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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended August 1, 2004

OR

( ) TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-20269

        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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes   ___   No   X

APPLICABLE ONLY TO CORPORATE ISSUERS:

        4,380,203 shares of common stock, $.0001 par value (the issuer’s only class of common stock), were outstanding as of August 1, 2004.

PART I — FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

See accompanying notes to unaudited consolidated financial statements.

 

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Liabilities and Stockholders’ Equity

See accompanying notes to unaudited consolidated financial statements.

 

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See accompanying notes to unaudited consolidated financial statements.

 

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See accompanying notes to unaudited consolidated financial statements

 

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Duckwall-ALCO Stores, Inc.
And Subsidiaries
Notes to Unaudited Consolidated Financial Statements

        The accompanying unaudited consolidated financial statements are for interim periods and, consequently, do not include all disclosures required by generally accepted accounting principles for annual financial statements. It is suggested that the accompanying unaudited consolidated financial statements be read in conjunction with the consolidated financial statements included in the Company’s fiscal 2004 Annual Report. In the opinion of management of Duckwall-ALCO Stores, Inc., the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position of the Company and the results of its operations and cash flows for the interim periods.

        The consolidated financial statements include the accounts of Duckwall-ALCO Stores, Inc. and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

        The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. If the Company had elected to recognize compensation cost based on the fair value of the options granted at grant date, net earnings and net earnings per share would have been decreased to the pro forma amounts indicated in the table below:

        Basic net earnings per share is computed by dividing net earnings by the weighted average number of shares outstanding. Diluted net earnings per share reflects the potential dilution that could occur if contracts to issue securities (such as stock options) were exercised.

 

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        The average number of shares used in computing earnings per share was as follows:

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

        Operations. The Company is a regional discount retailer operating in 21 states in the central United States, with two business segments, consisting of:

        The thirteen weeks ended August 1, 2004 and August 3, 2003 are referred to herein as the second quarter of fiscal 2005 and 2004, respectively. For purposes of this management’s discussion and analysis of financial condition and results of operations, the financial numbers are presented in thousands.

        As used below the term “competitive market” refers to any town in which both an ALCO or Duckwall store and one or more national or regional full-line discount stores are located. The term “non-competitive market” refers to any town served by the Company where no national or regional full-line discount store is also located. The Company nevertheless faces competition in such markets from a variety of sources, including national and regional full-line discount stores located within a reasonable driving distance.

        The non-competitive markets where the Company operates ALCO or Duckwall stores generally consist of small towns where population growth is generally steady, but not dramatic. As no direct competitor or national or regional full-line discount store is located in these towns, they are generally considered under-served by full-line discount retailers except for the presence of an ALCO or Duckwall store.

        Strategy. The Company’s business operates in a highly competitive industry. However, to reduce the competition and improve the Company’s performance, the Company’s overall business strategy involves identifying, and opening stores in towns that currently have no direct competition from another larger national or regional full-line discount retailer. The Company thus positions itself as providing the most convenient access to local retail shopping within those towns. A key aspect of this strategy includes placing the Company’s stores in towns where the Company believes no such competition is likely to develop. This strategy does not eliminate the competition for the Company’s stores as the Company’s customers still shop at retail discount stores and other retailers located in regional trade centers. The Company also competes for retail sales with other entities, such as mail order companies, specialty retailers, mass merchandisers, dollar stores, manufacturer’s outlets, and the internet.

 

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        The Company is constantly evaluating the appropriate mix of merchandise to improve sales and gross margin performance. The Company uses centralized purchasing, merchandising, pricing and warehousing to obtain volume discounts, improve efficiencies and achieve consistency among stores and the best overall results. However, the Company utilizes information obtained from its point-of-sale system and regular input from its store associates to determine its merchandise offerings.

        The Company plans to upgrade its current point-of-sale systems over the next several years and has a project team, guided by an outside advisor, currently evaluating and selecting new software. The project team’s goal is to have one store in pilot in January, 2005. A required feature of this new point-of-sale system is perpetual inventory, which the Company does not currently have in its stores. Perpetual inventory allows tracking of on-hands at the item level, and enables automated replenishment. Once the Company has on-hand information and the ability to automatically replenish items in the stores, the benefits of these new systems can be significant. For example, the Company estimates it can reduce its inventory levels by 5% to 10%, and potentially more, because the system will have parameters set at the item level relating to how much inventory to order based on criteria set centrally. A reduction in inventory will improve the Company’s return on assets ratio. In addition to lowering inventory, the new system will also improve in-stock levels in the stores, thereby increasing same-store sales and profits. The new system will also enable other technology improvements in the stores such as e-mail, which is not currently available to the stores due to current technology limitations. Once those limitations are removed, the Company expects to re-engineer the stores to take full advantage of the new technology. As discussed below, the Company has decided to retain a business advisory firm to assist it in enhancing its operational effectiveness which may impact the schedule for testing and rolling out the new point-of-sale system.

        The Company, when appropriate, implements new merchandising and marketing initiatives in an effort to increase customer traffic and same-store sales. To maintain performance levels and upgrade stores with the latest merchandising concepts, the Company initiated a major store remodeling program four years ago. The remodeled stores feature an improved merchandise mix, with greater emphasis on consumables and everyday low values that are highlighted through a new and more dominant sign program. A total of 100 ALCO stores have been remodeled since the inception of the remodeling program. Since March, 2002, the Company has also opened a net total of 19 new ALCO stores that incorporate these latest merchandising concepts, bringing the total number of ALCO stores with the updated format to 119 as of August 1, 2004. In June 2004, the Company converted its first ALCO store to an “ALCO Market Place” store. This new format devotes approximately one fourth of its floor space to a limited, but greatly expanded assortment of foods, including produce, dry goods and products displayed in freezers and coolers. The significant enlargement of the grocery department represents a natural progression in the Company’s successful expansion of its consumable product offering that has been rolled out through the remodeling program. The Company converted a second store to the ALCO Market Place concept in August 2004, and plans to convert one additional ALCO in the current fiscal year. Company management is currently evaluating the results of this new concept to determine rollout plans for the next fiscal year.

        The Company is also proactive in looking for and implementing ways to improve the bottom line through expense reductions in selling, general and administrative expenses (“SG&A”). As examples, in fiscal year 2004, the Company improved throughput in its distribution center by 19% and, in the last 5 years alone, has reduced the number of labor hours required to operate a typical store by 10%. Other examples of proactive measures the Company has taken to control expenses include efforts to reduce rapidly escalating workers compensation expenses and medical insurance costs, as discussed under the heading “Critical Accounting Policies.”

        The Company’s top priority is improving stockholder value and it has taken aggressive actions over the years to achieve that objective, including the engagement of top advisers to help identify opportunities to improve its performance. As noted above, the Company is in the process of engaging another business advisory firm to do a strategic and operational review of the Company. It will focus on improvements in both top-line and bottom-line performance. The Company’s management, the Board and other advisors will also examine other means of enhancing stockholder value.

        Key Items in Fiscal 2005. The Company measures itself against a number of financial metrics to assess its performance. Some of the important financial items during the second quarter of fiscal 2005 were:

 

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	•	Net sales increased 0.8% to $109.6 million. Same store sales increased 0.1%.
	•	Gross margin increased to 32.9% of sales, compared to 32.7% in the prior year second quarter.
	•	Two new ALCO stores and two new Duckwall stores were opened and eight ALCO stores were remodeled.
	•	In June and August 2004, two ALCO stores were converted into ALCO Market Place stores, which include an expanded selection of grocery products. One additional store is expected to be converted to this new prototype by the end of the fiscal year.

         Same store sales growth is a measure which may indicate whether existing stores are maintaining their market share. Other factors, such as the overall economy, may also affect same store sales. The Company defines same stores as those stores that were open as of the first day of the prior fiscal year. While the same store sales for all Company stores was only 0.1%, the prototype ALCO stores (Class 18 ALCO stores), which represent 100 of the 186 ALCO stores as of the end of the second quarter, increased 0.4% during the second quarter of fiscal 2005. Sales in stores in non-competitive markets increased 0.9% during the second quarter of fiscal 2005.

        Gross margin percentage is a key measure of the Company’s ability to maximize profit on the purchase and subsequent sale of merchandise, while minimizing promotional and clearance markdowns, shrinkage, damage, and returns. Gross margin percentage is defined as sales less cost of sales, expressed as a percentage of sales. Gross margin percent increased slightly to 32.9% of sales in the second quarter of fiscal 2005, compared to 32.7% in second quarter of fiscal 2004.

        Earnings per share (“EPS”) growth is an indicator of the returns generated for the Company’s stockholders. EPS was reduced to $0.27 per diluted share for the second quarter of fiscal 2005, compared to $0.37 per diluted share for the second quarter of the prior fiscal year.

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS, FINANCIAL CONDITION OR BUSINESS

        Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact may constitute “forward-looking statements” within the meaning of Section 21E of the Exchange Act. These statements are subject to risks and uncertainties, as described below. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, income or loss, earnings or loss per share, capital expenditures, store openings, store closings, payment or non-payment of dividends, capital structure and other financial items, (ii) statements of plans and objectives of the Company’s management or Board of Directors, including plans or objectives relating to inventory, store development, marketing, competition, business strategy, store environment, merchandising, purchasing, pricing, distribution, transportation, store locations and information systems, (iii) statements of future economic performance, and (iv) statements of assumptions underlying the statements described in (i), (ii) and (iii). Forward-looking statements can often be identified by the use of forward-looking terminology, such as “believes,” “expects,” “may,” “will,” “should,” “could,” “intends,” “plans,” “estimates”, “projects” or “anticipates,” variations thereof or similar expressions.

        Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. The Company’s future results of operations, financial condition and business operations may differ materially from the forward-looking statements or the historical information stated in this Quarterly Report on Form 10-Q. Stockholders and investors are cautioned not to put undue reliance on any forward-looking statement.

        There are a number of factors and uncertainties that could cause actual results of operations, financial condition or business contemplated by the forward-looking statements to differ materially from those discussed in the forward-looking statements made herein or elsewhere orally or in writing, by, or on behalf of, the Company, including those factors described below. Other factors not identified herein could also have such an effect. Factors that could cause actual results to differ materially from those discussed in the forward-looking statements and from historical information include, but are not limited to, those factors described below.

Critical Accounting Policies

        Inventory: As discussed in Note 1 (d) to the Consolidated Financial Statements, inventories are stated at the lower of cost or net realizable value with cost determined using the last-in, first-out (LIFO) method. The retail inventory method (“RIM”) used by the Company is an averaging method that has been widely used in the retail

 

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industry. This method calculates a cost to retail ratio that is applied to the retail value of inventory to calculate cost inventory and the resulting gross margin. Use of the RIM method does not eliminate the use of management judgments and estimates, including markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. The Company continually evaluates product categories to determine if markdown action is appropriate, or if a markdown reserve should be established. The Company recognizes that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventories. As of August 1, 2004 and August 3, 2003, the Company had recorded markdowns that had not been taken and which served to reduce inventories to lower of cost or market by approximately $679 and $619, respectively. Management believes that the RIM provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market.

        Property and Equipment: The Company’s policy is to capitalize property and equipment if it has a useful life beyond one year. Major improvements are capitalized, while maintenance and repairs, which do not extend the useful life of the asset, are expensed as incurred. The nature and extent of the repair, as well as the relative dollar amount of the repair in relation to the cost of the asset determine whether the expenditure is capitalized or expensed.

        Impairment of Long-Lived Assets: The Company considers determination of impairment of long-lived assets as a critical accounting policy because determination as to whether the long-lived assets of a store are impaired and, if impaired, the fair value of such assets requires the use of judgment, particularly as it relates to projecting whether the sum of expected undiscounted future cash flows for the store over an extended period of time will equal or exceed the carrying value of such assets. Management uses the best information available to make the determination; however, actual future cash flows for the store may vary significantly from the cash flows projected in conjunction with the impairment assessment. The potential impact on the financial statements of incorrect judgments regarding impairment of long-lived assets is that a provision for impairment could be needlessly recorded if projected future cash flows for a store are significantly under estimated or a provision for impairment could be deferred until later determined necessary in a future period if initial projected cash flows are over estimated. See Note 1(l) of Notes to Consolidated Financial Statements for a description of the Company’s accounting policy for impairment of long-lived assets.

        Insurance: The Company considers general insurance cost a critical accounting policy. As described below, the Company is essentially self insured for its workers compensation, medical insurance and general liability insurance. Due to the fact that it takes more than one year to determine the actual costs under these plans, these costs are estimated based on the Company’s historical loss experience and estimates from the insurance carriers and consultants.

        Income Taxes: The Company’s tax provision and establishment of reserves for potential tax liabilities involves the use of estimates and professional judgment. The Company has identified exposures for which they have established a reserve, such as differences in interpretation of tax laws at the federal, state, and local units of government.

 

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RESULTS OF OPERATIONS

Thirteen and Twenty-Six Weeks Ended August 1, 2004 Compared to Thirteen and Twenty-Six Weeks Ended August 3, 2003

        The Company continues to execute its basic strategy of opening stores in towns in which no national or regional full-line discount retailers are located. During the second quarter of fiscal 2005, the Company opened two new ALCO stores, which were in new, non-competitive markets, opened two new Duckwall stores, and converted one ALCO store into an ALCO Market Place store. One ALCO store and two Duckwall stores were closed in the current period, and the operations of such stores closed in the current and prior year have been reflected as discontinued operations. As of August 1, 2004, 88% of the Company’s 266 stores are in non-competitive markets.

       Net Sales

        Net sales for the second quarter of fiscal 2005 increased $882 or 0.8% to $109,601 compared to $108,719 for the second quarter of fiscal 2004. Same store sales increased $101 or 0.1%. Sales comparisons to the prior year quarter were unfavorably impacted by higher gasoline prices that affected discretionary consumer spending, the absence of Federal tax rebates distributed during the summer of last year, the shift in a Texas sales tax “holiday” from July last year to August this year, generally much cooler weather patterns that impacted sales of warm weather merchandise, and the timing of a back-to-school advertising circular for the Duckwall division.

        Net sales for the twenty-six week period ending August 1, 2004 increased $4,420 or 2.1% to $212,449 compared to $208,029 in the comparable twenty-six week period of the prior fiscal year. Same store sales decreased $175, or 0.1%. The same store sales increase in the second quarter of fiscal 2005 was more than offset by the decrease in the first quarter of fiscal 2005, resulting in the 0.1% decrease for the twenty-six week period ending August 1, 2004.

       Gross Margin

        Gross margin for the second quarter of fiscal 2005 increased $532 or 1.5% to $36,063 compared to $35,531 in the second quarter of fiscal 2004. Gross margin as a percentage of sales was 32.9% for the second quarter of fiscal 2005 compared to 32.7% for the second quarter of fiscal 2004. The improvement in the gross margin percentage was primarily due to lower shrinkage and merchandise acquisitions costs. The Company continues to take aggressive action to maintain and reduce the levels of shrinkage. In addition, the Company’s logistics department was able to reduce freight expenses, as a percentage of sales, despite significantly higher fuel prices and federal legislation that increased transportation costs. While the Company continues to aggressively manage its freight expense, it cannot predict whether it will be able to maintain these savings or whether freight providers will be able to pass their increased costs on to the Company. Where possible, the Company plans to pass any increased freight expenses it incurs on to its customers.

        Gross margin for the twenty-six week period ended August 1, 2004 was $70,184, which was $1,556 or 2.3% higher than last year’s twenty-six week gross margin of $68,628. The increase was due primarily to the new stores that have been opened over the course of the last twelve months. As a percent of net sales, gross margin was 33.0% for the twenty-six week period of both fiscal years.

       SG&A

        SG&A expense increased $892 or 2.9% to $32,120 in the second quarter of fiscal 2005 compared to $31,228 in the second quarter of fiscal 2004. As a percentage of net sales, selling, general and administrative expenses in the second quarter of fiscal 2005 were 29.3%, compared to 28.7% in the second quarter of fiscal 2004. A significant factor in this increase was general insurance costs, which rose $625 (0.6% of sales), primarily due to an adjustment in the Company’s insurance reserves for workers compensation for the policy year ended May 31, 2004, as a result of revised actuarial estimates. The Company also experienced unusually high medical insurance costs and credit card processing fees rose due to higher credit card usage by the Company’s customers. These expenses were

 

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partially offset by lower depreciation and store remodeling costs, along with another solid performance from the Company’s distribution center. Additionally, the Company recorded a $275 reduction in expenses related to