THE 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 OCTOBER 30, 1999 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF --- THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 0-18632 THE WET SEAL, INC. (Exact name of registrant as specified in its charter) DELAWARE 33-0415940 (State of Incorporation) (I.R.S. Employer Identification No.) 26972 BURBANK FOOTHILL RANCH, CALIFORNIA 92610 (Address of principal executive offices) (Zip code) (949) 583-9029 (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 --- --- The number of shares outstanding of the registrant's Class A Common Stock and Class B Common Stock, par value $.10 per share, at December 10, 1999 were 10,889,886 and 2,912,665, respectively. There were no shares of Preferred Stock, par value $.01 per share, outstanding at December 10, 1999. THE WET SEAL, INC. FORM 10-Q INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Balance Sheets as of October 30, 1999 (unaudited) and January 30, 1999...........................................................3-4 Statements of Income and Comprehensive Income (unaudited) for the 13 and 39 weeks ended October 30, 1999 and October 1, 1998..................................................5 Statements of Cash Flows (unaudited) for the 39 weeks ended October 30, 1999 and October 31, 1998............................6 Notes to Financial Statements..................................7-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..........................10-18 Item 3. Quantitative and Qualitative Disclosures About Market Risk............................................................19 PART II. OTHER INFORMATION...............................................20 SIGNATURE PAGE..................................................21 THE WET SEAL, INC. BALANCE SHEETS OCTOBER 30 JANUARY 30, 1999 1999 ------------------- ------------------ (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents $7,727,000 $31,590,000 Short-term investments 25,823,000 21,943,000 Other receivables 2,293,000 3,665,000 Merchandise inventories 42,081,000 28,002,000 Prepaid expenses 7,689,000 - Deferred taxes 1,791,000 1,791,000 ------------------- ------------------ Total current assets 87,404,000 86,991,000 ------------------- ------------------ EQUIPMENT AND LEASEHOLD IMPROVEMENTS: Leasehold improvements 101,687,000 75,659,000 Furniture, fixtures and equipment 47,829,000 37,758,000 Leasehold rights 4,446,000 3,577,000 Construction in progress 2,000 489,000 ------------------- ------------------ 153,964,000 117,483,000 Less accumulated depreciation (70,344,000) (57,110,000) ------------------- ------------------ Net equipment and leasehold improvements 83,620,000 60,373,000 ------------------- ------------------ LONG-TERM INVESTMENTS 19,224,000 37,973,000 OTHER ASSETS: Deferred taxes and other assets 12,142,000 11,677,000 Goodwill, net of accumulated amortization of $894,000 and $656,000 as of October 30, 1999 and January 30, 1999, respectively 7,210,000 476,000 ------------------- ------------------ Total other assets 19,352,000 12,153,000 ------------------- ------------------ $209,600,000 $197,490,000 ------------------- ------------------ ------------------- ------------------ See accompanying notes to financial statements 3 THE WET SEAL, INC. BALANCE SHEETS OCTOBER 30 JANUARY 30, 1999 1999 ------------------- ------------------ (UNAUDITED) LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $43,648,000 $37,515,000 Accrued liabilities 17,190,000 20,430,000 Income taxes payable 1,795,000 6,190,000 Current portion of long-term debt 2,000,000 1,000,000 ------------------- ------------------ Total current liabilities 64,633,000 65,135,000 ------------------- ------------------ LONG-TERM LIABILITIES: Long-term debt 264,000 1,264,000 Deferred rent 8,396,000 7,458,000 Other long-term liabilities 3,872,000 3,355,000 ------------------- ------------------ Total long-term liabilities 12,532,000 12,077,000 ------------------- ------------------ Total liabilities 77,165,000 77,212,000 ------------------- ------------------ STOCKHOLDERS' EQUITY: Preferred Stock, $.01 par value, authorized 2,000,000 shares; none issued and outstanding - - Common Stock, Class A, $.10 par value, authorized 20,000,000 shares; 10,889,886 and 10,704,886 shares issued and outstanding at October 30, 1999 and January 30, 1999, respectively 1,122,000 1,071,000 Common Stock, Class B Convertible, $.10 par value, authorized 10,000,000 shares; 2,912,665 shares issued and outstanding at October 30, 1999 and January 30, 1999 291,000 291,000 Paid-in capital 60,014,000 58,356,000 Retained earnings 91,206,000 80,374,000 Other comprehensive income (139,000) (139,000) Treasury stock, 1,347,600 shares at cost (20,059,000) (19,675,000) ------------------- ------------------ Total stockholders' equity 132,435,000 120,278,000 ------------------- ------------------ $209,600,000 $197,490,000 ------------------- ------------------ ------------------- ------------------ See accompanying notes to financial statements 4 THE WET SEAL, INC. STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED) 13 WEEKS ENDED 39 WEEKS ENDED -------------------------------- -------------------------------- OCTOBER 30 OCTOBER 31, OCTOBER 30 OCTOBER 31, 1999 1998 1999 1998 ------------ ------------ ------------ ------------ SALES $131,465,000 $121,622,000 $381,204,000 $339,503,000 COST OF SALES (INCLUDING BUYING, DISTRIBUTION AND OCCUPANCY COSTS) 94,622,000 85,121,000 272,553,000 240,141,000 ------------ ------------ ------------ ------------ GROSS MARGIN 36,843,000 36,501,000 108,651,000 99,362,000 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES 32,940,000 28,648,000 92,802,000 79,924,000 ------------ ------------ ------------ ------------ OPERATING INCOME 3,903,000 7,853,000 15,849,000 19,438,000 INTEREST INCOME, NET 701,000 957,000 2,230,000 2,977,000 ------------ ------------ ------------ ------------ INCOME BEFORE PROVISION FOR INCOME TAXES 4,604,000 8,810,000 18,079,000 22,415,000 PROVISION FOR INCOME TAXES 1,857,000 3,392,000 7,247,000 8,630,000 ------------ ------------ ------------ ------------ NET INCOME $ 2,747,000 $ 5,418,000 $ 10,832,000 $ 13,785,000 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ COMPREHENSIVE INCOME $ 2,747,000 $ 5,418,000 $ 10,832,000 $ 13,785,000 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ NET INCOME PER SHARE, BASIC $ 0.22 $ 0.42 $ 0.87 $ 1.03 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ NET INCOME PER SHARE, DILUTED $ 0.22 $ 0.41 $ 0.84 $ 1.00 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ WEIGHTED AVERAGE SHARES OUTSTANDING, BASIC 12,455,973 12,915,100 12,415,880 13,358,342 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ WEIGHTED AVERAGE SHARES OUTSTANDING, DILUTED 12,574,681 13,249,208 12,833,058 13,849,798 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ See accompanying notes to financial statements 5 THE WET SEAL, INC. STATEMENTS OF CASH FLOWS (UNAUDITED) 39 WEEKS ENDED ------------------------------------- OCTOBER 30 OCTOBER 31, 1999 1998 ----------------- ----------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $10,832,000 $13,785,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 13,471,000 9,186,000 Changes in operating assets and liabilities: - (Increase) decrease in: Other receivables 1,371,000 214,000 Merchandise inventories (10,079,000) (9,371,000) Prepaid expenses (7,689,000) (5,496,000) Other assets (464,000) (585,000) (Decrease) increase in: Accounts payable and accrued liabilities (1,107,000) 10,581,000 Income taxes payable (4,394,000) (498,000) Deferred rent 937,000 740,000 Other long-term liabilities 517,000 518,000 ----------------- ----------------- Net cash provided by operating activities 3,395,000 19,074,000 CASH FLOWS FROM INVESTING ACTIVITIES: Investment in equipment and leasehold improvements (27,749,000) (19,586,000) Acquisition of store leases and related store assets (15,704,000) Investment in marketable securities (3,879,000) (32,785,000) Proceeds from sale of marketable securities 18,749,000 31,285,000 ----------------- ----------------- Net cash used in investing activities (28,583,000) (21,086,000) CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on long-term debt - (1,000,000) Purchase of treasury stock (384,000) (19,675,000) Proceeds from issuance of stock associated with stock options 1,709,000 148,000 ----------------- ----------------- Net cash provided by (used in) financing activities 1,325,000 (20,527,000) ----------------- ----------------- NET DECREASE IN CASH AND CASH EQUIVALENTS (23,863,000) (22,539,000) CASH AND CASH EQUIVALENTS, beginning of period 31,590,000 76,056,000 ----------------- ----------------- CASH AND CASH EQUIVALENTS, end of period $7,727,000 $53,517,000 ----------------- ----------------- ----------------- ----------------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $100,000 $154,000 Income taxes, net 11,386,000 6,290,000 See accompanying notes to financial statements 6 THE WET SEAL, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION: The information set forth in these financial statements is unaudited except for the January 30, 1999 balance sheet. These statements have been prepared in accordance with generally accepted accounting principles for interim financial information, the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation have been included. The results of operations for the 13 and 39 weeks ended October 30, 1999 are not necessarily indicative of the results that may be expected for the year ending January 29, 2000. For further information, refer to the financial statements and notes thereto included in the Company's Annual Report for the year ended January 30, 1999. NOTE 2 - LINE OF CREDIT AND LOAN PAYABLE TO BANK: Under an unsecured revolving line-of-credit arrangement with Bank of America National Trust and Savings Association ("Bank of America"), the Company may borrow up to a maximum of $50 million on a revolving basis through July 1, 2002. The cash borrowings under the arrangement bear interest at Bank of America's prime rate or, at the Company's option, LIBOR plus 1.75%. As of October 30, 1999, the Company had no borrowings outstanding under the credit arrangement. In June 1995, the Company entered into an unsecured five-year, $10 million term loan. The loan bears interest at Bank of America's prime rate plus 0.25% or, at the Company's option, LIBOR plus 1.75%. Under the terms of the loan agreement, the outstanding balance of $2,264,000 will be repaid in quarterly installments of $500,000, commencing October 31, 1999, until paid. Aggregate principal payments during fiscal 1999 and fiscal 2000 are $1,000,000 and $1,264,000, respectively. The credit arrangement and the term loan impose quarterly and annual financial covenants requiring the Company to maintain certain financial ratios and achieve certain levels of quarterly income. In addition, the credit arrangement and the term loan require that Bank of America approve the payment of dividends and restrict the level of capital expenditures. At October 30, 1999, the Company was in compliance with these covenants. 7 NOTE 3 - NET INCOME PER SHARE: The Company adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS No. 128") beginning with the Company's fourth quarter of fiscal 1997. Net income per share, basic, is computed based on the weighted average number of common shares outstanding for the period. Net income per share, diluted, is computed based on the weighted average number of common and potentially dilutive common equivalent shares outstanding for the period. A reconciliation of the numerators and denominators used in basic and diluted net income per share is as follows: 13 WEEKS ENDED 13 WEEKS ENDED 39 WEEKS ENDED 39 WEEKS ENDED OCTOBER 30, 1999 OCTOBER 31, 1998 OCTOBER 30, 1999 OCTOBER 31, 1998. ---------------- ---------------- ---------------- ----------------- Net income: Basic and diluted............................ $2,747,000 $5,418,000 $10,832,000 $13,785,000 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Weighted average Number of common shares: Basic........................................ 12,455,973 12,915,100 12,415,880 13,358,342 Effect of dilutive Securities-stock options..................... 118,708 334,108 417,178 491,456 ---------- ---------- ---------- ---------- Diluted...................................... 12,574,681 13,249,208 12,833,058 13,849,798 Net income per share: Basic........................................ $0.22 $0.42 $0.87 $1.03 Effect of dilutive Securities-stock options..................... 0.00 0.01 0.03 0.03 ---------- ---------- ---------- ---------- Diluted...................................... $0.22 $0.41 $0.84 $1.00 NOTE 4 - TREASURY STOCK: In fiscal 1998, the Company's Board of Directors authorized the repurchase of up to 20% of the outstanding shares of the Company's Class A common stock. As of October 30, 1999, 1,347,600 shares have been repurchased by the Company at a cost of $20,059,000. Such repurchased shares are reflected as Treasury Stock in the Company's Balance Sheet. 8 NOTE 5 - ACQUISITION: On February 1, 1999, the Company acquired the leases and furniture and fixtures for 80 store locations from Britches of Georgetowne, Inc. The purchase price, which aggregated $15,704,000, was allocated to equipment and leasehold improvements ($8,732,000) and goodwill ($6,972,000). Goodwill associated with this transaction will be amortized over 20 years. The Company converted the store locations to Arden B., Wet Seal, Contempo Casuals and Limbo Lounge stores during the first quarter of fiscal 1999, with the majority of the locations converted to Arden B. stores. 9 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The Company is one of the largest national mall-based specialty retailers focusing primarily on young women's apparel, and currently operates 545 retail stores in 42 states, Washington D.C. and Puerto Rico. Of the 545 stores, 244 operate under the name "Contempo Casuals," 200 operate under the name "Wet Seal," 79 operate under the name "Arden B.," 21 operate under the name "Limbo Lounge" and one store operates under the name "Next." On July 1, 1995, the Company acquired Contempo Casuals, a 237-store junior women's retail chain. This acquisition substantially increased the size of the Company. Effective February 2, 1997, Contempo Casuals, Inc. was merged with and into The Wet Seal, Inc. In January 1998, the Company introduced the "Wet Seal Catalog." In the first three quarters of fiscal 1998 there were approximately 11.0 million catalogs mailed, whereas there were no catalogs mailed during the first and second quarters and only 2 million catalogs mailed in the third quarter of fiscal 1999. For the second half of fiscal 1999, the Company has repositioned the catalog under the "Blue Asphalt" brand name. Blue Asphalt is the number one denim brand in both Wet Seal and Contempo Casuals stores, and has been expanded to a full assortment of fashion apparel and accessories. The first Blue Asphalt magalog was mailed at the beginning of August 1999 to approximately 2.0 million customers. The Company has also introduced a related web-site under the Blue Asphalt name as of the beginning of the third quarter of fiscal 1999. The new site includes an on-line shopping "magalog." The Blue Asphalt magalog and web-site both offer Blue Asphalt merchandise and youth-targeted editorial content intended to build brand awareness and increase customer base and sales. In November 1998, the Company introduced a new retail concept, Arden B., which offers a collection of dressy and casual apparel, accessories and footwear for the young contemporary customer. Arden B. serves to fill the void between a "junior" and a "missy" customer, aged 20 to 40. The Company currently operates 79 Arden B. stores, 67 of which were acquired through two acquisitions. On December 1, 1998, the Company acquired the leases and furniture and fixtures for 19 store locations from Mothers Work, Inc. The majority of the locations acquired were converted to Arden B. stores. On February 1, 1999, the Company acquired the leases and furniture and fixtures for 80 store locations from Britches of Georgetowne, Inc. The Company 10 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED: converted the locations to Arden B., Wet Seal, Contempo Casuals and Limbo Lounge stores during the first quarter of fiscal 1999, with the majority of the locations converted to Arden B. As of October 30, 1999, the end of the third quarter of fiscal 1999, the Company operated 545 stores compared to 424 stores as of October 31, 1998, the end of the third quarter of fiscal 1998. The Company opened 140 stores during the period from October 31, 1998 to October 30, 1999 and closed 19 stores. Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company's Financial Statements and the Notes related thereto. RESULTS OF OPERATIONS THE 13 WEEKS ENDED OCTOBER 30, 1999 (THIRD QUARTER OF FISCAL 1999) AS COMPARED TO THE 13 WEEKS ENDED OCTOBER 31, 1998 (THIRD QUARTER OF FISCAL 1998) Sales in the third quarter of fiscal 1999 were $131,465,000 compared to sales in the third quarter of fiscal 1998 of $121,622,000, an increase of $9,843,000 or 8.1%. The dollar increase in sales was primarily due to the net increase of 121 stores; 545 stores at the end of the third quarter of fiscal 1999 compared to 424 stores at the end of the third quarter of fiscal 1998. The increase in sales was offset somewhat by the 11.6% decrease in comparable store sales. Comparable store sales are defined as sales in stores that were open throughout the full prior 14 months. The increase in sales was also offset somewhat by the fact that the prior year included catalog sales from two catalog mailings with a total of 4.5 million circulation in the third quarter, whereas there was only one catalog mailing with a 2 million circulation in the current year third quarter. Cost of sales, including buying, distribution and occupancy costs, was $94,622,000 in the third quarter of fiscal 1999 compared to $85,121,000 in the third quarter of fiscal 1998, an increase of $9,501,000. The dollar increase in cost of sales was due to the increase in sales. As a percentage of sales, cost of sales was 72.0% in the third quarter of fiscal 1999 compared to 70.0% in the third quarter of fiscal 1998, an increase of 2.0%. This increase as a percentage of sales was due primarily to a 4.9% increase in occupancy costs as a percentage of sales along with a 0.2% increase in buying wages and a 0.1% increase in regional and district wages as a percentage of sales. The increase in occupancy costs as a percentage of sales was due 11 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED: primarily to the lack of leverage on store occupancy costs resulting from the decrease in comparable store sales and to a lesser extent due to the decrease in catalog sales. The increases in buying wages and in regional and district wages as a percentage of sales were due to additional headcounts added in the current year to support expansion and growth. These increases were offset to some extent by a 2.6% decrease in the cost of merchandise and a 0.6% decrease in distribution costs as a percentage of sales. The decrease in the cost of merchandise as a percentage of sales was due to improvement in the initial margins in the third quarter of fiscal 1999 along with a decrease in the shrink reserve, offset somewhat by higher markdowns. The 0.6% decrease in the distribution costs as a percentage of sales was due primarily to a decrease in the unit cost of processing in the current quarter. Selling, general and administrative expenses were $32,940,000 in the third quarter of fiscal 1999 compared to $28,648,000 in the third quarter of fiscal 1998, an increase of $4,292,000. The dollar increase in selling, general and administrative expenses was related to the increase in total sales. As a percentage of sales, selling, general and administrative expenses were 25.1% in the third quarter of fiscal 1999 compared to 23.6% in the third quarter of fiscal 1998, an increase of 1.5%. The increase as a percentage of sales was primarily related to increases in selling wages and advertising expenses as a percentage of sales offset somewhat by the impact of the fixed costs associated with catalog production on the prior year. Without the impact of the catalog operation on the prior year, selling, general and administrative expenses increased 2.6% as a percentage of sales. This increase was primarily due to an increase in selling wages as a percentage of sales due to the impact of the decrease in comparable store sales on the fixed portion of store wages. Additionally, the increase was due to the fact that the Company has implemented national advertising campaigns in the current year promoting the Arden B. store concept and the Blue Asphalt Collection. The Company expects to spend approximately $3 million in fiscal 1999 related to this advertising versus no expense in prior year. Interest income, net, was $701,000 in the third quarter of fiscal 1999 compared to $957,000 in the third quarter of fiscal 1998, a decrease of $256,000. The decrease was due to a decrease in the average cash balance invested compared to the prior year. Income tax provision was $1,857,000 in the third quarter of 12 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED fiscal 1999 compared to $3,392,000 in the third quarter of fiscal 1998. The effective tax rate was 40.3% compared to 38.5% in the prior year. The increase in the effective tax rate was due to the decrease in tax exempt interest in the current year. Due to the factors noted above, net income was $2,747,000 in the third quarter of fiscal 1999 compared to $5,418,000 in the third quarter of fiscal 1998. As a percentage of sales, net income was 2.1% in the third quarter of fiscal 1999 compared to 4.5% in the third quarter of fiscal 1998. THE 39 WEEKS ENDED OCTOBER 30, 1999 (THIRD QUARTER OF FISCAL 1999) AS COMPARED TO THE 39 WEEKS ENDED OCTOBER 31, 1998 (THIRD QUARTER OF FISCAL 1998) Sales in the 39 weeks ended October 30, 1999 were $381,204,000 compared to sales in the 39 weeks ended October 31, 1998 of $339,503,000, an increase of $41,701,000 or 12.3%. The dollar increase in sales was primarily due to the net increase of 121 stores during the period from October 31, 1998 to October 30, 1999. The increase in sales was offset somewhat by the 7.1% decrease in comparable store sales for the year to date. The increase in sales was also offset somewhat by the fact that the prior year included catalog sales from the 5 catalog mailings with 11.0 million in circulation for three quarters, whereas there was only one catalog mailing with a 2 million circulation in the three quarters of the current year. Cost of sales, including buying, distribution and occupancy costs, was $272,553,000 in the third quarter year to date of fiscal 1999 compared to $240,141,000 in the third quarter year to date of fiscal 1998, an increase of $32,412,000. The dollar increase in cost of sales was due to the increase in sales. As a percentage of sales, cost of sales was 71.6% in the third quarter year to date of fiscal 1999 compared to 70.7% in the third quarter year to date of fiscal 1998, an increase of 0.9%. This increase as a percentage of sales was due primarily to a 3.1% increase in occupancy costs as a percentage of sales along with a 0.1% increase in both the buying wages and regional and district wages as a percentage of sales. The increase in occupancy costs as a percentage of sales was due primarily to the lack of leverage on store occupancy costs resulting from the 7.1% decrease in comparable store sales and to a lesser extent due to the decrease in catalog sales. The increases in buying wages and in regional and district wages as a percentage of sales were due to additional headcounts added in the current year to support expansion and growth. These increases were offset by a 1.9% 13 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED: decrease in the cost of merchandise and a 0.8% decrease in distribution costs as a percentage of sales. The decrease in the cost of merchandise as a percentage of sales was due to improvement in the initial margins in the year to date third quarter of fiscal 1999 along with a decrease in the shrink reserve, offset somewhat by higher markdowns. The 0.8% decrease in the distribution costs as a percentage of sales was due primarily to a decrease in the unit cost of processing in the current year to date and due to the lack of distribution cost related to catalog this year compared to the prior year. Selling, general and administrative expenses were $92,800,000 for the third quarter year to date of fiscal 1999 compared to $79,924,000 for the third quarter year to date of fiscal 1998, an increase of $12,876,000. The dollar increase in selling, general and administrative expenses was related to the increase in total sales. As a percentage of sales, selling, general and administrative expenses were 24.3% in the third quarter year to date of fiscal 1999 compared to 23.5% in the third quarter year to date of fiscal 1998, an increase of 0.8%. The increase as a percentage of sales was primarily related to increases in selling wages and advertising expenses as a percentage of sales offset somewhat by the impact of the fixed costs associated with catalog production on the prior year. Without the impact of the catalog operation on the prior year, selling, general and administrative expenses increased 1.8% as a percentage of sales. This increase was primarily due to an increase in selling wages as a percentage of sales due to the impact of the decrease in comparable store sales on the fixed portion of store wages. Additionally, the increase was due to the fact that the Company has implemented national advertising campaigns in the current year promoting the Arden B. store concept and the Blue Asphalt Collection. The Company expects to spend approximately $3 million in fiscal 1999 related to this advertising versus no expense in prior year. Interest income, net, was $2,230,000 in the third quarter year to date of fiscal 1999 compared to $2,977,000 in the third quarter year to date of fiscal 1998, a decrease of $747,000. The decrease was due to a decrease in the average cash balance invested compared to the prior year. Income tax provision was $7,247,000 in the third quarter year to date of fiscal 1999 compared to $8,630,000 in the third quarter of fiscal 1998. The effective tax rate was 40.0% compared to 38.5% in the prior year. The increase in the effective tax rate was due to the decrease in tax exempt interest 14 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED in the current year. Due to the factors noted above, net income was $10,832,000 in the third quarter year to date of fiscal 1999 compared to $13,785,000 in the third quarter year to date of fiscal 1998. As a percentage of sales, net income was 2.8% in the third quarter year to date of fiscal 1999 compared to 4.1% in the third quarter year to date of fiscal 1998. SALES TRENDS Negative comparable store sales continue in the fourth quarter. As a result, fourth quarter merchandise margins will be negatively impacted due to the merchandise markdowns which management believes will be required to move current inventory. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities for the first three quarters of fiscal 1999 was $3,395,000. Working capital at October 30, 1999 was $22,771,000 compared to $21,856,000 at January 30, 1999, an increase of $915,000. This increase in working capital was primarily due to an increase in inventory, an increase in prepaid expenses due to the timing of rent payments, a decrease in income taxes payable due to the timing of tax payments, a decrease in accrued liabilities, offset somewhat by an increase in accounts payable. Inventory was $42,081,000 at October 30, 1999 compared to $28,002,000 at January 30, 1999, an increase of $14,079,000, due to the 100 new stores during this period and the seasonal nature of the business; inventory levels are typically at a low point at year end. The increase in accounts payable of $6,133,000 at October 30, 1999 compared to January 30, 1999 was primarily attributable to the increase in inventory. In the first three quarters of fiscal 1999, the Company invested $27,749,000 in equipment and leasehold improvements, compared to $19,586,000 in the same period of the prior year. These expenditures related primarily to the 100 new stores opened and twelve stores remodeled in the first three quarters of fiscal 1999 along with construction in progress for additional new and remodeled stores in the fourth quarter. On February 1, 1999, the Company acquired the leases and furniture and fixtures for 80 store locations from Britches of Georgetowne, Inc. for $15,704,000, of which $6,972,000 is classified as goodwill. The Company converted the locations to Arden B., Wet Seal, Contempo Casuals and Limbo Lounge stores during the first quarter of fiscal 1999, with the majority of the locations converted to Arden B. The Company currently estimates that the capital expenditures for the remainder of fiscal 1999 will be approximately $7,700,000. These planned expenditures relate primarily to new store openings and remodel construction. 15 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED The Company has an unsecured revolving line of credit arrangement with Bank of America National Trust and Savings Association ("Bank of America") in an aggregate principal amount of $50,000,000 and a five year amortizing term loan with Bank of America in the amount of $10,000,000, maturing on July 1, 2002. At October 30, 1999, there were no outstanding borrowings under the credit arrangement, there was $2,264,000 outstanding under the term loan, and the Company was in compliance with all terms and covenants of the credit arrangement and the term loan. The Company invests its excess funds primarily in an investment grade money market fund, investment grade commercial paper and U.S. Treasury and Agency obligations. Management believes the Company's working capital and cash flows from operating activities will be sufficient to meet the Company's operating and capital requirements for the foreseeable future. SEASONALITY AND QUARTERLY OPERATING RESULTS The Company's business is seasonal by nature with the Christmas season (beginning the week of Thanksgiving and ending the first Saturday after Christmas) and the back-to-school season (beginning the last week of July and ending the first week of September) historically accounting for the largest percentage of sales volume. In the Company's three fiscal years ended January 30, 1999, the Christmas and back-to-school seasons together accounted for an average of approximately 33% of the Company's annual sales, after adjusting for sales increases related to new stores. The Company does not believe that inflation has had a material effect on the results of operations during the past three years. However, there can be no assurance that the Company's business will not be affected by inflation in the future. 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," may contain various forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities 16 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED Act"), and Section 21E of the Securities Exchange Act of 1934, as amended, which represent the Company's expectations or beliefs concerning future events. The Company cautions that these statements are further qualified by important factors that could cause actual results to differ materially from those in the forward looking statements, including, without limitation, the retention by the Company of suppliers for both brand name and Company-developed merchandise, the ability of the Company to expand and to continue to increase comparable store sales and the sufficiency of the Company's working capital and cash flows from operating activities. In addition, these statements are further qualified by important factors that could cause actual results to differ materially from those in the forward looking statements, including, without limitation, a decline in demand for the merchandise offered by the Company, the ability of the Company to locate and obtain acceptable store sites and lease terms or renew existing leases, the ability of the Company to obtain adequate merchandise supply, the ability of the Company to hire and train employees, the ability of the Company to gauge the fashion tastes of its customers and provide merchandise that satisfies customer demand, management's ability to manage the Company's expansion, the effect of economic conditions, the effect of severe weather or natural disasters and the effect of competitive pressures from other retailers. The Company disclaims any obligation or undertaking to disseminate any updates or revisions to any forward looking statement contained herein or to reflect any change in the expectations of the Company after the date hereof or any change in events, conditions or circumstances on which any statement is based. YEAR 2000 COMPLIANCE The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. During fiscal 1999, the Company is in the process of completing the conversion of substantially all of its computer software systems and hardware. Prior to the purchase of the new systems and hardware, the Company obtained assurance from the vendors that the products purchased are in fact Year 2000 compliant. The company has completed an independent review of 17 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED such systems to further verify Year 2000 compliance. The Company also has performed a thorough review of its existing computer software systems and hardware to identify processes that may be affected by Year 2000 problems. At this time, no significant issues have been identified and the Company has developed an adequate plan for Year 2000 compliance should the conversions fall behind schedule. During fiscal 1999, the Company has completed a Year 2000 review of its relationships with suppliers and financial institutions to obtain assurance, where necessary, that these entities are Year 2000 compliant. The Company's total Year 2000 project costs include the estimated costs and time associated with the impact of a third party's Year 2000 issue on the Company, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company's business, results of operations, cash flows and financial condition. If the Company is not completely successful in mitigating internal and external Year 2000 risks, the result could be a system failure causing disruptions of operations, including, among other things, a temporary inability to process transactions, distribute merchandise, or engage in similar normal business activities at the Company or its vendors and suppliers. The Company believes that under a worst case scenario, it could continue the majority of its normal business activities on a manual basis. With respect to potential Year 2000 failures of its vendors and suppliers, the Company plans to mitigate this risk by not depending on any single vendor or supplier for products or merchandise. Due to the fact that the majority of the Company's computer software systems and hardware have been purchased or developed recently and were designed to be Year 2000 compliant, the Company does not expect to incur significant additional costs in addressing the Year 2000 issue. The total cost of the Year 2000 project is estimated at $300,000, and will be funded through operating cash flows. Year 2000 costs as of October 30, 1999 totaled $152,000. 18 ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to a variety of risks, including changes in interest rates affecting the cost of its bank debt. The Company's outstanding term loan balance of $2.264 million at October 30, 1999 bears interest at the lending bank's prime rate plus 0.25% or, at the Company's option, LIBOR plus 1.75%. The Company believes that if interest rates were to increase by as much as 10%, the impact on the Company's financial statements would not be material. 19 PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS. The Company is not party to any material legal proceedings, other than ordinary routine litigation incidental to the Company's business. ITEM 2 - CHANGES IN SECURITIES. Not Applicable ITEM 3 - DEFAULTS UPON SENIOR SECURITIES. Not Applicable ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Company held its most recent annual meeting on June 8, 1999. At the meeting, the Company's shareholders elected George H. Benter, Jr., Kathy Bronstein, Stephen Gross, Walter F. Loeb, Wilfred Posluns, Gerald Randolph, Alan Siegel, Irving Teitelbaum and Edmond Thomas to the Board of Directors with an affirmative vote of at least 8,528,234 Class A shares and 2,912,665 Class B shares for each director, with no more than 104,068 Class A shares voting against any director. The shareholders ratified and approved the performance bonus award and incentive bonus award to the Vice Chairman and Chief Executive Officer with an affirmative vote of 8,075,090 Class A shares and 2,912,665 Class B shares, with 403,954 Class A shares voting against. The shareholders ratified and approved the performance bonus award and incentive bonus award to the President and Chief Operating Officer with an affirmative vote of 8,110,110 Class A shares and 2,912,665 Class B shares, with 395,419 Class A shares voting against. The shareholders also ratified the Company's selection of Deloitte & Touche LLP as the independent certified public accountants for the fiscal year ending January 29, 2000 with an affirmative vote of 8,625,969 Class A shares and 2,912,665 Class B shares, with 1,608 Class A shares voting against. The proposal to increase the number of authorized shares did not pass, as it received an affirmative vote of 4,074,622 Class A shares and 2,912,665 Class B shares, while 3,546,036 Class A shares voted against the proposal. This proposal required an affirmative vote from the majority of Class A shares in order to pass. Class A shares are entitled to one vote per share. Class B shares are entitled to two votes per share. ITEM 5 - OTHER INFORMATION. Not Applicable ITEM 6(a) - EXHIBITS. (27) Financial Data Schedule ITEM 6(b) - REPORTS ON FORM 8-K. Not Applicable 20 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. The Wet Seal, Inc. (Registrant) Date: December 14, 1999 /s/ KATHY BRONSTEIN ---------------------- ------------------------------ Kathy Bronstein Vice Chairman and Chief Executive Officer (Principal Executive Officer) Date: December 14, 1999 /s/ EDMOND THOMAS ---------------------- ------------------------------- Edmond Thomas President and Chief Operating Officer Date: December 14, 1999 /s/ ANN CADIER KIM ----------------------- --------------------------- Ann Cadier Kim Senior Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting Officer) 21