10-Q 1 aform10q050104.txt FORM 10-Q FOR THE QUARTERLY PERIOD ENDED 050104 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 1O-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended May 1, 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 incorporation or organization) Identification No.) 4000 Ruffin Road, San Diego, CA 92123-1866 ------------------------------- ---------- (Address of principal executive office) (Zip Code) (858) 627-1800 -------------- (Registrant's telephone number, including area code) 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. [X] YES [ ] NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [X] YES [ ] NO The number of shares outstanding of the registrant's common stock, as of June 4, 2004 was 17,796,178 shares. (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. FACTORY 2-U STORES, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MAY 1, 2004 INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Factory 2-U Stores, Inc. Balance Sheets as of May 1, 2004 (Unaudited), May 3, 2003 (Unaudited) and January 31, 2004 ......................F-1 Factory 2-U Stores, Inc. Statements of Operations (Unaudited) for the 13 weeks ended May 1, 2004 and May 3, 2003 .........................F-3 Factory 2-U Stores, Inc. Statements of Cash Flows (Unaudited) for the 13 weeks ended May 1, 2004 and May 3, 2003 .........................F-4 Factory 2-U Stores, Inc. Notes to Financial Statements (Unaudited)..F-5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................3 Item 3. Quantitative and Qualitative Disclosures About Market Risk...........12 Item 4. Controls and Procedures .............................................12 PART II. OTHER INFORMATION Item 1. Legal Proceedings ...................................................12 Item 6. Exhibits and Reports on Form 8-K ....................................12 Signatures ................................................................13 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Balance Sheets (in thousands) May 1, May 3, January 31, 2004 2003 2004 ------ ------ ----------- (Unaudited) (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 5,487 $ 5,414 $ 9,963 Merchandise inventory 46,534 66,012 38,168 Accounts receivable, net 884 623 618 Income tax receivable - 1,756 - Prepaid expenses 3,863 6,258 2,740 Deferred income taxes - 9,753 - --------- --------- -------- Total current assets 56,768 89,816 51,489 Leasehold improvements and equipment, net 16,094 26,594 18,186 Deferred income taxes - 10,750 - Other assets 1,366 936 1,033 Goodwill - 26,301 - --------- --------- -------- $74,228 $154,397 $70,708 ========= ========= ========
The accompanying notes are an integral part of these financial statements. (continued) F-1
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Balance Sheets (in thousands) (continued) May 1, May 3, January 31, 2004 2003 2004 ------ ------ ----------- (Unaudited) (Unaudited) LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: DIP financing facility $ 3,015 $ - $ - Current maturities of long-term debt 36 3,021 36 Junior secured term loans - 7,500 - Accounts payable 16,013 43,844 8,257 Income tax payable 3,492 - 3,500 Sales tax payable 4,142 2,748 5,615 Accrued expenses 14,670 27,693 12,560 --------- -------- --------- Total current liabilities 41,368 84,806 29,968 Revolving credit facility - 11,535 - Long-term debt 83 6,754 92 Accrued restructuring charges - 1,747 - Deferred rent and other liabilities 2,073 2,822 2,518 --------- --------- --------- Total liabilities not subject to compromise 43,524 107,664 32,578 --------- --------- --------- Liabilities subject to compromise 67,986 - 63,062 Stockholders' equity (deficit): Common stock, $0.01 par value; 35,000 shares authorized and 17,796 shares, 15,657 shares and 17,921 shares issued and outstanding, respectively 178 157 179 Additional paid-in capital 137,965 126,513 137,964 Accumulated deficit (175,425) (79,937) (163,075) --------- --------- ---------- Total stockholders' equity (deficit) (37,282) 46,733 (24,932) --------- --------- ---------- $ 74,228 $154,397 $ 70,708 ========= ========= ===========
The accompanying notes are an integral part of these financial statements. F-2
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Statements of Operations (in thousands, except per share data) (Unaudited) 13 Weeks Ended -------------- May 1, May 3, 2004 2003 ------- ------ Net sales $ 80,326 $ 104,347 Cost of sales 52,913 66,712 ---------- ------------ Gross profit 27,413 37,635 Selling and administrative expenses 31,165 41,255 Pre-opening and closing expenses 14 138 ---------- ------------ Operating loss (3,766) (3,758) Interest expense, net 375 634 ---------- ------------ Loss before reorganization items and income tax benefit (4,141) (4,392) Reorganization items 8,210 - ---------- ------------ Loss before income tax benefit (12,351) (4,392) Income tax benefit - (1,671) ---------- ------------ Net loss $ (12,351) $ (2,721) ========== ============ Net loss per share, basic and diluted $ (0.70) $ (0.19) Weighted average common shares outstanding, basic and diluted 17,696 14,620
The accompanying notes are an integral part of these financial statements. F-3
FACTORY 2-U STORES, INC. (Debtor-in-Possession) Statements of Cash Flows (in thousands) (Unaudited) 13 Weeks Ended -------------- May 1, 2004 May 3, 2003 ----------- ----------- Cash flows from operating activities Net loss $ (12,351) $ (2,721) Adjustments to reconcile net loss to net cash used in operating activities Depreciation and amortization 2,349 3,305 Gain on disposal of equipment (4) - Deferred rent (621) (239) Reorganization items 7,874 - Stock subscription notes receivable valuation adjustment - (708) Issuance of common stock to board members as compensation - 5 Other non-cash changes (71) - Changes in operating assets and liabilities Merchandise inventory (8,366) (33,840) Prepaid expenses and other assets (2,225) 8,051 Advances to vendor - (16) Repayments from vendor 70 4 Accounts payable 7,756 15,883 Income taxes payable (8) (4,848) Accrued expenses and other liabilities (1,740) (17) Liabilities subject to compromise (94) - ------------ ------------ Net cash used in operating activities (7,431) (15,141) Cash flows from investing activities Purchases of leasehold improvements and equipment (51) (1,032) ------------ ------------- Net cash used in investing activities (51) (1,032) Cash flows from financing activities Borrowings on revolving credit facility 66,702 42,507 Payments on revolving credit facility (63,687) (37,272) Payments on long-term debt (9) - Proceeds from debt financing - 7,500 Proceeds from issuance of common stock, net - 5,672 Payment of deferred debt issuance costs - (428) Payments of stock subscription notes receivable - 143 ------------ ------------- Net cash provided by financing activities 3,006 18,122 Net increase (decrease) in cash (4,476) 1,949 Cash at the beginning of the period 9,963 3,465 ------------ ------------- Cash at the end of the period $ 5,487 $ 5,414 ============ ============= Supplemental disclosure of cash flow information Cash paid during the period for Interest $ 206 $ 347 Incomes taxes $ 9 $ 88 Supplemental disclosure of non-cash investing and financing activities Acquisition of equipment under notes payable $ - $ 92
The accompanying notes are an integral part of these financial statements. F-4 FACTORY 2-U STORES, INC. (Debtor-in-Possession) Notes to Financial Statements (Unaudited) (1) Basis of Presentation --------------------- The accompanying unaudited financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements and should be read in conjunction with the financial statements for the fiscal year ended January 31, 2004 included in our Form 10-K as filed with the Securities and Exchange Commission. We believe that the unaudited financial statements as of and for the 13 weeks ended May 1, 2004 and May 3, 2003 reflect all adjustments necessary to present fairly the financial position, results of operations and cash flows for the periods presented. Due to the seasonal nature of our business, the results of operations for the interim period may not necessarily be indicative of the results of operations for a full year. Certain prior period amounts have been reclassified to conform their presentation to the fiscal 2004 financial statements. 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. Since the Chapter 11 filing, we have applied the provisions of Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("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. 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 SOP 90-7, all pre-petition liabilities subject to compromise have been segregated in the Balance Sheets as of May 1, 2004 and 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 the 13 weeks ended May 1, 2004. F-5 (2) Accounting Policies ------------------- 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. Stock-based Compensation We have elected under the provisions of Statement of Financial Accounting Standard (the "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) 13 weeks ended ------------------------------------- May 1, May 3, 2004 2003 ---------- ----------- Net loss before stock-based compensation, as reported $ (12,351) $ (2,721) Stock based compensation using the fair value method, net of tax (546) (809) ----------- ---------- Pro-forma net loss $ (12,897) $ (3,530) =========== ========== Pro-forma net loss per share, basic and diluted $ $ (0.73) $ (0.27)
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 Black-Scholes option valuation model does not take into account our status as a debtor in possession, which may have a material effect on the value of our outstanding options. F-6 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: 13 Weeks Ended -------------- May 1, May 3, 2004 2003 ------ ------ (i) Expected dividend yield 0.00% 0.00% (ii) Expected volatility 111.81% 103.68% (iii) Expected life 6 years 7 years (iv) Risk-free interest rate 3.63 % 3.45%
Income (loss) per Share and Comprehensive Income 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 0 and 108,437 for the 13 weeks ended May 1, 2004 and May 3, 2003, respectively, are not included in the computation of diluted loss per share because the effect would have been anti-dilutive. Comprehensive loss for the 13 weeks ended May 1, 2004 and May 3, 2003 did not differ from net loss. Recent Accounting Pronouncements In March 2004, the Financial Accounting Standards Board (the "FASB") issued an exposure draft entitled "Share-Based Payment - an amendment of Statements No. 123 and 95 (Proposed Statements of Financial Accounting Standards)" The proposed statement would eliminate an issuer's ability to account for share-based compensation transactions using APB Opinion No. 25 and would generally require that such transactions be accounted for using a fair-value-based method of accounting. This accounting standard, if approved, will result in compensation expense charges to our future results of operations. The proposed statement, if adopted, would be applied to public entities prospectively for fiscal years beginning after December 15, 2004, as if all share-based compensation awards granted, modified or settled after December 15, 1994 had been accounted for using the fair-value method of accounting. Retrospective application of the proposed statement is not permitted. (3) 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 13 weeks ended May 1, 2004 were $8.2 million and consisted of: (1) a non-cash charge of $5.0 million for lease rejection claims associated with 31 lease rejections in conjunction with the 44 stores closed in the quarterly period ended May 1, 2004, as part of our reorganization efforts; (2) $2.8 million of professional fees and other expenses incurred in our bankruptcy case and reorganization efforts; and (3) $366,000 of additional costs to close the 44 stores. Cash payments resulting from reorganization items during the 13 weeks ended May 1, 2004 were approximately $221,000. F-7 (4) 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 Sheets as of May 1, 2004 and 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. We have mailed notices to all known creditors to inform them that the deadline for filing proofs of claim with the Court is June 15, 2004. The following table summarizes the components of Liabilities subject to compromise in our Balance Sheet as of May 1, 2004. (in thousands) May 1, January 31, 2004 2004 ------ ----------- Trade and other accounts payable $ 41,987 $ 41,734 Junior subordinated notes, net of discount 10,349 10,349 Restructuring costs, primarily lease rejection claims 5,929 6,044 Lease rejection claims 5,065 - General liability and workers compensation claims 2,273 2,283 Severance claims 1,385 1,385 Other 998 1,267 -------- ----------- Liabilities subject to compromise $ 67,986 $ 63,062 -------- -----------
F-8 (5) Store Closures -------------- 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 acted 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 of these stores and rejected the remaining 31 leases. As a result of these lease rejections, we recorded a non-cash charge of $5.0 million (included in Reorganization items) related to lease rejection claims per the maximum amount allowed under the Bankruptcy Code. 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 June 4, 2004, we have received $3.4 million as partial payment for the sale of inventory to Great American and are in the process of determining the remaining amount owed to us. In addition, we have received approximately $1.5 million of sale expense reimbursement. Other closing costs of approximately $366,000 not reimbursed by Great American have been included in Reorganization items for the 13 weeks ended May 1, 2004. On June 4, 2004, we filed a motion with the Court seeking authorization to close another 23 under-performing stores. Subject to the Court's approval, we currently plan to start the going-out-of-business sale process on or about July 1, 2004 and expect to close these stores by the end of August 2004. (6) 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. As of June 4, 2004, we have closed 20 of these 23 stores. We terminated the lease obligations on 14 of these closed stores prior to our Chapter 11 filing, and in conjunction with our Chapter 11 filing we rejected the other 6 leases. The three remaining stores have not been closed at this time due to lease concessions agreed to by the landlords. The balance of the liability of $4.6 million as of May 1, 2004 (included in "Liabilities subject to compromise" in the accompanying Balance Sheet) related to this fiscal 2002 restructuring charge was as follows: Balance at Non-cash Balance at January 31, Cash Charges and May 1, (in thousands) 2004 Payments Adjustments 2004 ----------- -------- ----------- --------- Lease termination costs $ 4,463 $ - $ - $ 4,463 Employee termination costs 65 (43) - 22 Other costs 147 (58) - 89 ----------- --------- ----------- ---------- $ 4,675 $(101) $ - $ 4,574 ----------- --------- ----------- ----------
As of May 1, 2004, the balance of non-cash inventory liquidation costs related to this fiscal 2002 restructuring charge was zero. F-9 (7) 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. We closed all 28 stores during fiscal 2002. We had terminated the lease obligations on 23 of these stores prior to our Chapter 11 filing and rejected the remaining 5 leases during the bankruptcy proceeding. The balance of the liability of $1.4 million as of May 1, 2004 (included in "Liabilities subject to compromise" in the accompanying Balance Sheet) related to the fiscal 2001 restructuring charge was as follows: Balance at Balance at January 31, Cash May 1, (in thousands) 2004 Payments 2004 ----------- --------- ---------- Lease termination costs $ 1,249 $ - $ 1,249 Other costs 120 (14) 106 ----------- --------- ---------- $ 1,369 $ (14) $ 1,355 ----------- --------- ----------
(8) 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 provided 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 three times; on January 30, 2004, March 10, 2004, and May 27, 2004, respectively. The most recent amendment is subject to the Court's approval, a hearing for which is scheduled on June 15, 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. 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. F-10 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. As of May 1, 2004, the financial covenants included 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 May 1, 2004, we were in compliance with our covenants and had borrowings of $3.0 million outstanding under the revolving credit facility and outstanding letters of credit of $15.1 million under the sub-facility for letters for credit. As of May 1, 2004, based on our eligible inventory and accounts receivable, we were eligible to borrow $14.7 million under the revolving credit facility and had $8.5 million available after giving effect for the availability block, as defined. The May 27, 2004 amendment, still subject to the Court's approval, modified our financial covenants, whereby covenants will include minimum availability, five-day availability covenants at each month end and minimum inventory per store. The Tranche B Lender will fully fund within five business days of the Court's approval of the amendment and we may repay the Tranche B amount after October 20, 2004 subject to certain conditions. (9) Provision for Income Taxes -------------------------- Due to our significant net operating losses and our Chapter 11 filing, we provided for a 100% valuation allowance on all deferred tax assets as of January 31, 2004 because we cannot conclude that it is more likely than not that the deferred tax assets will be realized in the foreseeable future. Accordingly, for the 13 weeks ended May 1, 2004, our income tax benefit was zero as we established a 100% valuation allowance to offset such benefit. (10) Stock Options and Warrants -------------------------- As of May 1, 2004, options to purchase 950,091 shares of our common stock and warrants to purchase 270,190 shares of our common stock were outstanding. The options have exercise prices in the range of $1.61 to $42.25 and expire on various dates between May 2004 and December 2013. The warrants have exercise prices in the range of $3.50 to $19.91 and expire on various dates between May 2005 and August 2006. (11) 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 Bankruptcy 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. F-11 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. 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. F-12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Cautionary Statements for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995 Certain statements in this Quarterly Report on Form 10-Q 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; changes in our business strategy or development plans, including anticipated growth strategies and capital expenditures; 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; the effectiveness of our operating initiatives and advertising and promotional strategies and other factors described in this Quarterly Report on Form 10-Q 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 Court with respect to motions in the Chapter 11 case 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 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. 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. 3 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 claim 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. General The following discussion and analysis should be read in conjunction with our financial statements and notes thereto, included elsewhere in this Form 10-Q. Despite our efforts in fiscal 2003 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, on January 13, 2004, we filed a voluntary petition to reorganize under Chapter 11 of the Bankruptcy Code in the Court, which is currently pending. 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. 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. 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. 4 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. 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, having a plan of reorganization confirmed by the Court. 5 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 "Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995" immediately preceding this session. On May 5, 2004, the Court granted us authorization to adopt and implement the key employee retention, emergence and severance plans. On June 3, 2004, the Court issued an order, subject to certain conditions, extending the period in which we have the exclusive right to file a proposed plan or reorganization through December 3, 2004. On June 4, 2004, we filed a motion with the Court seeking authorization to close another 23 under-performing stores. Subject to the Court's approval, we currently plan to start the going-out-of-business sale process on or about July 1, 2004 and expect to close these stores by the end of August 2004. As in the last two fiscal years, we continue to operate our business in a very soft retail environment. Our first quarter in fiscal 2004 started shortly after we filed for bankruptcy protection under Chapter 11. Our inventory position during the earlier part of the quarter was below our preferred level due, in part, to the uncertainties surrounding our Chapter 11 filing. Additionally, the filing adversely affected our sales in the first quarter. We have significantly reduced our marketing spend, in accordance with our marketing strategy, which has also negatively impacted our top line since the beginning of fiscal 2004, but which we believe will ultimately improve profitability. As previously disclosed, we started our 44 store closings in mid-February via a going-out-of-business process conducted by Great American. All 44 stores were closed by March 18, 2004 and we have terminated the lease obligations of these store locations either through mutual agreements with landlords or through lease rejections as allowed by the Court. As a result of a thorough review of the financial performance of our entire store base after the completion of the first quarter, we have sought the Court's approval to close an additional 23 stores to further improve our overall financial performance and enable us to concentrate on growing our business at our most productive locations. Currently, we are focusing our efforts on implementing our inventory strategy, enhancing distribution and store operating efficiency, and improving store execution. All these efforts are intended to ensure that we are well prepared for the upcoming back-to-school season. Critical Accounting Policies and Estimates 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. 6 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 May 1, 2004, we had an inventory valuation allowance of approximately $1.1 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 $921,000 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 assumptions in 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, at the end of fiscal 2003, we recorded an impairment charge of $26.3 million for our goodwill and an impairment charge of $2.4 million regarding fixed assets located at the 44 closed 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)." At the end of fiscal 2003, 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. 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. 7 o 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. Except for secured debt, employee payroll and benefits, sales, use and other taxes, and capital lease obligations, all pre-petition liabilities per our best estimate have been classified as liabilities subject to compromise. Adjustments to pre-petition liabilities may result from negotiations, payments authorized by Court order, additional rejection of executory contracts, including leases, or other events. We have mailed notices to all known creditors that the deadline for filing proofs of claims 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, and any necessary adjustments will be recorded accordingly. 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 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. 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 May 1, 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 operated 195 and 242 stores as of May 1, 2004 and May 3, 2003, respectively. The average number of stores in operation during the 13-week period ended May 1, 2004 was 198 versus 243 during the same period last year. Net sales were $80.3 million for the 13 weeks ended May 1, 2004 compared to $104.3 million for the 13 weeks ended May 3, 2003, a decrease of $24.0 million, or 23.0%. Comparable store sales for the 13-week period ended May 1, 2004 decreased 11.0% versus a decrease of 7.4% for the same period last year. The decline in net sales was primarily due to fewer stores in operation and negative comparable store sales. In addition, we believe reduced marketing efforts, as provided in our strategic plan, adversely affected net sales. Gross profit was $27.4 million for the 13 weeks ended May 1, 2004 compared to $37.6 million for the 13 weeks ended May 3, 2003, a decrease of $10.2 million or 27.2%. As a percentage of net sales, gross profit was 34.1% for the 13 weeks ended May 1, 2004 versus 36.1% for the same period last year. The decrease in gross profit as a percentage of net sales for the 13 weeks ended May 1, 2004 from the comparable period last year was primarily due to higher markdowns and shrink accrual, partially offset by higher initial mark-up. 8 Selling and administrative expenses were $31.2 million for the 13 weeks ended May 1, 2004 compared to $41.3 million for the 13 weeks ended May 3, 2003, a decrease of $10.1 million or 24.5%. As a percentage of net sales, selling and administrative expenses were 38.8% and 39.5% for the 13 weeks ended May 1, 2004 and May 3, 2003, respectively. Selling and administrative expenses decreased as a result of fewer stores in operation during the current quarter, lower advertising spend and lower general and administrative costs at corporate. The lower selling and administrative expenses were in line with our plan. Pre-opening and closing expenses were $14,000 for the 13 weeks ended May 1, 2004 compared to $138,000 for the same period last year, a decrease of approximately $124,000 or 89.9%. The decrease in pre-opening and closing expenses was due to no store opening activity in the first quarter of fiscal 2004, versus one new store opening during the same period last year and preopening costs incurred for the Otay Mesa distribution center, which was opened in May 2003. Reorganization items for the 13 weeks ended May 1, 2004 were $8.2 million and consisted of: (1) a non-cash charge of $5.0 million for lease rejection claims associated with 31 lease rejections in conjunction with the 44 stores closed in the quarterly period ended May 1, 2004, as part of our reorganization efforts; (2) $2.8 million of professional fees and other expenses incurred in our bankruptcy case and reorganization efforts; and (3) $366,000 of additional costs to close the 44 stores. Interest expense, net was $375,000 for the 13 weeks ended May 1, 2004 compared to $634,000 for the 13 weeks ended May 3, 2003, a decrease of $259,000 or 40.9%. The decrease in interest expense for the current quarter was primarily due to lower borrowings as compared to the same period last year. Income tax benefit for the 13 weeks ended May 1, 2004 was zero as compared to $1.7 million for the 13 weeks ended May 3, 2003. Due to our significant net operating losses and our Chapter 11 filing, we provided for a 100% valuation allowance on all deferred tax assets as of January 31, 2004 because we cannot conclude that it is more likely than not that the deferred tax assets will be realized in the foreseeable future. Accordingly, for the 13 weeks ended May 1, 2004, our income tax benefit was zero as we established 100% valuation allowance to offset such benefit. For the 13 weeks ended May 1, 2004, the net loss was $12.4 million as compared to $2.7 million for the 13 weeks ended May 3, 2003. The increase in net loss was primarily a result of the reorganization items discussed above. 9 Liquidity and Capital Resources General We finance our operations through credit provided by vendors and other suppliers, amounts borrowed under our DIP financing facility, 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. At May 1, 2004, we were in compliance with all financial covenants under our DIP financing facility, and had outstanding borrowings of $3.0 million and letters of credit of $15.1 million under our DIP financing facility. The financial covenants have since been amended in accordance with the May 27, 2004 amendment, subject to the Court's approval. This amendment modified our financial covenants, whereby covenants will include minimum availability, five-day availability covenants at each month end and minimum inventory per store. The Tranche B Lender will fully fund within five business days of the Court's approval of the amendment and we may repay the Tranche B amount after October 20, 2004 subject to certain conditions. With respect to cash flows for the quarterly period ended May 1, 2004, we used $7.4 million in operating activities, $51,000 in investing activities and generated $3.0 million from financing activities, which resulted in a net decrease in cash of $4.5 million. For the same period last year, we used $15.1 million in operating activities, $1.0 million in investing activities and generated $18.1 million from financing activities, which resulted a net increase in cash of $1.9 million. The decrease in cash used in operating activities was primarily due to the lower number of stores in operation. The decrease in cash used in investing activities was due to higher spending in the first quarter of fiscal 2003 related to the equipment acquisition for the Otay Mesa distribution facility. The decrease in cash generated from the financing activities was a result of net proceeds received from the private offering and the borrowings on the junior secured term loan in the same period last year. 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 shortening of payment terms with our vendors, a significant deterioration of credit terms with our 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. Capital Expenditures We anticipate capital expenditures of approximately $800,000 during the remaining nine months of the fiscal year ending January 29, 2005, which include necessary costs for replacement capital at existing stores. We intend to fund the anticipated capital expenditures from our sources of cash, including the DIP financing facility. Store Closures and Restructuring Initiatives 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 acted 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. As of June 4, 2004, we have terminated or assigned a total of 13 leases of these stores and rejected the remaining 31 leases. We do not expect any significant cash requirements relating to these 44 store closures for the remaining nine months of fiscal 2004. 10 As of June 4, 2004 we have closed 20 of the 23 stores identified in our Fiscal 2002 restructuring efforts and all 28 of the stores identified in our Fiscal 2001 restructuring efforts. In conjunction with our Chapter 11 filing, we have ceased to make cash payments for any remaining obligations regarding our Fiscal 2002 or 2001 restructuring plans except for 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. The cash requirements relating to these obligations for the remaining nine months of fiscal 2004 are expected to be approximately $991,000, which we intend to fund from our sources of cash, including the DIP financing facility. In addition, on June 4, 2004, we filed a motion with the Court seeking authorization to close another 23 under-performing stores. Subject to the Court's approval, we currently plan to start the going-out-of-business sale process on or about July 1, 2004 and expect to close these stores by the end of August 2004. We do not expect any significant cash requirements relating to these 23 store closures for the remaining nine months of fiscal 2004. Contractual Obligations and Commitments The following table summarizes, as of May 1, 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 6 - Fiscal 2002 Restructuring Charge", "Note 7 - Fiscal 2001 Restructuring Charge", and "Note 8 - DIP Financing Facility" in the accompanying unaudited financial statements, as well as our fiscal 2003 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Payments due by period ---------------------- 2005 and 2007 and (in thousands) Total 2004 2006 2008 Thereafter --------- -------- -------- -------- ---------- Operating lease obligations* $ 109,393 $ 18,649 $ 37,220 $ 22,644 $ 30,880 Restructuing charges 2,000 991 1,009 - - Notes payable 132 32 86 14 - --------- -------- -------- -------- -------- $ 111,525 $ 19,672 $ 38,315 $ 22,658 $ 30,880 ========= ======== ======== ======== ======== * Operating lease obligations have changed significantly from the disclosure in our most recent annual report on Form 10-K due to lease rejections associated with the 44 store closures.
Certain amounts included in the above table are related to executory contracts or lease obligations, which we have neither assumed nor rejected as of May 1, 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 non-cash charge of $5.0 million for lease rejection claims associated with 31 lease rejections in conjunction with the 44 stores closed in the quarterly period ended May 1, 2004, as part of our reorganization efforts; (2) $2.8 million of professional fees and other expenses incurred in our bankruptcy case and reorganization efforts; and (3) $366,000 of additional costs to close the 44 stores. We project cash requirements of approximately $4.5 million of professional fees and other related expenses for the remaining nine months of fiscal 2004. We believe that our sources of cash, including the DIP financing facility, should be adequate to fund the cash requirements for our reorganization efforts. 11 Item 3. 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 May 1, 2004, we had $3.0 million of borrowings outstanding under our DIP financing facility. Item 4. 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). 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. PART II - OTHER INFORMATION Item 1. Legal Proceedings See discussion of legal proceedings at Note 11 of the Notes to Financial Statements. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.26 Factory 2-U Stores, Inc. 2004 Key Employee Retention Plan. 10.27 Factory 2-U Stores, Inc. 2004 Key Employee Emergence Plan. 10.28 Factory 2-U Stores, Inc. 2004 Key Employee Severance Plan. 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 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 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. (b) Reports on Form 8-K On June 4, 2004, we furnished a report on Form 8-K regarding the extension of our exclusive right to file a proposed Plan of Reorganization and the filing of a motion with the Court seeking authorization to close additional 23 stores. The full text of our press dated June 4, 2004 was furnished and attached as an exhibit to the Form 8-K. 12 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FACTORY 2-U STORES, INC. Date: June 10, 2004 By: /s/Norman Dowling ----------------- Name: Norman Dowling Title:Executive Vice President and Chief Financial Officer (duly authorized officer and principal financial officer) 13