** **

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTOND.C. 20549**

** **

**Form 10-Q**

** **

**(Markone)**

| **ý****     QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                      |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                       |   |
| **For  the quarterly period ended May 3, 2003**                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                       |   |
| **OR**                                                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                                                       |   |
| **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 0-19536**                                                                                                                                                                                                                                        |

** **

**FAO, INC.**

(Exact name of Registrant as specified in its charter)

 

| **Delaware**                                                                                                     |   | **95-3971414**                        |
|------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                                  |   | (I.R.S. Employer  Identification No.) |
|                                                                                                             |   |                                  |
| **2520  Renaissance Blvd., King of Prussia, PA   19406**                                                    |
| (Address of principal executive  offices)          (Zip  Code) |
|                                                                                                             |   |                                  |
| **(610)  292-6600**                                                                                         |
| (Registrant’s telephone number, including area code)                                                        |
|                                                                                                             |   |                                  |
| (Former name, former address and former fiscal year, if changed since  last report.)                             |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes   ý     No   o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yes   o     No   ý

 

Indicateby check mark whether the registrant has filed all reports required to be filedby Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequentto the distribution of securities under a plan confirmed by a court.

Yes   ý     No   o

 

Asof June 12, 2003, there were 5,152,786 shares of FAO, Inc. common stockoutstanding.  Additionally, there wereapproximately 32,100 shares of FAO, Inc. convertible preferred stock that isconvertible at any time into approximately 21.4 million shares of common stock.

 

 

----

 

FAO, INC.

 

INDEX TO FORM 10-QFOR THE THIRTEEN WEEK PERIODENDED MAY 3, 2003

 
| PART I - FINANCIAL INFORMATION |
|--------------------------------|
|                           |
| Item  1.                       | Consolidated  Financial Statements (unaudited): |
|                           | Consolidated Balance Sheets |
|                           | Consolidated  Statements of Operations |
|                           | Consolidated  Statements of Cash Flows |
|                           | Notes to  Consolidated Financial Statements |
|                           |   |
| Item 2.                        | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |
|                           |   |
| Item  3.                       | Quantitative  and Qualitative Disclosures About Market Risk |
|                           |   |
| Item 4.                        | Controls  and Procedures |
|                           |
| PART II - OTHER  INFORMATION   |
|                           |
| Item 1.                        | Legal  Proceedings |
|                           |   |
| Item  2.                       | Changes in  Securities and Use of Proceeds |
|                           |   |
| Item 6.                        | Exhibits and Reports  on Form 8-K |
|                           |   |
| SIGNATURES                     |
|                           |
| Certifications                 |

 

2

----

 

**FAO, INC.**

**CONSOLIDATED BALANCE SHEETS**

(unaudited)

(in 000’s, except for share and per share data)

 
|                                                                                                                            |   | **May 3,  2003** |    | **February 1,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|----------------------------|------------|
|                                                                                                                            |   |                  |    |                       |       |
| ASSETS                                                                                                                          |   |                  |    |                       |       |
| Current  assets:                                                                                                                |   |                  |    |                       |       |
| Cash  and cash equivalents                                                                                                      |   | $                     | 2,602   |                       | $          | 26,107 |   |
| Accounts  and other receivables, net                                                                                            |   | 4,334                 |    | 7,055                      |       |
| Merchandise  inventories                                                                                                        |   | 57,837                |    | 103,125                    |       |
| Other  current assets                                                                                                           |   | 9,310                 |    | 5,736                      |       |
|                                                                                                                            |   |                  |    |                       |       |
| Total  current assets                                                                                                           |   | 74,083                |    | 142,023                    |       |
|                                                                                                                            |   |                  |    |                       |       |
| Noncurrent  assets:                                                                                                             |   |                  |    |                       |       |
| Property,  fixtures and equipment, net                                                                                          |   | 23,696                |    | 26,356                     |       |
| Goodwill                                                                                                                        |   | 4,578                 |    | 4,578                      |       |
| Other  noncurrent assets                                                                                                        |   | 4,326                 |    | 2,812                      |       |
|                                                                                                                            |   |                  |    |                       |       |
| Total  noncurrent assets                                                                                                        |   | 32,600                |    | 33,746                     |       |
|                                                                                                                            |   |                  |    |                       |       |
|                                                                                                                            |   | $                     | 106,683 |                       | $          | 175,769 |   |
|                                                                                                                            |   |                  |    |                       |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                            |   |                  |    |                       |       |
| Current  liabilities:                                                                                                           |   |                  |    |                       |       |
| Accounts  payable                                                                                                               |   | $                     | 10,837  |                       | $          | 1,393 |   |
| Current  portion of plan of reorganization obligations                                                                          |   | 9,513                 |    | —                     |       |
| Accrued  expenses                                                                                                               |   | 16,247                |    | 13,207                     |       |
| Accrued  salaries and wages                                                                                                     |   | 5,258                 |    | 5,074                      |       |
| Revolving  line of credit                                                                                                       |   | 2,973                 |    | 70,496                     |       |
| Current  portion of Purchase Money Notes                                                                                        |   | 1,382                 |    | —                     |       |
| Equipment  Notes                                                                                                                |   | 4,186                 |    | —                     |       |
|                                                                                                                            |   |                  |    |                       |       |
| Total  current liabilities                                                                                                      |   | 50,396                |    | 90,170                     |       |
|                                                                                                                            |   |                  |    |                       |       |
| Term  loan                                                                                                                      |   | 10,000                |    | —                     |       |
| Deferred  rent                                                                                                                  |   | 2,284                 |    | 3,394                      |       |
| Long  term portion of plan of reorganization obligations                                                                        |   | 2,796                 |    | —                     |       |
| Long  term portion of Purchase Money Notes                                                                                      |   | 80                    |    | —                     |       |
| Subsidiary  Subordinated Notes                                                                                                  |   | 9,900                 |    | —                     |       |
|                                                                                                                            |   |                  |    |                       |       |
| Total  liabilities not subject to compromise                                                                                    |   | 75,456                |    | 93,564                     |       |
|                                                                                                                            |   |                  |    |                       |       |
| Liabilities  subject to compromise                                                                                              |   | —                |    | 108,139                    |       |
|                                                                                                                            |   |                  |    |                       |       |
| Commitments  and contingencies                                                                                                  |   |                  |    |                       |       |
|                                                                                                                            |   |                  |    |                       |       |
| Stockholders’  equity (deficit):                                                                                           |   |                  |    |                       |       |
| Class  I Preferred Stock (50,000 shares authorized at $0.001 par value; 30,500  issued and outstanding)                         |   | —                |    | —                     |       |
| Class  J Preferred Stock (50,000 shares authorized at $0.001 par value; 40 issued  and outstanding)                             |   | —                |    | —                     |       |
| Common  stock (75,000,000 shares authorized at $0.001 par value; 5,132,298 and  2,567,563 issued and outstanding, respectively) |   | 5                     |    | 3                          |       |
| Additional  paid in capital                                                                                                     |   | 233,165               |    | 158,495                    |       |
| Accumulated  deficit                                                                                                            |   | (201,943              | )       | (184,432                   | )          |
| Total  stockholders’ equity (deficit)                                                                                      |   | 31,227                |    | (25,934                    | )          |
|                                                                                                                            |   |                  |    |                       |       |
|                                                                                                                            |   | $                     | 106,683 |                       | $          | 175,769 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

----

 

**FAO, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(unaudited)

(in 000’s, except for share and per share data)

 
|                                                 |   | **Thirteen  Weeks Ended** | ** ** |
|------------------------------------------------------|--------|---------------------------|------------|
|                                                 |   | **May 3,  2003**     |       | **May 4,  2002** | ** ** |
| Net sales:                                           |   |                      |       |   |   |
| Retail                                               |   | $                         | 69,804     |   | $ | 84,903 |   |
| Direct to customer                                   |   | 2,393                     |       | 2,448 |   |
| Shipping and handling revenues                       |   | 619                       |       | 505 |   |
|                                                 |   |                      |       |   |   |
|                                                 |   | 72,816                    |       | 87,856 |   |
|                                                 |   |                      |       |   |   |
| Costs and expenses:                                  |   |                      |       |   |   |
| Cost of goods sold, including distribution costs     |   | 66,787                    |       | 51,871 |   |
| Cost of shipping and handling                        |   | 727                       |       | 612 |   |
|                                                 |   |                      |       |   |   |
| Gross profit                                         |   | 5,302                     |       | 35,373 |   |
|                                                 |   |                      |       |   |   |
| Selling, general and administrative expenses:        |   |                      |       |   |   |
| Operating expense                                    |   | 19,601                    |       | 20,026 |   |
| Occupancy expense                                    |   | 16,177                    |       | 20,386 |   |
| Marketing and advertising expense                    |   | 1,501                     |       | 1,815 |   |
| General and administrative expense                   |   | 4,645                     |       | 6,648 |   |
| Depreciation and amortization expense                |   | 2,504                     |       | 1,489 |   |
| Store closing costs                                  |   | 1,336                     |       | — |   |
|                                                 |   |                      |       |   |   |
|                                                 |   | 45,764                    |       | 50,364 |   |
|                                                 |   |                      |       |   |   |
| Operating loss                                       |   | (40,462                   | )          | (14,991 | ) |
|                                                 |   |                      |       |   |   |
| Reorganization items, net                            |   | 63,081                    |       | — |   |
| Interest expense, net                                |   | (5,761                    | )          | (2,115 | )  |
|                                                 |   |                      |       |   |   |
| Income (loss) before income taxes                    |   | 16,858                    |       | (17,106 | ) |
| Income tax provision                                 |   | 51                        |       | 70 |   |
|                                                 |   |                      |       |   |   |
| Net income (loss)                                    |   | $                         | 16,807     |   | $ | (17,176 | ) |
|                                                 |   |                      |       |   |   |
| Basic and diluted loss per share:                    |   |                      |       |   |   |
| Net loss per share                                   |   | $                         | (6.35      | ) | $ | (12.66 | ) |
|                                                 |   |                      |       |   |   |
| Weighted average number of common shares outstanding |   | 2,757,760                 |       | 1,364,245 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

 

**FAO, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(unaudited)

(in 000’s)

 
|                                                                                                |   | **Thirteen  Weeks Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|--------|---------------------------|------------|
|                                                                                                |   | **May 3,  2003**     |       | **May 4,  2002** | ** ** |
|                                                                                                |   |                      |       |   |   |
| Cash flows from operating activities:                                                               |   |                      |       |   |   |
| Net income (loss)                                                                                   |   | $                         | 16,807     |   | $ | (17,176 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |   |                      |       |   |   |
| Depreciation and amortization                                                                       |   | 2,504                     |       | 1,489 |   |
| Deferred rent                                                                                       |   | 41                        |       | 431 |   |
| Amortization of debt issuance costs                                                                 |   | 22                        |       | 63 |   |
| Non-cash interest                                                                                   |   | 4,038                     |       | 66 |   |
| Gain on discharge of liabilities                                                                    |   | (66,310                   | )          | — |   |
| Change in assets and liabilities affecting  operations                                              |   | 43,754                    |       | (7,178 | ) |
|                                                                                                |   |                      |       |   |   |
| Net cash provided by (used in) operating  activities                                                |   | 856                       |       | (22,305 | ) |
|                                                                                                |   |                      |       |   |   |
| Cash flows from investing activities:                                                               |   |                      |       |   |   |
| Additions to property, fixtures and equipment                                                       |   | (301                      | )          | (780 | ) |
| Proceeds from fixture sales                                                                         |   | 503                       |       | — |   |
| Purchase price adjustments                                                                          |   | —                    |       | (957 | ) |
|                                                                                                |   |                      |       |   |   |
| Net cash provided by (used in) investing  activities                                                |   | 202                       |       | (1,737 | ) |
|                                                                                                |   |                      |       |   |   |
| Cash flows from financing activities:                                                               |   |                      |       |   |   |
| Net borrowings (payments) on revolving line of  credit                                              |   | (67,523                   | )          | 27,592 |   |
| Borrowings under term loan                                                                          |   | 10,000                    |       | — |   |
| Increase in bank overdraft                                                                          |   | 5,253                     |       | 4,708 |   |
| Payments on notes payable, Acquisition Obligations  and capital leases                              |   | (29                       | )          | (5,233 | ) |
| Redemption of Mandatorily Redeemable Preferred  Stock                                               |   | —                    |       | (3,000 | ) |
| Net proceeds from issuance of Class I Preferred Stock                                               |   | 29,221                    |       | — |   |
| Payments of financing costs                                                                         |   | (1,485                    | )          | (438 | ) |
| Proceeds from exercise of stock options and  warrants                                               |   | —                    |       | 144 |   |
|                                                                                                |   |                      |       |   |   |
| Net cash provided by (used in) financing  activities                                                |   | (24,563                   | )          | 23,773 |   |
|                                                                                                |   |                      |       |   |   |
| Net decrease in cash and cash equivalents                                                           |   | (23,505                   | )          | (269 | ) |
| Cash and cash equivalents at beginning of period                                                    |   | 26,107                    |       | 2,811 |   |
|                                                                                                |   |                      |       |   |   |
| Cash and cash equivalents at end of period                                                          |   | $                         | 2,602      |   | $ | 2,542 |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

----

 

FAO, INC.

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(unaudited)

 

NOTE 1:  Basis of Financial Statement Presentation

 

The accompanying unauditedconsolidated financial statements have been prepared in accordance with therequirements for Form 10-Q and Article 10 of Regulation S-X and,accordingly, certain information and footnote disclosures normally included inthe notes to the annual consolidated financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted. Reference is made to the Annual Report on Form 10-K as of and forthe year ended February 1, 2003 for FAO, Inc. and Subsidiaries (referredto herein as “FAO”, “we”, “us”, “our” and similar designations) as filedwith the Securities and Exchange Commission for additional disclosuresincluding a summary of the Company’s accounting policies.

 

In the opinion ofmanagement, the consolidated financial statements contain all adjustments,consisting of normal recurring adjustments, necessary to present fairly theconsolidated financial position of the Company for the periods presented. Sincethe Company’s operations are seasonal, the interim operating results of theCompany may not be indicative of operating results for the full year.

 

Certain prior year balancesin the financial statements have been reclassified to conform with the currentyear presentation.

 

NOTE 2:  Proceedings Under Chapter 11 of theBankruptcy Code

 

Chapter 11 Reorganization

 

On January 13, 2003(the “Petition Date”), we, together with our significant subsidiaries(collectively, the “Filing Entities”), filed for protection under Chapter 11 ofthe United States Bankruptcy Code in the United States Bankruptcy Court for theDistrict of Delaware in case number 03-10119(LK).    During the pendency of the Chapter 11 cases, we and oursubsidiaries continued to operate our businesses as debtors-in-possession underthe jurisdiction of the Bankruptcy Court and in accordance with the applicableprovisions of the Bankruptcy Code and orders of the Bankruptcy Court. Our FirstAmended Disclosure Statement with Respect to First Amended Joint Plan ofReorganization of FAO, Inc. and its Debtor Subsidiaries was approved by theBankruptcy Court on February 28, 2003.  Our First Amended Joint Plan of Reorganization of FAO, Inc. and itsDebtor Subsidiaries (“Plan of Reorganization”) was confirmed by the BankruptcyCourt on April 4, 2003, and became effective when we emerged frombankruptcy on April 23, 2003 (the “Effective Date”).  We decided to seek bankruptcy reorganizationbased upon a rapid decline in our liquidity resulting from reduced salesrelated to the events of September 11, 2001, a weak economic environment,a soft retail market, reduced travel and tourism, and restrained consumerspending at a time when we were continuing to integrate our FAO, Right Startand Zany Brainy operations, together with erosion of vendor credit support anda more restrictive advance rate covenant imposed by our prior senior securedlenders.  In particular, certain of ourstore locations did not perform to expectations, affecting our overalloperations.  We utilized Chapter 11 toclose most of the 111 stores we have closed or have slated to close, orapproximately 43% of our previously operated store base (four other stores werealso closed during the prior year unrelated to the Chapter 11 filing), rejector amend contracts and leases we felt were not economically favorable, auctionand sell certain real property leases yielding proceeds of approximately $3.3million and reach compromise on our outstanding indebtedness.   In addition, we sold 30,000 shares of ourClass I Convertible Preferred Stock (“Class I Convertible Preferred Stock”),convertible at $1.50 per common share, for gross proceeds of $30.0 million andreplaced our former revolving credit facility with an asset based revolvingLoan and Security Agreement (the “Loan Agreement”) with Fleet Retail Finance,Inc., as agent, which provides up to $77.0 million in aggregate borrowingcapacity.

 

6

----

 

Pursuant to our Plan ofReorganization, we:

 

•                  repaid our prior senior securedlenders the full amount of their claims;

 

•                  compromised $8.5 million in EquipmentNotes and accrued interest in exchange for (i) new convertible Equipment Notespayable January 11, 2004 in the amount of $4.0 million (of which $313,874was converted at $1.95 per common share into 160,959 shares of common stock asof May 3, 2003 and $3.7 million are outstanding as of that date), providedcertain payments to our pre-bankruptcy unsecured creditors have been made, (ii)4,542 shares of our Class J Convertible Preferred Stock convertible into2,329,025 shares of our common stock (converted to common stock inApril and May 2003), (iii) warrants to purchase 66,667 shares of ourcommon stock with an exercise price equal to $1.95 per share and (iv) repricingof previously issued warrants to purchase 43,333 shares of our common stockwith an exercise price equal to $1.95 per share after the repricing;

 

•                  compromised approximately $17.4million in old Subsidiary Subordinated Notes in exchange for (i) new SubsidiarySubordinated Notes in the aggregate principal amount of $9.9 million payableratably in three annual installments in December 2006, 2007 and 2008, (ii)$0.5 million in cash payable on January 11, 2004 and (iii) 500 shares ofour Class I Convertible Preferred Stock convertible into 333,333 shares of ourcommon stock;

 

•                  retained a note secured by equipmentin the aggregate outstanding principal amount of approximately $1.1 million;

 

•                  compromised smaller claims to aconvenience amount of $100 or to the full amount of the claim, whichever isless; and

 

•                  compromised our remaining unsecuredclaims depending on the individual choices of our unsecured creditors to: (i)38% of the allowed amount of the claim, payable as follows: 5% on the effectivedate of our Plan of Reorganization, 11% on December 22, 2003, 15% onDecember 22, 2004, and 7% on December 22, 2005; (ii) 21% of theallowed amount of the claim, payable as follows: 7% on the effective date ofour Plan of Reorganization, and 14% on December 22, 2003; or (iii) 35% ofthe allowed amount of the claim with cash payments representing 28% payable asfollows: 5% on the Effective Date, 8% on December 22, 2003, 9% onDecember 22, 2004, and 6% on December 22, 2005 and payment of equityfor the remaining 7%. A portion of the cash payments due, in each case, inDecember 2003 may be deferred if we do not meet certain borrowingavailability conditions.

 

Pursuant to our Plan of Reorganization we paid andmust pay the following amounts:

 

(i)                                     Anestimated $17.4 million to holders of unsecured claims; $4.4 million on theEffective Date, approximately $10.0 million on December 22, 2003,approximately $2.0 million on December 22, 2004 and approximately $1.0million on December 22, 2005.  In the event excess availability underthe Loan Agreement on December 18, 2003 is less than $37.0 million thenthe December 2003 payment obligation will be deferred untilDecember 22, 2004 pro rata, by the amount by which excess availability isless than $37.0 million; provided, however, in no event may theDecember 2003 payment to holders of unsecured claims be less than $1 million. In the event that excess availability under the Loan Agreement onDecember 18, 2004 is less than $40.0 million, then any deferredDecember 2003 payments to holders of unsecured claims will be deferreduntil December 22, 2005 pro rata, by the amount by which the excessavailability is less than $40.0 million; provided, however, in no event may theDecember 2004 payment to holders of unsecured claims be less than (i) theamounts due to unsecured creditors on December 22, 2004, plus (ii) $1.0million of the deferred December 2003 payments.  Any paymentsdeferred

 

7

----

 

until December 22, 2005 shall be due and payableno later than December 22, 2005 irrespective of excess availability underthe Loan Agreement.  The deferrals will be applicable if, and only if,excess availability under the Loan Agreement on December 18, 2003 is lessthan $37.0 million.

 

(ii)                                  $3.7million or the outstanding principal amount in payment of the new EquipmentNotes on the later of (a) January 11, 2004 or (b) the first business dayfollowing payment of all undisputed amounts due by the terms of our Plan ofReorganization to holders of unsecured claims through and includingDecember 22, 2003 provided such payments have not been deferred.

 

(iii)                               $0.5million on January 11, 2004 and $3.3 million on each of December 31,2006, 2007 and 2008 plus interest at a rate of 6% per annum through andincluding January 11, 2005, at which time the first interest payment shallbe made in cash with payments made quarterly thereafter, to the holders of thenew Subsidiary Subordinated Notes provided we are current with our payments toholders of the new convertible Equipment Notes and unsecured claims and suchpayments have not been deferred.

 

In addition:

 

(i)                                     holders ofunsecured claims received approximately 95,262 shares of our common stock;

 

(ii)                                  theholders of claims with respect to the Equipment Notes received 4,542 shares ofour Class J Convertible Preferred Stock convertible into 2,329,025 shares ofour common stock, warrants to purchase 66,667 shares of our common stock andrepriced warrants to purchase 43,333 shares of our common stock; and

 

(iii)                               holders ofthe old Subsidiary Subordinated Notes received 500 shares of our Class IConvertible Preferred Stock convertible into 333,333 shares of our commonstock.

 

Subsequent to May 3,2003, we sold an additional 1,600 shares of our Class I Convertible PreferredStock for gross proceeds of $1.6 million on similar terms as the prior sales.

 

Claims Resolution

 

Pursuant to thebankruptcy process, our claims agent received approximately 1,700 timely-filedproofs of claim totaling approximately $450.0 million in the aggregate,exclusive of approximately 120 proofs of claim filed by governmental agenciestotaling approximately $4.0 million in the aggregate.  The bar date (the final date for which claims can be filedtimely) was March 31, 2003 for most claimants.  For governmental agencies the bar date is July 13,2003.  For holders of canceled executorycontracts and real property leases the bar date is 60 days from the date theircontract or lease is rejected.

 

As is typical inreorganization cases, there are significant differences between amountsscheduled by us and claims filed by creditors; these differences are beinginvestigated and resolved in connection with the claims resolutionprocess.  The aggregate amount of claimsfiled with the Bankruptcy Court far exceeds our estimate of ultimate liability.  We believe that many of these claims areduplicative, based upon contingencies that have not occurred, or otherwise areoverstated, and are therefore invalid. As of June 11, 2003, we have filed one claims objection totalingapproximately $6.0 million and have identified approximately $280.0 million induplicative or otherwise invalid claims. We intend to include these in a claims objection to be filed with theBankruptcy Court.  In light of thenumber of claims asserted against the Filing Entities, the claims resolutionprocess is ongoing and may take considerable time to complete. A

 

8

----

 

number of significant claims remain to be resolved.  Accordingly, the ultimate number of andamount of allowed claims is not presently known.

 

9

----

 

NOTE 3:  Description of Business and SignificantAccounting Policies

 

We are a specialtyretailer of high quality developmental, educational and care products forinfants and children and high quality toys, games, books and multimediaproducts for children up to age 12 conducted through the FAO Schwarz®, RightStart® and Zany Brainy® brands.  Ourbusiness expanded in the last two fiscal years to include educational products,toys, games, books and multimedia products for children up to age 12 throughthe purchase of substantially all of the assets of Zany Brainy, Inc. andcertain assets of upscale toy seller F.A.O. Schwarz (now known as KBB RetailAssets Corp.).   Results for our firstquarter are not indicative of annual results in part because the first quarterof the year ending January 31, 2004 (“Fiscal 2003”) reflects operationswhile we were in bankruptcy that include store closings and inventoryliquidation, the costs and expenses associated with our bankruptcy case as wellas the one-time gains that occurred in connection with our emergence frombankruptcy.

 

On February 21,2003, we executed a letter of intent with Saks Incorporated with respect to theplacement of licensed departments in department stores comprising the SaksDepartment Store Group (consisting of Bergner’s, Boston Store, Carson PirieScott, Herberger’s, McRae’s, Parisian, Proffitt’s and Younkers).  OnApril 23, 2003, we entered into a Departmental License Agreementdocumenting the first portion of the letter of intent and setting forth theterms of operation of 15 test departments in nine stores (“SaksBoutiques”).  Under the terms of the Departmental License Agreement, wewill pay a license fee of the greater of 12% of net sales from the departmentor $35 per square foot per annum of licensed space plus our share ofcertain operational, advertising and customer relations programcosts.   The test departments will be operated for up to one yearand, if the parties are satisfied with the results, additional departments maybe placed in the remainder of Saks’ 244 department stores as the parties deemappropriate.   The departments will consist of FAO Schwarz, ZanyBrainy, The Right Start and FAO Schweetz® departments.  The letter ofintent also contemplates that we will negotiate with Saks to expand the numberof departments and add temporary shops for the holiday season, develop a lineof apparel, establish a baby gift registry from which each party would sell itsown merchandise and the merchandise of the other in its stores, and pursueother marketing, merchandising and cross-marketing initiatives.

 

Operating Results andLiquidity

 

We are primarily atoy retailer and expect to derive approximately 40% of our revenue during ourfourth quarter.  Historically, we haveincurred losses, though we expect to generate sufficient operating income inthe fourth quarter to offset actual and expected operating losses from thefirst three quarters of Fiscal 2003. We believe that our current cash on handat June 12, 2003, cash flow from operations and anticipated availabilityfrom the $77.0 million Loan Agreement with Fleet Retail Finance, Inc., asagent (the “Agent”) under which we are co-borrowers with our subsidiaries ZBCompany, Inc. and FAO Schwarz, Inc. will allow us to maintain ouroperations and fund working capital and capital expenditures for the next 12months. Our needs for additional funding will depend upon several factors,including, but not limited to, generating sufficient cash flow from operations,the expenses or income from incorporating the Saks Boutiques into ouroperations and our dependence on independent manufacturers and suppliers andtheir credit terms in order to maintain adequate inventory in-stock levels. Ifadditional capital is required to grow our business or execute our businessplan, we may seek to raise additional equity or incur additional debt. Therecan be no assurance given that adequate funds will be available to us onacceptable terms or at all.

 

The Loan Agreementmatures April 22, 2006 and consists of (i) a standard revolving lineof credit of up to $67.0 million under which borrowings bear interest, atour election, at an initial rate of 2.25% over the Agent’s calculatedEurodollar Rate or 0.25% over a base rate designated by Fleet National Bank(the "Bank") from time to time, and (ii) an additional specialterm subline of $10.0 million under which borrowings bear interest at arate of 15.5% per annum for the first year and thereafter at a rate of 11.25%over the base rate designated by the Bank. The Loan Agreement allows us to borrow 85% of credit card receivables,plus, (A) so long as the special term subline remains outstanding, up to95% of the current appraised liquidation value of our eligible inventory fromNovember 1 through August 14 and 102.5% of current appraisedliquidation value of our eligible inventory from August 15 throughOctober 31, and (B) when the special term subline is no

 

10

----

 

longer in effect, 85% of the current appraisedliquidation value of our eligible inventory, less reserves established by theAgent from time to time in its reasonable discretion for such items as aportion of outstanding gift certificates and merchandise credits, royaltyobligations, two months rent on certain store leases which we have not receivedcollateral access agreements which are acceptable to the landlord and the Agentand an availability block (initially set at $4.0 million which decreasesbetween September 7, 2003 and September 30, 2003 to $1.5 million andbetween October 1, 2003 and October 31, 2003 to $0.5 million).  Eligible inventory consists of inventory inwhich the Agent has a prior, perfected security interest less certainineligible items. The Loan Agreement contains one financial operating covenant.This covenant requires that we maintain minimum excess availability under theLoan Agreement of $5.0 million at all times. In order to meet this covenant, weare permitted to supplement our availability under the Loan Agreement throughletters of credit.  In connection withthe issuance of our Class I Convertible Preferred Stock, we have a commitmentfrom certain of the purchasers to provide a letter of credit with a statedamount of up to $5.0 million beginning any time after June 1, 2003. Theletter of credit, if issued, will expire no later than November 30, 2003,and is to expire undrawn by such expiration date, so long as we are not indefault under the Loan Agreement or would not be in default under the LoanAgreement once the letter of credit is returned.  If the letter of credit is issued we are required to issue to theproviders five-year warrants with an exercise price of $1.50 per share in anamount equal to 3% of our fully-diluted equity as of April 23, 2003 (or,if the stated amount of the letter of credit is less than $5.0 million, a prorata portion of such 3%), and, if the letter of credit is drawn, we arerequired to issue to the providers one-year notes in an aggregate principalamount equal to the stated amount of the letter of credit secured by ourequipment and bearing interest at a rate of 10% per annum, and if such noteshave not been repaid by November 30, 2003, we are further required toissue to the providers five-year warrants with an exercise price of $1.50 pershare in an amount equal to 4% of our fully diluted equity as of April 23,2003 (or, if the stated amount of the letter of credit is less than $5.0million, a pro rata portion of such 4%). The Loan Agreement also contains a default clause triggered by amaterial adverse change.

 

Based on the terms of the Loan Agreement, we haverecorded the outstanding borrowings under the $10.0 million term subline ($10.0million as of May 3, 2003) as long-term since the subline is payable inApril 2006.  Although the revolvingline of credit is scheduled to mature in April 2006, the outstandingborrowings under the $67.0 million revolving line of credit ($3.0 million as ofMay 3, 2003) have been classified as current based on the provisions ofEmerging Issues Task Force (“EITF”) Issue No. 95-22 since the Loan Agreementcontains provisions for blocked accounts with the Agent and also contains amaterial adverse change default provision.

 

The amount available to us under our borrowing formulafluctuates primarily with our level of inventory and the level of creditprovided by our suppliers. Additionally, availability is significantly affected by periodic changesin the advance rates against our eligible inventory, which fluctuate from monthto month (from a low of approximately 68% to a high of approximately 90%) andare subject to adjustment by the Agent based on third party appraisals of theliquidation value of our inventory. These appraisals are typically performed at least quarterly at therequest of the Agent and attempt to reflect the net cash that could be realizedby selling our inventory in a “going out of business” sale. The time of yearthat such a sale is assumed to take place is significant to the valuation andconsequently the resulting monthly advance rates can fluctuate substantially.For example, advance rates typically are lowest in the first half of the yearand begin to rise as the holiday season approaches. This increase in advancerates provides more availability as we begin to build our inventory levels tomeet holiday season demand.  As ofJune 16, 2003, the availability under the Loan Agreement was approximately$8.5 million, $3.5 million above the $5.0 million minimum excess availabilitycovenant. Management expects that the Company will continue to have sufficientavailability throughout the year based on its business plan and the borrowingformula under the Loan Agreement.

 

Stock Split

 

Effective onApril 22, 2003, our common shares were reverse split into one share forevery 15 shares outstanding.  The stated par value of the common shareswas not changed from its existing amount of $0.001 per share.  The numberof authorized shares of common stock remained at 75 million.  All shareand per share amounts have been restated to reflect the reverse stock split.

 

11

----

 

Bankruptcy Accounting

 

Since our Chapter 11bankruptcy filing, we have applied the provisions of Statement of Position(“SOP”) 90-7.  SOP 90-7 does notsignificantly change the application of accounting principles generallyaccepted in the United States of America; however, it does require that thefinancial statements for periods including and subsequent to the filing of athe Chapter 11 petition distinguish transactions and events that are directlyassociated with the reorganization from the ongoing operations of thebusiness.  Based on the provisions ofSOP 90-7, the Company is not eligible to apply fresh-start accounting.

 

Use of Estimates

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reportingperiod.  Actual results could differfrom those estimates.

 

Seasonality

 

Operating results for ourfirst quarter are generally not indicative of the results that may be expectedfor Fiscal 2003 because, in addition to the effects of our bankruptcy, we areprimarily a toy retailer and anticipate we will derive approximately 40% of ourrevenue from, and achieve all of our annual profitability, if any, in ourfourth quarter.

 

Vendor Incentives

 

For the thirteen weekperiod ended May 3, 2003, we had marketing and advertising expenses of$1.5 million, and no offsetting vendor incentives.

 

Revenue Recognition

 

Sales are generatedeither in our Retail segment or our Direct to customer segment.  ForRetail sales, sales are recorded when the customer takes possession of themerchandise and tenders payment.  For Direct to customer sales, sales arerecorded at the time the goods are received by the customer. Historically, damaged goods have not been significant. We permit returns solong as the goods are returned in saleable condition. Appropriate sales returnreserves are maintained and are estimated based on historical rates andadjusted for current conditions.

 

NOTE 4:  Reorganization Items, Net

 

Reorganization items, netrepresents amounts recognized and incurred as a direct result of our Chapter 11filing and emergence and are presented separately in our Consolidated Statementof Operations.  Such items consist ofthe following:

 
| **(in 000’s)**              |   | **Thirteen  weeks ended  May 3, 2003** |   |
|----------------------------------|--------|---------------------------------------------|--------|
|                             |   |                                        |   |
| Gain on discharge of liabilities |   | $                                           | 66,310 |   |
| Severance and retention expense  |   | (1,058                                      | )      |
| Gain on sale of leases           |   | 2,931                                       |   |
| Professional fees                |   | (5,102                                      | )      |
|                             |   | $                                           | 63,081 |   |

 

12

----

 

A summary of the activityrelated to the severance and retention reserve is as follows:

 
| **(in 000’s)**             |   |   | ** ** |
|---------------------------------|--------|--------|------------|
| Balance, February 1,  2003 |   | $      | 1,192      |   |
| Additional provision            |   | 1,058  |       |
| Cash payments                   |   | (955   | )          |
| Balance, May 3, 2003       |   | $      | 1,295      |   |

 

NOTE 5:  Per Share Data

 

Basic per share data iscomputed by dividing our loss available to common stockholders by the weightedaverage number of our common shares outstanding.  Diluted per share data is computed by dividing our net income orloss adjusted for costs associated with dilutive securities by the weightedaverage number of shares outstanding plus any potential dilution that couldoccur if securities or other contracts to issue common stock were exercised orconverted into common stock in each period unless the impact would beantidilutive.

 
|                                                                  |   | **Thirteen  weeks ended** | ** ** |
|-----------------------------------------------------------------------|--------|---------------------------|------------|
| **(in 000’s, except for share and per share data)**              |   | **May 3,  2003**     |       | **May 4,  2002** | ** ** |
|                                                                  |   |                      |       |   |   |
| Net income (loss)                                                     |   | $                         | 16,807     |   | $ | (17,176 | ) |
| Less:                                                                 |   |                      |       |   |   |
| Preferred stock accretion                                             |   | —                    |       | (90 | ) |
| Preferred stock dividends                                             |   | (55                       | )     | — |   |
| Beneficial conversion feature on Class I and Class  J Preferred Stock |   | (34,263                   | )          | — |   |
| Basic and diluted loss available to common  stockholders              |   | $                         | (17,511    | ) | $ | (17,266 | ) |
| Weighted average common shares, basic and diluted                     |   | 2,757,760                 |       | 1,364,245 |   |
| Loss per share, basic and diluted                                     |   | $                         | (6.35      | ) | $ | (12.66 | ) |

 

Certain of our securities were not included in thecomputation of diluted loss per share for the thirteen week periods because todo so would have been antidilutive for the periods presented.  Such securities include:

 
|                      |   | **Common  Stock Equivalents at** | ** ** |
|---------------------------|--------|----------------------------------|------------|
| **Securities**            |   | **May 3,  2003**            | ** ** | **May 4,  2002** | ** ** |
| Options                   |   | —                           |       | 312,727 |   |
| Class I  Preferred Stock  |   | 20,000,000                       |       | — |   |
| Class J  Preferred Stock  |   | 20,511                           |       | — |   |
| Warrants                  |   | 110,000                          |       | 37,933 |   |
| Junior  Convertible Notes |   | —                           |       | 228,438 |   |

 

Pursuant to our Plan of Reorganization all existingwarrants and options (other than 110,000 warrants issued or repriced incompromise of claims) were cancelled as of April 23, 2003.

 

NOTE 6:  Supplemental Disclosure of Cash Flow Information

 

Interest paid amounted to$1.7 million and $1.6 million for the thirteen weeks ended May 3, 2003,and May 4, 2002, respectively. Cash paid for income taxes was $59,000 and $25,000 for the thirteenweeks ended May 3, 2003, and May 4, 2002, respectively.

 

13

----

 

Changes in assets andliabilities which increased (decreased) cash provided by (used in) operatingactivities are as follows:

 
|                                                   |   | **Thirteen  weeks ended** | ** ** |
|--------------------------------------------------------|--------|---------------------------|------------|
| **(in 000’s)**                                    |   | **May 3,  2003**     |       | **May 4,  2002** | ** ** |
| Accounts and other receivables                         |   | $                         | 2,721      |   | $ | 5,697 |   |
| Merchandise inventories                                |   | 45,288                    |       | (8,117 | ) |
| Other current assets                                   |   | (3,574                    | )          | (4,391 | ) |
| Other noncurrent assets                                |   | (258                      | )          | (419 | ) |
| Accounts payable                                       |   | (3,609                    | )          | 4,699 |   |
| Accrued expenses                                       |   | 3,002                     |       | 690 |   |
| Accrued salaries and wages                             |   | 184                       |       | (5,337 | ) |
|                                                   |   | $                         | 43,754     |   | $ | (7,178 | ) |
|                                                   |   |                      |       |   |   |
| Non-cash  investing and financing activities:          |   |                      |       |   |   |
|                                                   |   |                      |       |   |   |
|                                                   |   | **Thirteen  weeks ended** | ** ** |
| **(in 000’s)**                                    |   | **May 3,  2003**     |       | **May 4,  2002** | ** ** |
| Conversion of Series B Preferred Stock to common stock |   | $                         | —     |   | $ | 188 |   |
| Conversion of Series E Preferred Stock to common stock |   | —                    |       | 11,919 |   |
| Conversion of Series F Preferred Stock to common stock |   | —                    |       | 3,996 |   |
| Conversion of Series G Preferred Stock to common stock |   | —                    |       | 5,500 |   |
| Conversion of Series H Preferred Stock to common stock |   | —                    |       | 20,000 |   |
| Conversion of Class J Preferred Stock to common stock  |   | 4,816                     |       | — |   |
| Preferred dividend accretion                           |   | —                    |       | 90 |   |
| Class I preferred dividends                            |   | 55                        |       | — |   |

 

NOTE7:  Stock-Based Compensation

 

We apply the provisions ofAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations to account for awards ofstock-based compensation granted to employees and directors.  Accordingly, compensationexpense is recorded for options awarded to employees and directors to theextent that the exercise prices are less than the fair market value of thecommon stock on the date of grant when the number of options and the exerciseprice are fixed.  The difference betweenthe fair value of the common stock and the exercise price of the stock optionis recorded as deferred compensation, which is charged to expense over thevesting period of the underlying stock option on a straight-line basis. In the periods reported, we have not issued any options with an exercise pricethat was less than the fair market value of the common stock on the date ofgrant.

 

We have adopted thedisclosure requirements of Statement of Financial Accounting Standards (“SFAS”)No. 123, “Accounting for Stock-Based Compensation.”  In accordancewith the provisions of SFAS No. 123, we apply APB Opinion No. 25 andrelated interpretations in accounting for our plans and do not recognizecompensation expense for our stock-based compensation plans based on the fairmarket value method prescribed by SFAS No. 123.  Based on theadditional disclosure requirements under SFAS No. 148, “Accounting forStock-Based Compensation – Transition and Disclosure,” the following table is areconciliation of net earnings and earnings per share had we adopted the fairvalue recognition provisions of SFAS No. 123.

 

14

----

 
|                                                                                                              |   | **Thirteen Weeks  Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|--------|---------------------------|------------|
| **(in 000’s except for per share data)**                                                                     |   | **May 3, 2003**      | ** ** | **May 4, 2002** | ** ** |
| Net  loss applicable to common stockholders, as reported                                                          |   | $                         | (17,511    | ) | $ | (17,266 | ) |
| Deduct:  Total stock-based employee compensation expense determined under fair-value  based method for all awards |   | —                    |       | (67 | ) |
| Pro  forma net loss applicable to common stockholders                                                             |   | $                         | (17,511    | ) | (17,333 | ) |
| Basic  and diluted net loss per share:                                                                            |   |                      |       |   |   |
| As  reported                                                                                                      |   | $                         | (6.35      | ) | (12.66 | ) |
| Pro  forma                                                                                                        |   | $                         | (6.35      | ) | (12.71 | ) |
|                                                                                                                   |        |                           |            |  |  |  |  |

 

Uponemergence from bankruptcy, all of our then outstanding option awards werecancelled.

 

NOTE 8:  Stockholders’ Equity (Deficit)

 

Preferred Stock

 

In April 2003, we sold30,000 shares of our Class I Convertible Preferred Stock for gross proceeds of$30.0 million.  In addition, we issued500 shares of Class I Convertible Preferred Stock in April 2003 inconnection with the settlement of certain outstanding debt obligations.  Class I Convertible Preferred Stock carriesa cumulative dividend at a rate of 6% per annum payable semiannually onDecember 1 and June 1, with the first payment commencingDecember 1, 2003.  We have theoption through December 2005 to pay the dividends through the issuance ofadditional Class I Convertible Preferred Stock shares at conversion pricesbased on the market price of our common stock. The Class I Convertible Preferred Stock carries a liquidation preferenceof $1,000 per share plus all accrued and unpaid dividends.  The Class I Convertible Preferred Stock isconvertible into common stock at the rate of $1.50 per share, subject toadjustment.  We recorded cumulativedividends on the Class I Convertible Preferred Stock of $55,000 as ofMay 3, 2003.  We incurred costs of$779,000 in connection with the sale of the Class I Convertible PreferredStock.

 

In April 2003,  we issued 4,856 shares of Class JConvertible Preferred Stock in connection with the settlement of certainoutstanding debt obligations (4,542 shares issued in connection witht the Planof Reorganization for $4.5 million of Equipment Notes and 314 shares issuedfrom the exchange of $313,874 of new convertible Equipment Notes).  The Class J Convertible Preferred Stock hasterms similar to the Class I Convertible Preferred Stock except that the ClassJ Convertible Preferred Stock is convertible into common stock at the rate of$1.95 per share.  In April 2003,4,816 shares of the Class J Convertible Preferred Stock were converted into 2,469,473shares of common stock and the remainder was converted in May 2003.

 

Beneficial ConversionFeature

 

Generally acceptedaccounting principles require that we recognize the difference between the  negotiated conversion  price of an instrument  and the actual closing price of theunderlying common stock as a beneficial conversion feature and charge it to: a)a dividend in the case of an equity instrument; b) non-cash interest expense inthe case of a debt instrument; or c) non-cash compensation expense in the caseof an employee stock option grant. The interest and compensation  expense is to be amortized  over the period, or periods, prior to therelated instruments becoming freely convertible (in this instance, the debt is convertible at any time andtherefore the charge is immediate).  Inthe current period we recorded the following amounts as beneficial conversionfeatures:

 

15

----

 
| **(in  000’s)  Instrument** |   | **Beneficial  Conversion Feature  Amount** | ** ** |
|----------------------------------|--------|--------------------------------------------|------------|
| Class I Preferred Stock          |   | $                                          | 30,000     |   |
| Class J Preferred Stock          |   | 4,263                                      |       |
| Total Preferred Stock            |   | 34,263                                     |       |
| Convertible Equipment Notes      |   | 4,000                                      |       |
| Total                            |   | $                                          | 38,263     |   |

 

The Convertible EquipmentNotes with a principal amount of $4.0 million issued in connection with the Planof Reorganization include conversion rights for the holders to convert theoutstanding principal balance into Class J Preferred at a rate of $1,000 pershare.  As noted above the Class JPreferred is convertible into common stock at a rate of $1.95 per share.  Based on these terms a beneficial conversioncharge of $4.0 million was recorded as interest expense for the thirteen weeksended May 3, 2003.  During thethirteen weeks ended May 3, 2003, outstanding Convertible Equipment Notestotaling $313,784 have been converted into Class J Preferred and subsequentlyconverted into common stock.

 

NOTE9:  Income Taxes

 

TheCompany has incurred operating losses and generated a significant accumulateddeficit through May 3, 2003.  As aresult of the review undertaken for the year ended February 1, 2003, weconcluded that it was appropriate to establish a full valuation allowance forour net deferred tax assets.  For thethirteen weeks ended May 3, 2003, we continued to record a full valuationallowance.  The provision for incometaxes for the thirteen week periods ended May 3, 2003 and May 4, 2002is related to certain minimum state income and franchise taxes.

 

We have federal and statenet operating loss carryforwards at May 3, 2003.  These carryforwards will expire in fiscal years ending 2004through 2023.  Management believes thata change of control, as defined by the U.S. Internal Revenue Code, took placeon March 26, 2002 and April 23, 2003 in connection with theconversion of certain preferred stock to common stock and in connection withthe issuance of equity in accordance with the bankruptcy Plan ofReorganization, respectively.  Thechange of control has the effect of limiting the amount of net operating losscarryforwards that can be used in any one year, subject to limited carryforwardperiods.  In addition to the reductionor limitation of net operating loss carryforwards as a result of certainchanges in control, restructuring of certain debt pursuant to the bankruptcyPlan of Reorganization may cause a significant amount of net operating losscarryforwards to be eliminated.

 

NOTE 10:  New Accounting Pronouncements

 

In December 2002,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148 whichamends SFAS No. 123 to provide alternative methods of transition for avoluntary change to the fair value method of accounting for stock-basedemployee compensation.  In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements.  Certain of the disclosure modifications arerequired for fiscal years ending after December 15, 2002 and are includedin the notes to our consolidated financial statements.

 

In March 2003, theEITF reached a consensus on EITF No. 02-16, “Accounting by a Customer(Including a Reseller) for Certain Consideration Received from a Vendor.”  EITF No. 02-16 addresses the incomestatement classification of cash considerations received by a customer, includinga reseller, from a vendor and provides guidance regarding the timing ofrecognition of volume rebates.  We haveadopted EITF No. 02-16 as of January 1, 2003 and the adoption did not havea material effect on our financial position or results of operations.

 

In April 2003, theFASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities.”  SFAS No. 149amends and clarifies accounting for derivative

 

16

----

 

instruments, including certain derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133. SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 andfor hedging relationships designated after June 30, 2003. The guidance shouldbe applied prospectively. We do not expect the adoption of SFAS No. 149 to havea material effect on our financial position or results of operations.

 

In May 2003, theFASB issued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  SFAS No. 150 clarifies the accounting for certain financialinstruments with characteristics of both liabilities and equity and requiresthat those instruments be classified as liabilities in statements of financialposition. Previously, many of those financial instruments were classified asequity. SFAS No. 150 is effective for financial instruments entered into ormodified after May 31, 2003 and otherwise is effective at the beginning ofthe first interim period beginning after June 15, 2003. We do not expectthe adoption of SFAS No. 150 to have a material effect on our financialposition or results of operations.

 

NOTE 11:  Segment Information

 

At May 3, 2003, andMay 4, 2002, we operated in two reportable segments: Direct to customer,which includes online and catalog operations, and Retail, which includesactivities related to our retail stores.

 

The accounting policiesof the segments are the same as those described in the summary of significantaccounting policies.  We evaluateperformance based on profit or loss from operations before income taxes.

 

We allocate costs forcertain services provided by the Retail segment to the Direct to customersegment.

 

Our reportable segmentshave operations that offer the same or similar products but have a differentmethod of delivery to their customers.

 

Segment information forthe thirteen weeks ended May 3, 2003, is as follows:

 
| **(in  000’s)**                  |   | **Direct to customer** | ** ** | **Retail** | ** ** | **Total** | ** ** |
|---------------------------------------|--------|------------------------|------------|------------|------------|-----------|------------|
| Net sales                             |   | $                      | 2,858      |       | $          | 69,958    |       | $ | 72,816 |   |
| Interest expense, net (2)             |   | 58                     |       | 5,703      |       | 5,761     |       |
| Depreciation and amortization expense |   | 77                     |       | 2,427      |       | 2,504     |       |
| Income before income taxes (1)        |   | 2,308                  |       | 14,550     |       | 16,858    |       |
| Total assets                          |   | 8,124                  |       | 98,559     |       | 106,683   |       |
| Fixed asset additions                 |   | —                 |       | 301        |       | 301       |       |
|                                       |        |                        |            |            |            |           |            |  |  |  |

 

----

(1)          Income before income taxes includes reorganization items totaling $63.1million recorded in relation to our emergence from bankruptcy.  Direct to customer and Retail operationswere allocated $3.0 million and $60.1 million, respectively.  The $63.1 million consists primarily of again on discharge of liabilities of $66.3 million, net of other reorganizationitems (see Note 4).

 

(2)          Interest expense, net includes a beneficial conversion charge of $4.0million.  The $4.0 million was allocatedentirely to Retail operations.

 

Segmentinformation for the thirteen weeks ended May 4, 2002 is as follows:

 
| **(in  000’s)**                  |   | **Direct to customer** | ** ** | **Retail** | ** ** | **Total** | ** ** |
|---------------------------------------|--------|------------------------|------------|------------|------------|-----------|------------|
| Net sales                             |   | $                      | 2,953      |       | $          | 84,903    |       | $ | 87,856 |   |
| Interest expense, net                 |   | 6                      |       | 2,109      |       | 2,115     |       |
| Depreciation and amortization expense |   | 24                     |       | 1,465      |       | 1,489     |       |
| Income (loss) before income taxes     |   | 171                    |       | (17,277    | )          | (17,106   | )          |
| Total assets                          |   | 808                    |       | 188,212    |       | 189,020   |       |
| Fixed asset additions                 |   | —                 |       | (780       | )          | (780      | )          |
|                                       |        |                        |            |            |            |           |            |  |  |  |

 

17

----

 

 

NOTE 12:  Related Party Transactions

 

We have a note receivable of $0.5 million fromour Chief Executive Officer.  The notereceivable bears interest, payable upon maturity, at the same interest ratethat the Company incurs under its primary bank loan agreement.  The note is collateralized by options topurchase shares of our common stock (if and when such options are issued) andproceeds from a split-dollar life insurance policy with respect to the officerand is due on the earlier of July 3, 2004, termination of employment orupon death.  This note receivable,including interest receivable of $25,000, is included in other non-currentassets in the Consolidated Balance Sheet as of May 3, 2003.

 

On April 23, 2003,our director Richard Kayne, Fred Kayne, chairman of our board of directors, andtheir affiliates purchased Class I Convertible Preferred Stock convertible into9,266,667 shares of our common stock.

 

We compromised $8.5million in Equipment Notes and accrued interest held by Richard Kayne, FredKayne and Kayne Anderson Investment Management, Inc. in exchange for (i) newconvertible Equipment Notes payable January 11, 2004 in the amount of $4.0million (of which $313,874 was converted at $1.95 per common share into 160,959shares of common stock as of May 3, 2003 and $3.7 million are outstandingas of that date), provided certain payments to our pre-bankruptcy unsecuredcreditors have been made, (ii) 4,542 shares of our Class J ConvertiblePreferred Stock convertible into 2,329,025 shares of our common stock(converted to common stock in April and May 2003), (iii) warrants topurchase 66,667 shares of our common stock with an exercise price equal to$1.95 per share and (iv) repricing of previously issued warrants to purchase43,333 shares of our common stock with an exercise price equal to $1.95 pershare after the repricing   We alsocompromised approximately $17.4 million in old Subsidiary Subordinated Notesheld by affiliates of Royal Vendex KBB, a beneficial owner of more than 10% ofour outstanding common stock, in exchange for new Subsidiary Subordinated Notesin the aggregate principal amount of $9.9 million payable inDecember 2006, 2007 and 2008, $0.5 million in cash payable onJanuary 11, 2004 and 500 shares of our Class I Convertible Preferred Stockconvertible into 333,333 shares of our common stock.

 

NOTE 13:  Other Developments

 

Contingencies

 

We are a party to variouslegal actions arising in the ordinary course of business.  We believe that the ultimate outcome ofthese matters will not have a material adverse effect on our financial positionor results of operations.

 

Prior to our bankruptcyfiling we negotiated a settlement of a suit with Oxygen Media, LLC (“Oxygen”)regarding a disputed term sheet in which Oxygen alleged we and our formersubsidiary, RightStart.com, owed Oxygen for advertising services.  The parties each had alleged fraud wascommitted by the other party as well as various contract claims anddefenses.  By October 2002, most ofthe discovery had been completed and the parties reached a tentative agreement.  But before the settlement agreement wasfinalized and executed, we filed for bankruptcy protection under Chapter11.  The settlement amount wasconfidential but immaterial to our business. Oxygen has filed a claim in our Chapter 11 proceedings for $20.0 millionwhich we have disputed as unliquidated. Management does not believe this claim will result in a material adverseeffect to our business or operations, financial position or results ofoperations.

 

OnFebruary 19, 2003, Edward Steele filed a class action claim against ourdirectors Jerry R. Welch, Fred Kayne and Richard Kayne in United StatesDistrict Court for the Eastern District of Pennsylvania claiming violations ofSections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5promulgated thereunder based on alleged misrepresentations made by thedefendants.  Mr. Steele has filed aproof of claim on behalf of himself and others for $50.0 million in ourbankruptcy case.  On April 3, 2003,

 

18

----

 

another case was filed in the same court, making the same claimsagainst the same defendants.  The twocases have been consolidated.  We havenot been named as a defendant nor has there been any claim made for indemnitythough the defendants did file proofs of claim on our indemnificationobligations set forth in our articles and bylaws.   Our directors and officers insurance carrier has acknowledgedcoverage with a reservation of claims, counsel has been retained and an amendedconsolidated complaint is currently required to be filed by July 14,2003.  Management currently does notbelieve this claim will result in a material adverse effect to our business oroperations, financial position or results of operations, however, the amended complaintmay raise new issues that could have such an effect or management’s initialevaluation may prove inaccurate.

 

During our Chapter 11 proceedings most litigationagainst us was stayed other than proceedings before the Bankruptcy Court.  Absent further order of the BankruptcyCourt, substantially all of our pre-petition liabilities are subject tosettlement under our plan of reorganization. In addition to the matters outlined, there are numerous other matters filedwith the Bankruptcy Court in our reorganization proceedings by creditors,landlords or other third parties related to our business operations or theconduct of our reorganization activities. Management currently believes none of these matters will have a materialadverse effect on our financial position or results of operations, however,management’s initial evaluation may prove inaccurate.

 

NOTE 14:  Subsequent Events

 

We have sold an additional 1,600 shares of our Class IConvertible Preferred Stock to four investors for gross proceeds of $1.6million since our emergence from bankruptcy. These shares are convertible at the option of the holder into anaggregate of 1,066,667 shares of our common stock.  We will record an additional $1.6 million beneficial conversionfeature charge in the second quarter of Fiscal 2003.

 

19

----

 

ITEM2.

MANAGEMENT’S DISCUSSIONAND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-LookingStatements

 

This report contains“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the SecuritiesExchange Act of 1934, as amended. The forward-looking statements in thisQuarterly Report are intended to be subject to the safe harbor protectionprovided by Sections 27A and 21E. These forward-looking statements are based onour current expectations, assumptions, estimates and projections about ourcompany and our industry.  When used inthis report, the words “believes,” “anticipates,” “intends,” “expects” andsimilar expressions are intended to identify such forward-looking statementswith respect to our financial condition, results of operations andbusiness.  You will find theseforward-looking statements at various places throughout this report and thedocuments incorporated by reference, including amendments.  These forward-looking statements involverisks, uncertainties and assumptions. Actual results may differ materially from those expressed in theseforward-looking statements. You are cautioned not to unduly rely on anyforward-looking statements. We undertake no obligation to publicly release anyrevisions to these forward-looking statements to reflect events orcircumstances after that date.  Furtherinformation on potential factors that could materially affect our financialcondition is included elsewhere in our Annual Report on Form 10-K underthe heading “Risks” and in our filings with the Securities and ExchangeCommission.

 

Overview

 

Part I, Item 2 of thisreport should be read in conjunction with Part II, Item 7 of our Annual Reporton Form 10-K for the year ended February 1, 2003. The informationcontained herein is not a comprehensive discussion and analysis of ourfinancial condition and results of operations, but rather updates disclosuresmade in the earlier filing.

 

FAO, Inc. (formerly knownas The Right Start, Inc., and referred to herein as “FAO,” “we,” “us,” “our,”the “Company” and similar designations) operates 142 go forward retail stores(89 Zany Brainy stores, 38 Right Start stores, and 15 FAO Schwarz stores) in 29states throughout the United States as of June 16, 2003, as well as 14additional stores that we closed or are closing but operated during thequarter.  We operated 256 retail storesas of May 4, 2002.  The stores’product mix includes a wide variety of items to meet the needs of infants,small children and their care givers and children through age 12 presented inthree distinct formats identified by the brands FAO Schwarz, The Right Startand Zany Brainy.

 

On January 13, 2003(the “Petition Date”), we, together with our significant subsidiaries, filedfor protection under Chapter 11 of the United States Bankruptcy Code in theUnited States Bankruptcy Court for the District of Delaware in case number 03-10119(LK).   During the pendency of the Chapter 11cases, we and our subsidiaries continued to operate our businesses asdebtors-in-possession under the jurisdiction of the Bankruptcy Court and inaccordance with the applicable provisions of the Bankruptcy Code and orders ofthe Bankruptcy Court.  Our First AmendedDisclosure Statement with Respect to First Amended Joint Plan of Reorganizationof FAO, Inc. and its Debtor Subsidiaries was approved by the Bankruptcy Courton February 28, 2003.  Our FirstAmended Joint Plan of Reorganization of FAO, Inc. and its Debtor Subsidiaries(“Plan of Reorganization”) was confirmed by the Bankruptcy Court onApril 4, 2003, and became effective when we emerged from bankruptcy onApril 23, 2003 (the “Effective Date”).  In addition, we sold 30,000 shares of our Class IConvertible Preferred Stock, convertible at $1.50 per common share, for grossproceeds of $30.0 million and replaced our former revolving credit facilitywith the Loan Agreement which provides up to $77.0 million in aggregateborrowing capacity.

 

Effective on April 22,2003, common shares of the Company were reverse split into one share for every15 shares outstanding.  All share and per share amounts have been restatedto reflect the reverse stock split.

 

20

----

 

Pursuant to our Plan ofReorganization, we:

 

•                  repaid our prior senior securedlenders the full amount of their claims;

 

•                  compromised $8.5 million in EquipmentNotes and accrued interest in exchange for (i) new convertible Equipment Notespayable January 11, 2004 in the amount of $4.0 million (of which $313,874was converted at $1.95 per common share into 160,959 shares of  common stock as of May 3, 2003 and $3.7million are outstanding as of that date), provided certain payments to ourpre-bankruptcy unsecured creditors have been made, (ii) 4,542 shares of ourClass J Convertible Preferred Stock convertible into 2,329,025 shares of ourcommon stock (converted to common stock in April and May 2003), (iii)warrants to purchase 66,667 shares of our common stock with an exercise priceequal to $1.95 per share and (iv) repricing of previously issued warrants topurchase 43,333 shares of our common stock with an exercise price equal to$1.95 per share after the repricing;

 

•                  compromised approximately $17.4million in old Subsidiary Subordinated Notes in exchange for (i) new SubsidiarySubordinated Notes in the aggregate principal amount of $9.9 million payableratably in three annual installments in December 2006, 2007 and 2008, (ii)$0.5 million in cash payable on January 11, 2004 and (iii) 500 shares ofour Class I Convertible Preferred Stock convertible into 333,333 shares of ourcommon stock;

 

•                  retained a note secured by equipmentin the aggregate outstanding principal amount of approximately $1.1 million;

 

•                  compromised smaller claims to aconvenience amount of $100 or to the full amount of the claim, whichever isless; and

 

•                  compromised our remaining unsecuredclaims depending on the individual choices of our unsecured creditors to: (i)38% of the allowed amount of the claim, payable as follows: 5% on the effectivedate of our Plan of Reorganization, 11% on December 22, 2003, 15% onDecember 22, 2004, and 7% on December 22, 2005; (ii) 21% of the allowedamount of the claim, payable as follows: 7% on the effective date of our Planof Reorganization, and 14% on December 22, 2003; or (iii) 35% of theallowed amount of the claim with cash payments representing 28% payable asfollows: 5% on the Effective Date, 8% on December 22, 2003, 9% onDecember 22, 2004, and 6% on December 22, 2005 and payment of equityfor the remaining 7%.  The holders ofunsecured claims received approximately 95,262 shares of our common stock. Aportion of the cash payments due, in each case, in December 2003 may bedeferred if we do not meet certain borrowing availability conditions in theLoan Agreement.

 

21

----

 

Thefollowing tables set forth the statement of operations data for the thirteenweeks ended May 3, 2003 and May 4, 2002:

 
|                                  |   | **Thirteen Weeks Ended** | ** ** |
|---------------------------------------|--------|--------------------------|------------|
| **(in 000’s)**                   |   | **May 3,  2003**    | ** ** | **May 4, 2002** | ** ** |
| Retail net sales                      |   | $                        | 69,804     |   | 95.9 | % | $ | 84,903 |   | 96.6 | % |
| Direct-to-customer net sales          |   | 2,393                    |       | 3.3 | % | 2,448 |   | 2.8 | % |
| Shipping and handling revenues        |   | 619                      |       | 0.8 | % | 505 |   | 0.6 | % |
| Net Sales                             |   | 72,816                   |       | 100.0 | % | 87,856 |   | 100.0 | % |
| Cost of goods sold                    |   | 66,787                   |       | 91.7 | % | 51,871 |   | 59.0 | % |
| Cost of shipping and handling         |   | 727                      |       | 1.0 | % | 612 |   | 0.7 | % |
| Gross profit                          |   | 5,302                    |       | 7.3 | % | 35,373 |   | 40.3 | % |
| Operating expense                     |   | 19,601                   |       | 26.9 | % | 20,026 |   | 22.8 | % |
| Occupancy expense                     |   | 16,177                   |       | 22.2 | % | 20,386 |   | 23.2 | % |
| Marketing and advertising expense     |   | 1,501                    |       | 2.1 | % | 1,815 |   | 2.1 | % |
| General and administrative expenses   |   | 4,645                    |       | 6.4 | % | 6,648 |   | 7.5 | % |
| Depreciation and amortization expense |   | 2,504                    |       | 3.4 | % | 1,489 |   | 1.7 | % |
| Store closing costs                   |   | 1,336                    |       | 1.8 | % | — |   | 0.0 | % |
|                                  |   | 45,764                   |       | 62.8 | % | 50,364 |   | 57.3 | % |
| Operating loss                        |   | (40,462                  | )          | (55.5 | )% | (14,991 | ) | (17.0 | )% |
|                                  |   |                     |       |   |   |   |   |   |   |
| Reorganization items, net             |   | 63,081                   |       | 86.6 | % | — |   | 0.0 | % |
| Interest expense, net                 |   | (5,761                   | )          | (7.9 | )% | (2,115 | ) | (2.4 | )% |
| Income (loss) before income taxes     |   | 16,858                   |       | 23.2 | % | (17,106 | ) | (19.4 | )% |
| Income tax provision                  |   | 51                       |       | 0.1 | % | 70 |   | 0.1 | % |
| Net income (loss)                     |   | $                        | 16,807     |   | 23.1 | % | $ | (17,176 | ) | (19.5 | )% |
| # of stores open at end of period     |   | 156                      |       |   |   | 256 |   |   |   |

 

Thirteen Weeks Ended May3, 2003 Compared With May 4, 2002

 

*Retailnet sales.*  Retail net sales for the thirteen weekperiod ended May 3, 2003 decreased $15.1 million, or 17.8%, compared tothe thirteen week period ended May 4, 2002.  Same store sales, defined as sales attributed to 141 of our 142go forward stores that have been open for at least 14 full fiscal months,decreased 16.7% from $54.2 million to $45.2 million in the thirteen weeks endedMay 3, 2003 compared to the thirteen weeks ended May 4, 2002.  Sales not attributable to same store salesamounted to $24.6 million in the thirteen weeks ended May 3, 2003 of which$0.9 million relates to a new store opened during the thirteen weeks endedMay 4, 2002 and $23.7 million related to stores that have closed or arecurrently in the process of closing. Management believes that same store sales were negatively impactedprimarily by poor in-stock conditions due to significantly reduced inventoryreceipts during the bankruptcy along with some cannibalization of sales by ourclosing store liquidations and a generally sluggish retail environment.  The retail environment was further impactedby global political uncertainty, and adverse weather conditions, includingsevere winter weather in February and a delay in the onset of Springweather in much of the United States compared to last year.  Conversely, during the bankruptcy, we tookthe opportunity to clear a substantial amount of discontinued merchandise inour go-forward stores that generated approximately 30% of total sales in the goforward stores, selling at discounts averaging 70% off retail price.  The clearance sales ended on April 30,2003, however, same store sales in the go forward stores remain below averagetrends as compared to the thirteen weeks ended May 3, 2003.  We cannot assure you that our salesdecreased solely due to lower in stock levels or that sales will increase as weimprove our stock levels.  Other factorsthat may have caused reduced sales are customer perceptions of the quality ofour services or goods as a result of our clearance and cost-cutting efforts andfactors discussed in our Annual Report on Form 10-K.  We cannot assure you that these factors have been overcome.

 

*Cost ofgoods sold.*  Cost of goods sold consists primarilyof the cost of products sold, inbound freight costs, inventory shrinkage costs,and costs related to the distribution and warehousing of our retailmerchandise.  Retail gross margindecreased in the thirteen week period ended May 3, 2003 to 7.3% from

 

22

----

 

40.3% in the thirteen week period ended May 4, 2002.  The decrease is primarily attributable tothe liquidation sales in the closing stores and the impact of the clearancesales in the go forward stores.  Grossmargins in the closed and closing stores during the quarter were a negative16%, as a result of writing down the remaining closing store inventories to netrealizable value.  Go forward storegross margins since the end of the clearance sale have been averaging in the lowto mid 40% range.

 

*Operatingexpense.*   Operating expense consists ofstore operational expenses, retail personnel costs and store pre-openingcosts.  Operating expense was$19.6 million in the thirteen week period ended May 3, 2003 comparedto $20.0 million for the thirteen week period ended May 4, 2002.  The decrease of $0.4 million was dueprimarily to lower operating expenses related to the 100 stores closed duringthe current period offset by additional costs associated with the liquidationof these closed stores incurred as a result of fees and expenses from theemployment of a third party liquidation service.  Pre-opening costs were $0.1 million for the thirteen weeks endedMay 4, 2002.  There were nopre-opening costs for the thirteen weeks ended May 3, 2003.  Go forward stores operating expense remainedrelatively flat at approximately $9.7 million for the thirteen week periodsended May 3, 2003 and May 4, 2002. Operating expense as a percentage of sales was higher in the currentperiod due to lower sales volume for the go forward stores.

 

*Occupancyexpense.*   Occupancy expense consistsprimarily of rent, real estate taxes, common area maintenance and othermiscellaneous expenses.  Occupancyexpense was $16.2 million for the thirteen week period ended May 3, 2003,a decrease of $4.2 million compared to the thirteen week period endedMay 4, 2002.  This decrease isprimarily attributable to the 100 stores closed since the end of the firstquarter of Fiscal 2002.  Occupancyexpense on the comparable 141 go forward stores was down $0.4 million due toreduced rents resulting from negotiations during the bankruptcy.

 

*Marketingand advertising expense.*   Retail marketingand advertising expense generally consists of print advertising in national andregional publications, as well as promotional mailings to our customers.  Marketing and advertising expense remainedconsistent as a percentage of retail sales comparing the thirteen week periodsended May 3, 2003 and May 4, 2002. Marketing and advertising expense for the current period consists of$0.5 million related to liquidation sale advertising for the closed stores and$1.0 million related to go forward stores clearance sale advertising during thebankruptcy and normal advertising promotions.

 

*Generaland administrative expense.*   General andadministrative expense consists primarily of the costs related to management,financial, merchandising, inventory management, professional service fees andother administrative support.  Generaland administrative expense decreased $2.0 million, or 30.1%, to $4.6 million inthe thirteen week period ended May 3, 2003 compared to $6.6 millionin the thirteen week period ended May 4, 2002.  This change is primarily attributable to the consolidation of operations across all threebrands in the fiscal year ended February 1, 2003 (“Fiscal 2002”) as wellas administrative staff reductions which occurred in the last quarter of Fiscal2002, which resulted in decreases of $0.9 million and $1.1 million,respectively.

 

*Depreciationand amortization expense.*   Depreciation andamortization expense during the thirteen week period ended May 3, 2003 was$2.5 million ($1.0 million on the go forward stores, $0.5 million on thecorporate offices and warehouses and $1.0 million on the closed stores andclosed warehouses), an increase of $1.0 million, compared to the thirteen weekperiod ended May 4, 2002.  Theincrease is primarily attributable to the acceleration of depreciation due tostore closures associated with the bankruptcy, the addition of Right Startshops within the Zany Brainy stores, the additional depreciation related to ournew west coast distribution center and the conversion of Right Start and FAOSchwarz point-of-sale and merchandising systems.

 

*Storeclosing costs. *Storeclosing costs consist primarily of costs associated with the retention of athird party liquidation service to manage the store closings.  For the thirteen week period endedMay 3, 2003, store closing costs were $1.3 million.

 

*Reorganizationitems, net.*   Reorganization items, net of$63.1 million in the thirteen week period ended May 3, 2003 consist of the$66.3 million gain recorded in connection with the compromise of

 

23

----

 

liabilities, a $2.9 million gain on the sale of certain leases offsetpartially by employee severance and professional fees.  These items were incurred as a result of theChapter 11 proceedings.  See Note 4 inthe footnotes to the Consolidated Financial Statements.

 

*Interestexpense, net.*   Interest expense, net,increased $3.6 million to $5.8 million for the thirteen week period endedMay 3, 2003 compared to $2.1 million for the thirteen week period endedMay 4, 2002.  The increase isprimarily due to the beneficial conversion feature of $4.0 million recorded inconnection with the new convertible Equipment Notes offset partially by adecrease in interest expense related to the line of credit due to a slightlylower outstanding balance in the current period compared to the comparativeprior year period.

 

*Taxprovision.*  Provisionfor income taxes is related to certain minimum state income and franchise taxesfor both of the thirteen week periods ended May 3, 2003 and May 4,2002.

 

Liquidity and Capital Resources

 

We are primarily atoy retailer and expect to derive approximately 40% of our revenue during ourfourth quarter.  Historically, we haveincurred losses, though we expect to generate sufficient operating income inthe fourth quarter to offset actual and expected operating losses from thefirst three quarters of the year ending January 1, 2004 (“Fiscal 2003”).We believe that our current cash on hand at June 12, 2003, cash flow fromoperations and anticipated availability from the $77.0 million Loan andSecurity Agreement (the “Loan Agreement”) with Fleet Retail Finance, Inc., asagent (the “Agent”) under which we are co-borrowers with our subsidiaries ZBCompany, Inc. and FAO Schwarz, Inc. will allow us to maintain ouroperations and fund working capital and capital expenditures for the next 12months. Our needs for additional funding will depend upon several factors,including, but not limited to, generating sufficient cash flow from operations,the expenses or income from incorporating the Saks Boutiques into ouroperations and our dependence on independent manufacturers and suppliers andtheir credit terms in order to maintain adequate inventory in-stock levels. Ifadditional capital is required to grow our business or execute our businessplan, we may seek to raise additional equity or incur additional debt. Therecan be no assurance given that adequate funds will be available to us onacceptable terms or at all.

 

The Loan Agreementmatures April 22, 2006 and consists of (i) a standard revolving lineof credit of up to $67.0 million under which borrowings bear interest, atour election, at an initial rate of 2.25% over the Agent’s calculatedEurodollar Rate or 0.25% over a base rate designated by Fleet National Bank(the "Bank") from time to time, and (ii) an additional special termsubline of $10.0 million under which borrowings bear interest at a rate of15.5% per annum for the first year and thereafter at a rate of 11.25% over thebase rate designated by the Bank.  TheLoan Agreement allows us to borrow 85% of credit card receivables, plus,(A) so long as the special term subline remains outstanding, up to 95% ofthe current appraised liquidation value of our eligible inventory fromNovember 1 through August 14 and 102.5% of current appraisedliquidation value of our eligible inventory from August 15 throughOctober 31, and (B) when the special term subline is no longer ineffect, 85% of the current appraised liquidation value of our eligibleinventory, less reserves established by the Agent from time to time in itsreasonable discretion for such items as a portion of outstanding giftcertificates and merchandise credits, royalty obligations, two months rent oncertain store leases which we have not received collateral access agreementswhich are acceptable to the landlord and the Agent and an availability block(initially set at $4.0 million which decreases between September 7, 2003and September 30, 2003 to $1.5 million and between October 1, 2003and October 31, 2003 to $0.5 million). Eligible inventory consists of inventory in which the Agent has a prior,perfected security interest less certain ineligible items. The Loan Agreementcontains one financial operating covenant. This covenant requires that wemaintain minimum excess availability under the Loan Agreement of $5.0 millionat all times. In order to meet this covenant, we are permitted to supplementour availability under the Loan Agreement through letters of credit.  In connection with the issuance of our ClassI Convertible Preferred Stock, we have a commitment from certain of thepurchasers to provide a letter of credit with a stated amount of up to $5.0million beginning any time after June 1, 2003. The letter of credit, ifissued, will expire no later than November 30, 2003, and is to expireundrawn by such expiration date, so long as we are not in default under theLoan Agreement or would not be in default under the Loan Agreement once the

 

24

----

 

letter of credit is returned.  If the letter of credit is issued we arerequired to issue to the providers five-year warrants with an exercise price of$1.50 per share in an amount equal to 3% of our fully-diluted equity as ofApril 23, 2003 (or, if the stated amount of the letter of credit is lessthan $5.0 million, a pro rata portion of such 3%), and, if the letter of creditis drawn, we are required to issue to the providers one-year notes in anaggregate principal amount equal to the stated amount of the letter of creditsecured by our equipment and bearing interest at a rate of 10% per annum, andif such notes have not been repaid by November 30, 2003, we are furtherrequired to issue to the providers five-year warrants with an exercise price of$1.50 per share in an amount equal to 4% of our fully diluted equity as of April 23,2003 (or, if the stated amount of the letter of credit is less than $5.0million, a pro rata portion of such 4%). The Loan Agreement also contains a default clause triggered by amaterial adverse change.

 

The amount available to us under our borrowing formulafluctuates primarily with our level of inventory and the level of creditprovided by our suppliers. Additionally, availability is significantly affected by periodic changesin the advance rates against our eligible inventory, which fluctuate from monthto month (from a low of approximately 68% to a high of approximately 90%) andare subject to adjustment by the Agent based on third party appraisals of theliquidation value of our inventory. These appraisals are typically performed at least quarterly at therequest of the Agent and attempt to reflect the net cash that could be realizedby selling our inventory in a “going out of business” sale. The time of yearthat such a sale is assumed to take place is significant to the valuation andconsequently the resulting monthly advance rates can fluctuate substantially.For example, advance rates typically are lowest in the first half of the yearand begin to rise as the holiday season approaches. This increase in advancerates provides more availability as we begin to build our inventory levels tomeet holiday season demand.  As ofJune 16, 2003, the availability under the Loan Agreement was approximately$8.5 million, $3.5 million above the $5.0 million minimum excess availabilitycovenant. Management expects that the Company will continue to have sufficientavailability throughout the year based on its business plan and the borrowingformula under the Loan Agreement.

 

In connectionwith our emergence from bankruptcy, we sold 30,000 shares of our Class I ConvertiblePreferred Stock, convertible at $1.50 per common share, for gross proceeds of$30.0 million as of the Effective Date, and an additional 1,600 shares for $1.6million in gross proceeds since the Effective Date, and replaced our formerrevolving credit facility with the Loan Agreement which provides up to $77.0million in aggregate borrowing capacity.

 

For the first thirteen weeksof Fiscal 2003,  $0.9 million in cashwas provided by our operating activities compared to $22.3 million used inoperating activities for the same thirteen week period of Fiscal 2002. Cash provided by operating activities in the first three months of Fiscal 2003was primarily from the liquidation and clearance of inventory offset bybankruptcy related expenses.

 

Cash provided byinvesting activities for the first thirteen weeks of Fiscal 2003 was $0.2million, resulting from the sale of closing stores’ property, fixtures andequipment.  Cash used in investingactivities for the first thirteen weeks of Fiscal 2002 of $1.7 million wasprimarily related to the conversion of Right Start and FAO Schwarzpoint-of-sale and merchandising systems, completing the construction of theFarmer’s Market FAO Schwarz store in Los Angeles and costs associated with theFAO Schwarz and Zany Brainy acquisitions.

 

Cash used in financingactivities for the first thirteen weeks of Fiscal 2003 was $24.6 million. The primary use of funds in financing activities for the Fiscal 2003 period wasthe payoff of the prior credit facility with the proceeds from issuance ofClass I Preferred Stock, from the Loan Agreement upon emergence from bankruptcyand from cash accumulating in the cash collateral account during ourbankruptcy.  In Fiscal 2003, we paid$1.5 million in financing costs for the Loan Agreement.  Cash provided byfinancing activities for the first thirteen weeks of Fiscal 2002 was $23.8million.  The primary source of fundsfrom financing activities for the Fiscal 2002 period were borrowings of $27.6 millionunder our former credit facility.  Thenet proceeds from certain Fiscal 2002 financing activities were primarily usedto fund our operations, complete the integration of our FAO, Right Start andZany Brainy operations,

 

25

----

 

pay $5.0 million in post-closing obligations in connectionwith the Zany Brainy Acquisition and satisfy the redemption of $3.0 million ofour Series A Mandatorily Redeemable Preferred Stock.

 

Pursuant to our Plan ofReorganization we paid and must pay the following amounts:

 

(i)                                     Anestimated $17.4 million to holders of unsecured claims; $4.4 million on theEffective Date, approximately $10.0 million on December 22, 2003,approximately $2.0 million on December 22, 2004 and approximately $1.0million on December 22, 2005.  In the event excess availability underthe Loan Agreement on December 18, 2003 is less than $37.0 million thenthe December 2003 payment obligation will be deferred untilDecember 22, 2004 pro rata, by the amount by which excess availability isless than $37.0 million; provided, however, in no event may theDecember 2003 payment to holders of unsecured claims be less than $1million.  In the event that excess availability under the Loan Agreementon December 18, 2004 is less than $40.0 million, then any deferredDecember 2003 payments to holders of unsecured claims will be deferreduntil December 22, 2005 pro rata, by the amount by which the excessavailability is less than $40.0 million; provided, however, in no event may theDecember 2004 payment to holders of unsecured claims be less than (i) theamounts due to unsecured creditors on December 22, 2004, plus (ii) $1.0million of the deferred December 2003 payments.  Any paymentsdeferred until December 22, 2005 shall be due and payable no later thanDecember 22, 2005 irrespective of excess availability under the LoanAgreement.  The deferrals will be applicable if, and only if, excessavailability under the Loan Agreement on December 18, 2003 is less than$37.0 million.

 

(ii)                                  $3.7million or the outstanding principal amount in payment of the new EquipmentNotes on the later of (a) January 11, 2004 or (b) the first business dayfollowing payment of all undisputed amounts due by the terms of our Plan ofReorganization to holders of unsecured claims through and includingDecember 22, 2003 provided such payments have not been deferred.

 

(iii)                               $0.5million on January 11, 2004 and $3.3 million on each of December 31,2006, 2007 and 2008 plus interest at a rate of 6% per annum through andincluding January 11, 2005, at which time the first interest payment shallbe made in cash with payments made quarterly thereafter, to the holders of thenew Subsidiary Subordinated Notes provided we are current with our payments toholders of the new convertible Equipment Notes and unsecured claims and suchpayments have not been deferred.

 

We are in the process ofcompleting the opening of Right Start stores within the four walls of ourexisting Zany Brainy stores (“RS Shops”). We expect to open an additional 26 RS Shops by the second quarter ofFiscal 2003 and have opened 59 as of February 1, 2003. The capital outlayfor a typical RS Shop averages approximately $25,000.  All 85 of the stores containing RS Shops will have new exteriorsignage and the typical capital outlay will be approximately $10,000 perstore.  In addition to the RS Shops, onApril 23, 2003, we entered into a Departmental License Agreement with SaksDepartment Store Group (consisting of Bergner’s, Boston Store, Carson PirieScott, Herberger’s, McRae’s, Parisian, Proffitt’s and Younkers)(“SaksBoutiques”) setting forth the terms of operation of 15 test departments in ninestores.   Under the terms of the Departmental License Agreement, wewill pay a license fee of the greater of 12% of net sales from the departmentor $35 per square foot per annum of licensed space plus our share of certainoperational, advertising and customer relations program costs.  The capital outlay for a typical SaksBoutique averages approximately $30,000 per test department.

 

26

----

 

*Critical Accounting Policies andEstimates*

 

Our consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States. These generally accepted accountingprinciples require management to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of net sales and expenses during the reporting period.

 

Our significantaccounting policies were described in Note 1 of “Notes to ConsolidatedFinancial Statements” contained in the Annual Report on Form 10-K as filed forthe fiscal year ended February 1, 2003.  We believe that thefollowing discussion addresses our critical accounting policies, which arethose that are most important to the portrayal of our financial condition andresults of operations and require management’s most difficult, subjective andcomplex judgments, often as a result of the need to make estimates about theeffect of matters that are inherently uncertain.  If actual results wereto differ significantly from estimates made, the reported results could bematerially affected.  We are not, however, currently aware of anyreasonably likely events or circumstances that would be reasonably likely toresult in materially different results.

 

We believe that thefollowing represents the areas where the most critical estimates andassumptions are used in the preparation of the financial statements.

 

Merchandise inventories:Merchandise inventories consist of finished goods purchased for resale and arestated at the lower of cost or market value. Cost is determined on a weightedaverage basis. A periodic review of inventory levels and inventory turns isperformed in order to determine if inventory is properly positioned at thelower of cost or market.  Factors relating to current inventories such asfuture customer demand, current analysis of merchandise based on receipt dateand current and anticipated retail markdowns are analyzed to determineestimated net realizable values.  Criteria we used to quantify agingtrends include merchandise received within the past 12 months, merchandisereceived more than 6 months before with quantities on-hand in excess of 26weeks of sales and merchandise selling below cost.  A provision isrecorded to reduce the cost of inventories to the estimated net realizablevalues, if required.  Inventories as of May 3, 2003 andFebruary 1, 2003 totaled $57.8 million and $103.1 million, respectively,representing 54.2% and 58.7% of total assets, respectively.  Given thesignificance of inventories to our consolidated financial statements, thedetermination of net realizable values is considered to be a criticalaccounting estimate.  Any significant unanticipated changes in the factorsnoted above could have a significant impact on the value of our inventories andour reported operating results.

 

Long-lived assets: Weperiodically evaluate whether events and circumstances have occurred thatindicate the remaining estimated useful lives of long-lived assets may warrantrevision or that the remaining balance may not be recoverable. These long-livedassets are recorded at cost and are amortized using the straight-line method,which deducts equal amounts of costs over the lesser of the applicable storelease term or the estimated useful life of the asset.  Net property,fixtures and equipment as of May 3, 2003 and February 1, 2003 totaled$23.7 million and $26.4 million, respectively, representing 22.2% and 15.0% oftotal assets, respectively.  When factors indicate that an asset should beevaluated for possible impairment, we use an estimate of the asset’sundiscounted net cash flows over its remaining life in measuring whether theasset is recoverable.  If economic conditions are substantially differentfrom our expectations, the carrying value of our long-lived assets may becomeimpaired.  In the thirteen weeks ended May 3, 2003, we did not recordany write-downs of long-lived assets, compared to $7.1 million recorded inFiscal 2002.

 

Income taxes: We accountfor income taxes using an asset and liability approach under which deferred taxliabilities and assets are recognized for the expected future tax consequencesof net operating

 

27

----

 

loss carryforwards and temporary differences between the carryingamounts and the tax bases of assets and liabilities. A valuation allowance isestablished against deferred tax assets when it is more likely than not thatall, or some portion, of such deferred tax assets may not be realized.  Wemust assess the likelihood that our deferred tax assets will be recovered fromfuture taxable income.  As a result of the review undertaken for the yearended February 1, 2003, we concluded that it was appropriate to establisha full valuation allowance for our net deferred tax assets.  We expect tocontinue to record a full valuation allowance on future tax benefits until anappropriate level of profitability is sustained.  Until an appropriatelevel of profitability is reached, we do not expect to recognize anysignificant tax benefits in future results of operations.

 

Impact of Inflation

 

The impact of inflationon the results of operations has not been significant during our last threefiscal years.

 

Seasonality

 

Operating results for ourfirst quarter are generally not indicative of the results that may be expectedfor Fiscal 2003 because, in addition to the effects of our bankruptcy, we areprimarily a toy retailer and anticipate we will derive approximately 40% of ourrevenue from, and achieve any of our annual profitability in, our fourthquarter.

 

New AccountingRequirements

 

In December 2002,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure” which amends SFAS No. 123, “Accountingfor Stock-Based Compensation,” to provide alternative methods of transition fora voluntary change to the fair value method of accounting for stock-basedemployee compensation.  In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements.  Certain of the disclosure modifications arerequired for fiscal years ending after December 31, 2002 and are includedin the notes to our consolidated financial statements.

 

In March 2003, theEmerging Issues Task Force (“EITF”) reached a consensus on EITF No. 02-16,“Accounting by a Customer (Including a Reseller) for Certain ConsiderationReceived from a Vendor.”  EITF No. 02-16addresses the income statement classification of cash considerations receivedby a customer, including a reseller, from a vendor and provides guidanceregarding the timing of recognition of volume rebates.  We have adopted EITF No. 02-16 as ofJanuary 1, 2003 and the adoption did not have a material effect on ourfinancial position or results of operations.

 

In April 2003, theFASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities”. SFAS No. 149 amends and clarifies accounting forderivative instruments, including certain derivative instruments embedded inother contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 andfor hedging relationships designated after June 30, 2003. The guidanceshould be applied prospectively. We do not expect the adoption of SFAS No. 149to have a material effect on our financial position or results of operations.

 

In May 2003, theFASB issued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity”.  SFAS No. 150 clarifies the accounting for certain financialinstruments with characteristics of both liabilities and equity and requiresthat those instruments be classified as liabilities in statements of financialposition. Previously, many of those financial instruments were classified asequity.  SFAS No. 150 is effective forfinancial instruments entered into or modified after May 31, 2003 andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. We do not expect the adoption of SFAS No. 150 to havea material effect on our financial position or results of operations.

 

28

----

 

ITEM 3.                                                     QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

In the ordinary course ofoperations, we face no significant market risk from derivativeinstruments.  Our purchase of importedproducts subjects us to a minimal amount of foreign currency risk.  Foreign currency risk is that riskassociated with recurring transactions with foreign companies, such aspurchases of goods from foreign vendors. If the strength of foreign currencies increases compared to the UnitedStates dollar, the price of imported products could increase.  We have no commitments, however, for futurepurchases with foreign vendors and, additionally, we have the ability to sourcemany products domestically in the event of significant import price increases.

 

Part I, Item 3 of thisreport should be read in conjunction with Part II, Item 7A of our Annual Reporton Form 10-K for the year ended February 1, 2003.

 

See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Liquidity and Capital Resources” above for a discussion of our debtobligations, the interest rates of which are linked to the Agent’s EurodollarRate or Base Rate.  For every $1 millionin debt outstanding under the Loan Agreement, an increase of 0.25% in ourinterest rate would cost us an additional $2,500 of interest expense peryear.  We have not entered into anyderivative financial instruments to manage interest rate risk, currency risk orfor speculative purposes and we are currently not evaluating the future use ofthese instruments.

 

ITEM 4.                                                     CONTROLS AND PROCEDURES

 

We maintain “disclosurecontrols and procedures,” as such term is defined in Rules 13a-14 and 15d-14 ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”), that aredesigned to ensure that information required to be disclosed in our reports,pursuant to the Exchange Act, is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate, to allowtimely decisions regarding the required disclosures.  In designing andevaluating the disclosure controls and procedures, management has recognizedthat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurances of achieving the desired control objectives,and management necessarily was required to apply its judgment in evaluating thecost benefit relationship of possible controls and procedures.

 

Our Chief ExecutiveOfficer and Senior Vice President Finance (our principal executive officer andprincipal accounting officer, respectively) have evaluated the effectiveness ofour “disclosure controls and procedures” within 90 days of the filing date ofthis Quarterly Report on Form 10-Q.  Based on their evaluation, theprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures are effective.  There were nosignificant changes in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date the controls wereevaluated.

 

PART II – OTHER INFORMATION

 

Item 1.             Legal Proceedings

 

We are a party to variouslegal actions arising in the ordinary course of business.  Management currently believes none of thesematters will have a material adverse effect on our financial position orresults of operations, however, management’s initial evaluation may proveinaccurate.

 

Prior to our bankruptcyfiling we negotiated a settlement of a suit with Oxygen Media, LLC (“Oxygen”)regarding a disputed term sheet in which Oxygen alleged we and our formersubsidiary, RightStart.com, owed Oxygen for advertising services.  The parties each had alleged fraud wascommitted

 

29

----

 

by the other party as well as various contract claims anddefenses.  By October 2002, most ofthe discovery had been completed and the parties reached a tentativeagreement.  But before the settlementagreement was finalized and executed, we filed for bankruptcy protection underChapter 11.  The settlement amount wasconfidential but immaterial to our business. Oxygen has filed a claim in our Chapter 11 proceedings for $20.0 millionwhich we have disputed as unliquidated. Management does not believe this claim will result in a material adverseeffect to our business or operations, financial position or results ofoperations.

 

OnFebruary 19, 2003, Edward Steele filed a class action claim against ourdirectors Jerry R. Welch, Fred Kayne and Richard Kayne in United StatesDistrict Court for the Eastern District of Pennsylvania claiming violations ofSections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5promulgated thereunder based on alleged misrepresentations made by thedefendants.    Mr. Steele has filed aproof of claim on behalf of himself and others for $50.0 million in ourbankruptcy case.  On April 3, 2003,another case was filed in the same court, making the same claims against thesame defendants.  The two cases havebeen consolidated.  We have not beennamed as a defendant nor has there been any claim made for indemnity though thedefendants did file proofs of claim on our indemnification obligations setforth in our articles and bylaws.   Ourdirectors and officers insurance carrier has acknowledged coverage with areservation of claims, counsel has been retained and an amended consolidatedcomplaint is currently required to be filed by July 14, 2003.  Management currently does not believe thisclaim will result in a material adverse effect to our business or operations,financial position or results of operations, however, the amended complaint mayraise new issues that could have such an effect or management’s initialevaluation may prove inaccurate.

 

During our Chapter 11 proceedings most litigationagainst us was stayed other than proceedings before the Bankruptcy Court.  Absent further order of the BankruptcyCourt, substantially all of our pre-petition liabilities are subject to settlementunder our plan of reorganization.  Inaddition to the matters outlined, there are numerous other matters filed withthe Bankruptcy Court in our reorganization proceedings by creditors, landlordsor other third parties related to our business operations or the conduct of ourreorganization activities.  Managementcurrently believes none of these matters will have a material adverse effect onour financial position or results of operations, however, management’s initialevaluation may prove inaccurate.

 

Item 2.             Changes in Securities and Use ofProceeds

 

In connectionwith our emergence from bankruptcy, we sold 30,000 shares of our Class IConvertible Preferred Stock, convertible at $1.50 per common share, for grossproceeds of $30.0 million as of the Effective Date, and an additional 1,600 sharesfor $1.6 million in gross proceeds since the Effective Date, and replaced ourformer revolving credit facility with the Loan Agreement which provides up to$77.0 million in aggregate borrowing capacity.

 

Except for 500 shares, ourClass I Convertible Preferred Stock was sold under Section 4(2) of theSecurities Act of 1933.  The proceeds of this issuance were used to fundour emergence from bankruptcy.  Fivehundred shares of the Class I Convertible Preferred Stock, convertible into333,333 shares of our common stock, were issued on the Effective Date incompromise of claims pursuant to Section 1145(a) of the Bankruptcy Code. Holders of 20,166,667 shares of common stock to be issued on conversion of theClass I Convertible Preferred Stock and certain holders of common stock issuedprior to our bankruptcy filing who had registration rights prior to suchfiling, have registration rights with respect to such common stock.  The Class I ConvertiblePreferred Stock is senior on liquidation, dissolution or winding up and in thepayment of dividends to our common stock. Holders of the Class I Convertible Preferred Stock vote with the commonon an as converted basis.  In addition, holdersof the Class I Convertible Preferred Stock have the right to elect a majorityof our directors in the event of material breach of the terms of the Class IConvertible Preferred Stock Certificate of Designation.

 

The Class J ConvertiblePreferred Stock issued in compromise of claims through our bankruptcy and sinceconverted into 2,329,023 shares of our common stock was issued pursuant toSection 4(2) of the Securities Act of 1933 or Section 445(a) of the BankruptcyCode and converted pursuant to Section 3(a)(9) of the Securities Act of 1933 ofSection 1145(a) of the Bankruptcy Code.

 

30

----

 

The warrants to purchase110,000 shares of our common stock issued in compromise of claims throughbankruptcy were issued pursuant to Section 4(2) of the Securities Act of 1933or Section 1145(a) of the Bankruptcy Code.

 

A portion of the newEquipment Notes was converted into 160,961 shares of our common stock pursuantto Section 3(a)(9) of the Securities Act of 1933 or 1145(a) of the BankruptcyCode.

 

Item 6.             Exhibits and Reports on Form 8-K

 

(a) Listing of Exhibits

 

**INDEXTO EXHIBITS**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                          |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| 99.1                |   | Certificate  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.       |
| 99.2                |   | Certificate  of Senior Vice President-Finance pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

(b)               Reports on Form 8-K

 

The followingreports on Form 8-K were filed during the thirteen weeks ended May 3,2003.

 
| **Date Filed  Report** |   | **Items Reported**                                  |
|------------------------|--------|-----------------------------------------------------|
| February 4        |   | Bankruptcy Filings –  Item 5                   |
| February 14       |   | Bankruptcy Filings –  Item 5                   |
| March 11          |   | Bankruptcy Filings –  Item 5                   |
| April 21          |   | Bankruptcy Confirmation  Order – Item 3        |
| April 30          |   | Nasdaq Continued  Listing Information – Item 5 |

 

SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Company hasduly caused this report to be signed on its behalf by the undersigned andthereunto duly authorized.

 
| FAO, INC.                      |
|--------------------------------|
|                           |
|                           |   |   |
| Date:  June 16, 2003 |   | /s/  Jerry R. Welch |   |
|                           | Jerry R. Welch  Chief Executive Officer and President |   |
|                           |   |   |
|                           |   |   |
| Date:  June 16, 2003 |   | /s/ Jerome A. Kollar |   |
|                           | Jerome A. Kollar  Senior Vice President-Finance |   |
|                                |  |  |  |  |

 

31

----

 

Sarbanes-Oxley Section 302(a)Certification

 

I, Jerry R. Welch, certify that:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of FAO, Inc. (the“Registrant”);

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport; and

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant asof, and for, the periods presented in this quarterly report.

4.               The Registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the Registrant and we have:

a)              designedsuch disclosure controls and procedures to ensure that material informationrelating to the Registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

b)             evaluated the effectiveness of theRegistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

c)              presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

5.               The Registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theRegistrant’s auditors and the audit committee of Registrant’s board ofdirectors:

a)              all significant deficiencies in thedesign or operation of internal controls which could adversely affect theRegistrant’s ability to record, process, summarize and report financial dataand have identified for the Registrant’s auditors any material weaknesses ininternal controls; and

b)             any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theRegistrant’s internal controls; and

6.               The Registrant’s other certifying officerand I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  June 16, 2003 |                                                  | /s/  Jerry R. Welch |   |
|--------------------------------|-------------------------------------------------------|---------------------|--------|
|                           | Jerry R. Welch  Chief Executive Officer and President |                |

 

32

----

 

Sarbanes-Oxley Section 302(a)Certification

 

I, Jerome A. Kollar, certify that:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of FAO, Inc. (the“Registrant”);

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport; and

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant asof, and for, the periods presented in this quarterly report.

4.               The Registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the Registrant and we have:

a)              designedsuch disclosure controls and procedures to ensure that material informationrelating to the Registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

b)             evaluated the effectiveness of theRegistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

c)              presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

5.               The Registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theRegistrant’s auditors and the audit committee of Registrant’s board ofdirectors:

a)              allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the Registrant’s ability to record, process, summarizeand report financial data and have identified for the Registrant’s auditors anymaterial weaknesses in internal controls; and

b)             anyfraud, whether or not material, that involves management or other employees whohave a significant role in the Registrant’s internal controls; and

6.               The Registrant’s other certifyingofficer and I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
| Date:  June 16, 2003 |                                                                            | /s/ Jerome A. Kollar |   |
|--------------------------------|---------------------------------------------------------------------------------|----------------------|--------|
|                           | Jerome A. Kollar  Senior Vice President-Finance  (Principal Accounting Officer) |                 |

 

33

----