regional vice presidents and managers, district managers, buyers and assistant buyers, planning and allocation personnel, loss prevention regional and district managers and all other corporate salaried employees. E. LEGAL DISPUTES Associates involved with a Company lawsuit or other legal dispute may not discuss it with outsiders or other Company associates without the prior approval of the Company's Chief Executive Officer or General Counsel. Failure to follow these restrictions could constitute a breach of the Company's attorney-client privilege and result in the loss of confidential information. Additionally, any associate contacted by any regulatory or law enforcement authority seeking Company information should promptly contact his or her supervisor who should immediately bring the matter to the attention of Company's Chief Executive Officer or General Counsel. No associate should respond to any such inquiry regarding the Company without first consulting with and obtaining the approval of the Company's Chief Executive Officer or General Counsel. III. CONFLICTS OF INTEREST ================================================================================ Attached as Exhibit C is the Company's Conflict of Interest Policy. IV. EQUAL EMPLOYMENT OPPORTUNITY AND UNLAWFUL HARASSMENT ================================================================================ The Company maintains a policy of equal employment opportunity for all associates and applicants for employment. It is the policy of the Company to provide equal employment opportunity without regard to race, color, religion, sex, sexual orientation, national origin, age, marital status or disability, as well as all other classifications protected by applicable laws. The Company is committed to adhering to all applicable federal, state and local laws pertaining to equal employment opportunity. All managers and associates are expected to help implement the Company's goals with regard to equal employment opportunity. The Company opposes unlawful harassment of others on the basis of sex, sexual orientation, age, race, color, national origin, religion, marital status, citizenship, disability and other characteristics protected by applicable laws. It is the policy of the Company to provide a non-discriminatory work environment free of harassment. All associates are expected to cooperate in maintaining this work environment. It is the Company's policy to investigate and remedy any incidents of unlawful harassment. In order to accomplish this, however, harassment must be brought to the attention of the Company. Accordingly, associates who feel aggrieved because of harassment have an obligation to communicate their problems immediately. An associate who feels he or she has been harassed should immediately notify their immediate supervisor or Human Resources. All complaints will be treated as confidentially as practicable and all investigations will be conducted expeditiously. There will be no retaliation against a person who, in good faith, files a complaint or participates in any way in the investigation of a complaint. Any associate who has been found, after appropriate investigation, to have harassed another associate will be subject to appropriate disciplinary action depending on the circumstances, up to and including dismissal. V. COMPLIANCE WITH LAWS =============================================================================== Each associate shall endeavor to act in compliance with applicable laws and regulations in dealing with the Company's customers, suppliers, competitors and associates. No associate shall unlawfully deal with anyone through abuse of privileged information, misrepresentation of material facts or any other unfair-dealing practice. If an associate knows of or suspects a violation of applicable laws and regulations, these Standards, or the Company's related policies, he should immediately report that information to his supervisor or a higher level of management. No associate reporting a suspected violation will be subject to retaliation because of a good faith report. Reported violations will be promptly investigated and treated confidentially to the extent practicable. It is imperative that the associate reporting the violation not conduct a preliminary investigation of his own. Investigations of alleged violations may involve complex legal issues. Associates who act on their own may compromise the integrity of an investigation and adversely affect both themselves and the Company. The Company intends to use every reasonable effort to prevent the occurrence of conduct not in compliance with these Standards and to halt any such conduct that may occur as soon as reasonably possible after its discovery. Associates who violate these Standards and other Company policies and procedures may be subject to disciplinary action, up to and including discharge. In addition, disciplinary action, up to and including discharge, may be taken against anyone who directs or approves infractions or has knowledge of them and does not move promptly to correct them in accordance with the Company's policies. Ultimate responsibility to ensure that the Company complies with the laws and ethical standards affecting its business rests on each of its associates. Associates must become familiar with and conduct themselves strictly in compliance with such laws and ethical standards as well as the Company's policies and guidelines pertaining to them. V. ACCOUNTING MATTERS ================================================================================ Every associate must cooperate fully with the Company's internal accounting process and its independent auditors. Any associate who becomes aware of a questionable accounting or auditing practice, or has a complaint regarding the Company's accounting, internal accounting controls or auditing matters, should immediately make a report to one of his or her supervisors or, if such associate desires, he or she may contact any member of the Company's Audit Committee. Any supervisor receiving a report from a subordinate must in turn make a report to any member of the Audit Committee. All reports will be treated as confidentially as possible and no associate will be subject to any retaliation or adverse consequence for making any such report in good faith. It is the Company's policy that all records that form the basis of an audit or review be retained for a reasonable period of time. Any associate who is unsure whether a particular record must be retained should consult his or her supervisor or the Company's Chief Financial Officer. CERTIFICATION I acknowledge that I have received a copy of the Factory 2-U Stores, Inc. Standards of Business Conduct. I certify that I have read, understand and will comply with the policies and procedures set forth in the Standards of Business Conduct. I understand that, if I am an associate of the Company, my failure to comply with the Company's Standards of Business Conduct, or any other Company policies, could lead to disciplinary action, up to and including termination of my employment. - ---------------------- ------------ Associate Signature Date - ---------------------- Printed Name EXHIBIT A EMPLOYEE AGREEMENT CONCERNING CONFIDENTIALITY TRADE SECRETS AND OUTSIDE EMPLOYMENT THIS AGREEMENT ("Agreement") is made and effective as of the date it is signed by the Employee below (or as of the Employee's hire date if no date is indicated below), by and between Factory 2-U Stores, Inc. (the "Company"), and ________________________________ ("Employee"). The purpose of this Agreement is to define the obligations of Employee and the Company as they relate to: 1) confidential and/or proprietary information or documents; 2) protection of the Company's trade secrets; 3) limitations on external employment, consulting or contracting by Employee to third-parties during Employee's employment by the Company. In consideration of Employee's employment by the Company and the mutual promises herein contained, the parties hereby agree as follows: 1) Protection of Trade Secrets. The Company intends to and has expended substantial sums of money and devoted a great deal of time, labor and effort to the development, creation and acquisition of a large body of confidential information that is used by it in its business and is not generally known or available to the public. Such confidential information gives the Company a valuable advantage over its competitors and prospective competitors and is proprietary to the Company. Such confidential and proprietary information includes, but is not limited to, lists of actual or potential customers, clients or candidates; techniques and formulas; marketing and sales plans; materials relating to other employee's; financial information; cost rate and pricing information; business plans, diagrams; sources of supplies, drawings; plans; processes; proposals; codes; notebooks; and the content of any contracts or proposals involving the Company which are made, developed, perfected, devised, conceived or first reduced to practice by Employee, the Company or its employees, agents, consultants, affiliates or assistants, either alone or jointly with others (collectively "Trade Secrets"). Employee agrees that he/she will treat any information of the Company which is not readily publicly available as a Trade Secret of the Company unless the Company advises Employee otherwise in writing. Employee acknowledges that Trade Secrets include not only technical information, but also any business information that the Company treats as confidential. a. Confidentiality. Employee agrees that he/she will not, without the Company's prior written consent, publish, disclose or otherwise use at any time either during or subsequent to his/her employment with the Company, any Trade Secrets of the Company. Nothing in this section precludes employee from disclosing Trade Secret information to other employees or authorized contractors of the Company, if such employees and/or authorized contractors have signed an agreement with the Company concerning Trade Secrets. b. Respect for the Company's Business. Employee agrees that he/she will not at any time use any Trade Secrets of the Company in any manner which may directly or indirectly have an adverse affect upon the business of the Company, nor will he/she perform any acts which would tend to reduce the proprietary value of such Trade Secrets to the Company. c. Return of Records and Other Items. Upon termination of Employee's employment, Employee agrees to promptly surrender to the Company all correspondence, drawings, blueprints, manuals, letters, notes, notebooks, reports, flow charts, diagrams, programs, proposals, or any other physical items or documents relating to the Company's Trade Secrets, and agrees that he/she will not make or retain any unauthorized copies or other reproductions of such materials. Employee recognizes that the unauthorized taking of any of the Company's Trade Secrets is a crime under California Penal Code section 499(c) and is punishable by imprisonment for a period not exceeding one year, or by a fine not exceeding five thousand dollars ($5,000.00), or both. Employee further acknowledges that such unauthorized misappropriation of the Company's Trade Secrets could also result in civil liability under California Code section 3426, and that willful misappropriate may result in an award against Employee for double the amount of the Company's damages and the Company's fees in collecting such damages. 2) Outside Employment. Unless otherwise agreed in writing by the Company and Employee, employment by the Company is to be considered a full time endeavor for those employees hired on a full time basis. Consequently, Employee (if he/she is a full time employee) agrees not to offer or provide his/her services to another employer, person or business entity of any type, whether as an employee, contractor, consultant or otherwise, without the prior written approval of the Company. 3) Miscellaneous Provisions. a) Remedies. Employee agrees that the breach of any provision of this Agreement will cause the Company irreparable injury and damage. Consequently, Employee agrees that because remedies at law may be inadequate to protect the Company against breach of this Agreement, the Company shall be entitled, in addition to all other remedies available to it, to the granting of an injunction, including ex parte temporary relief, restraining Employee from violating this Agreement. Any violation of this Agreement by Employee may, in the sole discretion of Factory 2-U Stores, Inc. also result in termination of Employee's employment. b) Effect on Other Agreements. This Agreement is supplementary to, and shall not be considered a waiver of, any rights of the Company that may exist independently of this Agreement. c) Validity. Should any provision of this Agreement be determined to be invalid or unenforceable under applicable law, then such provision shall be construed to cover only that duration, extent, or activity which is valid and enforceable. Employee acknowledges the uncertainty of the law in this respect and expressly stipulates that this Agreement be given the construction which renders its provisions valid and enforceable to the maximum extent permissible (not exceeding its express terms) under applicable law. d) Successors. The provisions of this Agreement shall insure to the benefit of and shall be binding upon Employee's agents, successors, assigns, heirs and personal representatives, as well as upon the Company's successors, subsidiaries, affiliated corporations, join ventures or assignees. No other persons or entities shall possess any rights under this Agreement. e) Entire Agreement. This Agreement constitutes the entire agreement between the parties pertaining to the subject matter hereof and supersedes all prior and contemporaneous oral, written or implied agreements, representations, and understandings of the parties pertaining to the subject matter hereof. This Agreement may not be modified except in writing signed by both parties. No waiver of any provisions of this Agreement shall be deemed, or shall constitute, a waiver of any other provision. f) Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of California. Venue for any action relating to this Agreement shall be in San Diego County, California. FACTORY 2-U STORES, INC. Dated: ____________________ By: ________________________________ Title: _______________________________ EMPLOYEE Dated: _____________________ ____________________________________ (Signature) ------------------------------------ (Print Name) EXHIBIT B Policy Adopted By The Board Of Directors Relating to Insider Trading In Company Securities And Confidentiality Of Information To: All Directors, Management and Corporate Personnel From: Executive Committee The Board of Directors has adopted the following Policy which applies to all personnel (including directors and officers) of our corporation and its subsidiaries (collectively called the "Company") arising from our legal and ethical responsibilities as a public company. 1. Prohibition Against Trading on Undisclosed Material Information: If you are aware of material information relating to the Company which has not yet been made available to the public by the Company (often called "inside information"), you are prohibited from trading in our securities, directly or indirectly, and from disclosing such information to any other persons who may trade in our securities. Any information, positive or negative, is "material" if it might be of significance to an investor in determining whether to purchase, sell or hold our securities. Information may be significant for this purpose even if it would not alone determine the investor's decision. Examples include, but are not limited to, a potential business acquisition, internal information about revenues, earnings or other aspects of financial performance which departs in any way from what the market would expect based upon prior disclosures, important business developments, the acquisition or loss of a major customer, or an important transaction. We emphasize that this list is merely illustrative. Once the Company announces material information, trading can occur after a lapse of two full trading days, but only during the "window periods" described in Section 2 below. Therefore, if an announcement is made before the commencement of trading on a Monday during a window period, an employee may trade in the Company's stock starting on the Wednesday of that week, because two full trading days would have elapsed by then (all of Monday and Tuesday). If the announcement is made on Monday during a window period after trading begins, employees may not trade in the Company's stock until Thursday. Please consult one of our officers if you are uncertain when trading may commence following an announcement. The above prohibition against trading on inside information generally reflects the requirements of law as well as the Company's Policy. As more fully discussed below, a breach of this Policy probably will constitute a serious legal violation as well. 2. Restricted Periods: To minimize the possibility of an unintentional violation of law or corporate policy, all personnel (and their affiliates, including a spouse and other relatives) must effect any proposed transaction in the Company's securities only during specified trading window periods. No personnel should trade any securities of the Company except during the trading window periods designated by the Company. The Company will provide, from time to time, the specific dates for the applicable window period. However, if a "no trading" directive is in effect as to you during all or any part of the window period, neither you nor your affiliates may engage in any transaction in the Company's securities during the pendency of the "no trading" directive. Special rules apply to stock option exercises. If you desire to pay all or a portion of the exercise price for an option in the Company securities (whether by surrender of previously acquired securities, as part of a "cashless exercise" through a broker or otherwise), you may only exercise the option when the trading window is open and only if a "no trading" directive is not in effect. If, however, you desire to exercise an option using only cash, you may exercise the option at any time, except during the pendency of a "no trading" directive. Although it may not be possible, if you desire to exercise an option while a "no trading" directive is in effect, please contact the Company's General Counsel or Chief Financial Officer. Note that the limitations in Section 1 above relating to material undisclosed information remain applicable in the period when trading is permitted by this Section 2. The two sections apply independently. 3. Confidentiality Generally: Serious problems could be caused for the Company by unauthorized disclosure of internal information about the Company (or confidential information about our customers or vendors), whether or not for the purpose of facilitating improper trading in our stock. Company personnel should not discuss internal Company matters or developments with anyone outside of the Company, except as required in the performance of regular corporate duties. This prohibition applies specifically (but not exclusively) to inquiries about the Company which may be made by the financial press, investment analysts or others in the financial community. It is important that all such communications on behalf of the Company be made only through an appropriately designated officer under carefully controlled circumstances. Unless you are expressly authorized to the contrary, if you receive any inquiries of this nature, you should decline comment and refer the inquiry to the Company's Chief Executive Officer or Chief Financial Officer. 4. Information About Other Companies: In the course of your employment, you may become aware of material non-public information about other public companies - for example, other companies with which our Company has business dealings. You are prohibited from trading in the securities of any other public company at a time when you are in possession of material non-public information about such company. 5. Tipping: Improper disclosure of non-public information to another person who trades in the stock (so-called "tipping") is also a serious legal offense by the tipper and a violation of the terms of this Policy. If you disclose information about our Company, or information about any other public company which you acquire in connection with your employment with our Company, you may be fully responsible legally for the trading of the person receiving the information from you (you "tippee") and even persons who receive the information directly or indirectly from your tippee. Accordingly, in addition to your general obligations to maintain confidentiality of information obtained through your employment and to refrain from trading while in possession of such information, you must take utmost care not to discuss confidential or non-public information with family members, friends or others who might abuse the information by trading in securities. 6. Limitation on Certain Trading Activities: We encourage interested employees to own our securities as a long-term investment at levels consistent with their individual financial circumstances and risk bearing abilities (since ownership of any security entails risk). However, Company personnel may not trade in puts, calls or similar options on our stock or sell our stock "short." (You may, subject to the provisions of Section 2, exercise any stock options granted to you by the Company.) 7. Consequence of Violation: The Company considers strict compliance with this Policy to be a matter of utmost importance. We would consider any violation of this Policy by an employee as a threat to our reputation. Violation of this Policy could cause extreme embarrassment and possible legal liability to you and the Company. Knowing or willful violations of the letter or spirit of this Policy will be grounds for immediate dismissal from the Company. Violation of the Policy might expose the violator to severe criminal penalties as well as civil liability to any person injured by the violation. The monetary damages flowing from a violation could be three times the profit realized by the violator as well as the attorney's fees of the persons injured. 8. Resolving Doubts: If you have any doubt as to your responsibilities under this Policy, seek clarification and guidance before you act from the Company's General Counsel or Chief Financial Officer. 9. A Caution About Possible Inability to Sell: Although the Company encourages employees to own our securities as a long-term investment (see Section 6), all personnel must recognize that trading in securities may be prohibited at a particular time because of the existence of material non-public information. Anyone purchasing our securities must consider the inherent risk that a sale of the securities could be prohibited at a time he or she might desire to sell them. The next opportunity to sell might not occur until after an extended period, during which the market price of the securities might decline. 10. Trading Plans: The prohibitions and restrictions set forth in Section 1 and Section 2 above are not applicable to trades made pursuant to a trading plan that satisfies the requirements of Rule 10b5-1(c) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), provided that such plan and all modifications thereto have been approved in advance by the Company. 11. Pre-Clearance: To assure compliance with this Policy and proper and timely disclosure of trades, notice of all prospective trades by directors and executive officers must be given to the Company's General Counsel or Chief Financial Officer at least two business days prior to making any such trades and the trades must be approved by the Company as being in compliance with this Policy before they may be effected. In addition, such trades will also be subject to review and approval by the Company in light of Section 16 of the Exchange Act and other factors in the Company's reasonable discretion. EXHIBIT C Conflict of Interest Policy While employed with Factory 2-U Stores, Inc. (FTUS), Associates must avoid any business, activity or other situations which may constitute, or give the appearance of, a conflict between personal interests and interests of the company. In dealings with current or potential customers, suppliers, contractors and competitors, Associates should act in the best interests of the Company to the exclusion of personal advantage. A potential or actual conflict of interest occurs whenever an Associate is in a position to influence a decision that may result in a personal gain for the Associate or an immediate family member (i.e. a spouse or significant other, children, parents, siblings) or close personal friend as a result of the Company's business dealings. If you feel a conflict exists, a statement must be forwarded to the Director of Human Resources AND Executive VP responsible for the Associate's department to determine if a conflict exists. If it is determined that a conflict of interest is involved, every reasonable and realistic alternative will be explored. The purpose of this policy is to require disclosure to protect our Associates from any conflict of interest that might arise. A violation of this policy may result in disciplinary action, up to and including termination. While it is virtually impossible to anticipate and therefore set forth an all inclusive list of conflict of interest situations and we ask you to rely on common sense, outlined below are some examples of situations which most frequently occur and may involve, or appear to involve, a conflict of interest and therefore require disclosure and approval by the Director of Human Resources or the CEO of Factory 2 - U Stores, Inc.: 1. Receiving of Gifts, Trips, Meals & Entertainment: a. Gifts FTUS's Associates may not accept any cash gifts from any supplier, vendor, customer, competitor or any other party with whom we do business. Associates may not accept gifts or business courtesies of value from any supplier, vendor, customer or competitor or other party with whom we do business. If an associate receives any gift or "business courtesy" with the exception of Holiday Gift Baskets (food and other consumable items), which must be shared within the Associate's department, the Associate must either return the gift or turn the gift over to the Director of Human Resources or CEO for disposition. (No Manager or Department Head may authorize a waiver of this policy.) A "business courtesy" is defined as a gift, or favor, from persons or firms with whom FTUS maintains, or may establish a business relationship and for which fair market value is not paid by the recipient. A "business courtesy" may be a tangible or intangible benefit, including, but not limited to, such items as non-monetary gifts, gift certificates, meals, drinks, entertainment, hospitality, recreation, door prizes, transportation discounts, tickets, passes, promotional items, or use of a donors time, materials or equipment. b. Trips Requests for permission to attend business trips paid for by an outside party with whom we have or may have a business relationship must be submitted to the Director of Human Resources or department EVP. Each request for permission should state the specific details of the trip, including destination, duration, purpose and benefit to FTUS. FTUS Associates are not permitted to take a personal overnight trip, whether with, or without, an outside party with whom we have or may have a business relationship, if any material part of the trip is paid for by the outside concern, such as hotel expenses, air fare or other travel expenses, or staying at a property owned or rented by the outside concern. Requests for exceptions to this policy must be submitted to the Director of Human Resources and approved by the C.E.O. c. Meals and Entertainment Business related entertainment in a non-business environment (restaurant, private home, etc.) could be a useful, desirable, and perfectly ethical practice if it is not excessive. Entertainment may be provided at Company expense, if it is authorized in advance by the Associate's department EVP, job-related, and not overly lavish and will not place the recipient in a potentially awkward situation with his employer or the public. Excessive entertainment of any sort is unacceptable. Accepting entertainment provided by actual or potential suppliers, customers or competitors, defined as business contacts, which falls within the guidelines set forth above is also permissible, if approved by the department EVP. Full disclosure is required from the Associate. Please note that the business contact must be in attendance for meals. The business contact, whenever possible, should be in attendance at an entertainment event such as a sporting event, concerts or theater. In the event the business contact is not attending the event, defined above, the Associate must submit the tickets to the EVP of HR for appropriate disposition. The Associate is advised to inform the vendor as to our policy regarding the disposition of the tickets. 2. Bribes, Kickbacks and Other Illegal Acts: All Associates and others acting in behalf of the company are prohibited from: a. Soliciting, accepting, or attempting to accept any kickback, bribe or other illegal payment. b. Accepting samples or taking "free" samples for personal use. Nothing of value shall be offered or given in violation of the Foreign Corrupt Practices Act, or any other applicable US or foreign law or regulation. Our company policy in this area is clear: Any Associate, who takes anything of value from an outside concern to do, or not do, something for the outside concern in its business relationship with FTUS will have their employment with FTUS terminated immediately and prosecuted where circumstances warrant. "Anything of value" includes, but is not limited to, cash, stocks, bonds, jewelry, precious metals, merchandise, vehicles, boats, trips, frequent expensive dinners, favors or illegal drugs. If a payoff is offered to an Associate, he or she is not only required to refuse it, but must report it immediately to the Director of Human Resources and department EVP. 3. Business: As of the effective date of this policy, Associates, or immediate family members (defined as spouses and members within the Associate's family who reside in the same household as such Associate) may not engage in, or enter into, any business activity (outside of FTUS) providing goods or services to FTUS without first disclosing this relationship to the Director of Human Resources and obtaining approval (i.e. using corporate vendors to provide personal services such as, carpet cleaning). 4. Exclusive Service to FTUS: No Associate, or an immediate family member (as defined above), shall render services to, represent, or undertake to act for, any supplier, vendor, customer, competitor or other party with whom FTUS does business, whether for compensation or not, unless a request for approval first has been submitted to the Director of Human Resources and it has been determined that such relations with any supplier, vendor, customer, competitor or other party with whom FTUS does business do not conflict with the interest of FTUS or otherwise create the appearance of impropriety, and there is no likelihood that such relations will influence the Associate's judgment or actions in performing duties for FTUS. If an immediate family member who does not reside in the same household as the FTUS Associate, or any other familial relationship or close personal friend, renders such services to, represent, or undertakes to act for, any supplier, vendor, customer, competitor or other party with whom FTUS does business, the Associate shall immediately disclose such services, representation or acts to the Director of Human Resources for determination whether such relations with the supplier, vendor, customer, competitor or other party with whom FTUS does business do not conflict with the interest of FTUS or otherwise create the appearance of impropriety. Associates may not offer for sale to customers or potential customers of the company, any products that are not sold by FTUS. Such an activity might generate a conflict of interest or create the impression that such goods and services were offered, sponsored, endorsed or underwritten with FTUS's approval. 5. Compensation from Outside Concerns: FTUS must be the only source of compensation for each Associate for work performed on behalf of, or relating to, FTUS. Therefore, bonuses, commissions, prizes, rebates or similar items, whether cash or merchandise, provided by a supplier, vendor, customer, competitor or other party with whom FTUS does business are clearly the property of FTUS and must be reported to Director of Human Resources. It is in the best interest of professionalism and FTUS's business to apply any such payments, when possible, to reduce the cost of goods. 6. Investments: Direct beneficial ownership of any interest in securities of a supplier, vendor, customer, competitor or other party with whom FTUS does business is prohibited, with the exception that the investment in a publicly owned corporation is permitted if such investment represents: a. Less than 1% of the corporation's outstanding shares; and b. Less than 10% of the market value of the associate's investment portfolio. Written exceptions may be granted on a case-by-case basis, provided Associates give full disclosure to the Director of Human Resources. 7. Improper Use Of Corporate Assets: Company assets are to be used solely for the benefit of FTUS. Company assets are much more than our equipment, inventory, merchandise samples, corporate funds or office supplies. They include concepts, business strategies and plans, financial data, intellectual property rights and other information about our business. In addition, Associates must be aware that FTUS retains legal ownership of the product of their work. No work product created while employed by FTUS can be claimed, construed, or presented as property of the Associate, even after employment by FTUS has been terminated or the relevant project has been completed. This includes written and electronic documents, audio, and video recordings, system code, and also any concepts, ideas or other intellectual property developed for FTUS, regardless of whether the intellectual property is actually used by FTUS. Company assets may not be improperly used to provide personal gain for Associates. On occasion, some assets (as electronic equipment, cars) of the Company that are no longer needed in the business may be sold to an Associate. Such sales must be supported by properly approved documentation signed by the Associate's Department EVP and approved by the Director of Human Resources. I have read and fully understand the Conflict of Interest Policy and hereby affirm that I am presently in compliance with it and will observe it at all times during my employment with Factory 2 - U Stores, Inc. If you have questions, please see your respective EVP or the Director of Human Resources. Please place your initials on either line 1 or line 2 below, whichever is applicable. 1. ________ I have no potential or current conflict issues that need to be discussed or disclosed. 2. ________ I have current or potential conflicts to discuss with the Director of Human Resources. (Please describe in the area below) ------------------------------------------------------------------- ------------------------------------------------------------------- ------------------------------------------------------------------- ------------------------------------------------------------------- Date: _____________ ___________________________________________ (Signature) ------------------------------------------- (Print name) Signing the agreement does not constitute a commitment on behalf of FTUS regarding the duration of employment. EX-23 7 ex231043004.txt ERNST & YOUNG CONSENT Exhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements on Form S-8 (nos. 333-76011, 333-89267, 333-94123 and 333-40682) and in the related Prospectus and the Registration Statements on Form S-3 (nos. 333-108809 and 333-105011) of Factory 2-U Stores, Inc. of our report dated April 19, 2004, with respect to the financial statements and schedule of Factory 2-U Stores, Inc. included in this Annual Report (Form 10-K) for the year ended January 31, 2004. /s/ERNST & YOUNG LLP San Diego, California April 29, 2004 EX-23 8 ex232043004.txt INFORMATION REGARDING CONSENT OF AA LLP EXHIBIT 23.2 NOTICE REGARDING CONSENT OF ARTHUR ANDERSEN LLP Section 11(a) of the Securities Act of 1933, as amended, provides that if part of a registration statement at the time it becomes effective contains an untrue statement of a material fact, or omits a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring a security pursuant to such registration statement (unless it is proved that at the time of such acquisition such person knew of such untruth or omission) may assert a claim against, among others, an accountant who has consented to be named as having certified any part of the registration statement or as having prepared any report for use in connection with the registration statement. On April 24, 2002, the Board of Directors of Factory 2-U Stores, Inc. (the "Company"), upon recommendation of its Audit Committee, decided not to renew the engagement of Arthur Andersen LLP ("Arthur Andersen") as the Company's independent public accountants for the fiscal year ended February 1, 2003 and authorized the engagement of Ernst & Young LLP to serve as the Company's independent public accountants. For additional information, see the Company's Current Reports on Form 8-K filed with the Securities and Exchange Commission on May 1, 2002 and May 8, 2002. After reasonable efforts, the Company has been unable to obtain Arthur Andersen's written consent to the incorporation by reference into the Company's registration statements on Form S-3 (Nos. 333-105011 and 333-108809) and registration statements on Form S-8 (Nos. 333-76011, 333-89267, 333-94123 and 333-40682) of which this Exhibit is a part and the related prospectus (the "Registration Statement") of Arthur Andersen's audit report with respect to the Company's financial statements as of February 2, 2002. Under these circumstances, Rule 437a under the Securities Act permits the Company to file this registration statement without a written consent from Arthur Andersen. As a result, with respect to transactions in the Company's securities pursuant to the Registration Statement, Arthur Andersen will not have any liability under Section 11(a) of the Securities Act for any untrue statements of a material fact contained in the financial statements audited by Arthur Andersen or any omissions of a material fact required to be stated therein. Accordingly, you would be unable to assert a claim against Arthur Andersen under Section 11(a) of the Securities Act. EX-31 9 ex311043004.txt 302 CERTIFICATION CEO EXHIBIT 31.1 I, Norman G. Plotkin, certify that: 1. I have reviewed this Annual Report on Form 10-K of Factory 2-U Stores, Inc. (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, a including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in b this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluations; and c) Disclosed in this report any change in the registrant's internal control over financial reporting c that occurred during the registrant's fourth quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the Audit Committee of the registrant's Board of Directors: a)All significant deficiencies and material weaknesses in the design or operation of internal control a over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control. Date: April 30, 2004 /s/ Norman G. Plotkin --------------------- Norman G. Plotkin Chief Executive Officer EX-31 10 ex312043004.txt 302 CERTIFICATION CFO EXHIBIT 31.2 I, Norman Dowling, certify that: 1. I have reviewed this Annual Report on Form 10-K of Factory 2-U Stores, Inc. (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, a including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in b this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluations; c) Disclosed in this report any change in the registrant's internal control over financial reporting c that occurred during the registrant's fourth quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the Audit Committee of the registrant's Board of Directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control a over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control. Date: April 30, 2004 /s/ Norman Dowling --------------------- Norman Dowling Executive Vice President and Chief Financial Officer EX-32 11 ex321043004.txt 906 CERTIFICATION CEO EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 (AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002) In connection with the Annual Report of Factory 2-U Stores, Inc. (the "Company") on Form 10-K for the period ended January 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Norman G. Plotkin, Chief Executive Officer of the Company, certify to my knowledge and in my capacity as an officer of the Company, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of the dates and for the periods expressed in the Report. IN WITNESS WHEREOF, the undersigned has executed this Certificate, effective as of April 30, 2004. /s/ Norman G. Plotkin --------------------- Norman G. Plotkin Chief Executive Officer A signed original of this written statement required by Section 906 has been provided to Factory 2-U Stores, Inc. and will be retained by Factory 2-U Stores, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. EX-32 12 ex322043004.txt 906 CERTIFICATION CFO EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 (AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002) In connection with the Annual Report of Factory 2-U Stores, Inc. (the "Company") on Form 10-K for the period ended January 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Norman Dowling, Executive Vice President and Chief Financial Officer of the Company, certify to my knowledge and in my capacity as an officer of the Company, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of the dates and for the periods expressed in the Report. IN WITNESS WHEREOF, the undersigned has executed this Certificate, effective as of April 30, 2004. /s/ Norman Dowling --------------------- Norman Dowling Executive Vice President and Chief Financial Officer A signed original of this written statement required by Section 906 has been provided to Factory 2-U Stores, Inc. and will be retained by Factory 2-U, Inc. and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----