10-Q 1 d01973e10vq.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 -------------------------------------------------------------------------------- FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED NOVEMBER 2, 2002 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 0-26732 ------- GADZOOKS, INC. -------------------------------------------------------------------------------- (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) TEXAS 74-2261048 -------------------------------------------------------------------------------- (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER) INCORPORATION OR ORGANIZATION) 4121 INTERNATIONAL PARKWAY CARROLLTON, TX 75007 -------------------------------------------------------------------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 972-307-5555 ------------ -------------------------------------------------------------------------------- (FORMER NAME, FORMER ADDRESS AND FISCAL YEAR, IF CHANGED SINCE LAST REPORT.) 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 ( ) As of December 13, 2002, the number of shares outstanding of the registrant's common stock is 9,158,466. GADZOOKS, INC. FORM 10-Q For the Quarter Ended November 2, 2002 INDEX
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Condensed Consolidated Balance Sheets as of 3 November 2, 2002 and February 2, 2002 Condensed Consolidated Statements of Operations 4 for the Third Quarter Ended and Nine Months Ended November 2, 2002 and November 3, 2001 Condensed Consolidated Statements of Cash Flows for 5 the Nine Months Ended November 2, 2002 and November 3, 2001 Notes to Consolidated Financial Statements 6-8 Item 2. Management's Discussion and Analysis 9-12 of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures 13 About Market Risk Item 4. Controls and Procedures 13-14 PART II. OTHER INFORMATION 14 SIGNATURE PAGE 15 CERTIFICATIONS PURSUANT TO SECTION 302 16-17 INDEX TO EXHIBITS 18
2 PART 1 -- FINANCIAL INFORMATION GADZOOKS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS -------------------------------------------------------------------------------- (IN THOUSANDS) (UNAUDITED)
NOVEMBER 2, FEBRUARY 2, 2002 2002 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 2,347 $ 14,868 Accounts receivable 1,561 1,682 Inventory 66,402 63,660 Other current assets 7,883 1,931 ------------ ------------ 78,193 82,141 ------------ ------------ Leaseholds, fixtures and equipment, net 42,141 41,009 Deferred tax assets 2,458 2,530 ------------ ------------ $ 122,792 $ 125,680 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 23,407 $ 27,091 Accrued expenses and other current liabilities 6,783 6,277 Income taxes payable -- 1,733 ------------ ------------ 30,190 35,101 ------------ ------------ Accrued rent 4,092 3,726 Shareholders' equity Common stock 92 91 Additional paid-in capital 44,893 44,385 Retained earnings 43,724 42,708 Treasury stock (199) (331) ------------ ------------ 88,510 86,853 ------------ ------------ $ 122,792 $ 125,680 ============ ============
The accompanying notes are an integral part of these consolidated financial statements. 3 GADZOOKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS -------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
THIRD QUARTER ENDED NINE MONTHS ENDED ---------------------------- --------------------------- NOVEMBER 2, NOVEMBER 3, NOVEMBER 2, NOVEMBER 3, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Net sales $ 73,734 $ 73,177 $ 228,706 $ 216,568 Cost of goods sold including buying, distribution and occupancy costs 56,785 54,317 170,823 163,498 ------------ ------------ ------------ ------------ Gross profit 16,949 18,860 57,883 53,070 Selling, general and administrative expenses 18,360 17,317 56,308 50,121 ------------ ------------ ------------ ------------ Operating income (loss) (1,411) 1,543 1,575 2,949 Interest income, net 19 48 85 327 ------------ ------------ ------------ ------------ Income (loss) before income taxes (1,392) 1,591 1,660 3,276 Provision (benefit) for income taxes (536) 590 644 1,212 ------------ ------------ ------------ ------------ Net income (loss) $ (856) $ 1,001 $ 1,016 $ 2,064 ============ ============ ============ ============ Net income (loss) per share Basic $ (0.09) $ 0.11 $ 0.11 $ 0.23 ============ ============ ============ ============ Diluted $ (0.09) $ 0.11 $ 0.11 $ 0.22 ============ ============ ============ ============ Weighted average shares outstanding Basic 9,132 9,070 9,121 9,028 ============ ============ ============ ============ Diluted 9,132 9,264 9,255 9,326 ============ ============ ============ ============
The accompanying notes are an integral part of these consolidated financial statements 4 GADZOOKS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS -------------------------------------------------------------------------------- (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED ------------------------------ NOVEMBER 2, NOVEMBER 3, 2002 2001 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,016 $ 2,064 Adjustments to reconcile net income to cash provided by (used in) operating activities: Loss on disposal of assets 486 150 Depreciation 7,045 6,089 Changes in operating assets and liabilities (13,046) (16,158) ------------ ------------ NET CASH USED IN OPERATING ACTIVITIES (4,499) (7,855) ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (8,663) (11,566) Purchase of short-term investments (5,957) -- Proceeds from redemption of short-term investments 5,957 -- ------------ ------------ NET CASH USED IN INVESTING ACTIVITIES (8,663) (11,566) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from line of credit -- 1,753 Issuance of common stock 460 958 Sale of treasury stock under employee benefit plan 181 141 ------------ ------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 641 2,852 ------------ ------------ Net decrease in cash and cash equivalents (12,521) (16,569) Cash and cash equivalents at beginning of period 14,868 20,284 ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,347 $ 3,715 ============ ============
The accompanying notes are an integral part of these consolidated financial statements 5 GADZOOKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION The accompanying condensed consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of November 2, 2002 and February 2, 2002, and the results of operations and cash flows for the third quarter and nine months ended November 2, 2002 and November 3, 2001. The results of operations for the third quarter and nine months then ended are not necessarily indicative of the results to be expected for the full fiscal year. The condensed consolidated balance sheet as of February 2, 2002 is derived from audited financial statements. The condensed consolidated financial statements should be read in conjunction with the financial statement disclosures contained in the Company's Annual Report on Form 10-K for the fiscal year ended February 2, 2002. Fiscal year: The Company's fiscal year is the 52- or 53-week period that ends on the Saturday closest to the end of January. "Fiscal 2002" is the 52-week period ending February 1, 2003. 2. LONG-TERM OBLIGATIONS On June 1, 2002, the Company entered into a restated and amended credit facility with Wells Fargo Bank (the "Bank"). The restated facility provided an unsecured revolving line of credit totaling $15 million. The total amount available to borrow pursuant to the credit agreement is limited to 140% of cash flow (as defined in the credit agreement) for the trailing 12-month period. Amounts borrowed under the revolving line bear interest at the lesser of either the bank's prime rate, or 195 basis points above LIBOR. The credit agreement also provides for the issuance of letters of credit that are generally used in connection with international merchandise purchases. Outstanding letters of credit issued by the bank reduce amounts otherwise available for borrowing under the revolving line of credit. The credit facility subjects the Company to various restrictions on the incurrence of additional indebtedness, acquisitions, loans to officers and stock repurchases, and includes various financial covenants. At November 2, 2002, the Company was in technical default of its line of credit covenant that requires net income of not less than $1 on a trailing two-quarter basis determined as of each fiscal quarter end. On November 11, 2002, the Company and the Bank entered into the First Amendment to the First Amended and Restated Credit Agreement and Waiver of Defaults, which provides the Bank with a security interest in the Company's inventory, accounts receivable and other rights to payment, furniture and fixtures, and machinery and equipment and includes a waiver of the specific covenant violation for the quarter ended November 2, 2002. The covenant will remain in effect for future periods. Amounts available to borrow under the line of credit, as limited by the cash flow multiple and/or outstanding letters of credit, totaled $13.0 million at November 2, 2002. No borrowings (other than letters of credit, totaling $2.0 million) were outstanding under the revolving line at November 2, 2002. Any amount borrowed under the revolving line of credit will become due on June 1, 2003, the date the credit agreement matures. 6 3. EARNINGS PER SHARE The following table outlines the Company's calculation of weighted average shares outstanding (in thousands):
QUARTER ENDED NINE MONTHS ENDED ----------------------------- ----------------------------- NOVEMBER 2, NOVEMBER 3, NOVEMBER 2, NOVEMBER 3, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Weighted average common shares outstanding (basic) 9,132 9,070 9,121 9,028 Effect of dilutive options -- 194 134 298 ------------ ------------ ------------ ------------ Weighted average common shares outstanding (diluted) 9,132 9,264 9,255 9,326 ------------ ------------ ------------ ------------
The treasury stock method is used to determine dilutive potential common shares outstanding related to stock options. Options, which based on their exercise price would be antidilutive, are not considered in the treasury stock method calculation. Options excluded from the earnings per share calculation due to their antidilutive nature totaled 1,309,980 and 474,668 for the quarters ended November 2, 2002 and November 3, 2001, and 772,729 and 376,248 for the nine months ended November 2, 2002 and November 3, 2001, respectively. 4. IMPAIRMENT OF LONG LIVED ASSETS During the second quarter of 2002, the Company abandoned its point of sale software implementation project after learning that the software provider would offer a new point of sale software product in 2003 and would discontinue sales of the current software. As a result of the abandonment of the project, certain costs related to the original project have been written off. The total impact of the write-off was a $310,000 ($191,000 after tax, or $.02 per diluted share) loss on disposal during the second quarter of fiscal 2002. In the first quarter of fiscal 2002, the Company hired a consulting firm to review the current store base and provide recommendations on ways to update the look of more mature stores and enhance visual merchandising in all stores. The store update and visual enhancement program developed in conjunction with the consulting firm was finalized during the second quarter and was implemented primarily during the second and third quarters of 2002 in an attempt to increase the visual appeal, flow and shopability of all stores. The program includes the removal of certain leasehold improvements and fixtures prior to the end of their estimated useful life. As a result, the Company recognized accelerated depreciation and loss on disposal of assets related to the project of approximately $365,000 ($224,000 after tax, or $.02 per diluted share) and $61,000 ($38,000 after tax) in the second and third quarters of fiscal 2002, respectively. 5. RETIREMENT AGREEMENT Effective August 28, 2002, the Company entered into an executive retirement agreement with Gerald R. Szczepanski, Chairman of the Board and Chief Executive Officer, pursuant to which Mr. Szczepanski or his estate shall be eligible to receive certain benefits on termination of his employment with Gadzooks as a result of either death, termination without cause or retirement. Upon such termination (i) Gadzooks will continue to provide Mr. Szczepanski (and his spouse, if applicable) medical, dental and life insurance coverage, (ii) Gadzooks will enter into a consulting relationship with Mr. Szczepanski for 24 months whereby Mr. Szczepanski will receive a consulting fee of $300,000 per year to facilitate an orderly transition to Mr. Szczepanski's successor; (iii) Mr. Szczepanski will receive his pro rata bonus for the fiscal year in which he retires; (iv) all of Mr. Szczepanski's stock options will become vested in full; and (v) all of Mr. Szczepanski's stock options with an exercise price equal to or greater than $9.00 will be amended to include a term equal to the lesser of (a) three years from such termination or (b) the original expiration date of such stock options. In addition, Mr. Szczepanski agrees that upon termination of his employment with Gadzooks, he will not disclose any confidential information relating to Gadzooks and he will not solicit, interfere or compete with Gadzooks, its business, its clients or its customers for a period of two years. 7 Pursuant to the agreement, Mr. Szczepanski is fully vested in the postretirement benefits available under the executive retirement agreement. Accordingly, during the third quarter, the Company recognized $115,000 as SG&A expense, which represents the estimated present value of the future health insurance benefits payable pursuant to the contract. In accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees" and FIN 44, "Accounting for Certain Transactions Involving Stock Compensation", the Company will not record any compensation expense related to the potential stock option amendments due to the exercise price of the options potentially amended by the modification being more than the stock price at the execution date of the agreement. 6. NEW ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143, "Accounting for Asset Retirement Obligations", effective for fiscal years beginning after June 15, 2002. SFAS 143 addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets. We do not expect that the adoption of SFAS 143 will have a significant impact on our financial statements. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", effective for transactions occurring after May 15, 2002. SFAS 145 requires gains and losses from extinguishment of debt to be reported as part of recurring operations, unless the transaction is considered unusual or infrequent in which case the transaction would be classified as an extraordinary item. This standard also eliminates an inconsistency between the accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. The Company's consolidated financial statements will not be impacted by the adoption of SFAS 145. SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" was issued on July 30, 2002 and replaces Emerging Issues Task Force Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity." SFAS 146 requires companies to recognize certain costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. 8 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Gadzooks is a mall-based specialty retailer of casual apparel and related accessories for young men and women principally between the ages of 14 and 18. As of November 2, 2002, the Company had opened 11 new Gadzooks stores and closed one store since the beginning of the fiscal year and operated 437 Gadzooks stores and four Orchid stores for a total of 441 stores in 41 states. The Company's business is subject to seasonal influences with higher sales during the Christmas holiday, back-to-school and spring break seasons. Management's discussion and analysis should be read in conjunction with the Company's financial statements and the notes related thereto. CRITICAL ACCOUNTING POLICIES The preparation of Gadzooks' consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet date, as well as the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates such estimates including sales return rates, inventory reserves, impairment of long-lived assets, income taxes and accrued expenses. Actual results may differ from estimates. Gadzooks accounting policies are generally straightforward, but the following items require more significant management judgments and estimates. REVENUE RECOGNITION. Retail merchandise sales are recognized at the point of sale less sales returns and employee discounts. Management records a provision for estimated sales returns based on historical return rates. If sales return rates change, an additional allowance may be required. INVENTORY VALUATION. Inventories are valued at the lower of average cost or market. In addition, inventories include an allocation of buying and distribution costs to prepare product for the stores. This inventory valuation method requires certain management estimates and judgments, including estimates of merchandise markdowns, which could significantly affect gross margin. Management estimates the markdown reserve based on several factors, including but not limited to, merchandise quantities, historical markdown percentages, and seasonal merchandise and future merchandise plans. If future demand or merchandise markdowns are less favorable than those projected by management, additional inventory adjustments may be required. On a monthly basis, management estimates shrink based on historical shrink rates. These estimates are compared to actual results as inventory counts are taken and reconciled to the general ledger during the second and fourth quarters of each year. LONG-TERM ASSET IMPAIRMENT. Management periodically reviews its long-lived assets for impairment and records a provision whenever events or circumstances indicate that the net book value of the asset may not be recoverable. Impairment is determined based on several factors, including but not limited to, current year operating loss or cash flow loss combined with a history and forecast of operating or cash flow losses and significant negative industry or economic trends. If management determines that an impairment exists, an impairment loss is recognized if the sum of the expected future cash flows (undiscounted and before interest) from the use of the assets is less than net book value of the assets. The amount of the impairment is measured as the difference between the net book value of the assets and the estimated fair market value of the related assets. DEFERRED TAX ASSETS. The Company does not currently have a valuation allowance recorded against its deferred tax assets. If management determines it is more likely than not that its deferred tax assets would not be realizable in the future, a valuation allowance would be recorded to reduce the deferred tax asset to its net realizable value. ACCRUED EXPENSES. On a monthly basis, certain expenses are estimated in an effort to reflect these expenses in the proper period. Gadzooks' most material estimates relate to self-insurance reserves, store level operating expenses and bonuses. The self-insurance reserves for medical and worker's compensation claims are recorded 9 based on historical claim levels adjusted for growth in the employee base. If the historical claims used to calculate these estimates are not reflective of actual results, additional expenses may be incurred up to the point that the Company's stop loss insurance begins. The Company is self-insured for property and casualty claims at the store level. Property and casualty claims at a store level are recorded as incurred. Accrued store level operating expenses are estimated based on current activity and historical results. Bonuses are based on performance and projected performance for the remainder of the bonus period. If actual results are significantly different from Gadzooks' expectations, an adjustment to expenses may be required. RESULTS OF OPERATIONS The third quarter ended November 2, 2002 compared to the third quarter ended November 3, 2001 Net Sales Net sales increased approximately $557,000, or 0.8 percent, to $73.7 million during the third quarter of fiscal 2002 from $73.2 million during the comparable quarter of fiscal 2001. The total Company sales increase was due to $4.1 million of sales from the 37 new stores not yet included in the comparable store sales base partially offset by a comparable store sales decrease of $3.6 million. Comparable store sales decreased 5.1 percent for the third quarter of fiscal 2002. Sales by category in the average store changed as follows versus the prior year quarter: shoes - increased a low single digit percentage; junior apparel - decreased a low single digit percentage; accessories - decreased a low single digit percentage; and men's apparel - decreased a high single digit percentage. The Company's average transaction size increased 1.3 percent, and the number of transactions per average store declined by 6.0 percent. Gross profit Gross profit decreased approximately $1.9 million to $16.9 million during the third quarter of fiscal 2002 from $18.9 million during the comparable quarter of fiscal 2001. As a percentage of net sales, gross profit decreased 2.8 percentage points to 23.0 percent from 25.8 percent for the comparable quarter of last year. Merchandise margins as a percentage of sales were 0.9 percent lower than the prior year. This decrease is primarily attributable to an increase in retail markdowns taken during the period partially offset by a reduction in the inventory shrinkage accrual based on the last physical inventory count results. Occupancy costs as a percentage of sales increased by 1.8 percent. The increase in occupancy costs (which are relatively fixed in nature) as a percentage of sales was due equally to the negative leverage effect of the comparable store sales decrease and the higher costs related to new stores. Selling, general and administrative expenses Selling, general and administrative expenses increased approximately $1.1 million to $18.4 million during the third quarter of 2002 from $17.3 million during the comparable quarter of fiscal 2001. The aggregate increase in SG&A is primarily attributable to additional store expenses as a result of the Company's expanded store base during the past year and an increase in administrative costs to support the larger store chain. As a percentage of net sales, SG&A increased by 1.2 percentage points to 24.9 percent during the third quarter of fiscal 2002 from 23.7 percent during the third quarter of last year. The increase in the SG&A percentage is a result of negative leverage from the comparable store sales decrease. Interest The Company's net interest income decreased $29,000 to $19,000 during the third quarter of fiscal 2002 from $48,000 in the comparable period of last year due primarily to lower average cash balances and lower market interest rates. 10 The nine months ended November 2, 2002 compared to the nine months ended November 3, 2001. Net sales Net sales increased approximately $12.1 million, or 5.6 percent, to $228.7 million during the first nine months of fiscal 2002 from $216.6 million during fiscal 2001. The total Company sales increase was attributable to new stores sales of $19.5 million, net of a comparable store sales decrease of $7.4 million, or 3.6 percent for the first nine months of fiscal 2002. The Company experienced comparable store sales decreases in all categories except footwear. The Company's average transaction size increased by 3.6 percent, and the number of transactions per average store decreased by 6.7 percent. Gross profit Gross profit increased approximately $4.8 million to $57.9 million during the first nine months of fiscal 2002 from $53.1 million during the comparable period of fiscal 2001. As a percentage of sales, gross profit increased 0.8 percentage points to 25.3 percent from 24.5 percent for the comparable nine months of last year. The merchandise margin as a percentage of sales was 2.3 percent higher than the prior year. This increase is primarily attributable to a significant reduction in retail markdowns taken during the first half of the year as well as improved inventory shrinkage results. Partially offsetting the improvement in merchandise margin was a 1.6 percent increase in occupancy costs as a percentage of sales. The increase in occupancy costs as a percentage of sales was due to the negative leverage effect of the comparable store sales decrease, as well as higher costs related to new stores. Selling, general and administrative expenses Selling, general and administrative expenses increased approximately $6.2 million to $56.3 million during the first nine months of 2002 from $50.1 million during the comparable nine months of fiscal 2001. The aggregate increase in SG&A is primarily attributable to additional store expenses as a result of the Company's expanded store base during the past year and an increase in administrative costs to support the larger store chain. As a percentage of net sales, SG&A increased 1.5 percent to 24.6 percent during the first nine months of fiscal 2002 from 23.1 percent during the comparable nine months of last year. The increase in the SG&A percentage is a result of the negative leverage effect of the comparable store sales decrease, an increase in store payroll expense, increased advertising and visual marketing costs and the write-off of certain project costs related to an abandoned information systems project. Interest The Company's net interest income decreased $242,000 to $85,000 during the first nine months of fiscal 2002 from $327,000 in the comparable period of last year due primarily to lower average cash balances and lower market interest rates. LIQUIDITY AND CAPITAL RESOURCES General The Company's primary uses of cash are financing new store openings, store refurbishments and purchasing merchandise inventories. The Company is currently meeting its cash requirements through cash flow from operations and cash and cash equivalents on-hand. Cash Flows At November 2, 2002, cash and cash equivalents were $2.4 million, a decrease of $12.5 million since February 2, 2002. The primary uses of cash were capital expenditures of $8.7 million for new stores, store refurbishments and information systems, an increase in other assets of $6.0 million, a decrease in accounts payable of $3.7 million, an increase in inventory of $2.7 million and a decrease in income taxes payable of $1.7 million. 11 Credit Facility On June 1, 2002, the Company entered into a restated and amended credit facility with Wells Fargo Bank (the "Bank"). The restated facility provided an unsecured revolving line of credit totaling $15 million. The total amount available to borrow pursuant to the credit agreement is limited to 140% of cash flow (as defined in the credit agreement) for the trailing 12-month period. Amounts borrowed under the revolving line bear interest at the lesser of either the bank's prime rate, or 195 basis points above LIBOR. The credit agreement also provides for the issuance of letters of credit that are generally used in connection with international merchandise purchases. Outstanding letters of credit issued by the bank reduce amounts otherwise available for borrowing under the revolving line of credit. The credit facility subjects the Company to various restrictions on the incurrence of additional indebtedness, acquisitions, loans to officers and stock repurchases, and includes various financial covenants. At November 2, 2002, the Company was in technical default of its line of credit covenant that requires net income of not less than $1 on a trailing two-quarter basis determined as of each fiscal quarter end. On November 11, 2002, the Company and the Bank entered into the First Amendment to the First Amended and Restated Credit Agreement and Waiver of Defaults, which provides the Bank with a security interest in the Company's inventory, accounts receivable and other rights to payment, furniture and fixtures, and machinery and equipment and includes a waiver of the specific covenant violation for the quarter ended November 2, 2002. The covenant will remain in effect for future periods. Amounts available to borrow under the line of credit, as limited by the cash flow multiple and/or outstanding letters of credit, totaled $13.0 million at November 2, 2002. No borrowings (other than letters of credit, totaling $2.0 million) were outstanding under the revolving line at November 2, 2002. Any amount borrowed under the revolving line of credit will become due on June 1, 2003, the date the credit agreement matures. Capital Expenditures As of the filing date of this document, the Company has opened all 11 new Gadzooks stores scheduled for opening this year. Capital expenditures for the remainder of the year should approximate $500,000 to $1,000,000 to complete the new stores, update the look of selected existing stores and purchase and/or upgrade information systems. The Company hired a consulting firm to review the current store base and provide recommendations on ways to update the look of more mature stores and enhance visual merchandising in all stores. The store update and visual enhancement program developed in conjunction with the consulting firm was finalized during the second quarter and was primarily implemented during the second and third quarters of 2002 in an attempt to increase the visual appeal, flow and shopability of all stores. Accelerated depreciation and loss on disposal of assets related to the project was approximately $365,000 and $61,000 for the second and third quarters, respectively. Management believes that the Company's working capital, credit facility and cash flows from operating activities will be sufficient to meet the Company's operating and capital requirements through the end of fiscal 2002. 12 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not engage in trading market risk sensitive instruments and does not purchase as investments, as hedges, or for purposes "other than trading" instruments that are likely to expose the Company to market risk, whether it be from interest rate, foreign currency exchange, commodity price or equity price risk. The Company has issued no debt instruments, entered into no forward or futures contracts, purchased no options and entered into no swaps. The Company's primary market risk exposure is that of interest rate risk. A change in LIBOR, or the Prime Rate as set by Wells Fargo Bank, would affect the rate at which the Company could borrow funds under its credit facility. RELATED PARTY TRANSACTIONS Gadzooks has entered into an executive retirement agreement with Gerald R. Szczepanski, Chairman of the Board and Chief Executive Officer, pursuant to which Mr. Szczepanski or his estate shall be eligible to receive certain benefits on termination of his employment with Gadzooks as a result of either death, termination without cause or retirement. Upon such termination (i) Gadzooks will continue to provide Mr. Szczepanski (and his spouse, if applicable) medical, dental and life insurance coverage, (ii) Gadzooks will enter into a consulting relationship with Mr. Szczepanski for 24 months whereby Mr. Szczepanski will receive a consulting fee of $300,000 per year to facilitate an orderly transition to Mr. Szczepanski's successor; (iii) Mr. Szczepanski will receive his pro rata bonus for the fiscal year in which he retires; (iv) all of Mr. Szczepanski's stock options will become vested in full; and (v) all of Mr. Szczepanski's stock options with an exercise price equal to or greater than $9.00 will be amended to include a term equal to the lesser of (a) three years from such termination or (b) the original expiration date of such stock options. In addition, Mr. Szczepanski agrees that upon termination of his employment with Gadzooks, he will not disclose any confidential information relating to Gadzooks and he will not solicit, interfere or compete with Gadzooks, its business, its clients or its customers for a period of two years. STATEMENT REGARDING FORWARD-LOOKING DISCLOSURE Certain sections of this Quarterly Report on Form 10-Q, including the preceding "Management's Discussion and Analysis of Financial Condition and Results of Operations," contain various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used in this report, words such an "anticipate," "believe," "estimate," "expect," "intend," "predict," "project," and similar expressions, as they relate to us or our management, identify forward-looking statements. These forward-looking statements are based on information currently available to our management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including fluctuations in store sales results, changes in economic conditions, fluctuations in quarterly results and other factors described under the "Risk Factors" section of the Company's Annual Report on Form 10-K for the fiscal year ended February 2, 2002. Such statements reflect the current views of our management with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. All subsequent written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by this paragraph. CONTROLS AND PROCEDURES Within 90 days prior to the date of the filing date of this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934, as amended). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by us in such reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussions regarding required disclosure. 13 There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date the Chief Executive Officer and Chief Financial Officer completed their evaluation. PART II - OTHER INFORMATION Items 1-5 - None Item 6 - Exhibits and Reports on Form 8-K. (a) See Index to Exhibits (b) None 14 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. GADZOOKS, INC. (Registrant) DATE: December 13, 2002 By: /s/ JAMES A. MOTLEY ------------------------------------------- James A. Motley Vice President / Chief Financial Officer (Chief Accounting Officer and Duly Authorized Officer of the Registrant) 15 CERTIFICATION I, James A. Motley, Vice President, Chief Financial Officer and Secretary of Gadzooks, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Gadzooks, Inc.; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly 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 quarterly 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-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. DATE: December 13, 2002 By: /s/ James A. Motley ---------------------------------------- James A. Motley Vice President, Chief Financial Officer and Secretary 16 CERTIFICATION I, Gerald R. Szczepanski, Chairman of the Board and Chief Executive Officer of Gadzooks, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Gadzooks, Inc.; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly 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 quarterly 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-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. DATE: December 13, 2002 By: /s/ Gerald R. Szczepanski ----------------------------------- Gerald R. Szczepanski Chairman of the Board and Chief Executive Officer 17 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION OF DOCUMENTS ------- ------------------------ 3.1-- Third Restated Articles of Incorporation of the Company (filed as Exhibit 4.1 to the Company's Form S-8 (No. 33-98038) filed with the Commission on October 12, 1995 and incorporated herein by reference). 3.2-- Amended and Restated Bylaws of the Company (filed as Exhibit 4.2 to the Company's Form S-8 (No. 33-98038) filed with the Commission on October 12, 1995 and incorporated herein by reference). 3.3-- First Amendment to the Amended and Restated Bylaws of the Company (filed as Exhibit 3.3 of the Company's Quarterly Report on Form 10-Q for the quarter ended August 2, 1997 filed with the Commission on September 16, 1997 and incorporated herein by reference). 4.1-- Specimen Certificate for shares of Common Stock, $.01 par value, of the Company (filed as Exhibit 4.1 to the Company's Amendment No. 2 to Form S-1 (No. 33-95090) filed with the Commission on September 8, 1995 and incorporated herein by reference). 4.2-- Rights Agreement dated as of September 3, 1998, between the Company and Mellon Services, L.L.C. (filed as Exhibit 1 to the Company's Form 8-A filed with the Commission on September 4, 1998 and incorporated herein by reference). 10.1-- Credit Agreement dated as of May 31, 2002 between the Company and Wells Fargo Bank (Texas), National Association (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended May 4, 2002 filed with the Commission on June 14, 2002 and incorporated herein by reference). 10.2-- Executive Retirement Agreement dated August 28, 2002 between Gadzooks Management, L.P. and Gerald R. Szczepanski. 10.3*-- First Amendment to First Amended and Restated Credit Agreement and Waiver of Defaults dated as of November 11, 2002 between the Company and Wells Fargo Bank (Texas) National Association. 10.4*-- Continuing Security Agreement - Rights to Payment and Inventory dated as of November 8, 2002 between the Company and Wells Fargo Bank (Texas) National Association. 10.5*-- Security Agreement - Equipment Inventory dated as of November 8, 2002 between the Company and Wells Fargo Bank (Texas) National Association. 99.1*-- Certification of Chief Executive Officer pursuant to Sarbanes-Oxley Act of 2002. 99.2*-- Certification of Chief Financial Officer pursuant to Sarbanes-Oxley Act of 2002.
*Filed herewith (unless otherwise indicated, exhibits are previously filed). 18