10-Q 1 quality_10q.txt SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 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 May 5, 2001 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 0-24902 QUALITY STORES, INC. (Exact Name of Registrant As Specified In Its Charter) Delaware 42-1425562 (State of Incorporation) (I.R.S. Employer No.) 455 E. Ellis Road, Muskegon, MI 49441 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (231) 798-8787 Not Applicable (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 |X| No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of May 5, 2001: 100. All of the registrant's stock is held by QSI Holdings, Inc., and is not publicly traded. -1- QUALITY STORES, INC. INDEX PAGE PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Condensed consolidated balance sheets as of the three months ended May 5, 2001 (unaudited) and the three months ended February 3, 2001 (audited)............................................3 Condensed consolidated statements of operations (unaudited) for the three months ended May 5, 2001, and the three months ended April 29, 2000 .................................................4 Condensed consolidated statements of cash flows (unaudited) for the three months ended May 5, 2000, and the three months ended April 29, 2000..................................................5 Notes to condensed consolidated financial statements (unaudited)......6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - QUALITY STORES, INC...................................................7 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (See "Market Risk" Section of Item 2.) PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS....................................................10 ITEM 2. CHANGES IN SECURITIES................................................10 ITEM 3. DEFAULTS UPON SENIOR SECURITIES......................................10 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..................10 ITEM 5. OTHER INFORMATION....................................................10 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.....................................10 INDEX TO EXHIBITS ............................................................12 -2-

-3- QUALITY STORES, INC. Condensed Consolidated Statements of Operations (Unaudited) (In Thousands, Except Ratio) Three Months Ended ------------------------- May 5, April 29, 2001 2000 --------- --------- Net sales $ 185,991 $ 274,256 Cost of sales 126,835 196,178 --------- --------- Gross profit 59,156 78,078 Selling, general, and administrative expense 55,366 70,717 Merger integration expenses -- 1,822 Amortization of intangibles 1,955 2,199 --------- --------- Operating income 1,835 3,340 Interest expense 10,877 10,722 --------- --------- Loss before income tax credit (9,042) (7,382) Income tax credit (3,222) (2,371) --------- --------- Net loss and comprehensive loss $ (5,820) $ (5,011) ========= ========= Deficiency of earnings to fixed charges $ (9,042) $ (7,382) ========= ========= See accompanying notes to condensed consolidated financial statements. -4-

-5- QUALITY STORES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1. PRESENTATION OF FINANCIAL INFORMATION Quality Stores, Inc., [formerly Central Tractor Farm & Country, Inc.] is a wholly owned subsidiary of QSI Holdings, Inc., [formerly CT Holding, Inc. ("Holdings")], an affiliate of J.W. Childs Equity Partners, L.P. ("Childs"). The condensed consolidated financial statements include Quality Stores, Inc., and its wholly owned subsidiaries (hereinafter, collectively, the "Company"). The condensed unaudited consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions for the Securities and Exchange Commission's Form 10-Q and Article 10 of Regulation S-X, and do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The condensed unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany items and transactions have been eliminated in the consolidation. In the preparation of the condensed unaudited consolidated financial statements, all adjustments (consisting of normal recurring accruals) have been made which are, in the opinion of management, necessary for the fair and consistent presentation of such financial statements. The operating results for the interim periods are not necessarily indicative of the results that may be expected for the year. The Company's fiscal year ends on the Saturday closest to January 31. It is suggested that the condensed unaudited consolidated financial statements contained herein be read in conjunction with the statements and notes in the Company's Annual Report on Form 10-K ("Form 10-K") for the fiscal year ended February 3, 2001 ("Fiscal 2000"). NOTE 2. NONRECURRING CHARGES On January 29, 2001, a plan was approved to reorganize the Company's distribution network. The reorganization includes the closure of six of the Company's satellite distribution facilities and a full-line distribution center in Des Moines, Iowa, including the elimination of 110 positions in those facilities. The closures will be fully completed by July 2001. Liabilities of $4.6 million for remaining occupancy obligations and $0.3 million for severance payments to terminated employees were recorded as of the plan's approval date. As of May 5, 2001, $0.6 million had been incurred and charged against these liabilities ($0.2 million in the first quarter of 2001), and approximately 79 employees remained in the facilities being closed. Primarily during the fourth quarter of fiscal 2000, the Company terminated the employment of 10 executive and 45 administrative personnel at its corporate headquarters. Severance liabilities of $2.3 million were recorded as of the employee termination dates in fiscal 2000. As of May 5, 2001, $1.4 million of severance payments had been made and charged against these liabilities ($0.6 million in the first quarter of 2001). NOTE 3. FINANCIAL INSTRUMENTS Effective February 4, 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities". The standard requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. At May 5, 2001, the Company had an interest rate cap agreement with a notional amount of $65.0 million that expired on May 10, 2001. Due to the short remaining life of the agreement, the cumulative effect of adopting SFAS No. 133 did not have a material effect on the Company's balance sheet or operations as of and for the three-month period ended May 5, 2001. -6- QUALITY STORES, INC. Certain statements in this Report may contain "forward-looking" information (as defined in the Private Securities Litigation Reform Act of 1995). All forward-looking statements involve uncertainty, and actual future results and trends may differ materially depending on a variety of factors. For a discussion identifying some important factors that could cause actual results or trends to differ materially from those anticipated in the forward-looking statements contained herein, please see Exhibit 99 to this Report. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS First Quarter of Fiscal 2001 Compared to First Quarter of Fiscal 2000 Net sales for the first quarter of fiscal 2001 were $186.0 million, a decrease of $88.3 million, or 32.2% as compared to net sales for the first quarter of fiscal 2000 of $274.3 million. This decrease was primarily due to a decrease in comparable store sales and stores closed during fiscal 2000, partially offset by new stores opened since the first quarter of 2000. Comparable store sales decreased 31.8% in the first quarter of fiscal 2001 as compared to the first quarter of fiscal 2000. The decrease was primarily the result of (1) lower customer purchases of "big-ticket" power equipment, reflecting an economic slowdown and a deliberate reduction of sales efforts by the Company related to these and other lower-margin product lines, (2) fewer sales generated by advertising and related promotional pricing as part of the Company's change in advertising strategy, (3) weather-related delays in the start of the spring selling season compared to the first quarter of fiscal 2000, particularly affecting lawn and garden sales, and (4) out-of-stock issues experienced during the first quarter of 2001. The company improved its percentage of in-stock inventory by 15% by the end of the first quarter as vendors gradually resumed normal shipping patterns subsequent to the amendment of the Company's credit facility (see "Amended Credit Facility" below).

Gross profit for the first quarter of fiscal 2001 was $59.2 million, a decrease of $18.9 million, or 24.2%, as compared to $78.1 million for the first quarter of fiscal 2000, principally as a result of the sales decrease noted above. Gross profit as a percentage of net sales increased to 31.8% for the first quarter of fiscal 2001, as compared to 28.5% for the first quarter of fiscal 2000. The increase in gross profit percentage is attributable to (1) the elimination of less profitable stock-keeping units (SKU's) as part of the Company's ongoing assortment review, (2) reductions in promotional pricing associated with the Company's reduced emphasis on advertising, and (3) tight control of distribution costs, including a slight benefit in the first quarter from the consolidation of the distribution network, which was substantially complete at the end of the first quarter. The company expects to receive greater benefit from the distribution reorganization in subsequent quarters. This increase in gross profit percentage was partially offset by sales of older inventory at reduced margins in the first quarter of 2001. Selling, general, and administrative (SGA) expenses for the first quarter of fiscal 2001 were $55.4 million, a decrease of $15.3 million, or 21.6%, as compared to SGA expenses for the first quarter of fiscal 2000 of $70.7 million. This decrease is a result of cost reductions either planned as part of the Company's new operating strategies or implemented in response to the lower sales activity. Specifically, the decline in SGA expenses is summarized as follows: -7-

SGA expenses increased as a percentage of net sales to 29.8% for the first quarter of fiscal 2001 as compared to 25.8% for the first quarter of fiscal 2000 because of the lower sales volume for the first quarter of fiscal 2001. There were no merger and integration expenses during the first quarter of fiscal 2001, compared to charges of $1.8 million for the first quarter of fiscal 2000. These merger and integration expenses related to costs associated with the Quality Stores acquisition, which was substantially complete at the end of the first quarter of fiscal 2000. Operating income for the first quarter of fiscal 2001 was $1.8 million, a decrease of $1.5 million as compared to operating income of $3.3 million for the first quarter of fiscal 2000. Operating income as a percentage of net sales decreased to 1.0% for the first quarter of fiscal 2001 from 1.2% for the first quarter of fiscal 2000. The decrease was a result of the factors noted above, principally the decline in comparable store sales offset by reductions in SGA expenses. Interest expense increased to $10.9 million for the first quarter of fiscal 2001, as compared to $10.7 million for the first quarter of fiscal 2000. This modest increase is due to higher borrowings under the Company's revolving line of credit in the first quarter of 2001 compared to the first quarter of 2000, partially offset by a decrease in the Company's average borrowing rates between the two periods. The credit for income taxes for the first quarter of fiscal 2001 was $3.2 million, compared to a credit of $2.4 million for the first quarter of fiscal 2000. The first quarter income tax credit as a percentage of the pretax loss was 35.6% in 2001, and 32.1% in 2000. Goodwill amortization, which is not deductible for income tax purposes, has a significant effect on the Company's effective income tax rate. The net loss for the first quarter of fiscal 2001 was $5.8 million, compared to a net loss of $5.0 million for the first quarter of fiscal 2000, as a result of the factors discussed above. Amended Credit Facility At February 3, 2001, the Company had a bank credit agreement for which borrowings totaled $189.4 million under two term loan facilities (Tranche A and B) and $121.2 million under a revolving credit agreement. On February 6, 2001, contemporaneous with an equity infusion of $15.0 million, an amendment to the bank credit agreement (the "Amended Credit Agreement") increased the Company's maximum revolving credit availability to $160.0 million, through a combination of revolving credit borrowings up to $150.0 million and letters of credit up to $15.0 million. (The combination is limited to $160.0 million in the aggregate.) The amendment also eliminated certain covenants for the period ended February 3, 2001, and adjusted such covenants for periods thereafter. The Amended Credit Agreement requires a reduction of the revolving credit to $130.0 million for 30 consecutive days during the period from July 1, 2001 to September 30, 2001. Thereafter, no specific reductions will be required for the remaining period of the revolving credit facility, which extends through October 31, 2004. The revolver balance will continue to be governed through the ratio of senior debt to inventory. The Tranche A term loan is payable in alternating quarterly installments of $2.5 million and $7.5 million through April 30, 2004 and final quarterly installments of $11.25 million and $0.9 million through October 31, 2004. The Tranche B term loan requires alternating quarterly installments of $0.2 million and $0.5 million through October 31, 2004 and then alternating quarterly installments of $28.4 million and $5.5 million through April 30, 2006. The Company is required to make mandatory prepayments based on the Company's excess cash flow, as defined, or upon the sale of certain assets or the issuance of additional equity. Borrowings under the Amended Credit Agreement are secured by all assets of the Company and bear interest at the prime or eurodollar rates plus a margin. The revolving credit debt is also subject to a 0.5% commitment fee on its unused portion. The Company's long-term borrowing agreements contain covenants, which require the Company to maintain certain other financial ratios and also restrict, among other things, the payment of dividends, incurrence of -8- additional debt, capital expenditures, mergers and acquisitions, and the disposition of assets. The Company has made all debt payments and has complied with all bank covenants since February 3, 2001. Liquidity and Capital Resources The Company's principal ongoing cash requirements are those necessary to fund its operations and meet its debt service obligations. The Company's primary sources of liquidity have been funds generated from operations, borrowings pursuant to its revolving and term credit facilities, short-term trade credit, and additional equity investments. On May 5, 2001, the Company had working capital of $175.9 million, a $23.8 million increase from working capital of $152.1 million on February 3, 2001. This increase resulted primarily from a $43.5 million aggregate increase in the Company's inventory, partially offset by a $32.6 million increase in accounts payable. The increases in the Company's accounts payable and inventory balances since February 3, 2001 are due primarily to increases in inventory for the spring season. Net cash used in operating activities was $21.1 million for the three months ended May 5, 2001. This was a decrease of $22.3 million from the first quarter of fiscal 2000, during which $43.4 million of cash was used in operating activities. This decrease resulted primarily from a smaller investment in net working capital during the first quarter of 2001 as compared to the first quarter of 2000, during which an "overbuy" of approximately $60.0 million of spring product occurred. The Company's capital expenditures were $0.2 million and $19.1 million for the three months ended May 5, 2001, and April 29, 2000, respectively. This decrease reflects the Company's focus on improving the profitability of its existing operations and limiting capital expenditures to necessary repairs and maintenance in fiscal 2001. Capital expenditures in the first quarter of 2000 included expenditures for new stores and merger-related information systems expenditures. The Company anticipates that its principal uses of cash in the foreseeable future will be working capital requirements, debt service requirements and capital expenditures. Based upon current and anticipated levels of operations, and particularly upon the Company's revised business model and operating strategies, the Company believes that its cash flow from operations, together with amounts available under the Amended Credit Agreement, will be adequate to meet its anticipated requirements in the foreseeable future for working capital, capital expenditures and debt service, and will continue to enhance its credit position in the vendor community and improve vendor business relationships. Seasonality and Weather Prior to the management and operational issues and related nonrecurring charges encountered during fiscal 2000, the Company historically generated positive operating income in each of its four fiscal quarters. However, because the Company is an agricultural specialty retailer, its sales fluctuate with the seasonal needs of the agricultural community. The Company responds to this seasonality by attempting to manage inventory levels (and the associated working capital requirements) to meet expected demand, and by varying its use of part-time employees. Historically, the Company's sales and operating income have been highest in the second quarter (May through July) of each fiscal year due to the farming industry's planting season and the sale of seasonal products. Working capital needs are highest during the first quarter (February through April). The Company expects these trends to continue for the foreseeable future. The Company's results are also impacted by weather patterns, and can be adversely affected by temperature and precipitation fluctuations outside the expected pattern for each season. Unseasonable weather and excessive rain, drought, or early or late frosts may affect the Company's sales and operating income. Inflation Management does not believe its operations have been materially affected by inflation. Market Risk The Company's exposure to market risk has not changed significantly during the first quarter from that discussed in its Form 10-K, other than the expiration of its interest rate cap agreements. -9- QUALITY STORES, INC. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS.................................................None ITEM 2. CHANGES IN SECURITIES.............................................None ITEM 3. DEFAULTS UPON SENIOR SECURITIES...................................None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............None ITEM 5. OTHER INFORMATION.................................................None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS - See Index to Exhibits Included Elsewhere Herein (b) Reports on Form 8-K The Company filed a current report on Form 8-K dated March 23, 2001, reporting an amendment of the Company's credit agreement dated February 6, 2001, and filing as exhibits Amendment Numbers 5 and 6 of the Amended Credit Agreement. -10- SIGNATURE(S) 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. Date: June 6, 2001 QUALITY STORES, INC. /s/ Thomas J. Reinebach Thomas J. Reinebach Senior Vice-President, Finance and Chief Financial Officer (Principal Financial and Accounting Officer) -11- QUALITY STORES, INC. INDEX TO EXHIBITS EXHIBIT 12 Statement Re: Computation of Ratio (Deficiency) of Earnings to Fixed Charges EXHIBIT 99 Important Factors Regarding Forward-Looking Statements -12-

QUALITY STORES INC 10-Q