Selling, general and administrative expenses, as a percent of sales, increased 0.8% in the three months ended September 30, 2006 to 42.9% from 42.1% in the three months ended September 30, 2005. In 2006 we began expensing stock-based compensation as required by SFAS No.123(R). This expense totaled $643,000 for the third quarter, and accounted for 0.5% of the increase in selling, general and administrative expenses. Costs associated with studies by outside consultants for store operations and price elasticity studies accounted for 0.3% of the increase in selling, general and administrative expenses for the quarter. It is anticipated that we will continue to incur additional expenses of this nature as we implement various other initiatives that we believe will be profit-achieving.
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Store Pre-Opening Expenses. We expense store pre-opening expenses as they are incurred which include rent holidays prior to a store opening. Pre-opening expenses for the three stores we opened in the third quarter of 2006, and lease costs related to the new stores which we will open later in 2006 amounted to $930,000. In the third quarter of 2005, we incurred store pre-opening expenses of $1,194,000 related to the stores opened in that quarter and lease costs related to stores opened later in 2005.
Net Interest Expense. In the third quarter of 2006, we had net interest expense of $216,000 compared with net interest expense of $202,000 for the same period in 2005.
Income Taxes. Our tax provision rate for the third quarter of 2006 was 40.0%. This tax provision is the result of an expected income tax rate 38.0% for the year ended December 31, 2006 plus the expected impact of accounting for incentive stock options (“ISOs”) under SFAS No. 123(R). Tax benefits relating to ISOs are recognized in future periods when and if disqualifying dispositions occur. The effective tax rate was 39.3% for the three months ended September 30, 2005.
Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005
Net Sales. Net sales increased $40.2 million or 11.4% to $391.7 million in the nine months ended September 30, 2006 from $351.5 million in the comparable 2005 period. This increase is comprised of (i) net sales of $10.0 million from nine stores opened in 2006, (ii) net sales of $26.7 million from stores opened in 2005 not included in the comparable store base, and (iii) a comparable store sales increase of $3.5 million or 1.0%. For the nine months ended September 30, 2006, customer transactions in comparable stores were down 0.2% and the average sale increased by 1.2% compared with the same period in 2005.
Gross Margin. Gross margin as a percent of net sales was 40.6% for the nine months ended September 30, 2006, and 40.0% for the nine months ended September 30, 2005. The mix of merchandise sold increased margins by 0.5% and the improved productivity in our warehouse increased margins by 0.1% as a result of a reduction in our distribution costs.
Selling, General and Administrative Expenses. Selling, general and administrative expenses, as a percent of sales, increased 1.3% in the nine months ended September 30, 2006 to 40.9% from 39.6% in the nine months ended September 30, 2005. Stock-based compensation totaled $2,528,000 for the nine months ended September 30, 2006, of which $2,228,000 was included in selling, general and administrative expenses. Stock- based compensation accounted for 0.6% of the increase in selling, general and administrative expenses. Workers’ compensation, general liability claims and medical costs were 0.3% greater in the first nine months of 2006 compared with the same period in 2005. Costs associated with studies by outside consultants for store operations and price elasticity studies accounted for 0.1% of the increase in selling, general and administrative expenses for the first nine months of 2006. The remainder of the increase was due to greater first quarter advertising costs and the impact of a first quarter comparable store sales decrease.
Costs Related To Change In Management. We incurred a cost of $2.9 million in the nine month period ended September 30, 2006 related to a change in management. This cost includes severance for departing officers and employees as well as recruiting costs for new officers. Between June 1, 2006 and September 30, 2006, we replaced, reclassified or separated a total of 21 officers at the vice president level and above. Changes in management include but are not limited to the following: (i) appointment of a new Chief Executive Officer on June 1, 2006 to replace the previous Chief Executive Officer who retired on June 1, 2006; (ii) appointment of a new Chief Financial Officer on September 13, 2006 to replace the former Chief Financial Officer who retired on July 31, 2006; (iii) replacement of 11 field vice president positions with seven district manager positions; (iv) retirement of the Executive Vice President, Merchandising on June 30, 2006; (v) departure of the Executive Vice President, Merchandising and Marketing on July 31, 2006; (vi) departure of four vice presidents; and (vii) hiring of two new vice presidents to fill two new positions. Subsequent to September 30, 2006, the Company’s Senior Vice President of Human Resources retired and a new Vice President of Human Resources joined the Company. It is anticipated that the Company will continue to incur additional expenses of this nature as it implements various other changes through at least December 31, 2006.
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Store Pre-Opening Expenses. Pre-opening expenses for the nine stores we opened in the first nine months of 2006, and lease costs related to the new stores which we will open later in 2006 amounted to $2,225,000. In the first nine months of 2005, we incurred store pre-opening expenses of $2,300,000 related to the stores opened and lease costs related to stores opened later in 2005.
Net Interest Expense. In the first nine months of 2006, we had net interest expense of $342,000 compared with net interest expense of $324,000 for the same period in 2005.
Income Taxes. Our tax provision rate for the first nine months of 2006 was 40.0%. This tax provision is the result of an expected income tax rate 38.0% for the year ended December 31, 2006 plus the expected impact of accounting for incentive stock options (“ISOs”) under SFAS No. 123(R). Tax benefits relating to ISOs are recognized in future periods when and if disqualifying dispositions occur. The effective tax rate was 39.3% for the nine months ended September 30, 2005.
Liquidity and Capital Resources
Our cash is used primarily for working capital to support inventory requirements and capital expenditures, pre-opening expenses and beginning inventory for new stores. In recent years, we have financed our operations and new store openings primarily with cash from operations and the net proceeds we received from a secondary offering in 2002. In the first half of 2004 we borrowed $30.0 million under two mortgage agreements we have with Wachovia Bank to finance the construction of our corporate offices and distribution center.
At September 30, 2006 and December 31, 2005, our working capital was $149.9 million and $158.4 million, respectively. Cash used in operations was $25.7 million for the nine months ended September 30, 2006 principally as a result of an increase in inventories of $21.1 million due to expected seasonal increases and to support new stores.
Net cash used in investing activities during the nine months ended September 30, 2006 was $9.4 million, including $14.6 million for capital expenditures offset by proceeds from maturation of marketable securities of $5.2 million. In 2006, we expect to spend approximately $19.0 million on capital expenditures, which includes $11.0 million for new store openings, and the remainder for remodeling existing stores, upgrading systems in existing stores, warehouse equipment and corporate systems development. Of the $11.0 million in new store capital expenditures, we expect to receive $1.5 million back from landlords.
We have two mortgage agreements with Wachovia Bank on our corporate offices and distribution center of which $24.9 million was outstanding at September 30, 2006. The mortgages are secured by land, building and equipment. Of the original $30.0 million in mortgages, $22.5 million ($19.5 million as of September 30, 2006) is repayable over 15 years and $7.5 million ($5.4 million as of September 30, 2006) is repayable over 7 years. Monthly payments are $214,000. The mortgages bear interest at rates that will vary between LIBOR plus 85 basis points and LIBOR plus 135 basis points, depending on the debt service coverage ratio and the length of the mortgage payment. We have the option of fixing the interest rate at any time. The mortgages contain covenants that, among other things, restrict our ability to incur additional indebtedness or guarantee obligations in excess of $8.0 million, engage in mergers or consolidations, dispose of assets, make acquisitions requiring a cash outlay in excess of $10.0 million, make loans or advances in excess of $1.0 million, or change the nature of our business. We are restricted in capital expenditures, paying dividends and making other distributions unless certain financial covenants are maintained including those relating to tangible net worth, funded debt and a current ratio. The mortgages also define various events of default, including cross default provisions, defaults for any material judgments or a change in control. At September 30, 2006, we were in compliance with these agreements.
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We currently have a $35.0 million line of credit with Wachovia Bank which expires on May 31, 2007. Borrowings under this line will bear interest at LIBOR plus 95 basis points and are subject to the same covenants as the mortgages described above. At September 30, 2006, there were no borrowings outstanding under this agreement.
We believe the cash generated from operations during the year and available borrowings under the line of credit agreement will be sufficient to finance our working capital and capital expenditure requirements for at least the next 12 months.
Critical Accounting Estimates
Except as described below, our accounting policies are fully described in Note 1 of our notes to consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2005. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and accompanying notes. Since future events and their effects cannot be determined with absolute certainty, actual results may differ from those estimates. Management makes adjustments to its assumptions and judgments when facts and circumstances dictate. The amounts currently estimated by us are subject to change if different assumptions as to the outcome of future events were made. We evaluate our estimates and judgments on an ongoing basis and predicate those estimates and judgments on historical experience and on various other factors that management believes to be reasonable under the circumstances. Management believes the following critical accounting estimates encompass the more significant judgments and estimates used in preparation of our consolidated financial statements:
| • | merchandise inventories; |
| • | impairment of long-lived assets; |
| • | stock-based compensation under SFAS No. 123(R); |
| • | legal contingencies; and |
Other than accounting for stock-based compensation under SFAS No. 123(R), which is described below, the foregoing critical accounting estimates are more fully described in our Annual Report on Form 10-K for the year ended December 31, 2005. We believe that there have been no significant changes during the three months ended September 30, 2006 to the items that we disclosed as our critical accounting policies and estimates in our Annual Report Form 10-K for the year ended December 31, 2005, except as described below.
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Stock-Based Compensation Expense Under SFAS No. 123(R)
Effective January 1, 2006, we account for stock-based compensation in accordance with the provisions of SFAS No. 123(R). Under the fair value recognition provisions of SFAS No. 123(R), stock-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized as expense ratably over the service period for awards expected to vest. Determining the appropriate fair value model and calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected lives. For more discussion of stock-based compensation under SFAS No. 123(R), see Note 4 in our notes to consolidated financial statements contained in this Quarterly Report on Form 10-Q.
ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
We invest cash balances in excess of operating requirements primarily in money market mutual funds and to a lesser extent in interest-bearing securities with maturities of less than two years. The fair value of our cash and equivalents at September 30, 2006 approximated carrying value. We had no borrowings outstanding under our line of credit at September 30, 2006. The interest rates on our mortgages fluctuate with market rates and therefore the value of these financial instruments will not be impacted by a change in interest rates. Based on the amounts outstanding at September 30, 2006, the impact of a hypothetical increase or decrease in interest rates of 10% compared with the rates in effect at September 30, 2006 would result in an increase or decrease in our interest expense of $157,000 annually, and an increase or decrease in our interest income of $49,000 annually.
ITEM 4. | CONTROLS AND PROCEDURES |
We carried out an evaluation, with the participation of our principal executive officer and principal financial officer, of the effectiveness of our disclosure controls and procedures as of September 30, 2006. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of September 30, 2006, our disclosure controls and procedures, as defined in Rule 13a-15(e), were effective at the reasonable assurance level, to ensure that (i) information required to be disclosed by the issuer in the reports that it files or submits under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
Our management carried out an evaluation, with the participation of our principal executive officer and principal financial officer, of changes in our internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Based on this evaluation, our management determined that no change in our internal control over financial reporting occurred during the quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II – OTHER INFORMATION
On April 4, 2003, Kathleen Stahl, a former store merchandiser for the Company, filed a civil action against us in the Superior Court of New Jersey, Burlington County–Law Division for alleged retaliatory harassment and constructive discharge under the New Jersey Conscientious Employee Protection Act. The plaintiff sought lost wages, compensatory and punitive damages, and costs. The complaint was dismissed without prejudice on December 5, 2003 and reinstated on April 15, 2005. On October 23, 2006, a jury trial on the case began. On October 30, 2006, the jury returned a verdict in favor of the plaintiff for $19,600 in lost wages, $1.8 million for emotional distress and $1.5 million in punitive damages. We are disappointed with the jury’s verdict and believe it is not supported by the evidence. We will vigorously pursue an appeal.
We are involved in other legal proceedings from time to time in the ordinary course of business. Management believes that none of these other legal proceedings will have a materially adverse effect on our financial condition or results of operations. However, there can be no assurance that future costs of such litigation would not be material to our financial condition or results of operations.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K for the year ended December 31, 2005 are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
The information presented below updates, and should be read in conjunction with, the risks described in our Annual Report on Form 10-K for the year ended December 31, 2005.
Our success depends on key personnel whom we may not be able to retain or hire.
We are dependent on the services, abilities and experience of our senior management team. On June 1, 2006, we appointed Rick A. Lepley as our new Chief Executive Officer. On September 13, 2006, we appointed Marc D. Katz as our new Chief Financial Officer. Since June 1, 2006, we have replaced, reclassified or separated a total of 22 officers at the vice president level or above. The loss of the services of senior executives and any general instability in the composition of our senior management team could have a negative impact on our ability to execute on our business and operating strategy. Our business may be impacted by the familiarity of newly appointed executives with our business, and their abilities to develop relationships with our team members and vendors and to implement or change our business and operating strategy. In addition, our success in the future is dependent upon our ability to attract and retain other qualified personnel, including store managers. Any inability to do so may have a material adverse impact on our business and operating results.
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An increase in our sales, profitability and cash flow will depend on our ability to increase the number of stores we operate and increase the productivity and profitability of our existing stores.
The key components of our growth strategy are to increase the number of stores we operate and increase the productivity and profitability of our existing stores. If we are unable to implement this strategy, our ability to increase our sales, profitability and cash flow could be significantly impaired. To the extent we are unable to open new stores as planned, our sales growth would come only from increases in comparable store sales. Growth in profitability in that case would depend significantly on our ability to increase margins or reduce our costs as a percentage of sales. Further, as we implement new initiatives to reduce the cost of operating our stores, our sales and profitability may be negatively impacted. In particular, we are currently evaluating our store model as it relates to levels of staffing and compensation. There can be no assurance as to whether and to what extent a new store format will be successful.
There are many factors, some of which are beyond our control, which could impact our ability to implement our strategy for opening new stores. These factors include:
| • | our ability to identify suitable markets in which to expand, |
| • | the availability of suitable sites for additional stores, |
| • | the ability to negotiate acceptable lease terms for sites we identify, |
| • | the availability of acceptable financing to support our growth, |
| • | our ability to hire, train and retain a sufficient number of qualified managers and other store personnel, which ability may be impacted by any changes to store personnel compensation, and |
| • | the effectiveness of our advertising strategies. |
A disruption in the operations of our distribution center could have a material adverse effect on our financial condition and results of operations.
Our distribution center in suburban Philadelphia currently handles approximately 35% of the merchandise sold in our stores. As part of our efforts to improve operating efficiencies, we are implementing new processes within our supply chain, including routing increased amounts of merchandise and additional SKUs through our distribution center. Significant changes to our supply chain could have a material adverse impact on our operating results. Our distribution center, and thus our distribution operations, is vulnerable to damage or interruption from fire, flood, power loss, break-ins and similar events. We have no formal disaster recovery plan for our distribution center. The occurrence of unanticipated problems at our distribution center, all of which may not be covered by insurance, could cause interruptions or delays in our business which would have a material adverse effect on our financial condition and results of operations.
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ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
Not Applicable.
ITEM 3. | DEFAULTS UPON SENIOR SECURITIES |
Not Applicable.
ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
We held our Annual Meeting of Shareholders on August 3, 2006. At the meeting, shareholders voted on the following:
| 1. | To elect three Class A directors to hold office for a term of three years and until each of their respective successors is duly elected and qualified, as described in the accompanying proxy statement; and |
| 2. | To ratify the appointment of PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2006. |
The results of the voting were as follows:
| | For | | Against | | Abstain | | Withhold
Authority | |
| |
| |
| |
| |
| |
Joseph F. Coradino | | 19,188,248 | | 0 | | 179,931 | | 0 | |
William Kaplan | | 19,206,495 | | 0 | | 161,684 | | 0 | |
Lori J. Schafer | | 19,230,138 | | 0 | | 138,041 | | 0 | |
Ratification of PricewaterhouseCoopers LLP | | 19,321,961 | | 43,693 | | 2,524 | | 0 | |
The term of office for each of the following directors continued after the meeting: Michael J. Joyce, Rick A. Lepley, Richard J. Bauer, Richard J. Drake, Lawrence H. Fine and Richard Lesser.
Not Applicable.
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31.1 | Certification pursuant to Rule 13a-14(a) promulgated under the Securities Exchange Act of 1934, as amended (“Exchange Act”). |
31.2 | Certification pursuant to Rule 13a-14(a) promulgated under the Exchange Act. |
32.1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
32.2 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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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.
| | A.C. MOORE ARTS & CRAFTS, INC. |
Date: November 8, 2006
| | By: |
/s/ Rick A. Lepley
|
| | |
|
| | | Rick A. Lepley Chief Executive Officer (duly authorized officer and principal executive officer) |
Date: November 8, 2006
| | By: |
/s/ Marc Katz
|
| | |
|
| | | Marc Katz Executive Vice President, Chief Financial Officer (duly authorized officer and principal financial officer) |
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Exhibit Index
Exhibit No. | Description |
| |
31.1 | Certification pursuant to Rule 13a-14(a) promulgated under the Exchange Act. |
| |
31.2 | Certification pursuant to Rule 13a-14(a) promulgated under the Exchange Act. |
| |
32.1 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| |
32.2 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| |
