UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended: October 31, 2005
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 number: 1-15615
Whitehall Jewellers, Inc.
(Exact name of registrant as specified in its charter)
Delaware 36-1433610
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
155 N. Wacker Drive, Suite 500, Chicago, IL 60606
(Address of principal executive offices) (zip code)
312/782-6800
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal
year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes No X
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes X No
----- -----
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date: the number of shares of the
Registrant's common stock, $.001 par value per share, outstanding as of November
30, 2005 was 13,970,753 and the number of shares of the Registrant's Class B
common stock, $1.00 par value per share, outstanding as of November 30, 2005 was
142.
WHITEHALL JEWELLERS, INC.
INDEX TO FORM 10-Q
FOR THE QUARTER ENDED OCTOBER 31, 2005
Forward-Looking Statements
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Statements of Operations for the three months and nine months ended
October 31, 2005 and 2004 (unaudited)
Balance Sheets - October 31, 2005 (unaudited), January 31, 2005 and
October 31, 2004 (unaudited)
Statements of Cash Flows for the nine months ended October 31, 2005
and 2004 (unaudited)
Notes to Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Item 6. Exhibits
2
Forward-Looking Statements
This report contains certain forward-looking statements (as such term is defined
in Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934) and information relating to the Company that are based on
the current beliefs of management of the Company as well as assumptions made by
and information currently available to management including statements related
to the markets for our products, general trends and trends in our operations or
financial results, plans, expectations, estimates and beliefs. In addition, when
used in this report, the words "anticipate," "believe," "estimate," "expect,"
"intend," "plan," "predict," "opinion," "will" and similar expressions and their
variants, as they relate to the Company or our management, may identify
forward-looking statements. Such statements reflect our judgment as of the date
of this report with respect to future events, the outcome of which is subject to
certain risks, including the factors described above and below, which may have a
significant impact on our business, operating results or financial condition.
Investors are cautioned that these forward-looking statements are inherently
uncertain. Should one or more of these risks or uncertainties materialize, or
should underlying assumptions prove incorrect, actual results or outcomes may
vary materially from those described herein. The Company undertakes no
obligation to update forward-looking statements. The following factors, among
others, may impact forward-looking statements contained in this report: (1) our
ability to execute our business strategy and our continued net losses and
declines in comparable store sales; (2) our ability to manage our liquidity and
to obtain adequate financing on acceptable terms and the effect on us if an
event of default were to occur under any of the Company's financing
arrangements; (3) a change in economic conditions or the financial markets which
negatively impacts the retail sales environment and reduces discretionary
spending on goods such as jewelry; (4) reduced levels of mall traffic caused by
economic or other factors; (5) increased competition from specialty jewelry
retail stores, the Internet and mass merchant discount stores which may
adversely impact our sales and gross margin; (6) the high degree of fourth
quarter seasonality of our business and the impact on the Company's sales,
profitability and liquidity; (7) the extent and success of our merchandising,
marketing and/or promotional programs; (8) personnel costs and the extent to
which we are able to retain and attract key personnel and disruptions caused by
the loss of key personnel; (9) the availability, terms and cost of consumer
credit; (10) relationships with suppliers including the timely delivery to the
Company of appropriate merchandise on acceptable payment, delivery and other
terms; (11) our ability to maintain adequate information systems, capacity and
infrastructure; (12) our leverage and cost of funds and changes in interest
rates that may increase financing costs; (13) developments relating to the
Securities Purchase Agreement, Notes, Warrants and Registration Rights Agreement
with Prentice Capital Management, L.P. and Holtzman Opportunity Fund, L.P.,
including the impact of any adverse developments with respect to such
agreements, that may require the Company to seek new financing, for which there
can be no assurance of availability on acceptable terms or at all; (14) the
lease termination and other expenses that we will incur in connection with
closing stores and the revenues we achieve in the liquidation of their inventory
and associated inventory valuation allowances taken; (15) our ability to
maintain adequate loss prevention measures, especially in connection with stores
expected to be closed; (16) fluctuations in raw material prices, including
diamond, gem and gold prices; (17) the impact of current or future price
reductions on margins and resultant valuation allowances taken on certain
merchandise inventory identified from time to time as items which would not be
part of the Company's future merchandise presentation as well as alternative
methods of disposition of this merchandise inventory and resulting valuation
allowances taken; (18) developments relating to settlement of the consolidated
Capital Factors actions, the non-prosecution agreement entered into with the
United States Attorney's Office, the SEC investigation, and shareholder and
other civil litigation, including the impact of such developments on our results
of operations and financial condition and relationship with our lenders or with
our vendors; (19) regulation affecting the industry generally, including
regulation of marketing practices; and (20) the risk factors identified from
time to time in our filings with the SEC.
3
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Whitehall Jewellers, Inc.
Statements of Operations
for the three months and nine months ended October 31, 2005 and 2004
(unaudited, in thousands, except for per share data)
Three months ended Nine months ended
------------------------- -------------------------
October 31, October 31, October 31, October 31,
2005 2004 2005 2004
----------- ----------- ----------- -----------
Net sales $ 58,876 $ 63,340 $198,285 $208,652
Cost of sales (including buying
and occupancy expenses) 44,062 45,781 140,362 142,731
Inventory valuation allowance 17,920 -- 17,920 --
Impairment of long-lived assets 5,933 -- 9,003 --
-------- -------- -------- --------
Gross (loss) profit (9,039) 17,559 31,000 65,921
Selling, general and
administrative expenses 27,147 26,724 82,484 80,754
Professional fees and other
charges 2,978 1,428 5,207 5,725
Impairment of goodwill -- -- 5,662 --
-------- -------- -------- --------
Loss from operations (39,164) (10,593) (62,353) (20,558)
Interest expense 3,696 1,240 7,116 3,240
-------- -------- -------- --------
Loss before income taxes (42,860) (11,833) (69,469) (23,798)
Income tax (benefit) expense -- (3,525) 2,420 (8,610)
-------- -------- -------- --------
Net loss $(42,860) $ (8,308) $(71,889) $(15,188)
======== ======== ======== ========
Basic earnings per share:
Net loss $ (3.07) $ (0.60) $ (5.15) $ (1.09)
======== ======== ======== ========
Weighted average common share
and common share equivalents 13,975 13,948 13,966 13,941
======== ======== ======== ========
Diluted earnings per share:
Net loss $ (3.07) $ (0.60) $ (5.15) $ (1.09)
======== ======== ======== ========
Weighted average common share
and common share equivalents 13,975 13,948 13,966 13,941
======== ======== ======== ========
The accompanying notes are an integral part of the financial statements.
4
Whitehall Jewellers, Inc.
Balance Sheets
as of October 31, 2005, January 31, 2005 and October 31, 2004
(unaudited, in thousands except for share data)
October 31, January 31, October 31,
2005 2005 2004
----------- ----------- -----------
ASSETS
Current Assets:
Cash $ 1,749 $ 2,206 $ 1,296
Restricted cash 10,520 -- --
Accounts receivable, net 2,476 2,688 2,006
Merchandise inventories, net 185,683 183,676 201,558
Other current assets 2,627 383 1,311
Current income tax benefit 253 3,959 10,955
Deferred financing costs 2,257 360 301
Deferred income taxes, net -- 2,255 2,764
-------- -------- --------
Total current assets 205,565 195,527 220,191
Property and equipment, net 39,978 54,200 55,355
Goodwill, net -- 5,662 5,662
Deferred financing costs 2,405 539 528
Deferred income taxes, net -- 902 --
-------- -------- --------
Total assets $247,948 $256,830 $281,736
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Revolver loans $ 93,335 $ 73,793 $101,928
Bridge term loan, net of unaccreted
discount 28,477 -- --
Accounts payable 46,281 60,076 57,341
Customer deposits 3,037 3,042 3,232
Accrued payroll 5,346 3,829 4,134
Other accrued expenses and credits 15,990 14,587 18,063
-------- -------- --------
Total current liabilities 192,466 155,327 184,698
Accounts payable 22,291 -- --
Deferred income taxes, net -- -- 2,685
Warrants 2,094 -- --
Other long-term liabilities and credits 6,268 4,880 3,616
-------- -------- --------
Total liabilities 223,119 160,207 190,999
-------- -------- --------
Commitments and contingencies -- -- --
Stockholders' equity:
Common stock ($0.001 par value; 60,000,000 shares
authorized; 18,058,902 shares issued) 18 18 18
Class B common stock ($1.00 par value; 26,026 shares
authorized; 142 shares issued and outstanding) -- -- --
Additional paid-in capital 106,027 106,123 106,207
(Accumulated deficit) Retained earnings (42,461) 29,428 24,123
Treasury stock, at cost (4,088,149; 4,108,703 and
4,114,112 shares, respectively) (38,755) (38,946) (39,611)
-------- -------- --------
Total stockholders' equity, net 24,829 96,623 90,737
-------- -------- --------
Total liabilities and stockholders' equity $247,948 $256,830 $281,736
======== ======== ========
The accompanying notes are an integral part of the financial statements.
5
Whitehall Jewellers, Inc.
Statements of Cash Flows
for the nine months ended October 31, 2005 and 2004
(unaudited, in thousands)
Nine months ended
October 31, 2005 October 31, 2004
------------------ ----------------
Cash flows from operating activities:
Net loss $ (71,889) $ (15,188)
Adjustments to reconcile net loss to net cash (used in) provided by
operating activities:
Depreciation and amortization 9,599 9,267
Impairment of long-lived assets 9,003 --
Impairment of goodwill 5,662 --
Deferred compensation 125 104
Loss on disposition of assets 241 314
Proceeds from private label credit card contract
sign-on bonus 2,000 --
Changes in assets and liabilities:
Decrease in accounts receivable, net 161 538
(Increase) decrease in merchandise inventories, net (2,006) 4,588
(Increase) in other current assets (2,243) (436)
Decrease (increase) in current income tax
benefit 3,706 (8,661)
Decrease in deferred income taxes, net 3,157 1,994
(Decrease) in customer deposits (5) (369)
Increase (decrease) in accounts payable 10,945 (2,824)
Increase (decrease) in accrued payroll 1,517 (323)
Increase (decrease) increase in accrued
liabilities and other credits 1,129 (6,416)
(Decrease) increase in other long-term
liabilities and other credits (172) 81
--------- ---------
Net cash used in operating activities (29,070) (17,331)
Cash flows from investing activities:
Increase in restricted cash (10,520) --
Capital expenditures (3,850) (3,770)
--------- ---------
Net cash used in investing activities (14,370) (3,770)
Cash flows from financing activities:
Borrowing on revolver loan 266,666 769,521
Repayment of revolver loan (247,124) (747,933)
Proceeds from bridge term loan 30,000 --
Bridge term loan discount (1,523) --
Repayment of subordinated debt -- (640)
Proceeds from exercise of stock options -- 12
Proceeds under employee stock purchase plan 20 41
Financing costs (4,701) (132)
Warrants 2,094 --
Change in outstanding checks, net (2,449) (373)
--------- ---------
Net cash provided by financing activities 42,983 20,496
--------- ---------
Net change in cash and cash equivalents (457) (605)
Cash and cash equivalents at beginning of period 2,206 1,901
--------- ---------
Cash and cash equivalents at end of period $ 1,749 $ 1,296
========= =========
The accompanying notes are an integral part of the financial statements.
6
Whitehall Jewellers, Inc.
Notes to Financial Statements
1. DESCRIPTION OF OPERATIONS
The financial statements of Whitehall Jewellers, Inc. (the "Company")
include the results of the Company's chain of specialty retail fine jewelry
stores. The Company operates exclusively in one business segment, specialty
retail jewelry. The Company has a national presence with 389 stores as of
October 31, 2005, located in 38 states, operating in regional and super regional
shopping malls.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis for Presentation
The accompanying unaudited financial statements have been prepared in
accordance with Rule 10-01 of Regulation S-X. Consequently, they do not include
all of the disclosures required under accounting principles generally accepted
in the United States of America for complete financial statements.
The unaudited financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has experienced
recurring losses from operations in the first nine months of fiscal year 2005
and in the two previous fiscal years. During the second and third quarters of
fiscal year 2005, the Company slowed payments to certain vendors and received a
temporary extension of payment terms, beyond the stated payment terms, with
certain key vendors in order to manage its liquidity needs. On October 3, 2005,
the Company signed a securities purchase agreement with funds managed by
Prentice Capital Management, L.P. and the Holtzman Opportunity Fund, L.P.
(collectively "Prentice") which, if approved by the shareholders of the Company,
would bring substantial additional capital to the Company. For information
regarding the securities purchase agreement, refer to Note 9 to the financial
statements. Should the Company be unable to consummate the transaction
contemplated by the securities purchase agreement or other financing
alternatives, the Company may be unable to continue as a going concern and,
therefore, it may be unable to realize its assets and discharge its liabilities
in the normal course of business. The unaudited financial statements do not
include any adjustments that might result from the outcome of these
uncertainties.
The interim financial statements reflect all adjustments (consisting only
of normal recurring adjustments) which are, in the opinion of management,
necessary for a fair statement of the financial position, results of operations
and cash flows for the interim periods presented. For further information
regarding the Company's accounting policies, refer to the financial statements
and footnotes thereto for the fiscal year ended January 31, 2005 included in the
Whitehall Jewellers, Inc. Preliminary Proxy Statement as filed with the SEC on
November 14, 2005. References in the following notes to years and quarters are
references to fiscal years and fiscal quarters.
Consolidation
The consolidated financial statements include the accounts and transactions
of the Company and its subsidiaries. Intercompany accounts and transactions have
been eliminated.
Use of Estimates
The preparation of financial statements in conjunction with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the
7
reporting period. Valuation reserves for inventory, accounts receivable, sales
returns, deferred tax assets and projections of undiscounted future cash flows
used to evaluate the recoverability of long-lived asset carrying values are
significant examples of the use of such estimates. Actual results could differ
from those estimates.
Restricted Cash
The restricted cash balance as of October 31, 2005 represented cash that
was transferred into an escrow account on October 4, 2005 upon the closing of
the Bridge Term Loan Agreement (as defined in Note 8 to the financial
statements) and the Term Sheet (as defined in Note 7 to the financial
statements). The entire amount of the restricted cash was paid to the
participating suppliers during early November 2005 pursuant to the Term Sheet.
Merchandise Inventories
Merchandise inventories are stated principally at the lower of weighted
average cost or market. Purchase cost is reduced to reflect certain allowances
and discounts received from merchandise vendors. Periodic credits or payments
from merchandise vendors in the form of consignment conversions, volume or other
purchase discounts and other vendor consideration are reflected in the carrying
value of the inventory and recognized as a component of cost of sales as the
merchandise is sold. Additionally, to the extent it is not addressed by
established vendor return privileges, and if the amount of cash consideration
received from the vendor exceeds the estimated fair value of the goods returned,
that excess amount is reflected as a reduction in the purchase cost of the
inventory acquired. Allowances for inventory shrink, scrap and other provisions
are recorded based upon analysis and estimates by the Company.
Certain of the Company's agreements with merchandise vendors provide
credits for co-op advertising calculated as a percentage of net merchandise
purchases. The Company adopted Emerging Issues Task Force ("EITF") Issue No.
02-16, "Accounting by a Customer (Including a Reseller) for Certain
Consideration Received from a Vendor" ("EITF 02-16") in fiscal year 2002, which
was effective for all arrangements entered into after December 31, 2002. In
accordance with EITF 02-16, the Company classifies certain merchandise vendor
allowances as a reduction to inventory cost unless evidence exists supporting an
alternative classification. The Company earned $1,596,000 and $1,473,000 of
vendor allowances for advertising for the first nine months of fiscal years 2005
and 2004, respectively. The Company records such allowances as a reduction of
inventory cost, and as the inventory is sold, the Company will recognize a lower
cost of sales.
The Company also obtains merchandise from vendors under various consignment
agreements. The consigned inventory and related contingent obligations
associated with holding and safekeeping such consigned inventory are not
reflected in the Company's financial statements. At the time of sale of
consigned merchandise to customers, the Company records the purchase liability
and the related consignor cost of such merchandise in cost of sales.
Long-Lived Assets
On a quarterly basis or earlier whenever facts and circumstances indicate
potential impairment, the Company evaluates the recoverability of long-lived
asset carrying values, using projections of undiscounted future cash flows over
remaining asset lives. When impairment is indicated, any impairment loss is
measured by the excess of carrying values over fair values. In evaluating
long-lived retail store assets for impairment, the Company considers a number of
factors such as a history of consistent store operating losses, sales trends,
store management turn-over, local competition and changes in mall demographic
profiles.
8
Based on the nature of such estimates, it is possible that future results
of operations or net cash flows could be materially affected if actual outcomes
are significantly different from the Company's estimates related to these
matters.
Warrants
The Company accounts for warrants in accordance with FASB Statement of
Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." At
the date of issuance, a fair value is ascribed to the warrants based on a
valuation using the Black-Scholes model. The value of warrants outstanding at
the end of each fiscal quarter is marked to market based on a valuation using
the Black-Scholes model. The change in the value of warrants from the previous
reporting period is recognized as a component of interest expense.
Advertising and Marketing Expense
The Company expenses the production costs of advertising the first time the
advertising takes place, except for direct-response advertising, which is
capitalized and amortized over the expected period of future benefit.
Advertising expense was $4,558,000 and $4,712,000 for the first nine months of
fiscal year 2005 and 2004, respectively.
Direct-response advertising consists primarily of special offers, flyers
and catalogs that, from time to time, include value off coupons for merchandise.
Contract Sign-on Bonus
During the second quarter of fiscal year 2005, the Company received a $2.0
million contract sign-on bonus related to the renewal of the Company's private
label credit card contract. The Company is amortizing the contract proceeds over
the five-year term of the contract as a reduction to credit expense. The
unamortized portion of the contract sign-on bonus is included in the Company's
balance sheet.
Income Taxes
In the second quarter of fiscal year 2005, the Company recorded a valuation
allowance of $13.5 million against all of its deferred tax assets. In recording
the valuation allowance, management considered whether it was more likely than
not that some or all of the deferred tax assets would be realized. This analysis
included consideration of expected reversals of existing temporary differences
and projected future taxable income.
Due to the seasonal nature of its business, the Company tends to generate
all or a significant majority of its income in the fourth quarter. In accordance
with the guidance in FASB Interpretation No. 18 "Accounting for Income Taxes in
Interim Periods - an interpretation of APB Opinion No. 28" ("FIN 18"), the
Company's current estimate of the income tax expense associated with the
cumulative year-to-date fiscal year 2005 loss and valuation allowance recorded
against its deferred tax assets results in an effective income tax rate of 3.5%.
Based on the current facts and circumstances, the provisions of FIN 18
effectively limit the amount of income tax expense that can be recorded in the
interim period. To the extent that results in the fourth quarter are
significantly more or less than expected, the Company's effective income tax
rate for the fourth quarter and for the full year could vary significantly from
that of the first nine months of fiscal year 2005.
The Company did not record an income tax benefit associated with the
pre-tax loss for the three months ended October 31, 2005. The Company has
discontinued recognizing income tax benefits in the statement of operations
until it is determined that it is more likely than not that the Company will
generate sufficient taxable income to realize the deferred income tax assets.
9
The provision for income taxes on income differs from the statutory tax
expense computed by applying the federal corporate rate of 34% for the
respective three and nine-month periods ended October 31, 2005 and 2004.
Three months ended Nine months ended
----------------------------------- -----------------------------------
October 31, 2005 October 31, 2004 October 31, 2005 October 31, 2004
---------------- ---------------- ---------------- ----------------
(in thousands)
Income tax benefit computed
at statutory rate $(14,570) $(4,023) $(23,619) $(8,091)
State income tax benefit
net of federal tax effect (1,859) (655) (3,228) (1,622)
Valuation expense 16,599 470 30,304 788
Other (170) 683 (1,037) 315
-------- ------- -------- -------
Total income tax expense
(benefit) $ -- $(3,525) $ 2,420 $(8,610)
======== ======= ======== =======
Stock-Based Compensation
The Financial Accounting Standards Board (the "FASB") issued Statement of
Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based
Compensation-Transition and Disclosure," during 2002. SFAS 148 amends Statement
of Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for
Stock-Based Compensation," to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation and amends the disclosure requirements to require
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. The Company adopted the disclosure requirements
of SFAS 148 as of January 31, 2003.
The Company accounts for stock-based compensation according to Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
which results in no charge to earnings when options are issued at fair market
value.
The following table illustrates the effect on net income and earnings per
share for the three and nine months ended October 31, 2005 and 2004, as if the
Company had applied the fair value recognition provisions of SFAS 123, as
amended by SFAS 148, to stock-based employee compensation:
Three months ended Nine months ended
------------------------- -------------------------
October 31, October 31, October 31, October 31,
2005 2004 2005 2004
----------- ----------- ----------- -----------
(in thousands, except for per share amounts)
Net loss, as reported $(42,860) $(8,308) $(71,889) $(15,188)
Deduct: Total stock-based
employee compensation expense
determined under fair value
based method, net of related
tax effects 18 146 202 439
-------- ------- -------- --------
Pro forma net loss $(42,878) $(8,454) $(72,091) $(15,627)
======== ======= ======== ========
Earnings per share:
Basic-as reported $ (3.07) $ (0.60) $ (5.15) $ (1.09)
======== ======= ======== --------
Basic-pro forma $ (3.07) $ (0.61) $ (5.16) $ (1.12)
======== ======= ======== ========
Diluted-as reported $ (3.07) $ (0.60) $ (5.15) $ (1.09)
======== ======= ======== ========
Diluted-pro forma $ (3.07) $ (0.61) $ (5.16) $ (1.12)
======== ======= ======== ========
10
The FASB issued SFAS No. 123 (revised 2004), "Shared-Based Payment" ("SFAS
123R"). This statement revised SFAS No. 123 and requires companies to expense
the value of employee stock options and similar awards. The effective date of
this standard is annual periods beginning after June 15, 2005.
Upon the adoption of SFAS No. 123R, the Company will be required to expense
stock options over the vesting period in its statement of operations. In
addition, the Company will need to recognize compensation expense over the
remaining vesting period associated with unvested options outstanding for fiscal
years beginning after June 15, 2005. The Company is currently evaluating which
transition method to use and the effects on its financial statements in
connection with the adoption of SFAS No. 123R.
Accounting for Guarantees
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, an interpretation of FASB
Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34."
The Company has adopted the guidance of FIN 45 and has reflected the
required disclosures in its financial statements commencing with the financial
statements for the year ended January 31, 2003. Under its bylaws, the Company
has agreed to indemnify its officers and directors for certain events or
occurrences while the officer or director is serving, or was serving, at its
request in such capacity. The maximum potential amount of future payments the
Company could be required to make pursuant to these indemnification obligations
is unlimited; however, the Company has a directors and officers liability
insurance policy that, under certain circumstances, enables it to recover a
portion of any future amounts paid. The Company has no liabilities recorded for
these obligations as of October 31, 2005; however, reference should be made to
Note 11 to the financial statements with respect to legal contingencies.
3. ACCOUNTS RECEIVABLE, NET
As of October 31, 2005, January 31, 2005 and October 31, 2004, accounts
receivable consisted of (in thousands):
October 31, 2005 January 31, 2005 October 31, 2004
---------------- ---------------- ----------------
Accounts receivable $2,826 $3,083 $2,311
Less: allowance for doubtful accounts (350) (395) (305)
------ ------ ------
Accounts receivable, net $2,476 $2,688 $2,006
====== ====== ======
4. MERCHANDISE INVENTORIES, NET
As of October 31, 2005, January 31, 2005 and October 31, 2004, merchandise
inventories consisted of (in thousands):
October 31, 2005 January 31, 2005 October 31, 2004
---------------- ---------------- ----------------
Raw materials $ 8,549 $ 9,796 $ 11,586
Finished goods 200,354 178,137 195,040
Inventory reserves (23,220) (4,257) (5,068)
-------- -------- --------
Merchandise inventories, net $185,683 $183,676 $201,558
======== ======== ========
11
Raw materials primarily consist of diamonds, precious gems, semi-precious
gems and gold. Included within inventory reserves are provisions for inventory
valuation allowances, shrink, scrap and miscellaneous costs. As described in
Note 5 to the financial statements, the Company is liquidating inventory through
store closure sales, and such sales required additional inventory valuation
allowances. During the fiscal quarter ended October 31, 2005, the Company
recorded a valuation allowance of $17.9 million. The valuation allowance was
based upon management's best estimate of the net proceeds to be received from
the liquidation of inventory through the store closure sales of not less than
55% of the cost of such inventory. Additional inventory valuation allowances may
be required in future periods to the extent that actual net proceeds from the
sales of such merchandise are less than management's current estimate.
As of October 31, 2005, January 31, 2005 and October 31, 2004, consignment
inventories held by the Company that were not included in the balance sheets
totaled $65,241,000; $82,819,000; and $80,957,000, respectively.
Certain merchandise procurement, distribution and warehousing costs are
allocated to inventory. As of October 31, 2005, January 31, 2005 and October 31,
2004, the amounts included in inventory were $3,960,000; $3,589,000 and
$3,692,000, respectively.
5. IMPAIRMENT OF LONG-LIVED ASSETS AND STORE CLOSURES
When facts and circumstances indicate potential impairment, the Company
evaluates the recoverability of long-lived asset carrying values, using
projections of undiscounted future cash flows over remaining asset lives. In
evaluating long-lived retail store assets for impairment, the Company considers
a number of factors such as a history of consistent store operating losses,
sales trends, store management turn-over, local competition and changes in mall
demographic profiles. When impairment is indicated, any impairment loss is
measured by the excess of carrying values over fair values.
During the third quarter of fiscal year 2005, the Company recorded, in
accordance with Financial Accounting Standards No. 144 ("FAS 144") "Accounting
for the Impairment or Disposal of Long-Lived Assets" asset held for use model,
an impairment charge of $5,933,000. The impairment charge was the result of a
plan, as approved by the Company's Board of Directors and announced on November
1, 2005, to close seventy-seven of the Company's retail stores and for the
reduction in carrying value of two additional stores which will remain open. The
Company currently expects to close the seventy-seven stores by February 2006.
The decision to close these stores resulted in an impairment of the respective
stores' long-lived assets, as the carrying amount of the respective stores'
long-lived fixed assets will not be recoverable as such assets will be disposed
of before the end of their previously estimated useful lives.
To assist with the closing of these stores, the Company entered into an
agreement during early November 2005 with a third party. This third party is
currently liquidating inventory in the seventy-seven closing stores through
store closing sales. Pursuant to terms of this agreement, the Company will
receive cash proceeds from the liquidating stores of not less than 55% of cost
of the merchandise inventory, plus the reimbursement of certain operational
expenses. In accordance with this agreement, during November 2005 two standby
letters of credit were issued with the third party as the beneficiary in the
aggregate amount of $1,700,000. Such standby letters of credit are secured by
the Company's Senior Credit Agreement and expire on April 15, 2006. In addition,
the Company also entered into an agreement with another third party for the
purpose of selling, terminating or otherwise mitigating lease obligations
related to the store closings.
For the nine months ended October 31, 2005, the Company recorded impairment
charges of $9,003,000 compared to none in the prior year period.
In accordance with FASB Statement No. 146 ("SFAS 146"), "Accounting for
Costs Associated with Exit or Disposal Activities," the Company has not recorded
12
any exit or disposal related expenses, including lease terminations, personnel
costs and other expenses, associated with the planned store closures. Such
expenses will be recorded in the period in which the liability is incurred. At
this time, no agreements have been reached which would permit the Company to
estimate such disposal costs, which may be material to the financial statements.
6. GOODWILL, NET
In accordance with the FASB Statement of Financial Accounting Standards No.
142 ("SFAS 142"), "Goodwill and Other Intangible Assets," the Company evaluates
goodwill for impairment on an annual basis in the fourth quarter or earlier
whenever indicators of impairment exist. SFAS 142 requires that if the carrying
value of a reporting unit to which the goodwill relates exceeds its fair value,
an impairment loss is recognized to the extent that the carrying value of the
reporting unit goodwill exceeds the "implied fair value" of reporting unit
goodwill.
As of July 31, 2005, the Company evaluated goodwill for impairment using
discounted cash flow and a market multiple approach for impairment and concluded
that the entire amount of the Company's goodwill was impaired. This analysis was
based in part upon the Company's sales performance and financial results for the
second quarter of fiscal year 2005 and management's current expectation of
future financial results. The Company recorded a non-cash impairment charge of
$5,662,000 to write-off the entire goodwill asset in the second quarter of
fiscal year 2005.
7. ACCOUNTS PAYABLE
The current portion of accounts payable includes outstanding checks, which
were $1,584,000, $4,033,000 and $3,793,000 as of October 31, 2005, January 31,
2005 and October 31, 2004, respectively.
During the third quarter of fiscal year 2005, the Company, Prentice Capital
and the Banks (as defined in Note 8 to the financial statements) executed a term
sheet (the "Term Sheet") with certain trade vendors. Vendors holding over 99% of
the Company's aggregate trade debt to inventory suppliers ("Suppliers") executed
the Term Sheet. The Term Sheet provides a mechanism for (i) the Company's
satisfaction of its current trade debt ("Trade Debt") to participating
Suppliers, and (ii) the participating Suppliers' prompt delivery of merchandise
to the Company for the upcoming holiday season. Under the provisions of the Term
Sheet, the Company will make payments totaling 50% of the Trade Debt at various
times up to January 16, 2006. A final payment in the amount of 50% of the Trade
Debt, plus accrued interest at 6% from and after January 17, 2006, is required
to be made on or about September 30, 2007. The obligations to pay the final 50%
of the Trade Debt will be secured by a security interest in substantially all of
the Company's assets ranking junior to the interests securing the Senior Credit
Agreement, the Bridge Loan Agreement and the Notes. The Term Sheet is subject to
and conditioned upon the execution of definitive documentation among the
parties.
In connection with the Term Sheet, the Company reclassified approximately
$22,291,000, representing 50% of the aggregate trade debt of the suppliers that
executed the Term Sheet, of the trade accounts payable, to non-current accounts
payable. The Company will issue notes to the participating suppliers for the
non-current portion of accounts payable. Upon the issuance of such notes, the
Company will reclassify the non-current accounts payable to trade notes payable.
Pursuant to the Term Sheet, during early December 2005 a standby letter of
credit was issued to a trustee as the beneficiary for the participating
Suppliers, to be drawn upon only in the event the Company fails to make timely
required payments for sales of consignment goods. The face amount of this letter
of credit is $7,000,000 through December 18, 2005. The face amount of the letter
of credit increases to $10,000,000 from December 19, 2005 until the date of
payment for consignment sales through December 26, 2005. The face amount of the
letter of credit is $5,000,000 from December 27, 2005 through January 15, 2006.
Such
13
standby letter of credit is secured by the Company's Senior Credit Agreement and
expires on January 15, 2006.
8. FINANCING ARRANGEMENTS
Effective July 29, 2003, the Company entered into a Second Amended and
Restated Revolving Credit and Gold Consignment Agreement to provide for a total
facility of up to $125 million through July 28, 2007. On October 3, 2005, the
Company entered into a Waiver, Consent and Fourth Amendment (the "Fourth
Amendment") to the Second Amended and Restated Revolving Credit and Gold
Consignment Agreement (the "Senior Credit Agreement") by and among the Company,
LaSalle Bank National Association ("LaSalle"), as administrative agent and
collateral agent for the banks party thereto ("Banks"), the Banks, Bank of
America, N.A., as managing agent, and Back Bay Capital Funding LLC, as
accommodation facility agent. In connection with the Fourth Amendment to the
Senior Credit Agreement, the Company incurred $1,533,000 in financing costs,
which have been deferred on the Company's balance sheet and amortized over the
term of the Senior Credit Agreement and included in interest expense.
Under the Senior Credit Agreement (as amended by the Fourth Amendment), the
Banks provide a revolving line of credit of up to $140 million (the "Revolving
Facility") including an accommodation facility of $15 million (the
"Accommodation Facility"), each having a maturity date of October 3, 2008. The
Fourth Amendment removes the financial performance covenants and modifies the
borrowing base calculation and increases the minimum required availability
covenant. The Senior Credit Agreement remains secured by substantially all of
the assets of the Company. The Senior Credit Agreement continues to contain
affirmative and negative covenants and representations and warranties customary
for such financings. The Senior Credit Agreement contains certain restrictions,
including restrictions on investments, payment of dividends, assumption of
additional debt, acquisitions and divestitures.
As of October 31, 2005, the calculated revolver availability as determined
on October 26, 2005, pursuant to the Senior Credit Agreement was $120.9 million.
The Company had $93.3 million of outstanding borrowings under the revolving loan
facility as of October 31, 2005.
Borrowings under the Revolving Facility shall bear interest at the option
of the Company (i) at the LIBOR rate plus 250 basis points, or (ii) at the
lesser of (a) LaSalle Bank, National Association's prime rate and (b) the
federal funds effective rate plus 50 basis points (such lesser rate, the "Base
Rate"). Borrowings under the Accommodation Facility bear interest at the Base
Rate plus 800 basis points. The Company may prepay without penalty and reborrow
under the Revolving Facility. The Company will be required to pay an early
termination fee under certain circumstances if the Revolving Facility is
terminated early or if the Accommodation Facility is prepaid. The Banks may
accelerate the obligations of the Company under the Senior Credit Agreement to
be immediately due and payable upon an Event of Default.
The Company was in compliance with the financial covenants of the Senior
Credit Agreement as of October 31, 2005. Should the Company be unable to
consummate the transaction contemplated by the securities purchase agreement, as
described in Note 9 to the financial statements, the Company would be in default
of the Senior Credit Agreement.
On October 3, 2005, the Company entered into a Bridge Term Loan Credit
Agreement (the "Bridge Loan Agreement") with PWJ Lending LLC ("PWJ Lending"), an
investment fund managed by Prentice Capital Management, L.P. ("Prentice
Capital"), and Holtzman Opportunity Fund, L.P. ("Holtzman") (together with any
other lenders under such agreement from time to time, the "Lenders"), and PWJ
Lending as administrative agent and collateral agent for the Lenders. Under the
Bridge Loan Agreement, the Lenders provided a term loan (the "Term Loan") to the
Company in the aggregate principal amount of $30,000,000 (the "Commitment
Amount"), which bears interest at a fixed rate of 18% per annum, payable
monthly, and has a stated maturity date as early as December 30, 2005. The
proceeds of the Term Loan were
14
used, among other purposes, to repay a portion of the revolving credit loans
then outstanding under the Senior Credit Agreement, to fund a segregated account
that was disbursed into a third party escrow account established for the benefit
of certain of the Company's trade vendors and to pay fees and expenses
associated with the transaction. The Company's obligations under the Bridge Loan
Agreement are secured by a lien on substantially all of the Company's assets
which ranks junior in priority to the liens securing the Company's obligations
under the Senior Credit Agreement. The Bridge Loan Agreement contains a number
of affirmative and restrictive covenants and representations and warranties that
generally are consistent with those contained in the Company's Senior Credit
Agreement (as amended by the Fourth Amendment). The Company may prepay the Term
Loan at any time, provided, however, that if the Term Loan is prepaid with funds
from any source other than the proceeds of the Notes (as defined below), then
the Company will be required to pay to the Lenders an exit fee of 4% of the
Commitment Amount. Under the Bridge Loan Agreement, the Company is required to
use the proceeds of a sale of the Notes to retire the Term Loan. While the
Lenders may accelerate the obligations of the Company under the Bridge Loan
Agreement to be immediately due and payable upon an Event of Default (as defined
in the Bridge Loan Agreement), the rights of the Lenders to enforce the
obligations are subject to an intercreditor agreement with the holders of debt
under the Senior Credit Agreement. In connection with the Bridge Term Loan
Agreement, the Company incurred $795,000 in financing costs, which have been
deferred on the Company's balance sheet and amortized over the term of the
three-month life of the Bridge Term Loan and included in interest expense.
In connection with the Bridge Loan Agreement, the Company issued 7-year
warrants (the "Warrants"), which are immediately exercisable, with an exercise
price of $0.75 per share to the Lenders to purchase 2,792,462 shares of the
Company's common stock (i.e., 19.99% of the number of shares currently
outstanding). The exercise price of the Warrants will be reduced, subject to
certain limited exceptions, if the Company subsequently issues common stock or
the right to acquire common stock at a price of less than $0.75 per share.
The Warrants are being accounted for in accordance with FASB Statement of
Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
Based on a valuation using the Black-Scholes model, the fair value ascribed to
these Warrants, at the date of issuance, was determined to be $0.80 per share
for a total value of approximately $2,234,000. The value assigned to the
Warrants, constitute a discount to the Bridge Term Loan and will be accreted
over the three-month life of the Bridge Term Loan as non-cash interest expense.
The value of the Warrants outstanding at the end of each fiscal quarter are
being marked to market based on a valuation using the Black-Scholes model. As of
October 31, 2005, the fair value of these Warrants was determined to be $0.75
per share for a total fair value of approximately $2,094,000. The change in the
value of the Warrants as of October 31, 2005 from the time of issuance was
recognized as a reduction to interest expense for the three months ended October
31, 2005.
9. SECURITIES PURCHASE AND REGISTRATION RIGHTS AGREEMENTS
Contemporaneously with the entry into the Bridge Loan Agreement (as
described in Note 8 to the financial statements), the Company, PWJ Funding LLC
("PWJ Funding"), another fund affiliated with Prentice Capital, and Holtzman
entered into a Securities Purchase Agreement (the "Purchase Agreement," and PWJ
Lending, PWJ Funding and Holtzman are collectively referred to herein as
"Prentice").
Subject to certain terms and conditions set forth in the Purchase
Agreement, the Company has agreed to issue to Prentice $50,000,000 of secured
convertible notes (the "Notes"). The stated maturity of the Notes will be three
years after the date of issuance which maturity generally may be extended by the
Company for up to two years. Prentice will have the option to extend the
maturity date in the event and for so long as an event of default shall have
occurred and be continuing under the Notes or through the date that is ten
business days after the
15
consummation of a change of control of the Company in the event a change of
control is publicly announced prior to the maturity date. The Notes will be
secured by the same second security interest that secures the Term Loan.
The Notes will bear interest at a rate of 12% per annum, payable quarterly.
Interest that becomes payable during the initial three year term of the Notes
will be paid in shares of common stock of the Company at the Conversion Price
(initially $0.75 per share). The Conversion Price will be reduced, subject to
certain limited exceptions, if the Company subsequently issues common stock or
the right to acquire common stock at a price of less than $0.75 per share.
Interest that becomes payable after the initial three year term of the Notes
will be paid in cash.
Upon a change of control of the Company (as defined in the Purchase
Agreement), the holder of a Note may require the Company to redeem all or any
portion of the Note for a price equal to (i) the outstanding principal amount of
the Notes, together with any accrued and unpaid interest or late charges thereon
multiplied by (ii) 125% (unless the change of control is not approved by a
majority of the disinterested members of the Company's Board of Directors, in
which case the 125% will be 100%).
The issuance of the Notes under the Purchase Agreement is subject to
certain conditions including (i) the approval by the stockholders of the Company
of (A) the issuance of the shares of common stock pursuant to the terms of the
Notes, (B) an amendment to the Company's certificate of incorporation providing
for a 1-for-2 reverse stock split, and (C) the election of persons designated by
Prentice to the Company's board of directors (the "Board Nominees"), (ii) upon
election, such Board Nominees constituting a majority of the members of the
board of directors, and (iii) no occurrence of an event, circumstance or fact
which resulted in, would result in or could reasonably be expected to a result
in an extremely detrimental event to the Company. The Company may terminate the
Purchase Agreement under certain circumstances in order to accept a superior
proposal. The Notes will contain certain covenants, including limitations on
indebtedness, and liens and a prohibition on dividends.
Under the Purchase Agreement, the Company may not solicit offers, inquiries
or proposals or conduct negotiations with any third parties regarding a
transaction that involved debt or equity fundraising or that would otherwise be
done in lieu of the transaction with Prentice, subject to the Company's board of
directors fulfilling its fiduciary duties to the Company's shareholders and
creditors. The Company may terminate the Purchase Agreement under certain
circumstances in order to accept a superior proposal.
The shares of common stock issuable (i) upon exercise of the Warrants, (ii)
upon conversion of the Notes, and (iii) as payment of interest under the Notes,
will represent approximately 87% of the issued and outstanding shares of common
stock of the Company, assuming (A) no anti-dilution adjustment to the Conversion
Price or the Exercise Price and (B) no issuance of common stock or securities
convertible, exercisable or exchangeable for common stock prior to the closing
of the transaction, other than pursuant to the Notes and Warrants.
The proceeds to be received by the Company upon the sale of the Notes will
be used to retire the Term Loan and for general working capital purposes.
The Purchase Agreement contains a provision contemplating that 80% of any
proceeds to the Company from any proceedings by the Company against Beryl Raff
or certain other persons relating to the termination of her employment with the
Company, net of litigation costs and the costs relating to any counterclaim
against the Company, would be paid by the Company to a trust or other vehicle to
be established for the benefit of certain shareholders prior to the closing
under the Purchase Agreement and possibly certain creditors.
Contemporaneously with the entry into the Bridge Loan Agreement and the
Purchase Agreement, the Company and Prentice entered into a Registration Rights
16
Agreement pursuant to which the Company has agreed to provide certain
registration rights with respect to the shares of common stock that may be
issued (i) upon exercise of the Warrants, (ii) upon conversion of the Notes, and
(iii) in payment of interest under the Notes.
The Company's Board of Directors formed a Special Committee to consider the
terms of the Bridge Loan Agreement, Warrants, Securities Purchase Agreement and
Registration Rights Agreement, as well as other financing alternatives. In
connection with their evaluation of these transactions the Special Committee and
the Board of Directors received the opinion of Duff & Phelps, LLC that the terms
of these transactions are fair to the shareholders of the Company from a
financial point of view.
On October 26, 2005, the Company received a proposal from Newcastle
Partners, L.P. ("Newcastle"). The proposal, which is subject to a number of
conditions and definitive documentation, expresses Newcastle's willingness to
offer $1.10 per share in cash by merger or otherwise and cash out warrants and
in-the-money options based on that price. Under the proposal, Newcastle would
pay off the Company's recent $30 million bridge loan. Newcastle expects to
obtain a commitment to replace the Company's Senior Credit Agreement or obtain
consents from the Company's senior lenders. A copy of the proposal letter was
contained in an amendment to Newcastle's Schedule 13D which was filed
electronically with the SEC on October 27, 2005. On October 27, 2005, the
Special Committee of the Company's Board of Directors responded to the Newcastle
proposal by indicating that, on the advice of its financial advisors and
counsel, it could not conclude, from the information provided in the Newcastle
proposal, that such proposal is reasonably likely to result in a superior
proposal within the meaning of the Securities Purchase Agreement executed by the
Company in connection with the Prentice transactions.
10. DILUTIVE SHARES THAT WERE OUTSTANDING DURING THE PERIOD
The following table summarizes the reconciliation of the numerators and
denominators for the basic and diluted earnings per share ("EPS") computations
at October 31, 2005 and 2004.
Three months ended Nine Months Ended
------------------- -------------------
October October October October
31, 2005 31, 2004 31, 2005 31, 2004
-------- -------- -------- --------
(in thousands)
Net loss $(42,860) $(8,308) $(71,889) $(15,188)
Weighted average shares for
basic EPS 13,975 13,948 13,966 13,941
Incremental shares upon
conversions:
Stock options -- -- -- --
Weighted average shares for
diluted EPS 13,975 13,948 13,966 13,941
Stock options and warrants
excluded from the calculation of
diluted earnings per share due
to their antidilutive effect on
the calculations 2,159 2,329 2,430 2,319
17
11. COMMITMENTS AND CONTINGENCIES
Class Action Lawsuits
On February 12, 2004, a putative class action complaint captioned Greater
Pennsylvania Carpenters Pension Fund v. Whitehall Jewellers, Inc., Case No. 04 C
1107, was filed in the U.S. District Court for the Northern District of Illinois
against the Company and certain of the Company's current and former officers.
The complaint makes reference to the litigation filed by Capital Factors, Inc.
("Capital Factors") and settled as disclosed in the Company's Quarterly Report
on Form 10-Q for the fiscal quarter ended October 31, 2004 and to the Company's
November 21, 2003 announcement that it had discovered violations of Company
policy by the Company's Executive Vice President, Merchandising, with respect to
Company documentation regarding the age of certain store inventory. The
complaint further makes reference to the Company's December 22, 2003
announcement that it would restate results for certain prior periods. The
complaint purports to allege that the Company and its officers made false and
misleading statements and falsely accounted for revenue and inventory during the
putative class period of November 19, 2001 to December 10, 2003. The complaint
purports to allege violations of Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 ("1934 Act") and Rule 10b-5 promulgated thereunder.
On February 17, 2004, a putative class action complaint captioned Michael
Radigan v. Whitehall Jewellers, Inc., Case No. 04 C 1196, was filed in the U.S.
District Court for the Northern District of Illinois against the Company and
certain of the Company's current and former officers. The factual allegations
and claims of this complaint are similar to those made in the Greater
Pennsylvania Carpenters Pension Fund complaint discussed above.
On February 19, 2004, a putative class action complaint captioned Milton
Pfeiffer, v. Whitehall Jewellers, Inc., Case No. 04 C 1285, was filed in the
U.S. District Court for the Northern District of Illinois against the Company
and certain of the Company's current and former officers. The factual
allegations and claims of this complaint are similar to those made in the
Greater Pennsylvania Carpenters Pension Fund complaint discussed above.
On April 6, 2004, the District Court in the Greater Pennsylvania Carpenters
case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints with the
Greater Pennsylvania Carpenters action, and dismissed the Radigan and Pfeiffer
actions as separate actions. On April 14, 2004, the court designated the Greater
Pennsylvania Carpenters Pension Fund as the lead plaintiff in the action and
designated Greater Pennsylvania's counsel as lead counsel.
On June 10, 2004, a putative class action complaint captioned Joshua Kaplan
v. Whitehall Jewellers, Inc., Case No. 04 C 3971, was filed in the U.S. District
Court for the Northern District of Illinois against the Company and certain of
the Company's current and former officers. The factual allegations and claims of
this complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On June 14, 2004, lead plaintiff Greater Pennsylvania Carpenters Pension
Fund in Case No. 04C 1107 filed a consolidated amended complaint. On July 14,
2004, the District Court in the Greater Pennsylvania Carpenters action
consolidated the Kaplan complaint with the Greater Pennsylvania Carpenters
action, and dismissed the Kaplan action as a separate action. On August 2, 2004,
the Company filed a motion to dismiss the consolidated amended complaint. On
January 7, 2005, the motion to dismiss was granted in part and denied in part,
with plaintiffs granted leave to file an amended complaint by February 10, 2005.
On February 10, 2005, the lead plaintiff filed a first amended consolidated
complaint. On March 2, 2005, the Company filed a motion to dismiss the amended
complaint. On June 30, 2005, the Court denied Defendants' motions to dismiss. On
July 28, 2005, Defendants filed their Answers to the First Amended Consolidated
Complaint. Discovery is ongoing. On September 23, 2005, lead plaintiff filed its
18
motion for class certification. The Company's response to this motion is due
January 30, 2006. The plaintiffs' reply is due February 24, 2006. The parties
met on November 8, 2005, in an attempt to resolve, through mediation, the
10(b)-5 claims and the below described state and federal derivative claims.
Mediation of these matters was unsuccessful.
State Derivative Complaints
On June 17, 2004, a shareholder derivative action complaint captioned
Richard Cusack v. Hugh Patinkin, Case No. 04 CH 09705, was filed in the Circuit
Court of Cook County, Illinois, for the alleged benefit of the Company against
certain of the Company's officers and directors. The complaint asserts claims
for breach of fiduciary duty, abuse of control, gross mismanagement, waste of
corporate assets, unjust enrichment, breach of fiduciary duties for insider
selling and misappropriation of information, and contribution and
indemnification. The factual allegations of the complaint are similar to those
made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed
above.
On April 19, 2005, a shareholder derivative action complaint captioned
Marilyn Perles v. Executor of the Estate of Hugh M. Patinkin, Case No. 05 CH
06926, was filed in the Circuit Court of Cook County, Illinois, for the alleged
benefit of the Company against, inter alia, certain of the Company's officers
and directors. The complaint asserts claims for breach of fiduciary duty, abuse
of control, gross mismanagement, waste of corporate assets, unjust enrichment,
breach of fiduciary duties for insider selling and misappropriation of
information, and contribution and indemnification. The factual allegations of
the complaint are similar to those made in the Cusack complaint discussed above.
The Perles complaint also purports to assert claims on behalf of the Company
against PricewaterhouseCoopers LLP, the Company's outside auditor.
On June 13, 2005, a shareholder derivative action complaint captioned Carey
Lynch v. Berkowitz, Case No. 05CH09913, was filed in the Circuit Court of Cook
County, Illinois, for the alleged benefit of the Company against certain of the
Company's officers and directors. The complaint asserts, inter alia, a claim for
breach of fiduciary duty. The factual allegations of the complaint are similar
to those made in the Cusack and Perles complaints discussed above.
On July 18, 2005, the Circuit Court of Cook County consolidated the Cusack,
Perles and Lynch actions. On August 26, 2005, plaintiffs filed a consolidated
amended derivative complaint against certain of the Company's current and former
officers and directors and PricewaterhouseCoopers LLP, the Company's outside
auditor. On October 3, 2005, defendants, other than PricewaterhouseCoopers LLP,
filed their motion to dismiss the consolidated amended derivative complaint
based, inter alia, on the failure of plaintiffs to make a pre-suit demand upon
the Company's Board of Directors and failure to state a claim.
Federal Derivative Complaints
On February 22, 2005, a verified derivative complaint captioned Myra
Cureton v. Richard K. Berkowitz, Case No. 05 C 1050, was filed in the United
States District Court, Northern District of Illinois, Eastern Division, for the
alleged benefit of the Company against certain of the Company's officers and
directors. The complaint asserts a claim for breach of fiduciary duty. The
factual allegations of the complaint are similar to those made in the Cusack and
Greater Pennsylvania Carpenters Pension Fund complaints discussed above.
On April 13, 2005, a verified derivative complaint captioned Tai Vu v.
Richard Berkowitz, Case No. 05 C 2197, was filed in the United States District
Court, Northern District of Illinois, Eastern Division, for the alleged benefit
of the Company against certain of the Company's officers and directors. The
complaint asserts a claim for breach of fiduciary duty. The factual allegations
of the complaint are similar to those made in the Cusack and Greater
Pennsylvania Carpenters Pension Fund complaints discussed above. On May 11,
2005, plaintiffs in the Cureton and Vu actions filed an unopposed motion to
consolidate those two
19
actions, and these cases were consolidated on May 25, 2005. On June 20, 2005,
plaintiffs filed a consolidated amended derivative complaint asserting claims
for breach of fiduciary duty of good faith, breach of duty of loyalty, unjust
enrichment, a derivative Rule 10(b)-5 claim, and a claim against Browne for
reimbursement of compensation under Section 304 of the Sarbanes-Oxley Act. On
July 15, 2005, defendants moved to stay the consolidated action under the
Colorado River doctrine pending the outcome of the state derivative actions. The
motion is fully briefed and awaiting decision from the court.
The Company intends to contest vigorously these putative class actions and
the shareholder derivative suits and exercise all of its available rights and
remedies. Given that these cases are in their early stages and may not be
resolved for some time, it is not possible to evaluate the likelihood of an
unfavorable outcome in any of these matters, or to estimate the amount or range
of potential loss, if any. While there are many potential outcomes, an adverse
outcome in any of these actions could have a material adverse effect on the
Company's results of operations, financial condition and/or liquidity.
Other
As previously disclosed, in September 2003 the Securities and Exchange
Commission (the "SEC") initiated a formal inquiry of the Company with respect to
matters that were the subject of the consolidated Capital Factors actions. The
Company has fully cooperated with the SEC in connection with this formal
investigation.
By letter from counsel dated October 26, 2004, A.L.A. Casting Company, Inc.
("ALA"), a supplier and creditor of Cosmopolitan Gem Corporation
("Cosmopolitan"), informed the Company that it had been defrauded by
Cosmopolitan and was owed $506,081.55 for goods shipped to Cosmopolitan for
which payment was never received. ALA claimed that the Company is jointly and
severally liable for the full amount of $506,081.55 owed by Cosmopolitan because
the Company aided and abetted Cosmopolitan's fraud and participated in, induced
or aided and abetted breaches of fiduciary duty owed to ALA by Cosmopolitan. ALA
has indicated its intention to pursue its claim, but the Company has not
received notice that litigation has been filed. The Company intends to
vigorously contest this claim and exercise all of its available rights and
remedies.
On August 12, 2005, the Company announced that Ms. Beryl Raff was named
Chief Executive Officer and would join the Company's Board of Directors. On
September 8, 2005, the Company announced that Ms. Raff had resigned all
positions with the Company. On September 27, 2005, the Company filed an
arbitration proceeding, as required under the Beryl Raff employment agreement,
seeking damages and to enforce the non-competition provision. On October 21,
2005, the Company was served with a declaratory judgment action, filed by J.C.
Penney (Ms. Raff's employer), in the 380th Judicial District in Collin County,
Texas seeking a declaration of rights, that among other things, J.C. Penney has
not violated any of the rights of the Company with respect to Ms. Raff's
employment. The Company has reached a complete settlement with J.C. Penney and
Ms. Raff of all matters arising in connection with Ms. Beryl Raff's employment.
The details of the settlement are confidential.
The Company is also involved from time to time in certain other legal
actions and regulatory investigations arising in the ordinary course of
business. Although there can be no certainty, it is the opinion of management
that none of these other actions or investigations will have a material adverse
effect on the Company's results of operations or financial condition.
12. RELATED PARTY TRANSACTIONS
The Company offers health insurance coverage to the members of its Board of
Directors. The health insurance policy options and related policy cost available
20
to the Directors are similar to those available to the Company's senior level
employees.
13. SALES BY MERCHANDISE CATEGORY
The following table sets forth our percentage of total merchandise sales by
category for the following periods:
Three Months Ended Nine Months Ended
----------------------------------- -----------------------------------
October 31, 2005 October 31, 2004 October 31, 2005 October 31, 2004
---------------- ---------------- ---------------- ----------------
Diamonds 67.8% 69.0% 66.5% 68.2%
Gold 17.5 13.8 17.9 13.7
Precious/Semi-Precious 9.7 11.8 10.5 13.1
Watches 5.0 5.4 5.0 5.0
---------------- ---------------- ---------------- ----------------
Total Merchandise Sales 100.0% 100.0% 100.0% 100.0%
================ ================ ================ ================
Along with our merchandise assortments, we provide jewelry repair services
to our customers (sales from which represented 3.0% of net sales in both the
three months ended October 31, 2005 and 2004; and 2.9% of net sales in both the
nine months ended October 31, 2005 and 2004) and jewelry service plans provided
through a third party (sales from which represented 3.3% and 3.2% in the three
months ended October 31, 2005 and 2004, respectively; and 3.2% and 3.1% of net
sales in the nine months ended October 31, 2005 and 2004, respectively). Jewelry
repair services are provided through independent jewelers under contract.
14. SUBSEQUENT EVENTS
On November 1, 2005, the Company announced that Robert Baumgardner has been
hired as its President and Chief Executive Officer. Mr. Baumgardner joined the
Company on November 9, 2005. With the hiring of Mr. Baumgardner, Mr. Levy
resigned as interim Chief Executive Officer. Mr. Levy continues to serve on the
Company's Board of Directors and was elected Chairman of the Board of Directors
on November 10, 2005.
On November 14, 2005, the Company filed a preliminary proxy statement with
the SEC relating to the Company's solicitation of proxies for use at a special
meeting of stockholders to be held no later than January 31, 2006. At the
special meeting, stockholders will act upon (i) approval of the issuance of
shares of the Company's Common Stock pursuant to the terms of the Notes, (ii)
approval of an amendment to the Company's certificate of incorporation providing
a 1-for-2 reverse stock split of the Company's Capital Stock, and (iii) election
of persons designated by Prentice to the Company's Board of Directors. The
Company has not yet set a record date nor a date for this special meeting of
stockholders. Upon completion of the SEC review process, the Company will file
and mail to stockholders a definitive proxy statement.
On November 29, 2005, Newcastle filed with the SEC a Schedule TO announcing
its intention to commence a tender offer to acquire, through JWL Acquisition
Corp., a wholly owned subsidiary of Newcastle, all outstanding shares of common
stock of the Company.
On November 29, 2005, Newcastle filed with the SEC a preliminary proxy
statement relating to Newcastle's solicitation of proxies in opposition to the
proposals relating to a pending financing transaction between the Company and
investment funds managed by Prentice Capital Management, L.P. and Holtzman
Opportunity Fund, L.P. to be voted on at a special meeting of the Company's
stockholders.
On November 30, 2005, the Company received a letter, dated November 29,
2005, from Steven J. Pully, announcing Mr. Pully's resignation from the
Company's Board of Directors, effective November 29, 2005. Mr. Pully is the
President of Newcastle.
21
On December 5, 2005, Newcastle filed with the SEC a Schedule TO, a Schedule
14A and a Schedule 13D/A announcing that JWL acquisition Corp. had commenced the
tender offer.
On December 5 and 6, 2005, Holtzman and Prentice Capital exercised the
Warrants to purchase 2,792,462 shares of the Company's common stock at $0.75 per
share. The Company received proceeds from the respective exercises in the
aggregate of approximately $2,094,000 and has issued the shares of the common
stock to the Holtzman and Prentice Capital.
On December 7, 2005, the Company announced that its Board of Directors and
management are reviewing the financial and other terms of the unsolicited tender
offer, a copy of which is filed as an exhibit to the Company's Form 8-K dated
December 7, 2005. On or before December 16, 2005, the Board of Directors will
advise the Company whether it recommends acceptance or rejection of the tender
offer, expresses no opinion and remains neutral toward the tender offer, or is
unable to take a position with respect to the tender offer. At such time, the
Board of Directors will include the reasons for its position with respect to the
tender offer or its inability to take a position.
22
PART I - FINANCIAL INFORMATION
Item 2 - Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis of the Company's financial condition
and results of operations should be read in conjunction with the Company's
unaudited financial statements, including the notes thereto. This section
contains statements that constitute "forward-looking statements" within the
meaning of the Private Securities Litigation Reform Act of 1995. See the
Forward-Looking Statements included in this Form 10-Q.
Overview
The Company is a mall-based national retailer of fine jewelry operating 389
stores in 38 states as of October 31, 2005. The Company offers a selection of
merchandise in the following categories: diamond, gold, precious and
semi-precious jewelry and watches. Jewelry purchases are discretionary for
consumers and may be particularly affected by adverse trends in the general
economy and perceptions of such conditions, which affect disposable consumer
income and/or its use.
For the quarter ended October 31, 2005, the Company recorded a net loss of
$42.9 million. The primary contributors to the net loss were a 9.0% decline in
comparable store sales for the third quarter of fiscal year 2005; a decrease in
the merchandise gross margin rate; a non-cash charge of $17.9 million to record
a valuation allowance against merchandise inventory that is currently being
liquidated in connection with the closure of seventy-seven of the Company's
retail stores and a $5.9 million non-cash charge related to the impairment of
long-lived assets recorded under the FAS 144 asset held for use model, primarily
furniture, fixtures and leasehold improvements, in the Company's retail stores.
On August 12, 2005, the Company announced that Ms. Beryl Raff was named
Chief Executive Officer and would join the Company's Board of Directors. On
September 8, 2005, the Company announced that Ms. Raff had resigned all
positions with the Company. All transition related compensation paid to Ms. Raff
has been subsequently returned to the Company. In addition, all incentive stock
options granted to Ms. Raff by the Company have been cancelled. On September 27,
2005, the Company commenced an arbitration proceeding relating to Ms. Raff's
employment with the Company seeking damages as well as enforcement of a
non-competition agreement. On October 21, 2005, the Company was served with a
declaratory judgment action, filed by J.C. Penney (Ms. Raff's employer), in the
380th Judicial District in Collin County, Texas seeking a declaration of rights,
that among other things, J.C. Penney has not violated any of the rights of the
Company with respect to Ms. Raff's employment. The Company has reached a
complete settlement with J.C. Penney and Ms. Raff of all matters arising in
connection with Ms. Beryl Raff's employment. The details of the settlement are
confidential.
On October 11, 2005, the Company's Board of Directors elected Daniel H.
Levy to serve as interim Chief Executive Officer, while the Company conducted a
search to find a permanent Chief Executive Officer. On October 12, 2005, the
Company announced that Lucinda M. Baier resigned as President and Chief
Operating Officer.
On November 1, 2005, the Company announced that Robert Baumgardner has been
hired as its President and Chief Executive Officer. Mr. Baumgardner joined the
Company on November 9, 2005. With the hiring of Mr. Baumgardner, Mr. Levy
resigned as interim Chief Executive Officer. Mr. Levy continues to serve on the
Company's Board of Directors and was elected Chairman of the Board of Directors
on November 10, 2005.
The Company entered into a series of transactions on October 3, 2005,
designed to significantly improve its financial condition. The Company has
entered into agreements ("the Prentice Transaction") with investment funds
managed by Prentice Capital Management, L.P. and Holtzman Opportunity Fund, L.P.
23
(collectively, "Prentice") to provide financing to the Company, as described in
Notes 8 and 9 to the financial statements. The first stage of this financing was
a $30 million secured bridge loan made to the Company. The agreements also call
for the issuance of $50 million of secured convertible notes no- later than
January 31, 2006, which is contingent upon shareholder approval. Proceeds of the
planned issuance will be used to pay off the bridge loan and provide additional
liquidity for operations. Both the bridge loan and the convertible notes are
being secured by a lien on substantially all of the Company's assets ranking
junior to the liens securing the Company's bank debt. Giving effect to an
assumed conversion of the notes, the payment of shares as interest and an
exercise of the warrants, Prentice would own 87% of the Company's common stock.
In addition, the Company, its banks and Prentice have entered into an
agreement with key trade vendors who hold more than 99% of the Company's trade
debt. This agreement facilitated the purchase of fresh inventory for the holiday
season and provide for full payment of all amounts owed, plus interest, to those
vendors over time. Also, the Company reached agreement with its banks, LaSalle,
Back Bay and Bank of America, to increase the maximum borrowings under its
credit facility, depending on borrowing base calculations, by $15 million to
$140 million and extended the term of the facility until October 3, 2008.
The Company has experienced recurring losses from operations in the first
nine months of fiscal year 2005 and in the two previous fiscal years. During the
second quarter of fiscal year 2005, the Company slowed payments to certain
vendors and received a temporary extension of payment terms with certain other
vendors in order to manage its liquidity needs. Subsequent to July 31, 2005, the
Company has received temporary extension of payment terms, beyond the stated
payment terms, with certain of its key merchandise vendors. The Company's
ability to continue as a going concern is highly dependent upon the Prentice
Transaction being approved by the Company's shareholders. In the event that the
Prentice Transaction is not approved there can be no assurance that additional
funding, or another liquidity event, will become available to the Company. In
that event, the Company would be required to consider other alternatives,
including a reorganization under Chapter 11 of the U.S. bankruptcy code or a
liquidation of its assets.
During the third quarter of fiscal year 2005, the Company recorded, in
accordance with Financial Accounting Standards No. 144 ("FAS 144") "Accounting
for the Impairment or Disposal of Long-Lived Assets" asset held for use model,
an impairment charge of $5,933,000. The impairment charge was the result of a
plan, as approved by the Company's Board of Directors and announced on November
1, 2005, to close seventy-seven of the Company's retail stores and for the
reduction in carrying value of two additional stores which will remain open. The
Company currently expects to close the seventy-seven stores by February 2006.
The decision to close these stores resulted in an impairment of the respective
stores' long-lived assets, as the carrying amount of the respective stores'
long-lived fixed assets will not be recoverable as such assets will be disposed
of before the end of their previously estimated useful lives.
To assist with the closing of these stores, the Company entered into an
agreement during early November 2005 with a third party. This third party is
currently liquidating inventory in the seventy-seven closing stores through
store closing sales. Pursuant to terms of this agreement, the Company will
receive cash proceeds from the liquidating stores of not less than 55% of cost
of the merchandise inventory, plus the reimbursement of certain operational
expenses. During the fiscal quarter ended October 31, 2005, the Company recorded
a valuation allowance of $17.9 million in connection with the inventory
liquidation. The valuation allowance was based upon management's best estimate
of the net proceeds to be received from the liquidation of inventory through the
store closures. Additional inventory valuation allowances may be required in
future periods to the extent that actual net proceeds from the sales of such
merchandise are less than management's current estimate. In accordance with this
agreement, during November 2005 two standby letters of credit were issued with
the third party as the beneficiary in the aggregate amount of $1,700,000. Such
standby letters of credit are secured by the Company's Senior Credit Agreement
and expire on April 15, 2006. In addition, the Company also entered into an
agreement with another third party for the purpose of
24
selling, terminating or otherwise mitigating lease obligations related to the
store closings.
In accordance with FASB Statement No. 146 ("SFAS 146"), "Accounting for
Costs Associated with Exit or Disposal Activities," the Company has not recorded
any exit or disposal related expenses, including lease terminations, personnel
costs and other expenses, associated with the planned store closures. Such
expenses will be recorded in the period in which the liability is incurred. At
this time, no agreements have been reached which would permit the Company to
estimate such disposal costs, which may be material to the financial statements.
On October 17, 2005, the Company received notification from the New York
Stock Exchange (the "NYSE") that the Company was not in compliance with the NYSE
continued listing standards because its average market capitalization had been
less than $25 million over a consecutive 30 trading-day period. The Company's
common stock was delisted from the NYSE as of the close of the market on October
27, 2005. The Company's common stock currently is quoted on the "pink sheets".
On October 26, 2005, the Company received a proposal from Newcastle
Partners, L.P. ("Newcastle"). The proposal, which is subject to a number of
conditions and definitive documentation, expresses Newcastle's willingness to
offer $1.10 per share in cash by merger or otherwise and cash out warrants and
in-the-money options based on that price. Under the proposal, Newcastle would
pay off the Company's recent $30 million bridge loan. Newcastle expects to
obtain a commitment to replace the Company's Senior Credit Agreement or obtain
consents from the Company's senior lenders. A copy of the proposal letter was
contained in an amendment to Newcastle's Schedule 13D which was filed
electronically with the SEC on October 27, 2005. On October 27, 2005, the
Special Committee of the Company's Board of Directors responded to the Newcastle
proposal by indicating that, on the advice of its financial advisors and
counsel, it could not conclude, from the information provided in the Newcastle
proposal, that such proposal is reasonably likely to result in a superior
proposal within the meaning of the Securities Purchase Agreement executed by the
Company in connection with the Prentice transactions.
On November 14, 2005, the Company filed a preliminary proxy statement with
the SEC relating to the Company's solicitation of proxies for use at a special
meeting of stockholders to be held no later than January 31, 2006. At the
special meeting, stockholders will act upon (i) approval of the issuance of
shares of the Company's Common Stock pursuant to the terms of the Notes, (ii)
approval of an amendment to the Company's certificate of incorporation providing
a 1-for-2 reverse stock split of the Company's Capital Stock, and (iii) election
of persons designated by Prentice to the Company's Board of Directors. The
Company has not yet set a record date nor a date for this special meeting of
stockholders. Upon completion of the SEC review process, the Company will file
and mail to stockholders a definitive proxy statement.
On November 29, 2005, Newcastle filed with the SEC a Schedule TO announcing
its intention to commence a tender offer to acquire, through JWL Acquisition
Corp., a wholly owned subsidiary of Newcastle, all outstanding shares of common
stock of the Company.
On November 29, 2005, Newcastle filed with the SEC a preliminary proxy
statement relating to Newcastle's solicitation of proxies in opposition to the
proposals relating to a pending financing transaction between the Company and
investment funds managed by Prentice Capital Management, L.P. and Holtzman
Opportunity Fund, L.P. to be voted on at a special meeting of the Company's
stockholders.
On November 30, 2005, the Company received a letter, dated November 29,
2005, from Steven J. Pully, announcing Mr. Pully's resignation from the
Company's Board of Directors, effective November 29, 2005. Mr. Pully is the
President of Newcastle.
25
On December 5, 2005, Newcastle filed with the SEC a Schedule TO, a Schedule
14A and a Schedule 13D/A announcing that JWL acquisition Corp. had commenced the
tender offer.
On December 5 and 6, 2005, the Holtzman and Prentice Capital exercised the
Warrants to purchase 2,792,462 shares of the Company's common stock at $0.75 per
share. The Company received proceeds from the respective exercises in the
aggregate of approximately $2,094,000 and has issued the shares of the common
stock to the Holtzman and Prentice Capital.
On December 7, 2005, the Company announced that its Board of Directors and
management are reviewing the financial and other terms of the unsolicited tender
offer, a copy of which is filed as an exhibit to the Company's Form 8-K dated
December 7, 2005. On or before December 16, 2005, the Board of Directors will
advise the Company whether it recommends acceptance or rejection of the tender
offer, expresses no opinion and remains neutral toward the tender offer, or is
unable to take a position with respect to the tender offer. At such time, the
Board of Directors will include the reasons for its position with respect to the
tender offer or its inability to take a position.
The Company's business is highly seasonal. Historically, income generated
in the fourth fiscal quarter ending each January 31 represents all or a majority
of the income generated during the fiscal year. The Company has historically
experienced lower net sales in each of its first three fiscal quarters and
expects this trend to continue. The Company's quarterly and annual results of
operations may fluctuate significantly as a result of factors including, among
others: increases or decreases in comparable store sales; inventory availability
and the Company's ability to fund inventory purchases and to time such purchases
correctly; changes in the Company's cost of financing; marketing or credit
programs; timing of certain holidays and Company-initiated special events;
changes in the Company's merchandise; the timing of new store openings; net
sales contributed by new stores; timing of store remodels and closures; general
economic, industry, weather conditions and disastrous events that affect
consumer spending and the pricing, merchandising, marketing, credit and other
programs of competitors.
Results of Operations
The following table sets forth for the periods indicated, certain financial
information derived from the unaudited statements of operations of the Company
expressed as a percentage of net sales.
Three months ended Nine months ended
------------------------- -------------------------
October 31, October 31, October 31, October 31,
Percentage of net sales 2005 2004 2005 2004
- ----------------------- ----------- ----------- ----------- -----------
Net sales 100.0% 100.0% 100.0% 100.0%
Cost of sales (including buying
and occupancy expenses) 74.8 72.3 70.8 68.4
Inventory valuation allowance 30.4 -- 9.0 --
Impairment of long-lived assets 10.2 -- 4.5 --
----- ----- ----- -----
Gross profit (loss) (15.4) 27.7 15.7 31.6
Selling, general and
administrative expenses 46.1 42.2 41.6 38.7
Professional fees and other
charges 5.0 2.2 2.6 2.8
Impairment of goodwill -- -- 2.9 --
----- ----- ----- -----
Loss from operations (66.5) (16.7) (31.4) (9.9)
Interest expense 6.3 2.0 3.6 1.5
----- ----- ----- -----
Loss before income taxes (72.8) (18.7) (35.0) (11.4)
Income tax (benefit) expense -- (5.6) 1.2 (4.1)
----- ----- ----- -----
Net loss (72.8%) (13.1%) (36.2%) (7.3%)
----- ----- ----- -----
26
Results of Operations for the Three Months Ended October 31, 2005 Compared to
the Three Months Ended October 31, 2004
Net Sales
Net sales for the third quarter of fiscal 2005 decreased $4.4 million, or
7.0%, to $58.9 million from $63.3 million in the third quarter of fiscal 2004.
Comparable store sales decreased $5.4 million, or 9.0%, in the third quarter of
fiscal 2005 compared to the same period in fiscal year 2004. Additionally, sales
decreased by $0.1 million due to store closings and stores closed for remodeling
for limited periods. These decreases were partially offset by sales from new
store openings of $0.8 million. In addition, net sales increased by $0.3 million
primarily due to changes in the provision for sales returns and allowances
primarily due to a decrease in sales in the third quarter of fiscal year 2005 as
compared to the third quarter of fiscal year 2004. The comparable store sales
decrease was primarily due to lower unit sales in the third quarter of fiscal
year 2005 in comparison to the prior year period. The total number of
merchandise units sold decreased by 22.7% in the third quarter of fiscal year
2005 compared to the third quarter of fiscal year 2004 while the average price
per item sold increased by approximately 19.5% to $406 in the third quarter of
fiscal year 2005 from $340 in the prior year period. The decline in the number
of merchandise units sold was due in part to a decrease in the number of lower
price-point items sold during the third quarter of fiscal year 2005 compared to
the third quarter of fiscal year 2004. The decrease in unit sales in the third
quarter of fiscal year 2005 was also attributable to a major initiative launched
in July 2004 to accelerate the sale of merchandise which was inconsistent with
the Company's branding strategy.
Credit sales as a percentage of net sales decreased to 45.0% in the third
quarter of fiscal year 2005 from 47.5% in the third quarter of fiscal year 2004.
The Company opened 2 new stores and closed 1 in the third quarter of fiscal year
2005, and on October 31, 2005 operated 389 stores. As of October 31, 2004, the
Company operated 386 stores.
Gross Profit
Gross profit for the third quarter of fiscal 2005 decreased $26.6 million
to a loss of $9.0 million from a profit of $17.6 million in the same period in
fiscal 2004. Gross profit as a percentage of net sales decreased to a loss of
15.4% in the third quarter of fiscal year 2005 compared to a profit of 27.7% in
the third quarter of fiscal year 2004. The gross profit rate decreased by
approximately 3,040 basis points due to a $17.9 million inventory valuation
allowance recorded during the third quarter of fiscal year 2005 due to the
inventory liquidation sales being conducted through the closing of seventy-seven
of the Company's retail stores. The valuation allowance was based upon
management's best estimate of the net proceeds to be received from the
liquidation of inventory through the store closure sales of not less than 55% of
the cost of such inventory. Additional inventory valuation allowances may be
required in future periods to the extent that actual net proceeds from the sales
of such merchandise are less than management's current estimate. The gross
profit rate decreased by approximately 1,010 basis points due to the $5.9
million non-cash charge recorded during the third quarter of fiscal year 2005
related to the impairment of long-lived store fixed assets. In addition, the
gross profit rate decreased by approximately 210 basis points due to the
de-leveraging of store occupancy, depreciation and buying costs due to the
decrease in third quarter fiscal year 2005 sales, and an increase in such costs
as compared to the third quarter of fiscal year 2004. Gross margins decreased by
approximately 140 basis points primarily due to an increase in the provision for
substandard inventories. Also, merchandise gross margins decreased by
approximately 130 basis points due to lower margins resulting due in part from
increases in diamond and gold prices and changes in merchandise sales mix and
promotional offers in comparison to the prior year period. Merchandise gross
margins improved by 170 basis points as a result of lower sales on certain
discontinued merchandise compared to the prior year period that was partially
offset by lower margins due to additional discounts offered on such merchandise.
27
The Company has historically offered clearance merchandise for sale,
representing merchandise identified from time to time that will not be part of
its future merchandise presentation. During the second and third quarters of
fiscal year 2004, the Company reviewed its merchandise inventory presentation
and determined that, in addition to the items remaining in the Company's
clearance program, $70.4 million of its merchandise inventory at cost would not
be part of its future merchandise presentation. Price reductions were taken on
these items which have resulted in and will continue to result in lower than
historical margins on such merchandise. Sales of these items totaled
approximately $3.5 million with an approximate merchandise cost of $2.4 million
in the third quarter of fiscal year 2005. As of October 31, 2005, the Company
had approximately $35.8 million, at cost, of such discontinued merchandise
inventory. Substantially all of these goods are currently being liquidated
through the closing of seventy-seven of the Company's stores, as discussed
above.
The Company continues to review its merchandise inventory presentation and
offers discounts to accelerate sales on merchandise that would not be a part of
its future merchandise assortment through its ongoing clearance program. Based
on currently anticipated selling prices, the Company expects to achieve positive
merchandise margins on such merchandise. The Company in future periods may
consider alternative methods of disposition for this inventory. Such
alternatives may result in additional valuation allowances.
Expenses
Selling, general and administrative expenses, excluding professional fees
and other charges, for the third quarter of fiscal 2005 increased $0.4 million,
or 1.6%, to $27.1 million from $26.7 million in the third quarter of fiscal
2004. As a percentage of net sales, selling, general and administrative expenses
increased to 46.1% in the third quarter of fiscal 2005 from 42.2% in the third
quarter of fiscal 2004. The increase in selling, general and administrative
expenses was primarily related to higher personnel expense ($0.8 million)
partially offset by lower credit expense ($0.4 million) and lower advertising
expense ($0.1 million). The increase in personnel expense is primarily
attributable to an increase in the number of support office positions, higher
salary and wage rates, and an increase in medical benefit costs. The decrease in
credit expense is primarily due to a shift in the mix of private label credit
card promotions that carried a lower discount rate and a decrease in credit card
sales partially offset by an increase in the credit card discount rate due to
increases in the U.S. prime rate in comparison to the prior year period.
Professional fees and other charges increased by $1.6 million, or 108.5% to
a total of $3.0 million in the third quarter of fiscal 2005 from $1.4 million in
the prior year period. This increase is primarily attributable to an increase in
professional fees associated with the Prentice Transactions and liquidity
matters as well as severance related charges. These increases were partially
offset by a decrease in legal fees and charges associated with the consolidated
Capital Factors actions and the related United States Attorney and Securities
and Exchange Commission (the "SEC") investigations, which were incurred in the
year-ago period.
Loss from Operations
As a result of the factors discussed above, loss from operations was $39.2
million in the third quarter of fiscal 2005 compared to a loss of $10.6 million
in the third quarter of fiscal 2004. As a percentage of net sales, loss from
operations was 66.5% in the third quarter of fiscal 2005 compared to 16.7% in
the third quarter of fiscal 2004.
Interest Expense
Interest expense increased $2.5 million, or 198.1%, to $3.7 million in the
third quarter of fiscal year 2005 from $1.2 million in the prior year period.
The increase in interest expense resulted from higher average interest rates
associated with Bridge Term Loan and the amendment to the Senior Credit
Agreement, higher amortization of deferred loan costs associated with the Bridge
Term Loan
28
and the Senior Credit Agreement and increases in the U.S. prime rate as compared
with the year-ago period. Also, interest expense increased due to higher average
borrowings during the third quarter of fiscal year 2005 as compared to the prior
year period. In addition, interest expense increased due to the accretion of the
discount to the Bridge Term Loan partially offset by the change in the value of
the warrants as of October 31, 2005.
Income Tax Benefit
The Company did not record an income tax benefit associated with the
pre-tax loss for the three months ended October 31, 2005. The Company has
discontinued recognizing income tax benefits in the statement of operations
until it is determined that it is more likely than not that the Company will
generate sufficient taxable income to realize the deferred income tax assets.
For the three months ended October 31, 2004, the Company recorded an income tax
benefit of $3.5 million. The Company's annual effective income tax rate was
30.6% for fiscal 2004.
Results of Operations for the Nine Months Ended October 31, 2005 Compared to the
Nine Months Ended October 31, 2004
Net Sales
Net sales for the nine months ended October 31, 2005 decreased $10.4
million, or 5.0%, to $198.3 million from $208.7 million in the nine months ended
October 31, 2004. Comparable store sales decreased $12.5 million, or 6.2%, in
the first nine months of fiscal 2005 from the same period in fiscal 2004.
Additionally, sales decreased by $0.7 million due to store closings and stores
closed for remodeling for limited periods. These decreases were partially offset
by sales from new store openings of $2.2 million. In addition, net sales
increased by $0.6 million due primarily to changes in the provision for sales
returns and allowances primarily due to a decrease in sales in the first nine
months of fiscal year 2005 as compared to the first nine months of fiscal year
2004. The comparable store sales decrease was primarily due to lower unit sales
in the first nine months of fiscal year 2005 in comparison to the prior year
period. The total number of merchandise units sold decreased by 19.2% in the
first nine months of fiscal year 2005 compared to the prior year period while
the average price per item sold increased by approximately 17.0% to $354 in the
first nine months of fiscal year 2005 from $303 in the prior year period. The
decline in the number of merchandise units sold was due in part to a decrease in
the number of lower price-point items sold during the first nine months of
fiscal year 2005 compared to the first nine months of fiscal year 2004. The
decrease in unit sales in the third quarter of fiscal year 2005 was also
attributable to a major initiative launched in July 2004 to accelerate the sale
of merchandise which was inconsistent with the Company's branding strategy.
During the second half of July of last year, sales of such merchandise were
instrumental in generating double-digit comparable store sales increases.
Credit sales as a percentage of net sales decreased to 42.9% in the first
nine months of fiscal year 2005 from 43.4% in the first nine months of fiscal
year 2004. The Company opened eight new stores and closed one in the first nine
months of fiscal year 2005, and on October 31, 2005 operated 389 stores. As of
October 31, 2004, the Company operated 386 stores.
Gross Profit
Gross profit for the first nine months of fiscal 2005 decreased $34.9
million, or 53.0%, to $31.0 million from $65.9 million compared to the same
period in fiscal 2004. Gross profit as a percentage of net sales decreased to
15.6% in the first nine months of fiscal year 2005 compared to 31.6% in the
first nine months of fiscal year 2004. The gross profit rate decreased by
approximately 900 basis points due to a $17.9 million inventory valuation
allowance recorded during the third quarter of fiscal year 2005 due to the
inventory liquidation sales being conducted through the closing of seventy-seven
of the Company's retail stores. The valuation allowance was based upon
management's best estimate of the net
29
proceeds to be received from the liquidation of inventory through the store
closure sales of not less than 55% of the cost of such inventory. Additional
inventory valuation allowances may be required in future periods to the extent
that actual net proceeds from the sales of such merchandise are less than
management's current estimate. The gross profit rate decreased by approximately
450 basis points due to the $9.0 million non-cash charge recorded during the
second and third quarters of fiscal year 2005 related to the impairment of
long-lived store fixed assets. The gross profit rate decreased by approximately
150 basis points due the de-leveraging of store occupancy, depreciation and
buying costs due to the decrease in sales in the first nine months of fiscal
year 2005, and an increase in such costs as compared to the prior year period.
Merchandise gross margins declined by approximately 40 basis points resulting
primarily from price reductions on certain discontinued merchandise and by
approximately 40 basis points resulting from increases in diamond and gold
prices and changes in merchandise sales mix and promotional offers in comparison
to the prior year period. In addition, the gross profit rate decreased by
approximately 10 basis points due to lower vendor discounts and allowances
recognized during the first nine months of fiscal year 2005 compared to the
first nine months of fiscal year 2004. A decrease in the gross profit rate which
was primarily the result of an increase in the provision recorded for
substandard inventories during the third quarter of fiscal year 2005 was offset
by deceases in the provision recorded for inventory losses during the first six
months of fiscal year 2005.
The Company has historically offered clearance merchandise for sale,
representing merchandise identified from time to time that will not be part of
its future merchandise presentation. During the second and third quarters of
fiscal year 2004, the Company reviewed its merchandise inventory presentation
and determined that, in addition to the items remaining in the Company's
clearance program, $70.4 million of its merchandise inventory at cost would not
be part of its future merchandise presentation. Price reductions were taken on
these items which have resulted in and will continue to result in lower than
historical margins on such merchandise. Sales of these items totaled
approximately $15.8 million with an approximate merchandise cost of $10.5
million in the first nine months of fiscal year 2005. In addition, the Company
has reduced such discontinued merchandise by approximately $2.4 million due in
part to vendor returns during the first nine months of fiscal year 2005. As of
October 31, 2005, the Company had approximately $35.8 million, at cost, of such
discontinued merchandise inventory. Substantially all of these goods are
currently being liquidated through the closing of seventy-seven of the Company's
stores, as discussed above.
The Company continues to review its merchandise inventory presentation and
offers discounts to accelerate sales on merchandise that would not be a part of
its future merchandise assortment through its ongoing clearance program. Based
on currently anticipated selling prices, the Company expects to achieve positive
merchandise margins on such merchandise. The Company in future periods may
consider alternative methods of disposition for this inventory. Such
alternatives may result in additional valuation allowances.
Expenses
Selling, general and administrative expenses, excluding professional fees
and other charges, for the first nine months of fiscal 2005 increased $1.6
million, or 2.1%, to $82.4 million from $80.8 million for the first nine months
of fiscal 2004. As a percentage of net sales, selling, general and
administrative expenses increased to 41.6% in the first nine months of fiscal
2005 from 38.7% in the first nine months of fiscal 2004. The dollar increase was
primarily related higher personnel expense ($2.6 million) which was partially
offset by lower credit expense ($0.8 million). The increase in personnel
expenses is primarily attributable to an increase in the number of support
office positions, higher salary and wage rates, an increase in medical benefit
costs and an increase in the number of stores. The decrease in credit expense is
primarily due to a shift in the mix of private label credit card promotions that
carried a lower discount rate and a decrease in credit card sales partially
offset by an increase in the credit
30
card discount rate due to increases in the U.S. prime rate in comparison to the
prior year period.
Professional fees and other charges decreased by $0.5 million, or 9.0%, to
a total of $5.2 million in the first nine months of fiscal 2005 from $5.7
million in the prior year period, primarily attributable to the decrease in
legal fees and charges associated with the consolidated Capital Factors actions
and the related United States Attorney and SEC investigations partially offset
by higher professional fees associated with the Prentice Transactions and the
Company's liquidity matters and severance related charges.
Loss from Operations
As a result of the factors discussed above, loss from operations was $62.4
million in the first nine months of fiscal 2005 compared to a loss of $20.6
million in the first nine months of fiscal 2004. As a percentage of net sales,
loss from operations was 31.4% in the first nine months of fiscal 2005 as
compared to 9.9% in the prior year period.
Interest Expense
Interest expense increased $3.9 million, or 119.6%, to $7.1 million in the
first nine months of fiscal year 2005 from $3.2 million in the prior year
period. The increase in interest expense resulted from higher average interest
rates associated with Bridge Term Loan, the amendment to the Senior Credit
Agreement, higher amortization of deferred loan costs associated with the Bridge
Term Loan and the Senior Credit Agreement and increases in the U.S. prime rate
as compared with the year-ago period. Also, interest expense increased due to
higher average borrowings during the first nine months of fiscal year 2005 as
compared to the prior year period. In addition, interest expense increased due
to the accretion of the discount to the Bridge Term Loan partially offset by the
change in the value of the warrants as of October 31, 2005.
Income Tax Benefit
In the second quarter of fiscal year 2005, the Company recorded a valuation
allowance of $13.5 million against all of its deferred tax assets. In recording
the valuation allowance, management considered whether it was more likely than
not that some or all of the deferred tax assets would be realized. This analysis
included consideration of expected reversals of existing temporary differences
and projected future taxable income.
Income tax expense was $2.4 million in the first nine months of fiscal 2005
compared to an income tax benefit of $8.6 million in the first nine months of
fiscal 2004. In accordance with the guidance in FIN 18, the Company's current
estimate of the income tax expense associated with the cumulative year-to-date
fiscal year 2005 loss and valuation allowance recorded against its deferred tax
assets results in an effective income tax rate of 3.5%. Based on the current
facts and circumstances, the provisions of FIN 18 effectively limit the amount
of income tax expense that can be recorded in the interim period. To the extent
that results in the fourth quarter are significantly more or less than expected,
the Company's effective income tax rate for the fourth quarter and for the full
year could vary significantly from that of the first nine months of fiscal year
2005. The Company's annual effective income tax rate was 30.6% for fiscal year
2004.
Liquidity and Capital Resources
The Company's cash requirements consist principally of funding inventory
for existing stores, capital expenditures and working capital (primarily
inventory) associated with the Company's new stores and seasonal working capital
needs. The Company's primary sources of liquidity have historically been cash
flow from operations and bank borrowings under the Company's Second Amended and
Restated Revolving Credit and Gold Consignment Agreement dated July 29, 2003
(the "Senior Credit Agreement"), as amended effective October 3, 2005. As of
October 31, 2005, the calculated revolver availability as determined on October
26, 2005, pursuant
31
to the Senior Credit Agreement, was $120.9 million. The Company had $93.3
million of outstanding borrowings under the revolving loan facility as of
October 31, 2005.
As of October 31, 2005, the Company maintained standby letters of credit in
the aggregate of $4,780,000 issued to various third parties as beneficiaries
pursuant to contracts entered into in the normal course of business. Such
standby letters of credit are secured by the Company's Senior Credit Agreement
and reduce the calculated revolver availability pursuant to the Senior Credit
Agreement.
During November 2005 two standby letters of credit were issued with this
third party as the beneficiary in the aggregate amount of $1,700,000, in
accordance with the third party agreement that the Company entered into to
assist it with the closing of seventy-seven stores and related inventory
liquidation. Such standby letters of credit are secured by the Company's Senior
Credit Agreement and expire on April 15, 2006.
Pursuant to the Term Sheet (as defined below), during early December 2005 a
standby letter of credit was issued to a trustee as the beneficiary for the
participating Suppliers, to be drawn upon only in the event the Company fails to
make timely required payments for sales of consignment goods. The face amount of
this letter of credit is $7,000,000 through December 18, 2005. The face amount
of the letter of credit increases to $10,000,000 from December 19, 2005 until
the date of payment for consignment sales through December 26, 2005. The face
amount of the letter of credit is $5,000,000 from December 27, 2005 through
January 15, 2006. Such standby letter of credit is secured by the Company's
Senior Credit Agreement and expires on January 15, 2006.
The Company's inventory levels and working capital requirements have
historically been highest in advance of the Christmas season. The Company has
funded these seasonal working capital needs through borrowings under the
Company's revolver and increases in trade payables and accrued expenses. During
the second and third quarters of fiscal year 2005, the Company slowed payments
to certain vendors and received a temporary extension of payment terms, beyond
the stated payment terms, with certain key vendors in order to manage its
liquidity needs.
A net loss of $71.9 million and increases in merchandise inventories ($2.0
million) and other current assets ($2.2 million) were partially offset by
depreciation and amortization ($9.6 million), impairment of long-lived assets
($9.0 million) impairment of goodwill ($5.7 million) and increases in accounts
payable ($10.9 million), accrued payroll ($1.5 million) and other accrued
expenses and credits ($1.1 million) and decreases in deferred income taxes ($3.2
million) and current income tax benefit ($3.7 million) and the receipt of a $2.0
million contract sign-on bonus related to the renewal of the Company's private
label credit card contract.
The increase in merchandise inventories was attributable to the purchase of
goods previously held on consignment and increased purchasing activity related
to new merchandise assortments partially offset by an inventory valuation
allowance of $17.9 million recorded during the third quarter of fiscal year 2005
in connection with the inventory liquidation through store closure sales. The
increase in accounts payable was due in part to increased purchasing activity as
well as slowing payments to vendors in order to manage liquidity.
Cash used in investing activities included the funding of an escrow cash
account ($10.5 million) pursuant to the Term Sheet (as defined in Note 7) and
the funding of capital expenditures of $3.9 million, related primarily to the
opening of 8 new stores during the first nine months of fiscal year 2005,
compared to $3.8 million used for capital expenditures primarily related to the
opening of 6 new stores during the first nine months of 2004.
The Company generated cash from financing activities in the first nine
months of fiscal 2005 through proceeds from the Bridge Term Loan ($30.0 million)
and increases in its revolver borrowing ($19.5 million) and outstanding checks
32
($2.4 million). The Company paid financing costs ($4.7 million) associated with
the amendment to the Senior Credit Agreement, Bridge Term Loan and the Notes.
On October 3, 2005, the Company entered into a Bridge Term Loan Credit
Agreement (the "Bridge Loan Agreement") with PWJ Lending LLC ("PWJ Lending"), an
investment fund managed by Prentice Capital Management, L.P. ("Prentice
Capital"), and Holtzman Opportunity Fund, L.P. ("Holtzman") (together with any
other lenders under such agreement from time to time, the "Lenders"), and PWJ
Lending as administrative agent and collateral agent for the Lenders. Under the
Bridge Loan Agreement, the Lenders provided a term loan (the "Term Loan") to the
Company in the aggregate principal amount of $30,000,000 (the "Commitment
Amount"), which bears interest at a fixed rate of 18% per annum, payable
monthly, and has a stated maturity date as early as December 30, 2005. The
proceeds of the Term Loan were used, among other purposes, to repay a portion of
the revolving credit loans then outstanding under the Senior Credit Agreement,
to fund a segregated account that was disbursed into a third party escrow
account established for the benefit of certain of the Company's trade vendors
and to pay fees and expenses associated with the transaction. The Company's
obligations under the Bridge Loan Agreement are secured by a lien on
substantially all of the Company's assets which ranks junior in priority to the
liens securing the Company's obligations under the Senior Credit Agreement. The
Bridge Loan Agreement contains a number of affirmative and restrictive covenants
and representations and warranties that generally are consistent with those
contained in the Company's Senior Credit Agreement (as amended by the Fourth
Amendment). The Company may prepay the Term Loan at any time, provided, however,
that if the Term Loan is prepaid with funds from any source other than the
proceeds of the Notes (as defined below), then the Company will be required to
pay to the Lenders an exit fee of 4% of the Commitment Amount. Under the Bridge
Loan Agreement, the Company is required to use the proceeds of a sale of the
Notes to retire the Term Loan. While the Lenders may accelerate the obligations
of the Company under the Bridge Loan Agreement to be immediately due and payable
upon an Event of Default, the rights of the Lenders to enforce the obligations
are subject to an intercreditor agreement with the holders of debt under the
Senior Credit Agreement.
In connection with the Bridge Loan Agreement, the Company issued 7-year
warrants (the "Warrants"), which are immediately exercisable, with an exercise
price of $0.75 per share to the Lenders to purchase 2,792,462 shares of the
Company's common stock (i.e., 19.99% of the number of shares currently
outstanding). The exercise price of the Warrants will be reduced, subject to
certain limited exceptions, if the Company subsequently issues common stock or
the right to acquire common stock at a price of less than $0.75 per share.
The Warrants are being accounted for in accordance with FASB Statement of
Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity."
Based on a valuation using the Black-Scholes model, the fair value ascribed to
these Warrants was determined to be $0.80 per share for a total value of
approximately $2,234,000. The value assigned to the Warrants constitutes a
discount to the Bridge Term Loan and will be accreted over the three-month life
of the Bridge Term Loan as non-cash interest expense.
Contemporaneously with the entry into the Bridge Loan Agreement, the
Company, PWJ Funding LLC ("PWJ Funding"), another fund affiliated with Prentice
Capital, and Holtzman entered into a Securities Purchase Agreement (the
"Purchase Agreement," and PWJ Lending, PWJ Funding and Holtzman are collectively
referred to herein as "Prentice").
Subject to certain terms and conditions set forth in the Purchase
Agreement, the Company has agreed to sell to Prentice $50,000,000 of secured
convertible notes (the "Notes"). The stated maturity of the Notes will be three
years after the date of issuance which maturity generally may be extended by the
Company for up to two years. Prentice will have the option to extend the
maturity date in the event and for so long as an event of default shall have
occurred and be continuing under the Notes or through the date that is ten
business days after the consummation of a change of control of the Company in
the event a change of
33
control is publicly announced prior to the maturity date. The Notes will be
secured by the same second security interest that secures the Term Loan.
The Notes will bear interest at a rate of 12% per annum, payable quarterly.
Interest that becomes payable during the initial three year term of the Notes
will be paid in shares of common stock of the Company at the Conversion Price
(initially $0.75 per share). The Conversion Price will be reduced, subject to
certain limited exceptions, if the Company subsequently issues common stock or
the right to acquire common stock at a price of less than $0.75 per share.
Interest that becomes payable after the initial three year term of the Notes
will be paid in cash.
Upon a change of control of the Company (as defined in the Purchase
Agreement), the holder of a Note may require the Company to redeem all or any
portion of the Note for a price equal to (i) the outstanding principal amount of
the Notes, together with any accrued and unpaid interest or late charges thereon
multiplied by (ii) 125% (unless the change of control is not approved by a
majority of the disinterested members of the Company's Board of Directors, in
which case the 125% will be 100%).
The issuance of the Notes under the Purchase Agreement is subject to
certain conditions including (i) the approval by the stockholders of the Company
of (A) the issuance of the shares of common stock pursuant to the terms of the
Notes, (B) an amendment to the Company's certificate of incorporation providing
for a 1-for-2 reverse stock split, and (C) the election of persons designated by
Prentice to the Company's board of directors (the "Board Nominees"), (ii) upon
election, such Board Nominees constituting a majority of the members of the
board of directors, and (iii) no occurrence of an event, circumstance or fact
which resulted in, would result in or could reasonably be expected to a result
in a extremely detrimental event on the Company. The Company may terminate the
Purchase Agreement under certain circumstances in order to accept a superior
proposal. The Notes will contain certain covenants, including limitations on
indebtedness, and liens and a prohibition on dividends.
Under the Purchase Agreement, the Company may not solicit offers, inquiries
or proposals or conduct negotiations with any third parties regarding a
transaction that involves debt or equity fundraising or that would otherwise be
done in lieu of the transaction with Prentice, subject to the Company's board of
directors fulfilling its fiduciary duties to the Company's shareholders and
creditors. The Company may terminate the Purchase Agreement under certain
circumstances in order to accept a superior proposal.
The shares of common stock issuable (i) upon exercise of the Warrants, (ii)
upon conversion of the Notes, and (iii) as payment of interest under the Notes,
will represent approximately 87% of the issued and outstanding shares of common
stock of the Company, assuming (A) no anti-dilution adjustment to the Conversion
Price or the Exercise Price and (B) no issuance of common stock or securities
convertible, exercisable or exchangeable for common stock prior to the closing
of the transaction, other than pursuant to the Notes and Warrants.
The proceeds to be received by the Company upon the sale of the Notes will
be used to retire the Term Loan and for general working capital purposes.
Contemporaneously with the entry into the Bridge Loan Agreement and the
Purchase Agreement, the Company and Prentice entered into a Registration Rights
Agreement pursuant to which the Company has agreed to provide certain
registration rights with respect to the shares of common stock that may be
issued (i) upon exercise of the Warrants, (ii) upon conversion of the Notes, and
(iii) in payment of interest under the Notes.
Contemporaneously with the entry into the Bridge Loan Agreement and the
Purchase Agreement, the Company entered into a Waiver, Consent and Fourth
Amendment (the "Fourth Amendment") to the Second Amended and Restated Revolving
Credit and Gold Consignment Agreement (the "Senior Credit Agreement"), dated as
of
34
July 29, 2003, by and among the Company, LaSalle Bank National Association
("LaSalle"), as administrative agent and collateral agent for the banks party
thereto ("Banks"), the Banks, Bank of America, N.A., as managing agent, and Back
Bay Capital Funding LLC, as accommodation facility agent.
Under the Senior Credit Agreement (as amended by the Fourth Amendment), the
Banks provide a revolving line of credit of up to $140,000,000 (the "Revolving
Facility") including an accommodation facility of $15,000,000 (the
"Accommodation Facility"), each having a maturity date of October 3, 2008. The
Fourth Amendment removes the financial performance covenants and modifies the
borrowing base calculation and increases the minimum required availability
covenant. The Senior Credit Agreement remains secured by substantially all of
the assets of the Company. The Senior Credit Agreement continues to contain
affirmative and negative covenants and representations and warranties customary
for such financings. Borrowings under the Revolving Facility shall bear interest
at the option of the Company (i) at the LIBOR rate plus 250 basis points, or
(ii) at the lesser of (a) LaSalle Bank, National Association's prime rate and
(b) the federal funds effective rate plus 50 basis points (such lesser rate, the
"Base Rate"). Borrowings under the Accommodation Facility bear interest at the
Base Rate plus 800 basis points. The Company may prepay without penalty and
reborrow under the Revolving Facility. The Company will be required to pay an
early termination fee under certain circumstances if the Revolving Facility is
terminated early or if the Accommodation Facility is prepaid. The Banks may
accelerate the obligations of the Company under the Senior Credit Agreement to
be immediately due and payable upon an Event of Default. The Company intends to
use the proceeds for working capital needs, fees and costs associated with the
Bridge Loan Agreement and the proposed Note conversion and for general corporate
purposes.
The Company, Prentice Capital and the Banks executed a term sheet (the
"Term Sheet") with certain trade vendors. Vendors holding over 99% of the
Company's aggregate trade debt to inventory suppliers ("Suppliers") have now
executed the Term Sheet. The Term Sheet provides a mechanism for (i) the
Company's satisfaction of its current trade debt ("Trade Debt") to participating
Suppliers, and (ii) the participating Suppliers' prompt delivery of merchandise
to the Company for the upcoming holiday season. Under the provisions of the Term
Sheet, the Company will make payments totaling 50% of the Trade Debt at various
times up to January 16, 2006. A final payment in the amount of 50% of the Trade
Debt, plus accrued interest at 6% from and after January 17, 2006, is required
to be made on or about September 30, 2007. The obligations to pay the final 50%
of the Trade Debt will be secured by a security interest in substantially all of
the Company's assets ranking junior to the interests securing the Senior Credit
Agreement, the Bridge Loan Agreement and the Notes. The Term Sheet is subject to
and conditioned upon the execution of definitive documentation among the
parties.
The Company was in compliance with the financial covenants of the amended
Credit Agreement as of October 31, 2005. The Company's business is highly
seasonal, and historically, income generated in the fourth fiscal quarter ending
each January 31 represents all or a significant majority of the income generated
during the fiscal year. If an event of default occurs pursuant to the Credit
Agreement, the Company may be required to negotiate relief with its lenders or
to seek new financing. There is no assurance that new financing arrangements
would be available on acceptable terms or at all. If the existing lenders were
to cease funding under the revolving loan facility or require immediate
repayment and if the Company were not able to arrange new financing on
acceptable terms, this would have a material adverse effect on the Company,
which could affect the underlying valuation of its assets and liabilities.
Subject to the Prentice Transaction being approved by the Company's
Shareholders, the contingencies identified in Note 11 to the financial
statements and the matters described in the Risk Factors section and those
identified in Forward-Looking Statements, management expects that cash flow from
operating activities and funds available under the Company's revolving loan
facilities should be sufficient to support the Company's operations. In the
event that the Prentice Transaction is not approved there can be no assurance
that additional funding, or another liquidity event, will become available to
the Company. In
35
that event, the Company would be required to consider other alternatives,
including a reorganization under Chapter 11 of the U.S. bankruptcy code or a
liquidation of its assets.
The Company is involved in certain putative class action claims and
derivative suits as described in Note 11 to the financial statements. The
Company intends to contest vigorously the putative class actions and the
shareholder derivative suits and exercise all of its available rights and
remedies. Given that these cases are in their early stages and may not be
resolved for some time, it is not possible to evaluate the likelihood of an
unfavorable outcome in any of these matters, or to estimate the amount or range
of potential loss, if any. While there are many potential outcomes, an adverse
outcome in these actions could have a material adverse effect on the Company's
results of operations, financial condition and/or liquidity.
Contractual Obligations and Contingencies
The following summarizes the Company's contractual obligations at October
31, 2005:
PAYMENTS DUE BY PERIOD
Less than 1 - 3 4 - 5 More than
Total 1 year years years 5 years
-------- --------- -------- -------- ---------
(in thousands)
Revolver loans $ 93,335 $ -- $ 93,335 $ -- $ --
Standby letters of
credit 4,780 4,780 -- -- --
Bridge term loan 30,000 30,000 -- -- --
Accounts payable,
non-current 22,291 -- 22,291 -- --
Operating leases 169,206 30,649 79,429 32,614 26,514
-------- ------- -------- ------- -------
Total contractual
obligations $319,612 $65,429 $195,055 $32,614 $26,514
-------- ------- -------- ------- -------
In the normal course of business, the Company issues purchase orders to
vendors for the purchase of merchandise inventories. The outstanding amount of
these purchase orders is not included in the above table, as the purchase orders
may be cancelled prior to delivery at the option of the Company. In addition,
the Company is party to employment and severance agreements, previously filed
with the SEC, with certain executive officers.
Critical Accounting Policies and Estimates
The Company's critical accounting policies and estimates, including the
assumptions and judgments underlying them, are disclosed in the notes to the
Financial Statements and Management's Discussion and Analysis of Financial
Condition and Results of Operations in the Form 10-K filing for the year ended
January 31, 2005. These policies have been consistently applied in all material
respects and address such matters as revenue recognition, inventory valuation,
depreciation methods and asset impairment recognition. While the estimates and
judgments associated with the application of these policies may be affected by
different assumptions or conditions, the Company believes the estimates and
judgments associated with the reported amounts are appropriate in the
circumstances. Management has discussed the development and selection of these
critical accounting estimates with the Audit Committee of our Board of
Directors.
Warrants
The Company accounts for warrants in accordance with FASB Statement of
Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." At
the date of issuance, a fair value is ascribed to the warrants based on a
valuation using the
36
Black-Scholes model. The change in the value of warrants from the previous
reporting period is recognized as a component of interest expense.
NEW ACCOUNTING PRONOUNCEMENTS
ACCOUNTING FOR EXCHANGES OF NONMONETARY ASSETS
The Financial Accounting Standards Board (the "FASB") issued Statement of
Financial Accounting Standards No. 153 ("SFAS No. 153"), "Exchanges of
Nonmonetary Assets - An Amendment of Accounting Principles Board Opinion No. 29
("APB No. 29"), "Accounting for Nonmonetary Transactions." SFAS No. 153
eliminated the exception from fair value measurement for nonmonetary exchanges
of similar productive assets in paragraph 21(b) of APB No. 29, and replaces it
with an exception for exchanges that do not have commercial substance. SFAS No.
153 is effective for fiscal periods beginning after June 15, 2005. The Company
does not expect SFAS No. 153 to have a material impact on the Company.
ACCOUNTING FOR STOCK BASED COMPENSATION
The FASB issued SFAS No. 123 (revised 2004), "Shared-Based Payment" ("SFAS No.
123R"). This statement revised SFAS No. 123, "Accounting for Stock-Based
Compensation," and requires companies to expense the value of employee stock
options and similar awards. The effective date of this standard is annual
periods beginning after June 15, 2005. Historically, the Company has elected to
follow the intrinsic value method in accounting for its employee stock options
and employee stock purchase plans. No stock option based compensation costs were
reflected in net income, as no options granted under those plans had an exercise
price less than the market value of the underlying common stock on the date of
grant.
Upon the adoption of SFAS No. 123R, the Company will be required to expense
stock options over the vesting period in its statement of operations. In
addition, the Company will need to recognize this expense over the remaining
vesting period associated with unvested options outstanding for fiscal years
beginning after June 15, 2005. The Company is currently evaluating which
transition method to use and the effects on its financial statements in
connection with the adoption of SFAS No. 123R.
ACCOUNTING FOR CONDITIONAL ASSET RETIREMENT OBLIGATIONS
In March 2005, the FASB issued FASB Interpretation No. 47 ("FIN 47"),
"Accounting for Conditional Asset Retirement Obligations, an interpretation of
FASB Statement No. 143." FIN 47 clarifies that conditional asset retirement
obligations meet the definition of liabilities and should be recognized when
incurred if their fair values can be reasonably estimated. FIN 47 is effective
no later than the end of fiscal years ending after December 15, 2005. The
Company is in the process of evaluating the expected effects of the adopting of
FIN 47 on its financial statements.
ACCOUNTING CHANGES AND ERROR CORRECTIONS
In May 2005, the FASB issued Statement of Financial Accounting Standards
No. 154 ("SFAS No. 154"), "Accounting Changes and Error Corrections, a
replacement of APB No. 20 and FASB Statement No. 3." SFAS No. 154 requires
retrospective application to prior periods' financial statements of a voluntary
change in accounting principle unless it is impracticable. APB Opinion No. 20
"Accounting Changes," previously required that most voluntary changes in
accounting principle be recognized by including in net income of the period of
the change the cumulative effect of changing to the new accounting principle.
SFAS No. 154 is effective for fiscal years beginning after December 15, 2005.
ACCOUNTING FOR RENTAL COSTS INCURRED DURING CONSTRUCTION
In October 2005, the FASB issued FASB Staff Position No. FAS 13-1 ("FSP FAS No.
13-1"), which will require companies to expense rental costs associated with
operating leases that are incurred during the construction period. The effective
date of FSP FAS No. 13-1 is reporting periods beginning after December 15, 2005.
Currently, the Company capitalizes rent incurred during the construction period
of a retail store as a leasehold improvement.
37
Upon the adoption of FSP FAS No. 13-1, the Company will expense operating
lease rental costs during the construction period as lease expense.
ISSUER'S ACCOUNTING UNDER FASB STATEMENT NO. 150 FOR FREESTANDING WARRANTS AND
OTHER SIMILAR INSTRUMENTS ON SHARES THAT ARE REDEEMABLE
In June 2005, the FASB issued FASB Staff Position No. FAS 150-5 ("FSP FAS No.
150-5"). FAS No. 150-5 clarifies that warrants on redeemable shares are within
the scope of SFAS 150, regardless of the location of the redemption feature, the
likelihood of redemption, or the timing and amount of the redemption feature.
FSP FAS No. 150-5 shall be applied to the first reporting period beginning after
June 30, 2005. The Company has applied the guidance of FSP FAS No. 150-5 in
connection with the Warrants that were issued during October 2005.
Transactions with Affiliates and Related Parties
The Company offers health insurance coverage to the members of its Board of
Directors. The health insurance policy options and related policy cost available
to the Directors are similar to those available to the Company's senior level
employees.
Accounting for Guarantees
In November 2002, the Financial Accounting Standards Board issued FASB
Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission
of FASB Interpretation No. 34." The Company has adopted the guidance of FIN 45
and has reflected the required disclosures in its financial statements
commencing with the financial statements for the year ended January 31, 2004.
Under its bylaws, the Company has agreed to indemnify its officers and
directors for certain events or occurrences while the officer or director is
serving, or was serving, at its request in such capacity. The maximum potential
amount of future payments the Company could be required to make pursuant to
these indemnification obligations is unlimited; however, the Company has a
directors and officer liability insurance policy that, under certain
circumstances, enables it to recover a portion of any future amounts paid. The
Company has no liabilities recorded for these obligations as of October 31,
2005, however, reference should be made to Note 11 to the financial statements
with respect to legal contingencies.
Risk Factors
You should carefully consider each of the following risks and all of the
other information contained in this report. Our business, operating results or
financial condition or liquidity could be materially adversely affected by any
of these risks, and, as a result, the trading price of our common stock could
decline. The risks described below are not the only ones we face. Additional
risks not presently known to us or that we currently deem immaterial may also
impair our business operations.
WHITEHALL JEWELLERS SPECIFIC RISKS
We have recorded substantial net losses and declines in comparable store
sales in recent periods, and there is no assurance that we will not continue to
incur substantial losses and declines in comparable store sales.
We recorded net losses in fiscal year 2003, fiscal year 2004 and the first
nine months of fiscal year 2005. Comparable store sales also have decreased in
fiscal year 2003, fiscal year 2004 and the first nine months of fiscal year
2005. We expect to have declines in comparable store sales through at least the
balance of fiscal year 2005. It is likely that we will continue to have net
losses through at least fiscal year 2006. There is no assurance that we will not
continue to incur substantial losses and declines in comparable store sales in
the future.
38
IF WE FAIL TO CONSUMMATE THE PRENTICE TRANSACTION, WE MAY BE UNABLE TO CONTINUE
AS A GOING CONCERN.
We have entered into the Prentice Transaction, the closing of which is
subject to conditions including shareholder approval. We anticipate that a
shareholder meeting for this purpose will occur no later than January 2006. If
approved by our shareholders, the Prentice Transaction is expected to close
promptly thereafter. We believe that the financing provided by the Prentice
Transaction will provide sufficient funding for the next several months. If, for
any reason, the Prentice Transaction is not consummated, the Company's financial
position would be materially and adversely affected, which could result in a
default under the Bridge Loan and the Senior Credit Agreement and may force the
Company to consider the sale of assets or other strategic alternatives,
including a reorganization under Chapter 11 of the US Bankruptcy Code.
OUR CURRENT LEVELS OF DEBT COULD IMPACT OUR OPERATIONS IN THE FUTURE.
As of October 31, 2005, we had approximately $144.1 million of outstanding
debt constituting approximately 76.5% of our total debt and stockholders'
equity. Our debt levels fluctuate from time to time based on seasonal working
capital needs.
Our bank credit facility includes negative covenants and financial
covenants, which could restrict or limit our operations. In addition, the degree
to which we are leveraged, as well as the restrictions contained in our bank
credit facility, could impair our ability to obtain additional financing for
working capital or other corporate purposes.
We are more highly leveraged than many of our competitors, which may place
us at a competitive disadvantage, and our leverage could make us more vulnerable
to changes in general economic conditions or factors affecting the jewelry
business generally. In addition, a substantial portion of our indebtedness bears
interest at fluctuating rates and increases in interest rates would adversely
affect our results of operations or financial condition. Our costs of borrowings
are higher than many of our competitors.
OUR QUARTERLY OPERATING RESULTS WILL FLUCTUATE DUE TO SEASONALITY AND OTHER
FACTORS, AND VARIATION IN QUARTERLY RESULTS COULD CAUSE THE PRICE OF OUR COMMON
STOCK TO DECLINE.
Our business is highly seasonal, with a significant portion of our sales
and most of our net income generated during the fourth fiscal quarter ending
January 31. Sales in the fourth quarter of fiscal 2004 accounted for 38% of
annual sales for such fiscal year and income from operations for the fourth
quarter of fiscal 2004 was $5.3 million as compared to a net loss of $15.2
million recorded in the previous three quarters. We have historically
experienced lower net sales and minimal net income in each of our first three
fiscal quarters and we expect this trend to continue for the foreseeable future.
We expect to continue to experience fluctuations in our net sales and net income
due to a variety of factors. A shortfall in results for the fourth quarter of
any fiscal year could have a material adverse effect on our annual results of
operations. Our quarterly results of operations also may fluctuate significantly
as a result of a variety of factors, including increases or decreases in
comparable store sales, the timing of new store openings, net sales contributed
by new stores, timing of certain holidays and special events initiated by us,
changes in our merchandise, inventory availability and our ability to fund
inventory purchases, general economic, industry, weather conditions and
disastrous national events that affect consumer spending and the pricing,
merchandising, marketing, credit and other programs of our competitors.
OUR BUSINESS IS PARTICULARLY SUSCEPTIBLE TO ADVERSE ECONOMIC CONDITIONS.
Jewelry purchases are discretionary for consumers and may be particularly
affected by adverse trends in the general economy. The success of our operations
39
depends to a significant extent upon a number of factors relating to
discretionary consumer spending, including economic conditions (and perceptions
of such conditions) affecting disposable consumer income such as employment
wages and salaries, business conditions, interest rates, availability and cost
of credit and taxation, for the economy as a whole and in regional and local
markets where we operate. In addition, we are dependent upon the continued
popularity of malls as a shopping destination and the ability of malls or
tenants and other attractions to generate customer traffic for our stores. The
recent substantial increases in gasoline prices may affect the popularity of
malls as shopping destinations and our customer traffic, as well as having a
depressing effect on discretionary consumer spending generally. There can be no
assurance that consumer spending will not be adversely affected by general
economic conditions or a decrease in mall traffic, thereby negatively impacting
our results of operations or financial condition.
IF WE LOSE KEY PERSONNEL OR ARE UNABLE TO ATTRACT ADDITIONAL QUALIFIED
PERSONNEL, OUR BUSINESS COULD BE ADVERSELY AFFECTED.
We are highly dependent upon the ability and experience of our senior
executives and other key employees. It is likely that there will be changes to
our management team and other personnel as we focus on improving execution and
reducing costs. Our inability to retain highly qualified management personnel or
find suitable replacements could have a material adverse effect on our results
of operations or financial condition. We do not maintain "key executive" life
insurance on any of our executives.
Moreover, our success depends on our ability to attract and retain
qualified personnel generally. We have experienced high turnover among our
marketing and field personnel, especially store managers, and other personnel in
recent periods, which has had an adverse impact on our results of operations. We
cannot assure you that we will be able to attract and retain qualified personnel
in the future, or that there will not be disruptions to our operations as a
result of personnel changes.
WE FACE SIGNIFICANT COMPETITION.
The retail jewelry business is fragmented and subject to increasingly
intense competition. We compete with national and regional jewelry chains and
local independently owned jewelry stores, especially those that operate in malls
or off-mall superstores, as well as with department stores, discounters, direct
mail suppliers and televised home shopping networks. A number of our competitors
are substantially larger and have greater financial resources than us. Some of
our competitors, such as Signet Group plc, which owns Kay Jewelers, Jareds and
some regional chains, have substantially increased their number of stores and
marketing expenditures in recent years, which we believe has resulted in
increases in their market share and affected our results of operations. We
believe that the other primary competitive factors affecting our operations are
store location and atmosphere, quality of sales personnel and service, breadth
and depth of merchandise offered, pricing, credit and reputation. We also
believe that we compete for consumers' discretionary spending dollars with
retailers that offer merchandise other than jewelry. In addition, we compete
with jewelry and other retailers for desirable locations and qualified
personnel. The foregoing competitive conditions may adversely affect our results
of operations or financial condition.
We also face significant new competition from Internet jewelry retailers.
Over the past several years a number of businesses began marketing fine jewelry
via the Internet. Large scale consumer acceptance of Internet fine jewelry
retailing is impacting the jewelry retailing business, resulting in additional
competition for sales and lower margins, and has adversely affected our results
of operations and financial condition. We do not transact Internet sales of
jewelry.
40
A DECREASE IN THE AVAILABILITY OF OR AN INCREASE IN THE COST OF CONSUMER CREDIT
COULD HAVE A NEGATIVE IMPACT ON OUR BUSINESS.
The third party credit we offer to our customers is supplied to us
primarily through a "private label" credit card arrangement with G.E.C.C. During
fiscal 2004, private label credit card sales accounted for approximately 41% of
our net sales while total non-private label credit sales, including major credit
cards such as Visa, MasterCard, American Express and others, generally
constituted approximately 46% of our net sales. The loss or any substantial
modification of any of these arrangements could have a material adverse effect
on our results of operations or financial condition. During periods of
increasing consumer credit delinquencies in the retail industry generally,
financial institutions may reexamine their lending practices and procedures.
There can be no assurance that increased delinquencies being experienced by
providers of consumer credit generally would not cause providers of third party
credit offered by us to decrease the availability or increase the cost of such
credit.
WE DEPEND ON OUR MAJOR SUPPLIERS AND ON THE AVAILABILITY OF MERCHANDISE,
INCLUDING CONSIGNED MERCHANDISE, AND WE WILL NEED THEIR SUPPORT TO MAINTAIN OUR
LIQUIDITY.
We do not manufacture our own merchandise but instead work closely with a
number of suppliers. During fiscal 2004, our largest supplier accounted for
approximately 12% of our total purchases, and our largest five suppliers
accounted for approximately 38% of such purchases. Our relationships with our
primary suppliers are generally not pursuant to long-term agreements. We depend
on our suppliers to ship merchandise on time and within our quality standards.
Although we believe that there are a number of suppliers of fine jewelry, the
loss of one or more of our major suppliers, particularly at critical times
during the year, could have a material adverse effect on our results of
operations or financial condition.
In recent periods, we have requested temporary extensions of payment terms
from some of our key suppliers in order to manage liquidity needs and have also
slowed our accounts payable schedules generally. Our liquidity depends on
continued vendor support, and changes in the extensions of credit or other terms
by vendors could have a material adverse effect on us. Our current financial
condition may cause vendors to delay or suspend shipments of our orders for the
holiday season which could materially adversely affect our results.
A substantial portion of the merchandise we sell is carried on a
consignment basis prior to sale or is otherwise financed by vendors, thereby
reducing our direct capital investment in inventory. The weighted average
percentage of our total inventory that was carried on consignment for fiscal
2002, 2003 and 2004 and the first six months of 2005 (based on the inventory
levels at the end of each fiscal quarter) was 28.7%, 27.5%, 29.1% and 28.2%,
respectively. The willingness of vendors to enter into such arrangements may
vary substantially from time to time based on a number of factors, including the
merchandise involved, the financial resources of vendors, interest rates,
availability of financing, fluctuations in gem and gold prices, inflation, our
financial condition and a number of economic or competitive conditions in the
jewelry business or the economy generally or their perception of the
desireability of doing business with us. Any change in these relationships could
have a material adverse effect on our results of operations or financial
condition.
OUR BUSINESS IS PARTICULARLY SUSCEPTIBLE TO FLUCTUATIONS IN GEM AND GOLD PRICES.
Our Company and the jewelry industry in general are affected by
fluctuations in the prices of diamonds and gold and, to a lesser extent, other
precious and semi-precious metals and stones. During fiscal 2004, diamonds,
gold, precious and semi-precious jewelry accounted for approximately 94.3% of
our net merchandise sales. A significant change in prices or in the availability
of diamonds, gold or other precious and semi-precious metals and stones could
have a material adverse effect on our results of operations or financial
condition. In recent periods, we have experienced large increases in diamond
prices which we expect to continue to
41
increase our overall costs, adversely affecting our results of operations. There
appears to be increasing consumer acceptance of diamond substitutes and, as a
result, there may be less consumer willingness to pay higher diamond prices. The
supply and price of diamonds in the principal world markets are significantly
influenced by a single entity, the Central Selling Organization, a marketing arm
of DeBeers Consolidated Mines Ltd. of South Africa (the "CSO"). The CSO has
traditionally controlled the marketing of the substantial majority of the
world's supply of diamonds and sells rough diamonds to worldwide diamond cutters
from its London office in quantities and at prices determined in its sole
discretion. The availability of diamonds to the CSO and our suppliers is to some
extent dependent on the political situation in diamond producing countries, such
as South Africa, Botswana, Zaire, republics of the former Soviet Union and
Australia, and on continuation of the prevailing supply and marketing
arrangements for raw diamonds. Until alternate sources could be developed, any
sustained interruption in the supply of diamonds or any oversupply from the
producing countries could adversely affect us and the retail jewelry industry as
a whole. Higher priced jewelry items, such as the higher price point merchandise
that we have emphasized in recent periods, tend to have a slower rate of
turnover, thereby increasing the risks to us associated with price fluctuations
and changes in fashion trends.
WE ARE FACED WITH SECURITIES LITIGATION, SHAREHOLDER DERIVATIVE LITIGATION AND
OTHER PROCEEDINGS WHICH COULD BE MATERIAL AND WE ARE SUBJECT TO RESTRICTIONS SET
FORTH IN A NON-PROSECUTION AGREEMENT.
We are defendants in securities litigation, shareholder derivative
litigation and other proceedings. See Note 11 to the financial statements. There
is no assurance that these proceedings will not result in material expense to us
and the handling of these actions requires significant attention from our
management team. In addition, in connection with the Capital Factors litigation,
we entered into a non-prosecution agreement with the United States Attorney's
Office for the Eastern District of New York. The non-prosecution agreement
contains certain conditions, including our continued compliance with applicable
laws. If we were to fail to meet the conditions contained in the non-prosecution
agreement we could face criminal prosecution.
WE MAY HAVE TO TAKE ADDITIONAL ACCOUNTING CHARGES ON OUR FINANCIAL STATEMENTS.
We include as assets on our financial statements leasehold improvements,
furniture, fixtures, inventory, and other items that are subject to impairment
charges under generally accepted accounting principles if the net book values of
such items on our financial statements exceed their fair market values. For the
nine months ended October 31, 2005, we recorded a non-cash impairment charge of
$9.0 million relating to long-lived assets, primarily furniture, fixtures and
leasehold improvements at thirty-one of the Company's retail stores. This
impairment charge had the effect of reducing our earnings for the nine months
ended October 31, 2005. There can be no assurance that we will not take
additional impairment charges in the future as a result of additional store
closings, other restructurings, other impairments or the valuation of other
assets.
THE COSTS ASSOCIATED WITH OUR STORE-CLOSING PROGRAM MAY BE MATERIAL.
During the third quarter of fiscal year 2005, the Company recorded, in
accordance with Financial Accounting Standards No. 144 ("FAS 144") "Accounting
for the Impairment or Disposal of Long-Lived Assets" asset held for use model,
an impairment charge of $5,933,000. The impairment charge was the result of a
plan, as approved by the Company's Board of Directors and announced on November
1, 2005, to close seventy-seven of the Company's retail stores and for the
reduction in carrying value of two additional stores which will continue to
remain open. The Company currently expects to close the seventy-seven stores by
February 2006. The decision to close these stores resulted in an impairment of
the respective stores' long-lived assets, as the carrying amount of the
respective stores' long-lived fixed assets will not be recoverable as such
assets will be disposed of before the end of their previously estimated useful
lives.
42
To assist with the closing of these stores, the Company entered into an
agreement during early November 2005 with a third party. This third party is
currently liquidating inventory in the seventy-seven closing stores through
store closing sales. Pursuant to terms of this agreement, the Company will
receive cash proceeds from the liquidating stores of not less than 55% of cost
of the merchandise inventory, plus the reimbursement of certain operational
expenses. During the fiscal quarter ended October 31, 2005, the Company recorded
a valuation allowance of $17.9 million in connection with the liquidation of
such inventory. Additional inventory valuation allowances may be required in
future periods to the extent that actual net proceeds from the sales of such
merchandise are less than management's current estimate. In addition, the
Company also entered into an agreement with another third party for the purpose
of selling, terminating or otherwise mitigating lease obligations related to the
store closings.
WE NEED TO ALTER THE COMPOSITION OF OUR INVENTORY TO SUCCESSFULLY EXECUTE OUR
BUSINESS STRATEGY.
A substantial portion of our inventory consists of items that we do not
plan to incorporate into our merchandising strategies on a long-term basis. In
recent periods, we have emphasized higher price point merchandise. We are in the
process of modifying our merchandising strategy, however, and may increase our
emphasis on popularly priced merchandise in future periods. Much of our
inventory may not fit this new strategy. In addition, our inventory contains a
number of styles that we do not plan to reorder going forward. In recent periods
we have sought to reduce the amount of inventory that would no longer be a part
of the Company's future merchandise presentation through price reductions and
special promotional programs. The success of our business strategy will depend
to a substantial extent on our ability to sell such merchandise that would no
longer be a part of the Company's future merchandise presentation effectively as
well as to sell a substantial amount of other inventory that has been
slow-moving historically or does not fit with our ongoing merchandising
strategies.
WE ARE SUBJECT TO SUBSTANTIAL REGULATION.
Our operations are affected by numerous federal and state laws that impose
disclosure and other requirements upon the origination, servicing and
enforcement of credit accounts, and limitations on the maximum amount of finance
charges that may be charged by a credit provider. Although credit to our
customers is provided by third parties without recourse to us based upon a
customer's failure to pay, any restrictive change in the regulation of credit,
including the imposition of, or changes in, interest rate ceilings, could
adversely affect the cost or availability of credit to our customers and,
consequently, our results of operations or financial condition.
Our operations are also affected by federal and state laws relating to
marketing practices in the retail jewelry industry. In marketing to our
customers, we compare most of our prices to "reference prices." Our literature
indicates to customers that our reference price for an item is either the
manufacturer's suggested retail price or our determination of the non-discounted
price at which comparable merchandise of like grade or quality is advertised or
offered for sale by competitive retailers and is not our current selling price
or the price at which we formerly sold such item. We are, from time to time,
subject to regulatory investigation relating to our use of "reference prices" in
marketing to our customers. Although we believe that pricing comparisons are
common in the jewelry business, there can be no assurance that this practice
would be upheld.
WE MAY INCUR COSTS AND DISRUPTIONS IN CONNECTION WITH MOVING TO A NEW FACILITY.
The lease at the office building housing our corporate headquarters,
distribution functions and quality assurance operations expires on December 31,
2005. We are currently negotiating a lease extension; however, the landlord has
indicated that it ultimately intends to replace the building with a new
structure. If this occurs, we will need to find a new location for these
operations, which may be at a higher lease rate than the rent we pay currently.
In addition, moving
43
these functions to a new location may result in substantial disruptions to our
operations.
THE ISSUANCE OF COMMON STOCK UNDERLYING THE NOTES AND THE WARRANTS AS
CONTEMPLATED BY THE PRENTICE TRANSACTION WILL HAVE A SEVERE DILUTIVE EFFECT ON
THE INTERESTS OF OUR EXISTING STOCKHOLDERS AND OPTION HOLDERS.
The issuance of the shares of our common stock underlying the notes and the
warrants contemplated by the Prentice Transaction will have a severe dilutive
effect on the interests of our existing stockholders and option holders.
The shares of common stock underlying the warrants represent approximately
19.99% of our common stock currently outstanding. The shares of common stock
issuable (i) upon exercise of the warrants, (ii) upon conversion of the notes
and (iii) as payment of interest under the notes, in each case as contemplated
by the Prentice Transaction, will represent approximately 87% of the issued and
outstanding shares of our common stock (assuming no anti-dilution adjustment to
the conversion price or the exercise price and no issuance of common stock or
securities convertible, exercisable or exchangeable for common stock prior to
the closing of the Prentice Transaction, other than pursuant to the notes and
warrants).
The Prentice Transaction will also have a dilutive effect on the voting
rights of existing stockholders. If the notes are converted into shares of
common stock, Prentice will be able to control the vote on almost all matters
submitted to our stockholders. In addition, conflicts of interest may arise as a
consequence of the control relationship between us and Prentice, such as
conflicts with respect to corporate opportunities, contractual relationships or
the strategic direction of the Company.
THE SIGNIFICANT OWNERSHIP INTEREST IN THE COMPANY BY PRENTICE COULD ADVERSELY
AFFECT OUR OTHER STOCKHOLDERS.
As a result of the Prentice Transaction, Prentice will have the ability to
control substantially all matters submitted to our stockholders for approval,
including the election and removal of directors and any merger, consolidation,
or sale of our assets. Prentice also will have the ability to exert a
controlling influence on our management and affairs. This concentration of
ownership may delay or prevent a change in control; impede a merger,
consolidation, takeover, or other business combination involving us; discourage
a potential acquirer from making a tender offer or otherwise attempting to
obtain control of us; or result in actions that may be opposed by other
stockholders.
Prentice's ownership of our common stock and ability to direct the election
of our directors could create, or appear to create, potential conflicts of
interest when Prentice is faced with decisions that could have different
implications for Prentice and the Company. In addition, Prentice may from time
to time in the future enter into transactions with us. As a result, it may have
interests that are different from, or in addition to, its interest as a
stockholder in our Company. Such transactions may adversely affect our results
of operations or financial condition.
OUR COMMON STOCK HAS BEEN DELISTED FROM THE NEW YORK STOCK EXCHANGE, WHICH MAY
MAKE IT MORE DIFFICULT FOR TRADING IN OUR COMMON STOCK TO OCCUR.
On October 28, 2005, our common stock was delisted from the NYSE. Trading
in our common stock is now conducted in the over-the-counter market. As such, an
investor may find it more difficult to dispose of, or to obtain accurate
quotations as to the market value of, our common stock. It is also possible that
trading in our common stock could be subject to requirements under the
Securities Exchange Act of 1934 that require additional disclosures by
broker-dealers in connection with any trades involving a stock defined as a
"penny stock" (generally, any equity security that has a market price of less
than $5.00 per share and that is not listed for trading on a national securities
exchange, subject to certain exceptions). The additional burdens imposed upon
broker-
44
dealers by these requirements could discourage broker-dealers from facilitating
trades in our common stock, which could significantly limit the market liquidity
of the stock and the ability of investors to trade our common stock.
THE PRICE OF OUR COMMON STOCK COULD CONTINUE TO BE VOLATILE.
There has been in recent years and may continue to be significant
volatility in the market price for our common stock, and there can be no
assurance that an active market for our common stock can be sustained. Our stock
price may rise and fall in a manner which is not related to our performance.
Factors such as quarterly fluctuations in our financial results, whether or not
our quarterly results meet or exceed analysts' or investors' expectations, our
comparable store sales results, announcements by us and other jewelry retailers,
the overall economy and the condition of the financial markets and general
events and circumstances beyond our control could have a significant impact on
the future market price of our common stock and the relative volatility of such
market price.
ANTI-TAKEOVER PROVISIONS IN DELAWARE LAW AND OUR CHARTER AND BY-LAWS COULD DELAY
OR DETER A CHANGE IN CONTROL.
Certain provisions of our certificate of incorporation and by-laws and
certain sections of the Delaware General Corporation Law, including those which
authorize our Board of Directors to issue shares of preferred stock and to
establish the voting rights, preferences and other terms of preferred stock
without further action by stockholders, may be deemed to have an anti-takeover
effect and may discourage takeover attempts not first approved by our Board of
Directors (including takeovers which some stockholders may deem to be in their
best interests). These provisions could delay or frustrate the removal of
incumbent directors or the assumption of control by an acquiror, even if such
removal or assumption of control would be beneficial to our stockholders. These
provisions also could discourage or make more difficult a merger, tender offer
or proxy contest, even if they would be beneficial, in the short term, to the
interests of our stockholders.
The specific provisions of our certificate of incorporation which may be
deemed to have an anti-takeover effect include, among others, the following:
- a classified Board of Directors serving staggered three-year terms;
- the elimination of stockholder voting by written consent;
- a provision providing that only the Chairman of the Board of
Directors, the Chief Executive Officer, the President or the Board of
Directors may call special meetings of stockholders;
- the removal of directors only for cause, and then only by the holders
of at least a majority of the outstanding shares entitled to vote for
such removal;
- a provision permitting the Board of Directors to take into account
factors in addition to potential economic benefits to stockholders;
and
- advance notice requirements for stockholder proposals and nominations
for election to the Board of Directors.
We are also subject to Section 203 of the Delaware General Corporation Law
which, in general, imposes restrictions upon certain acquirors (including their
affiliates and associates) of 15% or more of our common stock. In connection
with the rights offering, our board of directors took action to provide that
shareholders who exceed the 15% threshold solely as a result of their
acquisition of shares of common stock in the rights offering are not deemed to
be "interested stockholders" for purposes of Section 203. We also have entered
into severance agreements with our senior executives, which could increase the
cost of any potential acquisition of us.
In addition, our Board of Directors has adopted a stockholders rights plan
pursuant to which each share of our common stock has associated with it one
right
45
entitling our stockholders, upon the occurrence of a triggering event, to
purchase shares of our preferred stock or shares of the acquiror at a discount
from the prevailing market price. Triggering events generally include events or
transactions that relate to a potential acquisition, merger or consolidation
involving Whitehall Jewellers that has not been approved by our Board of
Directors. In connection with the Prentice Transaction, we have amended the
stockholders rights plan to provide that to the extent that Prentice exceed the
applicable ownership thresholds set forth in the stockholder rights plan, such
occurrence will not be a triggering event under the stockholder rights plan. The
stockholders rights plan may be deemed to have an anti-takeover effect and may
discourage or prevent takeover attempts not first approved by our Board of
Directors (including takeovers which certain stockholders may deem to be in
their best interests). See "Description of Capital Stock - Anti-Takeover Effects
of Delaware Law and Certain Charter and By-law Provisions" and "Description of
Capital Stock - Preferred Stock Purchase Rights."
46
Item 3 - Quantitative and Qualitative Disclosure About Market Risk
Interest Rate Risk
The Company's exposure to changes in interest rates relates primarily to
its borrowing activities to fund business operations. The Company principally
uses floating rate borrowings under its revolving credit facility. The Company's
private label credit card provider charges the Company varying discount rates
for its customer's credit program purchases. These discount rates are sensitive
to significant changes in interest rates. The Company currently does not use
derivative financial instruments to protect itself from fluctuations in interest
rates.
Gold Price Risk
The Company does not hedge gold price changes. Current increases in gold
prices have had and may have a future negative impact on gross margin to the
extent sales prices do not increase commensurately.
Diamond Price Risk
Recent increases in diamond prices may have a future negative impact on
gross margin to the extent that sales prices for such items do not increase
commensurately.
Inflation
The Company believes that inflation generally has not had a material effect
on the results of its operations. There is no assurance, however, that inflation
will not materially affect the Company in the future.
Item 4. Controls and Procedures
The Company's management, with the participation of its Chief Executive
Officer and its Chief Financial Officer, have carried out an evaluation of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures (as defined in Rule 13a-15(e) promulgated under the Securities
Exchange Act of 1934, as amended). Based upon this evaluation, the Company's
Chief Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective as of October 31, 2005. There
were no changes in the Company's internal control over financial reporting that
occurred during the Company's fiscal quarter ended October 31, 2005 that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
47
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Class Action Lawsuits
On February 12, 2004, a putative class action complaint captioned Greater
Pennsylvania Carpenters Pension Fund v. Whitehall Jewellers, Inc., Case No. 04 C
1107, was filed in the U.S. District Court for the Northern District of Illinois
against the Company and certain of the Company's current and former officers.
The complaint makes reference to the litigation filed by Capital Factors, Inc.
("Capital Factors") and settled as disclosed in the Company's Quarterly Report
on Form 10-Q for the fiscal quarter ended October 31, 2004 and to the Company's
November 21, 2003 announcement that it had discovered violations of Company
policy by the Company's Executive Vice President, Merchandising, with respect to
Company documentation regarding the age of certain store inventory. The
complaint further makes reference to the Company's December 22, 2003
announcement that it would restate results for certain prior periods. The
complaint purports to allege that the Company and its officers made false and
misleading statements and falsely accounted for revenue and inventory during the
putative class period of November 19, 2001 to December 10, 2003. The complaint
purports to allege violations of Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 ("1934 Act") and Rule 10b-5 promulgated thereunder.
On February 17, 2004, a putative class action complaint captioned Michael
Radigan v. Whitehall Jewellers, Inc., Case No. 04 C 1196, was filed in the U.S.
District Court for the Northern District of Illinois against the Company and
certain of the Company's current and former officers. The factual allegations
and claims of this complaint are similar to those made in the Greater
Pennsylvania Carpenters Pension Fund complaint discussed above.
On February 19, 2004, a putative class action complaint captioned Milton
Pfeiffer, v. Whitehall Jewellers, Inc., Case No. 04 C 1285, was filed in the
U.S. District Court for the Northern District of Illinois against the Company
and certain of the Company's current and former officers. The factual
allegations and claims of this complaint are similar to those made in the
Greater Pennsylvania Carpenters Pension Fund complaint discussed above.
On April 6, 2004, the District Court in the Greater Pennsylvania Carpenters
case, No. 04 C 1107 consolidated the Pfeiffer and Radigan complaints with the
Greater Pennsylvania Carpenters action, and dismissed the Radigan and Pfeiffer
actions as separate actions. On April 14, 2004, the court designated the Greater
Pennsylvania Carpenters Pension Fund as the lead plaintiff in the action and
designated Greater Pennsylvania's counsel as lead counsel.
On June 10, 2004, a putative class action complaint captioned Joshua Kaplan
v. Whitehall Jewellers, Inc., Case No. 04 C 3971, was filed in the U.S. District
Court for the Northern District of Illinois against the Company and certain of
the Company's current and former officers. The factual allegations and claims of
this complaint are similar to those made in the Greater Pennsylvania Carpenters
Pension Fund complaint discussed above.
On June 14, 2004, lead plaintiff Greater Pennsylvania Carpenters Pension
Fund in Case No. 04C 1107 filed a consolidated amended complaint. On July 14,
2004, the District Court in the Greater Pennsylvania Carpenters action
consolidated the Kaplan complaint with the Greater Pennsylvania Carpenters
action, and dismissed the Kaplan action as a separate action. On August 2, 2004,
the Company filed a motion to dismiss the consolidated amended complaint. On
January 7, 2005, the motion to dismiss was granted in part and denied in part,
with plaintiffs granted leave to file an amended complaint by February 10, 2005.
On February 10, 2005, the lead plaintiff filed a first amended consolidated
complaint. On March 2, 2005, the Company filed a motion to dismiss the amended
complaint. On June 30, 2005, the Court denied Defendants' motions to dismiss. On
July 28, 2005, Defendants filed their Answers to the First Amended Consolidated
48
Complaint. Discovery is ongoing. On September 23, 2005, lead plaintiff filed its
motion for class certification. The Company's response to this motion is due
January 30, 2006. The plaintiffs' reply is due February 24, 2006. The met on
November 8, 2005 in an attempt to resolve, through mediation, the 10(b)-5 claims
and the below described state and federal derivative claims. Mediation of these
matters was unsuccessful.
State Derivative Complaints
On June 17, 2004, a shareholder derivative action complaint captioned
Richard Cusack v. Hugh Patinkin, Case No. 04 CH 09705, was filed in the Circuit
Court of Cook County, Illinois, for the alleged benefit of the Company against
certain of the Company's officers and directors. The complaint asserts claims
for breach of fiduciary duty, abuse of control, gross mismanagement, waste of
corporate assets, unjust enrichment, breach of fiduciary duties for insider
selling and misappropriation of information, and contribution and
indemnification. The factual allegations of the complaint are similar to those
made in the Greater Pennsylvania Carpenters Pension Fund complaint discussed
above.
On April 19, 2005, a shareholder derivative action complaint captioned
Marilyn Perles v. Executor of the Estate of Hugh M. Patinkin, Case No. 05 CH
06926, was filed in the Circuit Court of Cook County, Illinois, for the alleged
benefit of the Company against, inter alia, certain of the Company's officers
and directors. The complaint asserts claims for breach of fiduciary duty, abuse
of control, gross mismanagement, waste of corporate assets, unjust enrichment,
breach of fiduciary duties for insider selling and misappropriation of
information, and contribution and indemnification. The factual allegations of
the complaint are similar to those made in the Cusack complaint discussed above.
The Perles complaint also purports to assert claims on behalf of the Company
against PricewaterhouseCoopers LLP, the Company's outside auditor.
On June 13, 2005, a shareholder derivative action complaint captioned Carey
Lynch v. Berkowitz, Case No. 05CH09913, was filed in the Circuit Court of Cook
County, Illinois, for the alleged benefit of the Company against certain of the
Company's officers and directors. The complaint asserts, inter alia, a claim for
breach of fiduciary duty. The factual allegations of the complaint are similar
to those made in the Cusack and Perles complaints discussed above.
On July 18, 2005, the Circuit Court of Cook County consolidated the Cusack,
Perles and Lynch actions. On August 26, 2005, plaintiffs filed a consolidated
amended derivative complaint against certain of the Company's current and former
officers and directors and PricewaterhouseCoopers LLP, the Company's outside
auditor. On October 3, 2005, defendants, other than PricewaterhouseCoopers LLP,
filed their motion to dismiss the consolidated amended derivative complaint
based, inter alia, on the failure of plaintiffs to make a pre-suit demand upon
the Company's Board of Directors and failure to state a claim.
Federal Derivative Complaints
On February 22, 2005, a verified derivative complaint captioned Myra
Cureton v. Richard K. Berkowitz, Case No. 05 C 1050, was filed in the United
States District Court, Northern District of Illinois, Eastern Division, for the
alleged benefit of the Company against certain of the Company's officers and
directors. The complaint asserts a claim for breach of fiduciary duty. The
factual allegations of the complaint are similar to those made in the Cusack and
Greater Pennsylvania Carpenters Pension Fund complaints discussed above.
On April 13, 2005, a verified derivative complaint captioned Tai Vu v.
Richard Berkowitz, Case No. 05 C 2197, was filed in the United States District
Court, Northern District of Illinois, Eastern Division, for the alleged benefit
of the Company against certain of the Company's officers and directors. The
complaint asserts a claim for breach of fiduciary duty. The factual allegations
of the complaint are similar to those made in the Cusack and Greater
Pennsylvania Carpenters Pension Fund complaints discussed above. On May 11,
2005, plaintiffs
49
in the Cureton and Vu actions filed an unopposed motion to consolidate those two
actions, and these cases were consolidated on May 25, 2005. On June 20, 2005,
plaintiffs filed a consolidated amended derivative complaint asserting claims
for breach of fiduciary duty of good faith, breach of duty of loyalty, unjust
enrichment, a derivative Rule 10(b)-5 claim, and a claim against Browne for
reimbursement of compensation under Section 304 of the Sarbanes-Oxley Act. On
July 15, 2005, defendants moved to stay the consolidated action under the
Colorado River doctrine pending the outcome of the state derivative actions. The
motion is fully briefed and awaiting decision from the court.
The Company intends to contest vigorously these putative class actions and
the shareholder derivative suits and exercise all of its available rights and
remedies. Given that these cases are in their early stages and may not be
resolved for some time, it is not possible to evaluate the likelihood of an
unfavorable outcome in any of these matters, or to estimate the amount or range
of potential loss, if any. While there are many potential outcomes, an adverse
outcome in any of these actions could have a material adverse effect on the
Company's results of operations, financial condition and/or liquidity.
Other
As previously disclosed, in September 2003 the Securities and Exchange
Commission (the "SEC") initiated a formal inquiry of the Company with respect to
matters that were the subject of the consolidated Capital Factors actions. The
Company has fully cooperated with the SEC in connection with this formal
investigation.
By letter from counsel dated October 26, 2004, A.L.A. Casting Company, Inc.
("ALA"), a supplier and creditor of Cosmopolitan Gem Corporation
("Cosmopolitan"), informed the Company that it had been defrauded by
Cosmopolitan and was owed $506,081.55 for goods shipped to Cosmopolitan for
which payment was never received. ALA claimed that the Company is jointly and
severally liable for the full amount of $506,081.55 owed by Cosmopolitan because
the Company aided and abetted Cosmopolitan's fraud and participated in, induced
or aided and abetted breaches of fiduciary duty owed to ALA by Cosmopolitan. ALA
has indicated its intention to pursue its claim, but the Company has not
received notice that litigation has been filed. The Company intends to
vigorously contest this claim and exercise all of its available rights and
remedies.
On August 12, 2005, the Company announced that Ms. Beryl Raff was named
Chief Executive Officer and would join the Company's Board of Directors. On
September 8, 2005, the Company announced that Ms. Raff had resigned all
positions with the Company. On September 27, 2005, the Company filed an
arbitration proceeding, as required under the Beryl Raff employment agreement,
seeking damages and to enforce the non-competition provision. On October 21,
2005, the Company was served with a declaratory judgment action, filed by J.C.
Penney (Ms. Raff's employer), in the 380th Judicial District in Collin County,
Texas seeking a declaration of rights, that among other things, J.C. Penney has
not violated any of the rights of the Company with respect to Ms. Raff's
employment. The Company has reached a complete settlement with J.C. Penney and
Ms. Raff of all matters arising in connection with Ms. Beryl Raff's employment.
The details of the settlement are confidential.
The Company is also involved from time to time in certain other legal
actions and regulatory investigations arising in the ordinary course of
business. Although there can be no certainty, it is the opinion of management
that none of these other actions or investigations will have a material adverse
effect on the Company's results of operations or financial condition.
50
Item 6 - Exhibits
Exhibit Number Description
- -------------- -----------
31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange
Act of 1934
31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange
Act of 1934
32.1 Certification of Chief Executive Officer pursuant to 18 United States Code Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to 18 United States Code Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
51
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.
WHITEHALL JEWELLERS, INC.
(Registrant)
Date: December 9, 2005 By: /s/ John R. Desjardins
------------------------------------
John R. Desjardins
Executive Vice President -
Chief Financial Officer and
Treasurer
(duly authorized officer and
principal financial officer)
52