PETCO ANIMAL SUPPLIES INC - 10-Q Quarterly Report

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

FORM 10-Q

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended November 2, 2002
o	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 0-23574

PETCO ANIMAL SUPPLIES, INC.
(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		33-0479906 (IRS Employer Identification No.)
9125 Rehco Road, San Diego, California (Address of principal executive offices)		92121 (zip code)
(858) 453-7845 (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

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

(Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.)

Title	Date	Outstanding

Common Stock, $0.001 Par Value	November 26, 2002	57,366,473

PETCO ANIMAL SUPPLIES, INC.

FORM 10-Q
For the Quarter Ended November 2, 2002

INDEX

			Page
Part I	Financial Information
	Item 1.	Consolidated Financial Statements
		Consolidated Balance Sheets at February 2, 2002 and November 2, 2002	3
		Consolidated Statements of Operations for the thirteen and thirty-nine weeks ended November 3, 2001 and November 2, 2002	4
		Consolidated Statements of Cash Flows for the thirty-nine weeks ended November 3, 2001 and November 2, 2002	5
		Notes to Consolidated Financial Statements	6
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	19
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
	Item 4.	Controls and Procedures	24
Part II	Other Information
	Item 1.	Legal Proceedings	25
	Item 5.	Other Information	25
	Item 6.	Exhibits and Reports on Form 8-K	26
Signatures			27
Certifications			28

PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

			February 2, 2002			November 2, 2002
						(unaudited)
ASSETS
Current assets:
	Cash and cash equivalents		$	36,215		$	44,663
	Receivables			9,694			12,658
	Inventories			128,991			144,855
	Deferred tax assets			26,287			9,474
	Other			8,249			11,060

		Total current assets		209,436			222,710
Fixed assets, net				211,132			218,355
Debt issuance costs				6,086			6,099
Goodwill				40,928			40,644
Other assets				5,990			6,339

			$	473,572		$	494,147

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
	Accounts payable		$	52,223		$	52,009
	Accrued expenses			42,709			45,273
	Accrued interest			6,580			871
	Accrued salaries and employee benefits			32,943			36,194
	Current portion of long-term debt			2,000			2,000
	Current portion of capital lease and other obligations			4,552			451

		Total current liabilities		141,007			136,798
Long-term debt, excluding current portion				192,500			191,000
Senior subordinated notes payable				200,000			170,000
Capital lease and other obligations, excluding current portion				2,105			2,018
Accrued store closing costs				1,467			2,259
Deferred tax liability				6,219			6,219
Deferred rent and other liabilities				16,699			16,965

		Total liabilities		559,997			525,259

Preferred stock:
	$.01 par value, 5,000 shares authorized, 111 and 78 shares issued and outstanding at February 2, 2002 and no shares issued and outstanding at November 2, 2002
	14% Series A senior redeemable preferred stock			130,038			—
	12% Series B junior redeemable preferred stock			89,244			—
Stockholders' deficit:
	Common stock, $.001 par value, 250,000 shares authorized and 39,117 and 57,366 shares issued and outstanding at February 2, 2002 and November 2, 2002, respectively			39			57
	Additional paid-in capital			(187,380	)		64,920
	Deferred compensation			(8,439	)		—
	Accumulated deficit			(108,460	)		(95,751	)
	Accumulated other comprehensive loss			(1,467	)		(338	)

		Total stockholders' deficit		(305,707	)		(31,112	)

			$	473,572		$	494,147

See accompanying notes to consolidated financial statements.

PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share data)

		Thirteen weeks ended						Thirty-nine weeks ended
		November 3, 2001			November 2, 2002			November 3, 2001			November 2, 2002
Net sales		$	322,853		$	367,530		$	937,249		$	1,071,211
Cost of sales and occupancy costs			226,177			253,253			662,614			744,811

	Gross profit		96,676			114,277			274,635			326,400
Selling, general and administrative expenses			76,740			86,460			222,561			252,340
Management fees and termination costs			780			—			2,340			12,760
Stock-based compensation and other costs			4,708			—			12,292			8,176
Merger and non-recurring costs			—			—			445			—

	Operating income		14,448			27,817			36,997			53,124
Interest income			(179	)		(239	)		(492	)		(548	)
Interest expense			10,018			8,374			32,037			25,816

	Earnings before equity in loss of unconsolidated affiliate, income taxes and extraordinary item		4,609			19,682			5,452			27,856
Equity in loss of unconsolidated affiliate			(865	)		—			(2,505	)		—

	Earnings before income taxes and extraordinary item		3,744			19,682			2,947			27,856
Income taxes			1,562			7,676			1,895			13,143

	Earnings before extraordinary item		2,182			12,006			1,052			14,713
Extraordinary item-loss on early extinguishment of debt (net of income tax benefit of $7,888 and $1,332)			(12,942	)		—			(12,942	)		(2,004	)

	Net earnings (loss)		(10,760	)		12,006			(11,890	)		12,709
Increase in carrying amount and premium on redemption of preferred stock			(6,961	)		—			(20,493	)		(20,487	)

	Net earnings (loss) available to common stockholders	$	(17,721	)	$	12,006		$	(32,383	)	$	(7,778	)

Basic and diluted earnings (loss) per common share:
	Earnings (loss) before extraordinary item	$	(0.12	)	$	0.21		$	(0.51	)	$	(0.10	)
	Extraordinary loss on early extinguishment of debt		(0.34	)		—			(0.33	)		(0.04	)

Earnings (loss) per common share		$	(0.46	)	$	0.21		$	(0.84	)	$	(0.14	)

See accompanying notes to consolidated financial statements.

PETCO ANIMAL SUPPLIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

			Thirty-nine weeks ended
			November 3, 2001			November 2, 2002
Cash flows from operating activities:
	Net earnings (loss)		$	(11,890	)	$	12,709
	Depreciation and amortization			38,830			38,247
	Provision for deferred taxes			(5,423	)		16,443
	Equity in loss of unconsolidated affiliate			2,505			—
	Stock-based compensation			14,842			8,439
	Non-cash write-off of debt issuance costs			12,430			186
Changes in assets and liabilities:
	Receivables			(3,258	)		(2,964	)
	Inventories			(11,307	)		(15,864	)
	Other assets			(16,217	)		(2,270	)
	Accounts payable			2,514			(214	)
	Accrued expenses			15,171			3,666
	Accrued interest			(9,065	)		(5,709	)
	Accrued salaries and employee benefits			5,427			3,251
	Accrued store closing costs			(1,903	)		819
	Deferred rent and other liabilities			440			(124	)

		Net cash provided by operating activities		33,096			56,615

Cash flows from investing activities:
	Additions to fixed assets			(39,209	)		(44,362	)
	Investment in affiliate			(9,093	)		—

		Net cash used in investing activities		(48,302	)		(44,362	)

Cash flows from financing activities:
	Borrowings under long-term debt agreements			215,650			—
	Repayment of long-term debt agreements			(209,650	)		(31,500	)
	Debt issuance costs			(934	)		(1,465	)
	Repayment of capital lease and other obligations			(4,863	)		(4,188	)
	Net proceeds from the issuance of common stock			23			273,117
	Redemption of Series A senior redeemable preferred stock			—			(142,231	)
	Redemption of Series B junior redeemable preferred stock			—			(97,538	)

		Net cash provided by (used in) financing activities		226			(3,805	)

Net increase (decrease) in cash and cash equivalents				(14,980	)		8,448
Cash and cash equivalents at beginning of year				18,044			36,215

Cash and cash equivalents at end of period			$	3,064		$	44,663

See accompanying notes to consolidated financial statements.

PETCO ANIMAL SUPPLIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)

Note 1—General

In the opinion of management of PETCO Animal Supplies, Inc. (the "Company" or "PETCO"), the unaudited consolidated financial statements presented herein contain all adjustments, consisting of normal recurring adjustments, necessary to present the financial position, results of operations and cash flows as of November 2, 2002 and for the thirteen week and thirty-nine week periods ended November 3, 2001 and November 2, 2002. Because of the seasonal nature of the Company's business, the results of operations for the thirteen and thirty-nine weeks ended November 3, 2001 and November 2, 2002 are not necessarily indicative of the results to be expected for the full year. The Company's fiscal year ends on the Saturday closest to January 31, resulting in years of either 52 or 53 weeks. All references to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year. For example, references to fiscal 2002 refer to the fiscal year beginning on February 3, 2002, and ending on February 1, 2003. For further information, refer to the consolidated financial statements and footnotes thereto for fiscal 2001 included in the Company's Annual Report on Form 10-K and Form 10-K/A (File No. 0-23574) filed with the Securities and Exchange Commission on April 23, 2002 and April 30, 2002, respectively.

Note 2—New Accounting Standards

In July 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, which supersede Accounting Principles Board Opinion 17, Intangible Assets. SFAS No. 141 requires that all business combinations be accounted for under the purchase method. The statement further requires separate recognition of intangible assets that meet one of two criteria set forth in the statement. This statement applies to all business combinations initiated after June 30, 2001. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are tested at least annually for impairment. Separable intangible assets with defined lives will continue to be amortized over their useful lives. The provisions of SFAS No. 142 apply to goodwill and intangible assets acquired before and after the statement's effective date. SFAS No. 142 requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. The Company has completed its assessment and recorded $0.3 million of transitional goodwill impairment in the second quarter of 2002. The impact of this change in accounting principle is not material to the consolidated financial statements and, accordingly, the effect of this change is included in selling, general and administrative expenses in the accompanying consolidated statements of operations. Non-compete agreements, which comprise all of the Company's intangible assets with defined lives, had a carrying value of $0.5 million and $0.3 million and accumulated amortization of $1.5 million and $1.7 million at February 2, 2002 and November 2, 2002, respectively. Amortization of non-compete agreements was $0.1 million for each of the thirteen weeks ended November 3, 2001 and November 2, 2002 and $0.2 million for each of the thirty-nine weeks ended November 3, 2001 and November 2, 2002.

The effect of adoption of SFAS No. 142 on the reported net earnings (loss) for the periods presented is as follows:

	Thirteen Weeks Ended					Thirty-nine Weeks Ended
	November 3, 2001			November 2, 2002		November 3, 2001			November 2, 2002
Net earnings (loss) available to common stockholders as reported	$	(17,721	)	$	12,006	$	(32,383	)	$	(7,778	)
Add back goodwill impairment		—			—		—			173
Add back amortization of goodwill		771			—		2,309			—

Net earnings (loss) available to common stockholders as adjusted	$	(16,950	)	$	12,006	$	(30,074	)	$	(7,605	)

Basic and diluted net earnings loss) per common share
Net earnings (loss) as reported	$	(0.46	)	$	0.21	$	(0.84	)	$	(0.14	)
Add back amortization of goodwill		0.02			—		0.06			—

Net earnings (loss) as adjusted	$	(0.44	)	$	0.21	$	(0.78	)	$	(0.14	)

	Thirteen Weeks Ended					Thirty-nine Weeks Ended
	November 3, 2001			November 2, 2002		November 3, 2001			November 2, 2002
Before extraordinary item:
Net earnings (loss) available to common stockholders as reported	$	(4,779	)	$	12,006	$	(19,441	)	$	(5,774	)
Add back goodwill impairment		—			—		—			173
Add back amortization of goodwill		771			—		2,309			—

Net earnings (loss) available to common stockholders as adjusted	$	(4,008	)	$	12,006	$	(17,132	)	$	(5,601	)

Basic and diluted net earnings (loss) per common share
Net earnings (loss) as reported	$	(0.12	)	$	0.21	$	(0.51	)	$	(0.10	)
Add back amortization of goodwill		0.02			—		0.06			—

Net earnings (loss) as adjusted	$	(0.10	)	$	0.21	$	(0.45	)	$	(0.10	)

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs would be capitalized as part of the carrying amount of the long-lived asset and depreciated over the life of the asset. The liability is accreted at the end of each period through charges to operating expense. If the obligation is settled for other than the carrying amount of the liability, a company will recognize a gain or loss on settlement. The provisions of SFAS No. 143 are effective for fiscal years beginning after June 15, 2002. The Company does not expect implementation of SFAS No. 143 to have a significant effect on its results of operation or consolidated financial condition.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of April 2002, which is effective for fiscal years beginning after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4 which required that all gains and losses from extinguishment of debt be aggregated, and if material, classified as an extraordinary item. As a result, gains and losses from debt extinguishment are to be classified as extraordinary only if they meet the criteria set forth in Accounting Principles Board Opinion No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 145 also requires that sale-leaseback accounting be used for capital lease modifications with economic effects similar to sale-leaseback transactions. The Company does not expect implementation of SFAS No. 145 to have a significant effect on its results of operation or consolidated financial condition.

In June 2002, the FASB issued SFAS No. 146, Accounting for Restructuring Costs. SFAS No. 146 applies to costs associated with an exit activity (including restructuring) or with a disposal of long-lived assets, such as eliminating or reducing product lines, terminating employees and contracts, and relocating plant facilities or personnel. Under SFAS No. 146, a company will record a liability for a cost associated with an exit or disposal activity when that liability is incurred and can be measured at fair value. SFAS No. 146 will require a company to disclose information about its exit and disposal activities, the related costs, and changes in those costs in the notes to the interim and annual financial statements that include the period in which an exit activity is initiated and in any subsequent period until the activity is completed. SFAS No. 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, with earlier adoption encouraged. Under SFAS No. 146, a company may not restate its previously issued financial statements, and SFAS No. 146 grandfathers the accounting for liabilities that a company had previously recorded under Emerging Issues Task Force Issue 94-3. The Company has not yet determined the impact, if any, of the adoption of SFAS No. 146.

Note 3—Net Earnings Per Share

Basic net earnings per common share are computed using the weighted average number of common shares outstanding during the period. Diluted net earnings per common share incorporate the incremental shares issuable upon the assumed exercise of stock options and warrants.

Net earnings (loss) and the weighted average number of common shares used to compute net earnings (loss) per share, basic and diluted, are presented below:

	Thirteen Weeks Ended					Thirty-nine Weeks Ended
	November 3, 2001			November 2, 2002		November 3, 2001			November 2, 2002
Net earnings (loss) available to common stockholders as reported	$	(17,721	)	$	12,006	$	(32,383	)	$	(7,778	)
Common shares, basic		38,421			57,334		38,336			55,667
Dilutive effect of stock options		—			614		—			—

Common shares, diluted		38,421			57,948		38,336			55,667

Options and warrants to purchase common shares that were outstanding at November 3, 2001 and November 2, 2002, but were not included in the computation of diluted net earnings (loss) per share

because of their anti-dilutive impact on earnings (loss) per common share, were 1,878 and 1,295, respectively.

Note 4—Related Party Transactions

In October 2000, the Company entered into a management services agreement with two entities who were sponsors of the Company's merger and recapitalization transaction. Under the terms of this agreement, the Company paid management fees in an aggregate amount of $0.8 million in the thirteen weeks ended November 3, 2001, and $2.3 million and $0.3 million in the thirty-nine weeks ended November 3, 2001 and November 2, 2002, respectively, to these two related parties. Shortly after its initial public offering, the Company terminated the management services agreement and paid an aggregate amount of $12.5 million as a one-time termination fee.

The Company issued senior subordinated notes to related parties in October 2000 and redeemed them in October 2001. Interest expense incurred on the senior subordinated notes, primarily paid to related parties, including amortization of the discount, was $3.6 million and $12.0 million in the thirteen weeks and thirty-nine weeks ended November 3, 2001, respectively.

In February 2002, the Company redeemed, for approximately $239.8 million, all of the then outstanding series A and series B preferred stock, primarily from related parties.

Note 5—Initial Public Offering

On February 27, 2002, the Company completed an initial public offering of 14,500,000 shares of common stock for net proceeds of approximately $254.5 million, after deducting the underwriting discount and estimated offering expenses. On March 14, 2002, the Company received additional net proceeds of approximately $17.7 million from the sale of 1,000,000 additional shares of common stock pursuant to the exercise of the underwriters' over-allotment option. The Company used approximately $239.8 million of the net proceeds of its initial public offering to redeem in full all of the Company's then outstanding shares of series A and series B preferred stock. In connection with the initial public offering the Company also amended and restated its stockholders agreement and its securityholders agreement, terminated its management services agreement and used approximately $32.4 million of the net proceeds of the initial public offering, plus approximately $2.1 million in cash on-hand, to repurchase $30.0 million in aggregate principal amount of its 10.75% senior subordinated notes due 2011 at 110.5% of their face amount, plus accrued and unpaid interest through the repurchase date.

Concurrent with the initial public offering, warrants to purchase 2,132,000 shares of common stock were exercised, all outstanding options prior to the initial public offering became fully vested and the Company issued options to purchase 573,000 shares of common stock.

In connection with the initial public offering, the Company also effected a 2-for-1 stock split of its common stock. All references in the consolidated financial statements to the number of shares outstanding, price per share and per share amounts have been retroactively restated to reflect the stock split for all periods presented.

Note 6—Contingencies

In July 2001, two former employees instituted an action against the Company in the Superior Court of California for the County of Los Angeles. The complaint in the action was filed individually and on behalf of a purported class consisting of all current and former employees who worked as

salaried managers or assistant managers in the Company's stores in the state of California at any time between July 30, 1997 and the present. The complaint alleges that the individual plaintiffs and the purported class members worked hours for which they were entitled to receive, but did not receive, overtime compensation under California law, and that they were classified as "exempt" store management employees but were forced to work more than 50% of their time in non-exempt tasks. The complaint alleges violations of the California Labor Code and the California Business and Professions Code. The relief sought includes compensatory damages, penalties, preliminary and permanent injunctions requiring the Company to pay overtime compensation under California law, prejudgment interest, costs and attorneys' fees and such other relief as the court deems proper. In November 2001, the case was transferred to the Superior Court of California for the County of San Diego. The Company has answered the complaint and is vigorously defending the action. A motion for certification of this action as a class action was filed on November 1, 2002. The Company has filed its written opposition to the motion for class certification. A ruling is expected within the next 60 days. If successful, this litigation could have a material adverse effect on the Company's financial condition, and any required change in the Company's labor practices could have a negative impact on its results of operations.

Recently, allegations have been made in a complaint filed in the San Francisco Superior Court by the San Francisco City Attorney's office to the effect that certain PETCO associates have not properly cared for companion animals for sale in the Company's two San Francisco stores. The complaint which has been subsequently transferred to the Santa Clara Superior Court seeks damages, penalties and an injunction against the sale of companion animals in the Company's San Francisco stores. The complaint and related news reports have caused negative publicity in San Francisco and the surrounding area. The Company takes seriously any allegations regarding the proper care of companion animals and has taken steps to reiterate to all associates the importance of proper care for all companion animals in all stores. The Company is responding to the complaint and is defending it vigorously. The complaint and any similar actions which could be filed in the future could cause negative publicity which could have a material adverse effect on the Company's results of operations.

From time to time the Company is involved in routine litigation and proceedings in the ordinary course of its business. The Company is not currently involved in any other pending litigation matters that the Company believes would have a material adverse effect on the Company.

Note 7—Supplemental Guarantor Condensed Consolidating Financial Statements

In October 2001, the Company issued $200 million in principal amount of its 10.75% senior subordinated notes due 2011 under which certain of its subsidiaries (the guarantor subsidiaries) serve as guarantors on a full and unconditional basis. Certain other subsidiaries (the non-guarantor subsidiaries) will not guarantee such debt. In March 2002, the Company repurchased $30 million in aggregate principal amount of these notes.

The following tables present the unaudited condensed consolidating balance sheets of PETCO Animal Supplies, Inc., as a parent company, its guarantor subsidiaries and its non-guarantor subsidiaries as of November 2, 2002 and February 2, 2002 and the related unaudited condensed consolidating statements of operations for the thirteen weeks and thirty-nine weeks ended November 2, 2002 and November 3, 2001, and unaudited condensed consolidating statements of cash flows for the thirty-nine weeks ended November 2, 2002 and November 3, 2001.

PETCO ANIMA