FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 28, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
----- -----
Commission File No. 1-9223
SERVICE MERCHANDISE COMPANY, INC.
(Exact name of registrant as specified in its charter)
TENNESSEE 62-0816060
(State or other Jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P. O. Box 24600, Nashville, TN
37202-4600
(Mailing Address)
7100 Service Merchandise Drive, Brentwood, TN
(Address of principal executive offices)
37027
(Zip code)
(615) 660-6000
(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. Yes X No
--- ---
Indicate the number of shares outstanding of each of the Registrant's classes of
common stock as of the latest practicable date.
As of July 26, 1998, there were 100,364,902 shares of
Service Merchandise Company, Inc. common stock outstanding.
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
Page No.
PART I - FINANCIAL INFORMATION
Consolidated Statements of Operations (Unaudited) - Three
and Six Periods Ended June 28, 1998 and June 29, 1997 . . . . . 3
Consolidated Balance Sheets - June 28, 1998 (Unaudited),
June 29, 1997 (Unaudited) and December 28, 1997 . . . . . . . . 4
Consolidated Statements of Cash Flows (Unaudited) - Six
Periods Ended June 28, 1998 and June 29, 1997 . . . . . . . . . 5
Notes to Consolidated Financial Statements (Unaudited) . . . . . 6-9
Management's Discussion and Analysis of Financial Condition
and Results of Operations . . . . . . . . . . . . . . . . . . . 10-17
PART II - OTHER INFORMATION
Other Information . . . . . . . . . . . . . . . . . . . . . . . 18
Exhibits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
-2-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
Consolidated Statements of Operations (Unaudited)
(In thousands, except per share data)
Three Periods Ended Six Periods Ended
------------------------- ---------------------------
June 28 June 29 June 28 June 29
---------- ----------- ----------- ------------
1998 1997 1998 1997
---------- ----------- ----------- ------------
Net sales
Operations excluding closing facilities and remerchandising activities $681,645 $747,379 $1,269,449 $1,355,214
Closing facilities and remerchandising activities 3,467 129,982 9,845 208,547
---------- ----------- ----------- ------------
685,112 877,361 1,279,294 1,563,761
Costs and expenses:
Cost of merchandise sold and buying and occupancy expenses
Operations excluding closing facilities and remerchandising activities 512,495 559,552 957,332 1,026,659
Closing facilities and remerchandising activities 9,053 134,741 15,297 199,274
---------- ----------- ----------- ------------
521,548 694,293 972,629 1,225,933
Gross margin after cost of merchandise sold and buying and occupancy expenses
Operations excluding closing facilities and remerchandising activities 169,150 187,827 312,117 328,555
Closing facilities and remerchandising activities (5,586) (4,759) (5,452) 9,273
---------- ----------- ----------- ------------
163,564 183,068 306,665 337,828
Selling, general and administrative expenses
Operations excluding closing facilities and remerchandising activities 139,119 154,797 285,256 304,769
Closing facilities and remerchandising activities 801 21,996 2,300 36,474
---------- ----------- ----------- ------------
139,920 176,793 287,556 341,243
Restructuring charge - - - 129,510
Depreciation and amortization
Operations excluding closing facilities and remerchandising activities 14,258 14,237 28,606 27,631
Closing facilities and remerchandising activities - 1,407 87 2,825
---------- ----------- ----------- ------------
14,258 15,644 28,693 30,456
Earnings (loss) before interest and income taxes 9,386 (9,369) (9,584) (163,381)
Interest expense-debt 17,817 16,544 35,643 32,091
Interest expense-capitalized leases 1,708 2,161 3,473 4,150
---------- ----------- ----------- ------------
Loss before income taxes (10,139) (28,074) (48,700) (199,622)
Income taxes benefit (3,802) (10,527) (18,262) (74,858)
========== =========== =========== ============
Net loss ($6,337) ($17,547) ($30,438) ($124,764)
========== =========== =========== ============
Weighted average common shares - basic and diluted 99,701 99,296 99,702 99,279
========== =========== =========== ============
Per common share:
Net loss ($0.06) ($0.18) ($0.31) ($1.26)
========== =========== =========== ============
See Notes to Consolidated Financial Statements.
-3-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(In thousands, except per share data)
(Unaudited)
------------------------------
June 28, June 29, December 28,
1998 1997 1997 (1)
-------------- ------------- -------------
ASSETS
Current Assets:
Cash and cash equivalents $ 142,101 $ 57,486 $ 364,169
Accounts receivable, net of allowance of
$2,096, $3,125 and $3,456, respectively 44,750 44,577 43,130
Income taxes 3,947 61,964 -
Inventories 862,997 956,674 929,818
Prepaid expenses and other assets 17,163 17,227 25,276
Deferred income taxes 22,478 - 22,478
-------------- ------------- -------------
TOTAL CURRENT ASSETS 1,093,436 1,137,928 1,384,871
Property and equipment:
Owned assets, net of accumulated depreciation of
$526,449, $542,261 and $517,629, respectively 472,005 518,816 490,345
Capitalized leases, net of accumulated amortization of
$73,332, $76,847 and $76,735, respectively 29,463 38,534 33,289
Other assets and deferred charges 50,493 25,111 42,956
-------------- ------------- -------------
TOTAL ASSETS $1,645,397 $1,720,389 $1,951,461
============== ============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Notes payable to banks $ - $ 25,000 $ -
Accounts payable 281,969 384,494 482,235
Accrued expenses 183,820 175,090 214,451
State and local sales taxes 22,933 29,905 48,331
Accrued restructuring costs - current 18,420 24,570 21,178
Current maturities of long-term debt 23,193 34,470 23,723
Current maturities of capitalized lease obligations 8,152 8,302 8,452
Deferred income taxes - 7,437 -
-------------- ------------- -------------
TOTAL CURRENT LIABILITIES 538,487 689,268 798,370
Accrued restructuring costs 51,317 65,844 55,064
Long-term debt 703,338 597,374 711,512
Capitalized lease obligations 45,906 57,119 50,010
Deferred income taxes - 7,922 -
-------------- ------------- -------------
TOTAL LIABILITIES 1,339,048 1,417,527 1,614,956
-------------- ------------- -------------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Preferred stock, $1 par value, authorized 4,600 shares,
undesignated as to rate and other rights, none issued
Series A Junior Preferred Stock, $1 par value, authorized
1,100 shares, none issued
Common stock, $.50 par value, authorized 500,000 shares, issued
and outstanding 100,396, 99,812 and 100,376 shares,
respectively 50,198 49,906 50,188
Additional paid-in capital 7,876 5,739 7,908
Deferred compensation (2,483) (815) (2,787)
Retained earnings 250,758 248,032 281,196
-------------- ------------- -------------
TOTAL SHAREHOLDERS' EQUITY 306,349 302,862 336,505
-------------- ------------- -------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,645,397 $1,720,389 $1,951,461
============== ============= =============
(1) Derived from fiscal year ended December 28, 1997 audited consolidated financial statements.
See Notes to Consolidated Financial Statements.
-4-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
(In thousands)
Six Periods Ended
-----------------------------------
June 28 June 29
-----------------------------------
1998 1997
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ($30,438) ($124,764)
Adjustments to reconcile net loss to net
cash used by operating activities:
Depreciation and amortization 31,543 32,118
Gain on sale of property and equipment (10,289) (2,464)
Write down of property and equipment due to restructuring - 32,915
Changes in assets and liabilities (net of disposition):
Accounts receivable, net (1,620) 16,877
Inventories 66,821 96,295
Prepaid expenses 5,895 (1,766)
Accounts payable (200,266) (255,394)
Accrued expenses and state and local sales taxes (56,029) (68,313)
Accrued restructuring costs (6,505) 90,414
Income taxes (3,946) (95,862)
------------- -------------
NET CASH USED BY OPERATING ACTIVITIES (204,834) (279,944)
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment - owned (10,615) (15,121)
Proceeds from sale of property and equipment 19,362 3,779
Other assets, net (12,415) (3,328)
------------- -------------
NET CASH USED BY INVESTING ACTIVITIES (3,668) (14,670)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from short-term borrowings - 25,000
Proceeds from long-term debt - 6,560
Repayment of long-term debt (8,704) (5,199)
Repayment of capitalized lease obligations (4,295) (4,186)
Debt issuance costs (525) (129)
Exercise of stock options (forfeiture of restricted stock), net (42) 61
------------- -------------
NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES (13,566) 22,107
------------- -------------
NET DECREASE IN CASH AND CASH EQUIVALENTS (222,068) (272,507)
CASH AND CASH EQUIVALENTS-BEGINNING OF PERIOD 364,169 329,993
------------- -------------
CASH AND CASH EQUIVALENTS-END OF PERIOD $142,101 $ 57,486
============= =============
See Notes to Consolidated Financial Statements.
-5-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
A. The consolidated financial statements, except for the consolidated balance
sheet as of December 28, 1997, have been prepared by the Company without
audit.
In management's opinion, the information and amounts furnished in this
report reflect all adjustments (consisting of normal recurring adjustments)
considered necessary for the fair presentation of the consolidated
financial position and consolidated results of operations for the interim
periods presented. Certain prior period amounts have been reclassified to
conform to the current year's presentation. These consolidated financial
statements should be read in conjunction with the Company's Annual Report
on Form 10-K for the fiscal year ended December 28, 1997.
The Company has historically incurred a net loss for the first three
quarters of the year due to the seasonality of its business. The results of
operations for the quarters ended June 28, 1998 and June 29, 1997 are not
necessarily indicative of the operating results for an entire fiscal year.
B. The Company's income statement presentation changed beginning with the
second quarter of 1997. This change was made to disclose the financial
statement impact of the inventory liquidations associated with the closing
facilities and remerchandising activities. The line item "Closing
facilities and remerchandising activities" represents activity specifically
identifiable to inventory liquidations conducted in conjunction with (1)
the Company's Restructuring Plan announced in the first quarter of 1997 (2)
exiting the computer, infant, and pet supply categories and certain
components of the wireless communication and sporting goods categories as
part of a remerchandising program and (3) the writedown of inventory to net
realizable value for merchandise being discontinued to effect the SKU
reduction necessary to transition to a self-service format which will be
effected in the second and third quarters of 1998. As of June 28, 1998, 53
stores, one distribution center and the aforementioned merchandise
categories have completed the process of liquidation. All activity for
these items is classified in "Closing facilities and remerchandising
activities." Prior year amounts reflect operating results for these same
facilities and merchandise classifications. Selling, general and
administrative expenses for closing facilities and remerchandising
activities does not include any allocation of corporate overhead.
C. On March 25, 1997, the Company adopted a business restructuring plan to
close 60 underperforming stores and one distribution center. As a result, a
pre-tax charge of $129.5 million for restructuring costs was taken in the
first quarter of 1997. The components of the restructuring charge and an
analysis of the amounts charged against the accrual through June 28, 1998
are outlined in the following table:
-6-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (continued)
Activity to Date
----------------- ----------------- --------------
Original Accrued Restructuring
Charge Restructuring Asset Change In Costs as of
(In thousands) Recorded Costs Paid Write-downs Estimate June 28, 1998
---------------- ----------------- ----------------- -------------- -----------------------
Lease termination and other
real estate costs $ 83,225 $ (19,170) $ - $ 3,458 $ 67,513
Property and equipment
write-downs 32,915 - (32,915) - -
Employee severance 4,869 (3,616) (1,229) 24
-
Other exit costs 8,501 (4,072) (2,229) 2,200
-
---------------- ----------------- ----------------- -------------- -----------------------
Total $ 129,510 $ (26,858) $ (32,915) $ - 69,737
================ ================= ================= ==============
Less: Current portion (18,420)
--------------------
$ 51,317
====================
During the second quarter of 1998, the Company completed its store closures
under the corporate restructuring and repositioning plan announced on March
27, 1997. The Company closed a total of 53 stores and one distribution
center under this plan. Five underperforming stores were closed during the
second quarter of 1998. The decrease in the number of stores closed from
the original plan of 60 stores is primarily due to the inability to obtain
acceptable exit terms from the related lessors.
Underperforming closed stores included both owned and leased properties.
Lease termination and other real estate costs consist principally of the
remaining rental payments required under the closing stores' lease
agreements, net of any actual or reasonably probable sublease income, as
well as early termination costs.
After taking into account the above property and equipment write-downs, the
Company's carrying value of the property and equipment associated with the
closures is approximately $7.4 million as of June 28, 1998. All of this
amount is classified as available for sale as all store closures are now
complete. Assets available for sale totaling $6.2 million are classified as
current assets and are included with Prepaid Expenses and Other Assets. The
remaining $1.2 million of assets available for sale are considered
non-current assets and are included in Other Assets and Deferred Charges.
Management anticipates selling substantially all owned property and
equipment associated with the restructuring plan.
Changes in estimates are representative of management's assessments as of
June 28, 1998, that based on actual experience to date, certain charges
will be higher than originally estimated while others will be less than
originally estimated. Due to unfavorable sublease and termination
experience for stores closed, the Company increased the estimate for lease
termination and other real estate costs. These unfavorable results have
been offset by favorable experience in employee severance and other exit
costs.
-7-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (continued)
The employee severance provision was recorded for the planned termination
of approximately 4,100 employees, consisting primarily of store personnel.
Management was able to place a significant number of store employees
displaced by the store closures at other stores and the number of stores
anticipated to be closed decreased from 60 stores to 53 stores. As a
result, approximately 3,000 employees were terminated in conjunction with
the store closures. Other exit costs consist principally of professional
fees and miscellaneous costs associated with closing the stores and
distribution center.
Net sales associated with the 53 closed stores exclusive of remerchandising
activities were approximately $3.2 million and $111.4 million for the
second quarter ended June 28, 1998 and June 29, 1997, respectively. The
pre-tax operating losses associated with the closed stores, excluding
corporate allocations, were approximately ($6.8) million and ($15.1)
million for the quarter ended June 28, 1998 and June 29, 1997,
respectively. Net sales associated with the 53 closed stores were
approximately $8.7 million and $173.1 million for the six periods ended
June 28, 1998 and June 29, 1997, respectively. The pre-tax operating losses
associated with the closed stores, excluding corporate allocations, were
approximately ($12.6) million and ($18.3) million for the six periods ended
June 28, 1998 and June 29, 1997, respectively. Net sales associated with
the 53 closed stores exclusive of remerchandising activities were
approximately $209.9 million and $351.0 million for fiscal 1997 and 1996,
respectively. The pre-tax operating income (loss) associated with the 53
closed stores, excluding corporate allocations, was approximately ($40.7)
million and $1.6 million for fiscal 1997 and 1996, respectively.
D. The second quarter ended June 28, 1998 contained 90 selling days compared
to 91 selling days for the second quarter ended June 29, 1997. The six
periods ended June 28, 1998 and June 29, 1997 each contained 181 selling
days.
E. Basic net earnings (loss) per common share is computed by dividing net
earnings (loss) by the weighted-average number of common shares outstanding
during the year. Diluted net earnings (loss) per common share is computed
by dividing net earnings (loss) by the weighted-average number of common
shares outstanding during the year plus incremental shares that would have
been outstanding upon the assumed vesting of dilutive restricted stock and
the assumed exercise of dilutive stock options.
F. Cash payments for interest for the six periods ended June 28, 1998 and June
29, 1997 were $38.9 million and $34.3 million, respectively. Cash payments
(refunds) for income taxes for the six periods ended June 28, 1998 and June
29, 1997 were ($17.6) million and $21.0 million, respectively. The net
income tax refund for 1998 resulted primarily from the net operating loss
("NOL") recognized for the year ended December 28, 1997.
-8-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) (continued)
G. The Company has available a five-year, $900 million, fully-committed,
asset-based credit facility ("Amended and Restated Credit Facility"). The
Amended and Restated Credit Facility includes a $200 million term loan and
up to a potential maximum of $700 million in revolving loans including a
$175 million sub-facility for letters of credit. The Amended and Restated
Credit Facility matures on September 10, 2002. Interest rates on the
Amended and Restated Credit Facility are subject to change based on a
financial performance-based grid and cannot exceed a rate of LIBOR + 2.25%
on revolving loans and LIBOR + 2.50% on the term loan. As of June 28, 1998,
the term loan carried a rate of LIBOR + 2.25%. There is a commitment fee of
3/8% on the undrawn portion of the revolving loans. There were no revolving
loans outstanding under the Amended and Restated Credit Facility as of June
28, 1998. Short-term borrowings related to the Reducing Revolving Credit
Facility were $25.0 million as of June 29, 1997.
The Amended and Restated Credit Facility is secured by all material
unencumbered assets of the Company and its subsidiaries, including
inventory but excluding previously mortgaged property and leasehold
interests. These security interests will automatically terminate when the
Company's senior debt (or implied senior debt) achieves investment grade
credit rating or the Company meets certain operating performance targets.
Available borrowings under the Amended and Restated Credit Facility are
limited based on (1) a borrowing base formula which considers eligible
inventories, eligible accounts receivable and mortgage values on eligible
real properties, and (2) limitations contained in the Company's public
senior subordinated debt indenture. Approximately $307.9 million of
borrowings were unused and available under the Amended and Restated Credit
Facility as of June 28, 1998.
H. In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information." In February 1998, the FASB issued SFAS
No. 132, "Employers' Disclosures about Pensions and Other Postretirement
Benefits." These pronouncements are effective for financial statements
beginning after December 15, 1997. In March 1998, the FASB issued Statement
of Position 98-1, "Accounting for the Costs of Computer Software Developed
or Obtained for Internal Use." This pronouncement will be effective for
financial statements beginning after December 15, 1998. In June 1998, the
FASB issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." This pronouncement will be effective for all fiscal
quarters of fiscal years beginning after June 15, 1999. The Company
anticipates that the adoption of these Statements will not have a material
impact on its operating results or financial position.
-9-
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
For comparative purposes, interim balance sheets are more meaningful when
compared to the balance sheets at the same point in time of the prior year.
Comparisons to balance sheets of the most recent fiscal year end may not be
meaningful due to the seasonal nature of the Company's business.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Company's liquidity, capital resources and results of operations may be
affected from time to time by a number of factors and risks, including, but not
limited to, trends in the economy as a whole, which may affect consumer
confidence and consumer demand for the types of goods sold by the Company;
continuing availability of trade credit and terms with vendors; the ability and
success in completing and implementing plans regarding the Company's alternative
store formats; the ability to execute a strategic repositioning of the Company;
competitive pressures from other retailers, including specialized retailers and
discount stores which may affect the nature and viability of the Company's
business strategy; availability, costs and terms of financing, including the
risk of rising interest rates; the Company's use of substantial financial
leverage and the potential impact of such leverage on the Company's ability to
execute its operating strategies, to withstand significant economic downturns
and to repay its indebtedness; the ability to maintain gross profit margins; the
seasonal nature of the Company's business and the ability of the Company to
predict consumer demand as a whole, as well as demand for specific goods; the
ability of the Company to attract and retain customers by executing the
Company's remerchandising strategy and improving customer service; costs
associated with the shipping, handling and control of inventory and the
Company's ability to optimize its supply chain; potential adverse publicity;
availability and cost of management and labor employed; real estate occupancy
and development costs, including the substantial fixed investment costs
associated with opening, maintaining or closing a Company store and the ability
to effect conversions to new technological systems including, becoming year 2000
compliant.
This report includes, and other reports and statements issued on behalf of the
Company may include, certain forward-looking information that is based upon
management's beliefs as well as on assumptions made by and data currently
available to management. This information, which has been or in the future may
be, included in reliance on the "safe harbor" provisions of the Private
Securities Litigation Reform Act of 1995, is subject to a number of risks and
uncertainties, including but not limited to the factors identified above. Actual
results may differ materially from those anticipated in any such forward-looking
statements. The Company undertakes no obligation to update or revise any such
forward-looking statements to reflect subsequent events or circumstances.
-10-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
RESULTS OF OPERATIONS
The Company has embarked upon a plan to become a fresh new competitive fine
jewelry and home specialty retailer. Execution of this plan as it affects the
Company's stores began in the second quarter, and has involved the conversion of
the Company's traditional store format and merchandise selections into a new
business design with new merchandise selections, and the creation of a new
shopping experience. The disruption caused by the implementation of these
significant changes in the Company's stores has had a negative impact on
short-term performance which is expected to continue through the third quarter
of 1998.
The nature of the Company's business is highly seasonal. Historically, sales in
the fourth quarter have been substantially higher than sales achieved in each of
the first three quarters of the fiscal year. Thus expenses and, to a greater
extent, operating income vary greatly by quarter. Caution, therefore, is advised
when appraising results for a period shorter than a full year, or when comparing
any period other than to the same period of the previous year.
SECOND QUARTER ENDED JUNE 28, 1998 VS. SECOND QUARTER ENDED
JUNE 29, 1997
Net sales for the Company were $685.1 million for the second quarter of 1998
compared to $877.4 million for the second quarter of 1997. The $192.3 million
decrease reflects the $126.5 million loss in sales associated with closed
facilities and an 8.5% decrease in comparable store sales.
Net sales from operations excluding closing facilities and remerchandising
activities for the second quarter of 1998 were $681.6 million versus $747.4
million for the same period in 1997. This represents a net sales decrease of
$65.8 million, or 8.8%, with comparable store sales decreasing 8.5%. Jewelry
comp sales increased 0.1% while hardline comp sales were down 11.4% resulting
from lower sales in electronics, toys, fitness, sporting goods and seasonal
categories. The overall comp sales decline has been affected adversely by
transitioning out of certain merchandise prior to setting the new fall
merchandise assortments and a reduction in advertising effectiveness related to
a shift in marketing focus from existing to prospective customers.
Net sales from closing facilities and remerchandising activities were $3.5
million for the second quarter of 1998 versus $130.0 million for these same
facilities and merchandise classifications for the same period last year. During
the second quarter of 1998, the Company closed five underperforming stores.
GROSS MARGIN
Gross margin, after buying and occupancy expenses, for the Company for the
second quarter of 1998 was $163.6 million, or 23.9% of net sales compared to
$183.1 million, or 20.9% of net sales for the prior year quarter.
-11-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Gross margin, after buying and occupancy expenses, excluding closing facilities
and remerchandising activities, was $169.2 million, or 24.8% of net sales for
the second quarter of 1998 compared to $187.8 million, or 25.1% of net sales for
the prior year quarter. The decline in gross margin rate reflects the start of
clearance markdowns taken to effect the SKU reduction necessary to transition to
a self-service format. Additionally, fixed rent and occupancy costs rose as a
percent of the declining sales base.
Gross margin, after buying and occupancy expenses, from closing facilities and
remerchandising activities was ($5.6) million for the second quarter of 1998
compared to ($4.8) million for the prior year quarter. The negative gross margin
for the second quarter of 1998 is due to the write-down of inventory to net
realizable value for merchandise being discontinued to effect the SKU reduction
necessary to transition to a self-service format.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the second quarter of 1998 were
$139.9 million, or 20.4% of net sales, versus $176.8 million, or 20.2% of net
sales for the second quarter of 1997. The $36.9 million reduction is primarily
attributable to a decrease in expenses from closing facilities and
remerchandising activities. Additionally, income recognized from the Company's
private label credit card program and a pre-tax gain from the sale/leaseback of
its corporate aircraft contributed to the expense reduction. The increase as a
percentage of net sales was attributable to lower net sales.
Selling, general and administrative expenses, excluding closing facilities and
remerchandising activities, decreased $15.7 million to $139.1 million, or 20.4%
of net sales, as compared to $154.8 million, or 20.7% of net sales for the
second quarter last year. The decrease is primarily attributable to income of
$8.7 million recorded as a reduction to SG&A recognized from the Company's
private label credit card program, a pre-tax gain of $6.0 million recognized
from the sale/leaseback of its corporate aircraft and a pre-tax gain of $2.6
million recorded on the disposal of two vacant properties. These reductions to
SG&A were partially offset by a $3.4 million charge recorded for the retirement
package provided to the former Chairman of the Board and CEO, Raymond Zimmerman.
Selling, general and administrative expenses of closing facilities and
remerchandising activities were $0.8 million, or 23.1% of sales from closing
facilities and remerchandising activities for the second quarter of 1998
compared to $22.0 million, or 16.9% of sales from closing facilities and
remerchandising activities for the prior year quarter. The decrease in expenses
reflects the closure of 53 underperforming stores.
-12-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
INTEREST EXPENSE
Interest expense for the second quarter of 1998 was $19.5 million as compared to
$18.7 million for the second quarter of 1997. The increase in interest expense
reflects the addition of the term loan offset somewhat by lower average
borrowings against the Company's Amended and Restated Credit Facility.
INCOME TAXES
The Company recognized an income tax benefit of $3.8 million and $10.5 million
for the second quarter ended June 28, 1998 and June 29, 1997, respectively. The
effective tax rate for the second quarter ended June 28, 1998 and June 29, 1997
was 37.5%. For the fiscal year ended December 28, 1997, the effective income tax
rate was 37.5%.
SIX PERIODS ENDED JUNE 28, 1998 VS. SIX PERIODS ENDED JUNE 29, 1997
Net sales for the Company were $1,279.3 million for the first half of 1998
compared to $1,563.8 million for the first half of 1997. The decrease of $284.5
million, or 18.2% reflects the $198.7 million loss in sales associated with
closed facilities and remerchandising activities and a 7.0% decrease in
comparable store sales. Jewelry comp sales increased 0.3% while hardline comp
sales were down 9.5%.
GROSS MARGIN
Gross margin, after buying and occupancy expenses, for the first half of 1998
was $306.7 million, or 24.0% of net sales compared to $337.8 million, or 21.6%
of net sales for the same period last year. The improved gross margin rate
reflects the Company's focus on higher margin categories and a shift in sales
mix towards jewelry. Additionally, the gross margin rate for the first half of
1997 was impacted by the significant merchandise discounts associated with
inventory liquidations. The decline in gross margin dollars reflects the closure
of 53 underperforming stores.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses decreased to $287.6 million, or
22.5% of net sales, for the first half of 1998 compared to $341.2 million, or
21.8% of net sales for the same period a year ago. The decrease in selling,
general and administrative dollars is primarily attributable to the lower
operating expenses resulting from the closure of 53 underperforming stores.
Additionally, income of $13.0 million recognized from our private label credit
card program and a $6.0 million pre-tax gain recorded on the sale/leaseback of
corporate aircraft contributed to the expense reduction.
INTEREST EXPENSE
Interest expense for the first six periods of 1998 was $39.1 million as compared
to $36.2 million for the same period a year ago. Interest expense for the year
increased primarily due to the addition of the term loan offset somewhat by
lower average borrowings against the Company's Amended and Restated Credit
Facility.
-13-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
INCOME TAXES
The Company recognized an income tax benefit of $18.3 million for the first half
of 1998 compared to $74.9 million for the first half of 1997. The decrease in
the benefit is primarily due to the $129.5 million restructuring charge recorded
in the first quarter of 1997. The estimated annual effective tax rate for the
six periods ended June 28, 1998 and June 29, 1997 was 37.5%. For the fiscal year
ended December 28, 1997, the effective income tax rate was 37.5%.
RESTRUCTURING CHARGE, STORE LIQUIDATION AND REMERCHANDISING PROGRAM
On March 25, 1997, the Company adopted a business restructuring plan to close 60
underperforming stores and one distribution center. As a result, a pre-tax
charge of $129.5 million for restructuring costs was taken in the first quarter
of 1997. The components of the restructuring charge and an analysis of the
amounts charged against the accrual through June 28, 1998 are outlined in the
following table:
Activity to Date
----------------- ----------------- --------------
Original Accrued Restructuring
Charge Restructuring Asset Change In Costs as of
(In thousands) Recorded Costs Paid Write-downs Estimate June 28, 1998
---------------- ----------------- ----------------- -------------- -----------------------
Lease termination and other
real estate costs $ 83,225 $ (19,170) $ - $ 3,458 $ 67,513
Property and equipment
write-downs 32,915 - (32,915) - -
Employee severance 4,869 (3,616) (1,229) 24
-
Other exit costs 8,501 (4,072) (2,229) 2,200
-
---------------- ----------------- ----------------- -------------- -----------------------
Total $ 129,510 $ (26,858) $ (32,915) $ - 69,737
================ ================= ================= ==============
Less: Current portion (18,420)
--------------------
$ 51,317
====================
During the second quarter of 1998, the Company completed its store closures
under the corporate restructuring and repositioning plan announced on March 27,
1997. The Company closed a total of 53 stores and one distribution center under
this plan. Five underperforming stores were closed during the second quarter of
1998. The decrease in the number of stores closed from the original plan of 60
stores is primarily due to the inability to obtain acceptable exit terms from
the related lessors.
Changes in estimates are representative of management's assessments as of June
28, 1998, that based on actual experience to date, certain charges will be
higher than originally estimated while others will be less than originally
estimated. Due to unfavorable sublease and termination experience for stores
closed, the Company increased the estimate for lease termination and other real
estate costs. These unfavorable results have been offset by favorable experience
in employee severance and other exit costs.
-14-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
The restructuring plan was based on an analysis of individual store performance
based on cash flow return on committed capital, fit within marketing demographic
profiles and strategic geographic positioning. After the effect of charges and
costs related specifically to the closings, the immediate ongoing impact of the
closings on net income will be immaterial because the stores closed were near
break-even contributors.
During the second quarter of 1997, the Company also began implementing certain
remerchandising strategies, including the exit of the low margin computer
business and certain components of the wireless communication business.
Additional remerchandising decisions were executed in the first quarter of 1998
with the exit of infant and pet supply categories and certain components of the
sporting goods business.
LIQUIDITY AND CAPITAL RESOURCES
Working capital increased to $554.9 million at the end of the second quarter of
1998 from $448.7 million at June 29, 1997, an increase of $106.2 million or
23.7%. There were no short-term borrowings outstanding ($307.9 million available
for borrowing) at June 28, 1998 compared to $25.0 million outstanding ($483.7
million available for borrowing) at June 29, 1997. The increase in working
capital is due primarily to a $113.8 million shift from short-term to long-term
borrowings under the Company's credit facility (the "Amended and Restated Credit
Facility"). The shift to long-term borrowings reflects the net effect of the
addition of a $200 million term loan as a part of the Amended and Restated
Credit Facility partially offset by the retirement of $86.2 million of Senior
Notes Due 2001 in the third quarter of 1997. Inventory balances at the end of
the second quarter of 1998 decreased by $93.7 million primarily due to the
transition of the merchandise selections, supply chain initiatives and
additional store closings. Accounts payable decreased by $102.5 million to
$282.0 million compared to the second quarter of 1997 due to decreased purchase
volumes and reduced terms due to changes in merchandise mix. Current maturities
of long-term debt decreased $11.3 million due primarily to the Company's
agreement with the Long Term Credit Bank of Japan which extended the maturity of
a portion of the Company's First Mortgage Secured Notes.
Working capital requirements fluctuate significantly during the year due to the
seasonal nature of the Company's business and are at their peak during the
fourth quarter. Funding sources for the Company's working capital requirements
include availability under the Amended and Restated Credit Facility, internally
generated cash flow from operating activities and the availability of financing
terms from vendors. The current ratio at June 28, 1998 and June 29, 1997 was
2.0:1 and 1.7:1, respectively.
The Company has available a five-year, $900 million, fully-committed,
asset-based credit facility ("Amended and Restated Credit Facility"). The
Amended and Restated Credit Facility includes a $200 million term loan and up to
a potential maximum of $700 million in revolving loans including a $175 million
sub-facility for letters of credit. The Amended and Restated Credit Facility
matures on September 10, 2002. Interest rates on the Amended and Restated Credit
Facility are subject to change based on a financial performance-based grid and
cannot exceed a rate of LIBOR + 2.25% on revolving loans and LIBOR + 2.50% on
the term loan. As of June 28, 1998, the term loan carried a rate of LIBOR +
2.25%. There is a commitment fee of 3/8% on the undrawn portion of the revolving
loans.
-15-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
The Amended and Restated Credit Facility is secured by all material unencumbered
assets of the Company and its subsidiaries, including inventory but excluding
previously mortgaged property and leasehold interests. These security interests
will automatically terminate when the Company's senior debt (or implied senior
debt) achieves investment grade credit rating or the Company meets certain
operating performance targets.
Available borrowings under the Amended and Restated Credit Facility are limited
based on (1) a borrowing base formula which considers eligible inventories,
eligible accounts receivable and mortgage values on eligible real properties and
(2) limitations contained in the Company's public senior subordinated debt
indenture.
Total long-term debt, including current maturities and capitalized leases,
increased to $780.6 million at June 28, 1998 from $697.3 million at June 29,
1997. The increase in total long-term debt was primarily attributable to the
$113.8 million shift from short-term to long-term borrowings under the Company's
Amended and Restated Credit Facility slightly offset by the early extinguishment
of $8.9 million in mortgages and scheduled payments on capitalized leases,
mortgages and Industrial Revenue Bonds.
Additions to owned property and equipment were $10.6 million for the six periods
ended June 28, 1998 compared to $15.1 million for the same period last year. The
Company operated 353 stores as of June 28, 1998, a net increase of 5 stores from
June 29, 1997 (excluding the closing of 53 stores as part of the Company's
restructuring plan). The Company expects to incur capital expenditures of
approximately $54 million during fiscal 1998 and plans to fund these
expenditures through a combination of cash flows from operations, borrowings
under the Amended and Restated Credit Facility and potential future financings.
Additionally, the Company has allocated $13.6 million of restricted cash as a
reserve in connection with its credit card program as of June 28, 1998.
ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." In February 1998, the FASB issued SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits." These
pronouncements are effective for financial statements beginning after December
15, 1997. In March 1998, the FASB issued Statement of Position 98-1, "Accounting
for the Costs of Computer Software Developed or Obtained for Internal Use." This
pronouncement will be effective for financial statements beginning after
December 15, 1998. In June 1998, the FASB issued SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities." This pronouncement will be
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
The Company anticipates that the adoption of these Statements will not have a
material impact on its operating results or financial position.
-16-
Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
YEAR 2000 COMPLIANCE
An organization-wide program is currently being executed to ensure that all
systems critical to the operation of the Company are year 2000 compliant. This
program includes review of various systems, including the Company's core
business systems, end user systems and vendor systems. Replacement, conversion
and testing of hardware and system applications are expected to cost
approximately $2.5 million to $3.0 million upon completion of the program.
Through the second quarter of 1998, the Company has incurred approximately $1.7
million of costs, which are being expensed as incurred, related to its year 2000
efforts.
The Company expects its Year 2000 Program to be completed on a timely basis.
However, in the event the program is not completed on a timely basis, there may
be a material effect on the operations or financial results of the Company. The
Company has contacted all hardware/software vendors and is communicating with
key merchandising vendors on their compliance and testing. There can be no
assurance, however, that the systems of other entities on which the Company
relies will be converted in a timely manner or that any such failure to convert
by another entity would not have a material effect on the operations or
financial results of the Company.
-17-
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Not applicable.
Item 2. Changes in 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
At the Company's Annual Meeting of Shareholders which was held
on April 15, 1998, the following proposals were approved:
1) The election of three Class III directors to serve for a
term of three years and until their successors are duly
elected and qualified. The persons nominated for election
to the Board of Directors received the number of votes
shown opposite their respective names:
For Against Withheld
---------- --------- ----------
Harold Roitenberg 86,001,677 - 2,857,066
Gary M. Witkin 85,793,709 - 3,065,034
Raymond Zimmerman 85,870,070 - 2,988,673
2) The selection of Deloitte & Touche LLP as the Company's
Independent Public Accountants for fiscal year 1998. The
proposal received the following votes:
For Against Withheld
---------- --------- ----------
87,781,790 680,325 396,628
Current Directors whose terms have not expired and who were
therefore not up for re-election:
Year Term to Expire In
----------------------
Richard P. Crane, Jr. 1999
Charles V. Moore 1999
R. Maynard Holt 2000
James E. Poole 2000
-18-
PART II - OTHER INFORMATION (continued)
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
6(a) Exhibits filed with this Form 10-Q
Exhibit No. Under Items
601 of Regulation S-K Brief Description
----------------------- -----------------
10.1 Aircraft Lease Agreement with GE
Capital dated as of June 26, 1998.
10.2 Employment agreement dated May 11, 1998
regarding Jane Gilmartin, Senior Vice
President, Hardlines
27.1 Financial Data Schedule for the
Second Quarter Ended June 28, 1998.
27.2 Financial Data Schedule for the
Second Quarter Ended June 29, 1997.
6(b) Reports on Form 8-K
There were no reports on Form 8-K during the second quarter
ended June 28, 1998.
-19-
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.
SERVICE MERCHANDISE
COMPANY, INC.
Date: August 12, 1998 /s/ Gary M. Witkin
--------------------------
Gary M. Witkin
President
(Chief Executive Officer)
Date: August 12, 1998 /s/ S. Cusano
-------------------------
S. Cusano
Executive Vice President and
Chief Financial Officer
(Chief Financial Officer)
(Chief Accounting Officer)
-20-