| PETCO ANIMAL SUPPLIES INC ITEM 1A RISK FACTORS Certain Cautionary Statements Market data used throughout this Annual Report, including information relating to our relative position in the pet food, supplies and services retailing industry, is based on the good faith estimates of management, which estimates are based upon their review of internal surveys, independent industry publications and other publicly available information, including Packaged Facts reports and information prepared by the American Pet Products Manufacturers Association and Business Communications Company, Inc |
| Although we believe that these sources are reliable, we do not guarantee the accuracy or completeness of this information, and we have not independently verified this information |
| Some of the statements in this Annual Report, including, but not limited to, “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934 |
| These statements are therefore entitled to the protection of the safe harbor provisions of these laws |
| We generally identify forward-looking statements in this Annual Report using words like “believe,” “intend,” “target,” “expect,” “estimate,” “may,” “should,” “plan,” “project,” “contemplate,” “anticipate,” “predict” or similar expressions |
| You can also identify forward-looking statements by discussions of strategy, plans or intentions |
| These statements involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements |
| Such risks, uncertainties and other factors include, but are not limited to, those discussed below |
| You are cautioned not to place undue reliance on forward-looking statements, which reflect management’s view only as of the date of this Annual Report |
| Except as required by applicable law, including the securities laws of the United States, and the rules and regulations of the Securities and Exchange Commission, we do not plan to publicly update or revise any forward-looking statements after the date of this Annual Report, whether as a result of any new information, future events or otherwise |
| If we are unable to profitably open and operate new stores, maintain the profitability of our existing stores and successfully complete our store remodel program, our business, financial condition and results of operations may be harmed |
| We have opened between 50 and 89 stores per year (not including closures of existing stores) between fiscal 2001 and fiscal 2005 |
| We plan to increase our aggregate store square footage by 8prca to 10prca per year on a long-term basis, both by focusing on existing markets and by targeting one new geographic market per year |
| Our year-over-year increase in square footage in fiscal 2005 was 11dtta8prca, and our total store square footage at January 28, 2006 was approximately 11dtta3 million square feet |
| We plan to open approximately 90 new stores in fiscal 2006, or approximately 75 stores net of relocations and closings |
| 6 ______________________________________________________________________ [34]Table of Contents There can be no assurance that we will be able to open stores at this rate |
| The rate of our expansion will depend on several factors, including general economic and business conditions affecting consumer confidence and spending, the availability of desirable locations, the negotiation of acceptable lease terms, the availability of qualified personnel and our ability to manage the operational aspects of our growth |
| The rate of our expansion will also depend on the availability of adequate capital, which in turn will depend in large part on cash flow generated by our business and the availability of equity and debt capital |
| There can be no assurance that we will be able to obtain equity or debt capital on acceptable terms or at all |
| Moreover, our senior credit facility and the indenture governing our senior subordinated notes contain provisions that restrict the amount of debt we may incur in the future |
| If we are not successful in obtaining sufficient capital, we may be unable to open additional stores as planned, which may adversely affect our results of operations |
| Our continued growth also depends, to a significant degree, on our ability to increase sales in our new and existing stores |
| Our comparable store net sales increased by 5dtta6prca, 6dtta2prca and 2dtta7prca for fiscal 2003, 2004 and 2005, respectively |
| There also can be no assurance that our existing stores will maintain their current levels of sales and profitability or that new stores will generate sales levels necessary to achieve store-level profitability, much less profitability comparable to that of existing stores |
| New stores that we open in our existing markets may draw customers from our existing stores and may have lower sales growth relative to stores opened in new markets |
| New stores also may face greater competition and have lower anticipated sales volumes relative to previously opened stores during their comparable years of operations |
| These factors, together with increased pre-opening expenses at our new stores, may reduce our average store contribution and operating margins |
| In addition, we are opening new stores in, and are remodeling some of our existing stores into, our newer format, which incorporates our most recent merchandising strategies |
| There can be no assurance that our newer formats will be as or more profitable than our existing stores, and may be less profitable than historical levels for our other stores |
| If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, our business, financial condition and results of operations may be harmed |
| We may be unable to successfully execute our expansion strategy or manage and sustain our growth and, as a result, our business may be harmed |
| Our ability to open new stores depends on a number of factors, including: • adequate capital resources for leasehold improvements, fixtures, inventory and pre-opening expenses; • our ability to locate and obtain favorable store sites and negotiate acceptable lease terms; • our ability to obtain and distribute adequate product supplies to our stores, including by expanding our distribution facilities; • our ability to hire, train and retain skilled managers and personnel; and • our ability to continue to upgrade our information and other operating systems to control the anticipated growth and expanded operations |
| Our senior credit facility and the indenture governing our senior subordinated notes also contain covenants that may restrict or impair our growth plans |
| We currently expect to finance our store expansion plans from cash flow from operations, lease financing and capacity under our senior credit facility |
| To the extent that we are unable to obtain adequate financing for new store growth on acceptable terms, our ability to open new stores will be negatively impacted |
| In addition, our failure to expand our distribution facilities or other internal systems or procedures in accordance with our growth plans, or difficulties we may incur in operating our distribution facilities, could adversely affect our ability to deliver merchandise to our stores in a timely fashion |
| 7 ______________________________________________________________________ [35]Table of Contents In addition, we routinely evaluate our strategic alternatives with respect to each of our stores and our other operating assets and investments |
| In connection with this evaluation, we may elect to close stores or to sell or otherwise dispose of selected assets or investments |
| Excluding store relocations, we closed two stores in fiscal 2003, one store in fiscal 2004 and nine stores in fiscal 2005 |
| There can be no assurance that any future sale or disposition would be achieved on terms favorable to us because we incur closing costs or may lose sales to our competitors as a result |
| Our level of debt may limit the cash flow available for our operations and place us at a competitive disadvantage |
| As of January 28, 2006, our debt consisted primarily of (1) dlra60dtta0 million outstanding under our senior revolving credit facility (total available revolving credit of dlra200dtta0 million (reduced by the outstanding amount of letters of credit of dlra30dtta1 million at January 28, 2006) with an option to increase the available credit by an additional dlra125dtta0 million, subject to certain conditions) and (2) dlra89dtta3 million in principal amount of our senior subordinated notes |
| Our level of indebtedness has important consequences |
| For example, our level of indebtedness may: • require us to use a significant portion of our cash flow from operations to pay interest and principal on our debt, which would reduce the funds available to use for working capital, capital expenditures and other general corporate purposes; • limit our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other investments, which may limit our ability to carry out our business strategy; • result in higher interest expense if interest rates increase on our floating rate borrowings; or • heighten our vulnerability to downturns in our business or in the general economy and restrict us from exploiting business opportunities or making acquisitions |
| The agreements governing our debt impose restrictions on our business |
| The agreement governing our senior credit facility and the indenture governing our senior subordinated notes contain a number of covenants imposing significant restrictions on our business |
| These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise |
| These covenants place restrictions on our ability to, among other things: • incur more debt; • pay dividends, redeem or repurchase our stock or make other distributions; • make acquisitions or investments; • enter into transactions with affiliates; • merge or consolidate with others; • dispose of assets or use asset sale proceeds; • create liens on our assets; and • extend credit |
| If compliance with our debt obligations materially hinders our ability to operate our business and adapt to changing industry conditions, we may lose market share, our revenue may decline and our operating results may suffer |
| Our failure to satisfy covenants in our debt instruments would cause a default under those instruments |
| In addition to imposing restrictions on our business and operations, our debt instruments include a number of covenants relating to financial ratios and tests |
| Our ability to comply with these covenants may be affected by 8 ______________________________________________________________________ [36]Table of Contents events beyond our control, including prevailing economic, financial and industry conditions |
| The breach of any of these covenants would result in a default under these instruments |
| An event of default would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest |
| Moreover, the lenders under our senior credit facility would have the option to terminate any obligation to make further extensions of credit under our senior credit facility |
| If we are unable to repay debt to our senior lenders, these lenders could proceed directly against our assets |
| The loss of any of our three key vendors, or of our exclusive distribution arrangements with our vendors, would negatively impact our business |
| We purchase significant amounts of products from three key vendors: Hill’s Pet Products, Inc |
| (which produces Science Diet), Nutro Products, Inc |
| and The Iams Company |
| Supplies of products from these vendors accounted for approximately 8prca, 8prca and 7prca, respectively, of our net sales in fiscal 2005 and fiscal 2004 |
| We do not maintain long-term supply contracts with any of our vendors |
| While we believe that our vendor relationships are satisfactory, any vendor could discontinue selling to us at any time |
| The loss of any of our three key vendors or any other significant vendors of premium pet food or pet supplies offered by us would have a negative impact on our business, financial condition and results of operations |
| In addition, a change in how our key products are distributed could have a material adverse effect on our business |
| It could materially adversely affect our business if any premium pet food manufacturers were to make premium pet food products widely available in supermarkets or through mass merchants, or if the premium brands currently available to supermarkets and mass merchants were to increase their market share at the expense of the premium brands sold only through specialty pet food and supplies retailers |
| and Nutro Products, Inc |
| is widely available in supermarkets, warehouse clubs or mass merchants |
| One of our pet food vendors, The Iams Company, distributes its Iams brand of pet food to supermarkets, warehouse clubs and mass merchants across the country |
| The Eukanuba brand of premium pet food, which is also manufactured by The Iams Company, continues to be sold exclusively through specialty channels such as PETCO Our principal vendors also currently provide us with certain incentives such as volume purchasing, trade discounts, cooperative advertising and market development funds |
| A reduction or discontinuance of these incentives would increase our costs and could reduce our profitability |
| We also purchase significant amounts of pet supplies from a number of vendors with limited supply capabilities |
| There can be no assurance that our current pet supply vendors will be able to accommodate our anticipated growth and expansion of our stores |
| We continually seek to expand our base of pet supply vendors and to identify new pet-related products |
| An inability of our existing vendors to provide products in a timely or cost-effective manner could impair our business, financial condition and results of operations |
| Competition in the markets in which we operate is strong and if we are unable to compete effectively, our ability to generate sales may suffer and our operating income and net earnings would decline |
| The pet food and supplies retailing industry is highly competitive |
| We compete with a number of specialty pet store chains and traditional pet stores |
| We also compete with supermarkets, warehouse clubs and mass merchants |
| Many of these competitors are larger and have access to greater capital and management resources than we do |
| There can be no assurance that in the future we will not face greater competition from national, regional and local retailers |
| In particular, if any of our major competitors seeks to gain or retain market share by reducing prices or by introducing additional products, we may be required to reduce prices on our key products in order to remain competitive, which may negatively impact our profitability |
| 9 ______________________________________________________________________ [37]Table of Contents A prolonged economic downturn could result in reduced sales and lower revenues and profitability |
| Purchases of pet-related supplies may be affected by prolonged, negative trends in the general economy that adversely affect consumer spending |
| Any reduction in consumer confidence or disposable income in general may affect companies in pet-related and other retail industries more significantly than companies in industries that rely less on discretionary consumer spending |
| In addition, due to our level of debt we are more susceptible to some of these adverse economic effects than are some of our competitors that have greater financial and other resources than we do |
| Our operating results could be harmed if we are unable to integrate acquired companies into our operations |
| The pet food and supplies retailing industry is highly fragmented |
| We may pursue expansion and acquisition opportunities in the future, and we must efficiently integrate and combine operations of acquired companies to realize the anticipated benefits of acquisitions |
| To be successful, the integration process requires us to achieve the benefits of combining the companies, including generating operating efficiencies and synergies and eliminating or reducing redundant costs |
| Since we often have limited prior knowledge of acquired companies, there can be no assurance that the anticipated benefits of these acquisitions will be fully realized without incurring unanticipated costs or diverting management’s attention from our core operations |
| Our operating results could be harmed if we are unable to efficiently integrate newly acquired companies into our operations |
| Any future acquisitions also could result in potentially dilutive issuances of equity securities, or the incurrence of additional debt or the assumption of contingent liabilities |
| We have made investments in the past and may make investments in the future without being able to achieve an adequate return, if any, on our investment |
| In the past we have made, and in the future we may make, investments in strategic ventures or other complementary businesses in an effort to expand internationally or to otherwise grow our business |
| These investments typically involve many of the same risks posed by acquisitions, particularly those risks associated with the diversion of our resources, the inability of the new venture to generate sufficient revenues, the management of relationships with third parties and potential expenses |
| Strategic ventures have the added risk that the other strategic venture partners may have economic, business or legal interests or objectives that are inconsistent with our interests and objectives |
| Although we have no present plans to make any such investment, there can be no assurance that any investment we make in the future would achieve an adequate return, if any |
| In addition, in the past we have terminated, and in the future we may terminate, our relationship in a strategic venture after we have made substantial investments in that strategic venture |
| If we are required to restructure our operations to comply with regulations governing our business, it could have a material effect on our business and operations |
| The transportation and sale of small animals is governed by various state and local regulations |
| These laws vary from state to state and are enforced by the courts and by regulatory authorities with broad discretion |
| While we seek to structure our operations to comply with the laws and regulations of each state in which we operate, there can be no assurance that, given varying and uncertain interpretations of these laws, we would be found to be in compliance in all states |
| A determination that we are in violation of applicable laws in any state in which we operate could require us to restructure our operations to comply with the requirements of that state, which could have a material adverse effect on our business and operations |
| Negative publicity arising from claims that we do not properly care for animals we sell could adversely affect how we are perceived by the public and reduce our revenues and profitability |
| From time to time we are subject to claims or complaints that we do not properly care for some of the companion animals we sell, which may include birds, fish, reptiles and other small animals |
| Given the large 10 ______________________________________________________________________ [38]Table of Contents number of small animals we sell, deaths or injuries sometimes occur while they are in our care |
| As a result, we may be subject to claims that our animal care practices, or the related training of our associates, may not provide the proper level of care |
| Any such claims or complaints, as well as any related news reports, could cause negative publicity, which in turn could harm our business and have a material adverse effect on our results of operations |
| We depend on key personnel, and if we lose the services of any of our principal executive officers, including Mr |
| Devine, our Chairman, Mr |
| Myers, our Chief Executive Officer, and Mr |
| Hall, our President and Chief Operating Officer, we may not be able to run our business effectively |
| We are dependent upon the efforts of our principal executive officers |
| In particular, we are dependent upon the management and leadership of Brian K Devine, our Chairman, James M Myers, our Chief Executive Officer, and Bruce C Hall, our President and Chief Operating Officer |
| Hall or certain of our other principal executive officers could affect our ability to run our business effectively |
| Our success will depend on our ability to retain our current management and to attract and retain qualified personnel in the future |
| Competition for senior management personnel is intense and there can be no assurance that we can retain our personnel |
| The loss of a member of senior management requires the remaining executive officers to divert immediate and substantial attention to seeking a replacement |
| The inability to fill vacancies in our senior executive positions on a timely basis could adversely affect our ability to implement our business strategy, which would negatively impact our results of operations |
| We have been named as a party to several class action and derivative action lawsuits, and we may be named in additional litigation, all of which could require time and attention from certain members of management and result in significant legal expenses |
| An unfavorable outcome in one or more of these lawsuits could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| On April 18, 2005, we and our Chief Executive Officer and Chief Financial Officer were named as defendants in a purported class action filed in United States District Court for the Southern District of California alleging violations of Sections 10 and 20 of the Securities Exchange Act of 1934 |
| The named plaintiff purports to represent a class of purchasers of our stock during the period November 18, 2004 to April 14, 2005, and alleges that during such period the defendants misrepresented our financial position and that the plaintiff and the purported class of purchasers during that period were damaged by paying artificially and falsely inflated prices for our stock |
| Over the next several weeks, three additional purported class actions were filed in the same court alleging essentially the same claims against us and our officers and adding our Chairman as a defendant |
| These cases were consolidated, and in October 2005 a consolidated complaint was filed extending the class period from August 18, 2004 to August 25, 2005, adding additional but similar causes of action, and naming additional defendants, including our President and Chief Operating Officer, several of our Senior Vice Presidents, several former and current members of our Board of Directors, and two of our former stockholders |
| In January 2006, the defendants filed a motion to dismiss the consolidated complaint on the ground that it failed to state facts sufficient to state a claim under the securities laws |
| On April 22, 2005, an alleged owner of our stock derivatively sued all our directors and our Chief Executive Officer and Chief Financial Officer, purportedly on our behalf, alleging that such officers and directors engaged in breaches of fiduciary, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and other violations of California law during the period November 18, 2004 to the present |
| Also on April 22, 2005, another shareholder derivative action was filed in Superior Court of the State of California for the County of San Diego on behalf of another alleged owner of our stock against the same defendants and with substantially similar allegations to those described above |
| These actions have been consolidated |
| In August 2005, the defendants moved to dismiss the consolidated complaint on the ground that the stockholders had failed to make a demand on the Company’s Board and failed to adequately allege that a demand was excused |
| The Court granted the motion but gave plaintiffs leave to amend |
| The plaintiffs filed an amended complaint which defendants have again moved to dismiss |
| A hearing on the defendants’ motion is now scheduled for April 2006 |
| 11 ______________________________________________________________________ [39]Table of Contents While we have tendered these matters to our insurance carriers, the expense of defending such litigation may be costly and divert attention by certain members of management from the day-to-day operations of our business, which could adversely affect our business, results of operations and cash flows, resulting in a decline in the market price of our common stock |
| In addition, though we believe that any damages, if any, would be covered by our insurance, there can be no assurance that an unfavorable outcome in such litigation would not have a material adverse effect on our business, results of operations and cash flows, resulting in a decline in the market price of our common stock |
| Terrorism and the uncertainty of war may have a material adverse effect on our operating results |
| Terrorist attacks, such as the attacks that occurred in New York and Washington, DC on September 11, 2001, and other acts of violence or war may affect the operations of the United States securities markets, the markets in which we operate and our operations and profitability |
| Further terrorist attacks against the United States or US businesses may occur |
| The potential near-term and long-term effect these attacks may have for our customers, the markets for our services and the US economy are uncertain |
| The consequences of any terrorist attacks, or any armed conflicts which may result, are unpredictable, and we may not be able to foresee events that could have an adverse effect on our business |
| Future sales of shares of our common stock in the public market may depress our stock price |
| If our existing stockholders sell substantial amounts of our common stock in the public market or if there is a perception that these sales may occur, the market price of our common stock could decline |
| As of March 17, 2006, we had 57cmam893cmam803 shares of common stock outstanding |
| Substantially all of these shares are freely tradable in the public market without restriction or further registration under the Securities Act, unless the shares are held by “affiliates” of ours as such term is defined in Rule 144 of the Securities Act |
| We also have 6cmam142cmam054 shares of common stock reserved for issuance under our stock option and incentive plans, of which 4cmam489cmam800 shares were subject to outstanding options and 360cmam925 shares were subject to unvested restricted stock units as of March 17, 2006 |
| In March 2002, we filed a registration statement on Form S-8 to register all of the shares of common stock which could be purchased upon the exercise of stock options outstanding on that date and all other shares of common stock reserved for future issuance under our stock option and incentive plans |
| Accordingly, shares issued upon exercise of such options are freely tradable by holders who are not our affiliates and, subject to the volume and other limitations of Rule 144, by holders who are affiliates |
| The price of our common stock may be volatile |
| Since our initial public offering in February 2002, the price at which our common stock has traded has been subject to significant fluctuation |
| The market price for our common stock in the future may continue to be volatile |
| In addition, the stock market periodically experiences significant price and volume fluctuations that in many instances have been unrelated or disproportionate to the operating performance of specific companies |
| In the past, following periods of volatility in the market price of a particular company’s securities, securities class-action litigation has often been brought against that company, and we are currently subject to such litigation |
| The current and any similar litigation instituted against us in the future, could result in substantial costs and divert management’s attention and resources from our core business |
| Our stock price may be adversely affected because our results of operations may fluctuate from quarter to quarter |
| The timing of new store openings, related pre-opening expenses and the amount of revenue contributed by new and existing stores may cause our quarterly results of operations to fluctuate |
| Our business is also subject to seasonal fluctuation |
| Historically, we have realized a higher portion of our net sales during the month of December than during the other months of the year |
| If our quarterly revenue and operating results fall below the expectations of securities analysts and investors, the market price of our common stock could fall substantially |
| 12 ______________________________________________________________________ [40]Table of Contents Operating results also may vary depending on a number of factors, many of which are outside our control, including: • changes in our pricing policies or those of our competitors; • the hiring and retention of key personnel; • wage and cost pressures; • changes in fuel prices or electrical rates; • costs related to acquisitions of businesses; and • seasonal and general economic factors |
| Takeover defense provisions may adversely affect the market price of our common stock |
| Various provisions of the Delaware general corporation law, or the DGCL, and of our corporate governance documents may inhibit changes in control not approved by our board of directors and may have the effect of depriving our stockholders of an opportunity to receive a premium over the prevailing market price of our common stock in the event of an attempted hostile takeover |
| In addition, the existence of these provisions may adversely affect the market price of our common stock |
| These provisions include: • a classified board of directors; • a prohibition on stockholder action through written consents; • a requirement that special meetings of stockholders be called only by our board of directors, our chairman or our president; • advance notice requirements for stockholder proposals and nominations; and • availability of “blank check” preferred stock |
| We incur significant expenses as a result of being a public company |
| The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and Nasdaq, have required changes in corporate governance practices of public companies |
| These new rules and regulations have increased and will continue to increase, our legal and financial compliance costs and make some activities more time-consuming and costly |