1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended August 4, 2001 Commission File Number 1-14770 PAYLESS SHOESOURCE, INC. (Exact name of registrant as specified in its charter) DELAWARE 43-1813160 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 3231 SOUTHEAST SIXTH AVENUE, TOPEKA, KANSAS 66607-2207 (Address of principal executive offices) (Zip Code) (785) 233-5171 (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 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 issuer's classes of common stock, as of the latest practicable date. Common Stock, $.01 par value 22,261,579 shares as of September 7, 2001 2 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEET (Dollars in millions) AUGUST 4, JULY 29, FEB. 3, ASSETS 2001 2000 2001 ------ (UNAUDITED) (UNAUDITED) (AUDITED) ----------- ----------- --------- Current Assets: Cash and cash equivalents $ 51.3 $ 13.5 $ 10.4 Merchandise inventories 382.2 364.0 355.6 Current deferred income taxes 15.9 8.3 14.9 Other current assets 61.6 49.4 53.8 ---------- ---------- ---------- Total current assets 511.0 435.2 434.7 Property and Equipment: Land 8.0 7.2 7.4 Buildings and leasehold improvements 795.9 746.6 782.4 Furniture, fixtures and equipment 370.2 322.7 343.0 Property under capital leases 7.3 7.3 7.3 ---------- ---------- ---------- Total property and equipment 1,181.4 1,083.8 1,140.1 Accumulated depreciation and amortization (659.9) (588.6) (621.4) ---------- ---------- ---------- Property and equipment, net 521.5 495.2 518.7 Deferred income taxes 32.1 36.9 27.1 Other assets 19.0 9.8 22.3 ---------- ---------- ---------- Total Assets $ 1,083.6 $ 977.1 $ 1,002.8 ========== ========== ========== LIABILITIES AND SHAREOWNERS' EQUITY Current Liabilities: Current maturities of long-term debt $ 45.3 $ 0.8 $ 16.4 Accounts payable and accrued expenses 206.9 231.0 212.3 ---------- ---------- ---------- Total current liabilities 252.2 231.8 228.7 Long-term debt 278.5 323.7 309.2 Other liabilities 63.6 47.9 53.1 Minority Interest 4.6 -- 1.4 Total shareowners' equity 484.7 373.7 410.4 ---------- ---------- ---------- Total Liabilities and Shareowners' Equity $ 1,083.6 977.1 $ 1,002.8 ========== ========== ========== See Notes to Condensed Consolidated Financial Statements. 1 3 PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED) (Dollars and shares in millions, except per share) 13 WEEKS ENDED 26 WEEKS ENDED -------------- -------------- AUGUST 4, 2001 JULY 29, 2000 AUGUST 4, 2001 JULY 29, 2000 -------------- ------------- -------------- ------------- Net retail sales $ 806.0 $ 816.9 $ 1,574.3 $ 1,525.4 Cost of sales 547.9 545.3 1,072.8 1,027.1 Selling, general, and administrative expenses 192.0 183.7 379.6 353.2 Non-recurring item -- -- -- 8.0 --------- --------- ---------- ---------- Operating profit 66.1 87.9 121.9 137.1 Interest expense, net 7.2 8.0 15.2 9.6 --------- --------- ---------- ---------- Earnings before income taxes, minority interest, and extraordinary loss 58.9 79.9 106.7 127.5 Provision for income taxes 22.6 31.1 40.9 49.6 --------- --------- ---------- ---------- Earnings before minority interest and 36.3 48.8 65.8 77.9 extraordinary loss Minority interest 0.1 -- 0.3 -- --------- --------- ---------- ---------- Earnings before extraordinary loss 36.4 48.8 66.1 77.9 Extraordinary loss related to early extinguishment of debt, net of income taxes -- -- -- 3.6 --------- --------- ---------- ---------- Net Earnings $ 36.4 $ 48.8 $ 66.1 $ 74.3 ========= ========= ========== ========== Diluted Earnings per Share: Net earnings before extraordinary loss 1.60 2.16 2.90 3.04 Extraordinary Loss -- -- -- 0.14 --------- --------- ---------- ---------- Diluted Earnings per Share $ 1.60 $ 2.16 $ 2.90 $ 2.90 ========= ========= ========== ========== Basic Earnings per Share: Net earnings before extraordinary loss 1.64 2.19 2.98 3.07 Extraordinary Loss -- -- -- 0.14 --------- --------- ---------- ---------- Basic Earnings per Share $ 1.64 $ 2.19 $ 2.98 $ 2.93 ========= ========= ========== ========== Diluted Weighted Average Shares Outstanding 22.8 22.6 22.8 25.6 ========= ========= ========== ========== Basic Weighted Average Shares Outstanding 22.3 22.3 22.2 25.4 ========= ========= ========== ========== See Notes to Condensed Consolidated Financial Statements. 2 4 PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) (Dollars in millions) 26 WEEKS ENDED -------------- AUGUST 4, 2001 JULY 29, 2000 -------------- ------------- Operating Activities: Net earnings $ 66.1 $ 74.3 Adjustments for noncash items Included in net earnings: Extraordinary loss related to early extinguishment of debt -- 3.6 Depreciation and amortization 51.0 49.9 Amortization of unearned restricted stock 2.8 1.6 Deferred income taxes (5.9) (4.9) Changes in working capital: Merchandise inventories (26.6) (14.3) Other current assets (7.8) (5.8) Accounts payable and accrued expenses (5.4) 29.2 Other assets and liabilities, net 7.2 (1.2) ------- -------- Total Operating Activities 81.4 132.4 ------- -------- Investing Activities: Capital expenditures (58.7) (63.7) Disposition of property and equipment 4.8 1.6 ------- -------- Total Investing Activities (53.9) (62.1) ------- -------- Financing Activities: Issuance of long-term debt -- 400.0 Repayment of long-term debt (1.7) (207.0) Payment of debt issuance costs -- (8.9) Net issuances (purchases) of common stock 12.0 (405.1) Other investing activities 3.1 -- ------- -------- Total Financing Activities 13.4 (221.0) ------- -------- Increase (Decrease) in Cash and Cash Equivalents 40.9 (150.7) Cash and Cash Equivalents, Beginning of Year 10.4 164.2 ------- -------- Cash and Cash Equivalents, End of Period $ 51.3 $ 13.5 ======= ======== Cash paid during the period: Interest $ 16.7 $ 13.2 Income Taxes 27.8 45.3 See Notes to Condensed Consolidated Financial Statements. 3 5 PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. INTERIM RESULTS. These unaudited Condensed Consolidated Financial Statements of Payless ShoeSource, Inc. (the "Company") have been prepared in accordance with the instructions to Form 10-Q of the United States Securities and Exchange Commission and should be read in conjunction with the Notes to Consolidated Financial Statements (pages 20-25) in the Company's 2000 Annual Report. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited Condensed Consolidated Financial Statements are fairly presented and all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the results for the interim periods have been included; however, certain items are included in these statements based upon estimates for the entire year. The results for the three-month period and six-month period ended August 4, 2001 are not necessarily indicative of the results that may be expected for the fiscal year ending February 2, 2002. NOTE 2. INVENTORIES. Merchandise inventories are valued by the retail method and are stated at the lower of cost, determined using the first-in, first-out (FIFO) basis, or market. NOTE 3. REVOLVING CREDIT LINE. As of August 4, 2001, no amounts were drawn against the Company's $200.0 million line of credit. The availability under the line of credit has been reduced, however, by an $11.4 million outstanding letter of credit. NOTE 4. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. In order to mitigate the Company's exposure to fluctuations in interest rates, the Company has entered into a series of interest rate swap agreements whereby the Company will receive interest at the three-month LIBOR rate on a $240.0 million notional amount and pay a weighted average rate of 6.9%. Effective February 4, 2001, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 133 "Accounting for Derivative Instruments and Hedging Activities." The Company's interest rate swap agreements have been designated as cash flow hedging instruments. Such instruments are those, which effectively convert variable interest payments on debt instruments into fixed payments. For qualifying hedges, SFAS No. 133 allows derivative gains and losses to offset related results on hedged items in the consolidated statement of operations. As the critical terms of the Company's interest rate swap agreements match those of the related hedged obligations, the Company has concluded that there is no ineffectiveness in its hedges, and as a result, the adoption of SFAS No. 133 has no impact on net earnings. The Company's interest rate swap agreements are recorded in the consolidated balance sheet at August 4, 2001 as a liability measured at fair value. In connection with the adoption of SFAS No. 133, the Company recorded an after-tax loss of $4.7 million ($7.7 million pre-tax) to other comprehensive income as a cumulative effect of change in accounting principle during the first quarter of 2001. 4 6 Changes in the fair value of interest rate swap agreements designated as cash flow hedging instruments are reported in accumulated other comprehensive income. During the three months ended August 4, 2001, the Company recorded an after-tax loss of $1.2 million ($1.8 million pre-tax) to other comprehensive income representing the decline in fair value of its interest rate swap agreements. At August 4, 2001, the Company had a cumulative after-tax loss of $5.8 million ($9.3 million pre-tax) included in other accumulated comprehensive income related to cash flow hedging instruments. The amounts are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the floating rate debt obligations affects earnings. During the three months ended August 4, 2001, $0.9 million of after-tax losses ($1.5 million pre-tax) included in accumulated other comprehensive income related to interest rate swap agreements was reclassified to interest expense. For the year to end February 2, 2002, approximately $3.5 million of after-tax losses ($5.7 million pre-tax) in accumulated other comprehensive income related to interest rate swap agreements are expected to be reclassified into interest expense as a yield adjustment on the Company's variable-rate long-term debt. NOTE 5. COMPREHENSIVE INCOME. The following table shows the computation of comprehensive income: (Dollars in millions) 13 WEEKS ENDED 26 WEEKS ENDED -------------- -------------- AUGUST 4, 2001 JULY 29, 2000 AUGUST 4, 2001 JULY 29, 2000 -------------- ------------- -------------- ------------- Net Income $ 36.4 $ 48.8 $ 66.1 $ 74.3 Other Comprehensive Loss: After-tax cumulative effect of a change in accounting for -- -- (4.7) -- derivatives Change in fair value of derivatives (1.2) -- (2.0) -- Derivative losses reclassified into interest expense 0.9 -- 0.9 -- Foreign currency translation adjustments 0.7 -- (0.6) -- ------ ------ ------ ------ Total other comprehensive loss 0.4 -- (6.4) -- Total Comprehensive Income 36.8 48.8 59.7 74.3 ====== ====== ====== ====== NOTE 6. EARNINGS PER SHARE. Basic earnings per share are computed by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share include the effect of conversions of stock options. NOTE 7. RECLASSIFICATIONS. Certain reclassifications have been made to prior year balances to conform to the current year presentation. NOTE 8. FOREIGN CURRENCY TRANSLATION. Local currencies are the functional currencies for all subsidiaries. Accordingly, assets and liabilities of foreign subsidiaries are translated at the rate of exchange at the balance sheet date. Income and expense items of these subsidiaries are translated at average rates of exchange. ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the significant factors affecting operating results for the quarters ended August 4, 2001 (2001) and July 29, 2000 (2000). This discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and Notes to the Condensed Consolidated Financial Statements included in this Form 10-Q. REVIEW OF OPERATIONS NET EARNINGS Net earnings totaled $36.4 million in the second quarter of 2001 compared with $48.8 million in the second quarter of 2000. For the first six months of 2001 net earnings were $66.1 million, compared with $74.3 million in the 2000 period. Excluding the non-recurring item and extraordinary loss, net income for the first six months of 2000 would have been $82.8 million. The following table presents the components of costs and expenses, as a percent of revenues, for the second quarter of 2001 and 2000. 5 7 SECOND QUARTER FIRST SIX MONTHS -------------- ---------------- 2001 2000 2001 2000 ---- ---- ---- ---- Cost of sales 68.0% 66.8% 68.1% 67.3% Selling, general, and administrative expense 23.8 22.5 24.1 23.2 Non-recurring item -- -- -- 0.5 ----- ----- ------ ----- Operating profit 8.2 10.8 7.7 9.0 Interest expense, net 0.9 1.0 1.0 0.6 ----- ----- ------ ----- Earnings before income taxes, minority interest, and extraordinary loss 7.3 9.8 6.8 8.4 Effective income tax rate* 38.4% 38.9% 38.4% 38.9% ----- ----- ------ ----- Earnings before minority interest and extraordinary loss 4.5 6.0 4.2 5.1 Minority interest -- -- -- -- ----- ----- ------ ----- Earnings before extraordinary loss 4.5 6.0 4.2 5.1 Extraordinary loss, net of income tax -- -- -- 0.2 ----- ----- ------ ----- Net Earnings 4.5% 6.0% 4.2% 4.9% ===== ===== ====== ===== * Percent of pre-tax earnings NET RETAIL SALES Net retail sales represent the sales of stores operating during the period. Same-store sales represent sales of stores open during comparable periods. During the second quarter of 2001 total sales decreased 1.3% over the second quarter of 2000, consisting of a 3.7% decrease in unit volume and a 2.5% increase in average selling prices. For the first six months of 2001 total sales increased 3.2% over the same period in 2000, consisting of a 1.4% decrease in unit volume and a 4.7% increase in average selling prices. Sales percent increases (decreases) are as follows: SECOND QUARTER FIRST SIX MONTHS -------------- ---------------- 2001 2000 2001 2000 ---- ---- ---- ---- Net Retail Sales (1.3)% 6.4% 3.2% 4.7% Same-Store Sales (4.1)% 2.8% (0.1)% 1.8% COST OF SALES Cost of sales includes cost of merchandise sold, buying and occupancy costs. Cost of sales was $547.9 million in the 2001 second quarter, up 0.5% from $545.3 million in the 2000 second quarter. For the first six months of 2001, cost of sales was $1,072.8, a 4.4% increase from $1,027.1 million in the 2000 period. As a percentage of net retail sales, cost of sales was 68.0% in the second quarter of 2001, compared with 66.8% in the second quarter of 2000. The increase in cost of sales as a percentage of net retail sales during the second quarter of 2001 is due to higher occupancy costs including utilities, increased markdowns and negative leverage of buying and occupancy costs as a result of a decline in same-store sales. For the first six months of 2001, as a percentage of net retail sales, cost of sales was 68.1%, compared with 67.3% in the 2000 period. The increase in cost of sales as a percentage of net retail sales for the first six months of 2001 is due to an increase in markdowns and higher occupancy costs including utilities. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses were $192.0 million in the second quarter of 2001, up 4.5% from $183.7 million in the second quarter of 2000. For the first six months of 2001, selling, general and administrative expenses were $379.6, compared with $353.2 million in the 2000 period, a 7.5% increase. 6 8 As a percentage of net retail sales, selling, general and administrative expenses were 23.8% during the second quarter of 2001 compared with 22.5% in the second quarter of 2000. The increase, as a percentage of net retail sales, during the second quarter of 2001 was primarily attributed to increases in payroll costs. For the first six months of 2001, selling, general and administrative expenses as a percentage of net retail sales were 24.1% in 2001, compared with 23.2 % in 2000. The increase, as a percentage of net retail sales, during the first six months of 2001 was primarily attributed to increases in payroll costs. INTEREST EXPENSE, NET Interest expense decreased to $7.2 million in the second quarter of 2001 from $8.0 million in the second quarter of 2000. The decrease is the result of a lower average outstanding indebtedness and lower interest rates. For the first six months of 2001, interest expense increased to $15.2 million in 2001 from $9.6 million in the same period in 2000. The increase in the first six months of 2001 is the result of additional long-term debt issued during 2000 and short-term borrowings in the first quarter of 2001 under the revolving line of credit. EFFECTIVE INCOME TAX RATE The Company's effective income tax rate declined to 38.4% in the second quarter of 2001 from 38.9% in the second quarter of 2000. The decrease reflects benefits related to the previously implemented tax planning strategies. LIQUIDITY AND CAPITAL RESOURCES CASH FLOW Cash flow from operations during the six months ended August 4, 2001 was $81.4 million. This figure represented 5.2% of net retail sales in the first six months of 2001 compared with 8.7 % in the first six months of 2000. The reduction in cash flow in the first six months of 2001 was due to the decrease in net earnings, an increase in inventory as a result of second quarter 2001 sales results below expectations, and a decrease in accounts payable and accrued expenses due to the timing of inventory receipts and fewer new store and store remodeling projects in process. Internally generated funds are expected to continue to be the most important component of the Company's capital resources; however, the Company may from time to time draw on its revolving credit line to fund seasonal cash flow needs. CAPITAL EXPENDITURES Capital expenditures during the first six months of 2001 totaled $58.7 million with an additional $41.3 million estimated to be incurred in the remainder of fiscal year 2001. Included in the 2001 capital expenditures is $8.1 million related to the Company's expansion into Central America and the Caribbean, of which the Company's joint venture partner has funded $3.2 million. The Company anticipates that cash flow from operations, the revolving credit line, and its joint venture partner will be sufficient to finance projected capital expenditures. FINANCING ACTIVITIES As of August 4, 2001, no amounts were drawn against the Company's $200.0 million line of credit. The availability under the line of credit has been reduced, however, by an $11.4 million outstanding letter of credit. 7 9 FINANCIAL CONDITION RATIOS A summary of key financial information for the periods indicated is as follows: AUGUST 4, JULY 29, FEB. 3, 2001 2000 2001 ---- ---- ---- Current Ratio 2.0 1.9 2.0 Debt-Capitalization Ratio* 40.2% 46.5% 44.2% Fixed Charge Coverage** 2.7x 3.4x 3.1x * Debt-to-capitalization has been computed by dividing total debt, which includes current and long-term capital lease obligations, by capitalization, which includes current and long-term capital lease obligations, non-current deferred income taxes and equity. The debt-to-capitalization ratio, including the present value of future minimum rental payments under operating leases as debt and capitalization, would be 71.0%, 75.8% and 74.1% respectively, for the periods referred to above. The decrease in the debt to capitalization ratio at August 4, 2001 is the result of the increase in the Company's shareowners' equity, primarily from the Company's net earnings. ** Fixed charge coverage, which is presented for the trailing 52 weeks in each period ended above, is defined as earnings before income taxes, gross interest expense, and the interest component of rent expense, divided by gross interest expense and the interest component of rent expense. The decrease in the fixed charge coverage ratio at August 4, 2001 is primarily the result of the increase in interest expense resulting from the additional debt issued in April 2000 and the reduction in net earnings during the first six months of 2001. STORE ACTIVITY At the end of the second quarter of 2001, the Company operated 4,918 stores offering quality family footwear and accessories in 50 states, Canada, the Dominican Republic, El Salvador, Costa Rica, Guatemala, Guam, Saipan, Puerto Rico, and the U.S. Virgin Islands. The following table presents the change in store count for the second quarter of 2001 and 2000. SECOND QUARTER FIRST SIX MONTHS -------------- ---------------- 2001 2000 2001 2000 ---- ---- ---- ---- Beginning of quarter 4,908 4,709 4,912 4,712 Stores opened 48 257 117 321 Stores closed (38) (98) (111) (165) ----- ----- ------ ----- Ending store count 4,918 4,868 4,918 4,868 ===== ===== ===== ===== ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK Interest on the Company's Credit Facility is based on the London Interbank Offered Rate ("LIBOR") plus a variable margin as defined in the credit agreement. Therefore, the Company's future borrowing costs may fluctuate depending upon the volatility of LIBOR. The Company currently mitigates a portion of its interest rate risk through the use of interest rate swap agreements, whereby the Company has agreed to exchange, at specific intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional amount. 8 10 FORWARD-LOOKING STATEMENTS This report contains, and from time to time the Company may publish, forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, future store openings and international expansion, possible strategic alternatives and new business concepts and similar matters. Statements including the words "expects," "anticipates," "intends," "plans," "believes," "seeks," or variations of such words and similar expressions are forward-looking statements. The Company notes that a variety of factors could cause its actual results and experience to differ materially from the anticipated results or other expectations expressed in its forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company's business include, but are not limited to, the following: changes in consumer spending patterns; changes in consumer preferences and overall economic conditions; the impact of competition and pricing; changes in weather patterns; the financial condition of the suppliers and manufacturers from whom the Company sources its merchandise; changes in existing or potential duties, tariffs or quotas; changes in relationships between the United States and foreign countries; changes in relationships between Canada and foreign countries; economic and political instability in foreign countries or restrictive actions by the governments of foreign countries in which suppliers and manufacturers from whom the Company sources are located or in which the Company operates stores; changes in trade and/or tax laws; fluctuations in currency exchange rates; availability of suitable store locations on appropriate terms; the ability to hire, train and retain associates; and general economic, business and social conditions in the countries from which the Company sources products, supplies or has or intends to open stores. All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these cautionary statements. The Company does not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS There are no material pending legal proceedings other than ordinary routine litigation incidental to the business to which registrant or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 5 - OTHER INFORMATION None. ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: NUMBER DESCRIPTION ------ ------------ 11.1 Computation of Net Earnings Per Share* * Filed herewith (b) Reports on Form 8-K None. 9 11 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PAYLESS SHOESOURCE, INC. Date: September 17, 2001 By: /s/ Steven J. Douglass ------------------------------------ Steven J. Douglass Chairman of the Board and Chief Executive Officer Date: September 17, 2001 By: /s/ Ullrich E. Porzig ------------------------------------ Ullrich E. Porzig Senior Vice President 10