**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTOND.C. 20549**

 

**Form 10-Q**

 

**(Mark one)**

**ý****        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended August 2, 2003**

 

**OR**

 

**o****        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                  to                   **

 

**CommissionFile Number 0-19536**

 

**FAO, INC.**

(Exactname 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.)                        |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

Yes  ý      No  o

 

Indicate by check mark whether the registrant isan accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  o      No  ý

 

Indicate by check mark whether the registranthas filed all reports required to be filed by Sections 12, 13 or 15(d) of theSecurities Exchange Act of 1934 subsequent to the distribution of securitiesunder a plan confirmed by a court.

Yes  ý       No o

 

As of September 12, 2003, there were 5,152,775shares of FAO, Inc. common stock outstanding. Additionally, there were 32,350 shares of FAO, Inc. convertiblepreferred stock outstanding that are convertible at any time into 21,566,666shares of common stock.

 

 

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FAO,INC.

 

INDEXTO FORM 10-Q

 

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                  |

 

2

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**FAO, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(unaudited)

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

 
|                                                                                                                                     |   | **August 2,  2003** |    | **February  1, 2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-----------------------|--------|
|                                                                                                                                     |   |                |    |                  |   |
| ASSETS                                                                                                                                   |   |                |    |                  |   |
| Current assets:                                                                                                                          |   |                |    |                  |   |
| Cash and cash  equivalents                                                                                                               |   | $                   | 265     |                  | $      | 26,107 |   |
| Accounts and  other receivables, net                                                                                                     |   | 4,155               |    | 7,055                 |   |
| Merchandise inventories                                                                                                                  |   | 58,213              |    | 103,125               |   |
| Other current  assets                                                                                                                    |   | 6,700               |    | 5,736                 |   |
|                                                                                                                                     |   |                |    |                  |   |
| Total current  assets                                                                                                                    |   | 69,333              |    | 142,023               |   |
|                                                                                                                                     |   |                |    |                  |   |
| Noncurrent  assets:                                                                                                                      |   |                |    |                  |   |
| Property,  fixtures and equipment, net                                                                                                   |   | 22,609              |    | 26,356                |   |
| Goodwill                                                                                                                                 |   | 4,578               |    | 4,578                 |   |
| Other noncurrent  assets                                                                                                                 |   | 5,559               |    | 2,812                 |   |
|                                                                                                                                     |   |                |    |                  |   |
| Total noncurrent  assets                                                                                                                 |   | 32,746              |    | 33,746                |   |
|                                                                                                                                     |   |                |    |                  |   |
|                                                                                                                                     |   | $                   | 102,079 |                  | $      | 175,769 |   |
|                                                                                                                                     |   |                |    |                  |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                     |   |                |    |                  |   |
| Current  liabilities:                                                                                                                    |   |                |    |                  |   |
| Accounts payable                                                                                                                         |   | $                   | 13,528  |                  | $      | 1,393 |   |
| Plan of  reorganization obligations                                                                                                      |   | 9,362               |    | —                |   |
| Accrued expenses                                                                                                                         |   | 9,527               |    | 13,207                |   |
| Accrued salaries  and wages                                                                                                              |   | 4,079               |    | 5,074                 |   |
| Revolving line  of credit                                                                                                                |   | 19,224              |    | 70,496                |   |
| Current portion  of Purchase Money Notes                                                                                                 |   | 761                 |    | —                |   |
| Equipment Notes                                                                                                                          |   | 4,186               |    | —                |   |
|                                                                                                                                     |   |                |    |                  |   |
| Total current  liabilities                                                                                                               |   | 60,667              |    | 90,170                |   |
|                                                                                                                                     |   |                |    |                  |   |
| Term Loan                                                                                                                                |   | 10,000              |    | —                |   |
| Deferred rent                                                                                                                            |   | 2,406               |    | 3,394                 |   |
| Long term  portion of plan of reorganization obligations                                                                                 |   | 2,861               |    | —                |   |
| Long term  portion of Purchase Money Notes                                                                                               |   | 64                  |    | —                |   |
| Subsidiary  Subordinated Notes                                                                                                           |   | 9,900               |    | —                |   |
|                                                                                                                                     |   |                |    |                  |   |
| Total  liabilities not subject to compromise                                                                                             |   | 85,898              |    | 93,564                |   |
|                                                                                                                                     |   |                |    |                  |   |
| Liabilities  subject to compromise                                                                                                       |   | —              |    | 108,139               |   |
|                                                                                                                                     |   |                |    |                  |   |
| Commitments and  contingencies                                                                                                           |   |                |    |                  |   |
|                                                                                                                                     |   |                |    |                  |   |
| Stockholders’  equity (deficit):                                                                                                    |   |                |    |                  |   |
| Class I  Convertible Preferred Stock (50,000 shares authorized at $0.001 par value;  32,350 issued and outstanding as of August 2, 2003) |   | —              |    | —                |   |
| Common stock  (75,000,000 shares authorized at $0.001 par value; 5,152,786 and 2,567,563  issued and outstanding, respectively)          |   | 5                   |    | 3                     |   |
| Additional paid  in capital                                                                                                              |   | 238,973             |    | 158,495               |   |
| Accumulated  deficit                                                                                                                     |   | (222,797            | )       | (184,432              | )      |
| Total  stockholders’ equity (deficit)                                                                                               |   | 16,181              |    | (25,934               | )      |
|                                                                                                                                     |   |                |    |                  |   |
|                                                                                                                                     |   | $                   | 102,079 |                  | $      | 175,769 |   |

 

See accompanying notes toconsolidated financial statements

 

3

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**FAO, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(unaudited)

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

 
|                                                 |   | **Thirteen  Weeks Ended** |    | **Twenty-Six  Weeks Ended** |   |
|------------------------------------------------------|--------|---------------------------|---------|-----------------------------|--------|
|                                                 |   | **August 2,  2003**       |    | **August 3,  2002**         |   | **August 2,  2003** |   | **August 3,  2002** |   |
| Net sales:                                           |   |                      |    |                        |   |   |   |   |   |
| Retail                                               |   | $                         | 44,714  |                        | $      | 87,808 |   | $ | 114,518 |   | $ | 172,711 |   |
| Direct to customer                                   |   | 1,221                     |    | 1,628                       |   | 3,614 |   | 4,076 |   |
| Shipping and handling revenues                       |   | 377                       |    | 564                         |   | 996 |   | 1,069 |   |
|                                                 |   | 46,312                    |    | 90,000                      |   | 119,128 |   | 177,856 |   |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Costs and expenses:                                  |   |                      |    |                        |   |   |   |   |   |
| Cost of goods sold, including distribution costs     |   | 27,471                    |    | 53,851                      |   | 94,258 |   | 105,722 |   |
| Cost of shipping and handling                        |   | 345                       |    | 697                         |   | 1,071 |   | 1,310 |   |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Gross profit                                         |   | 18,496                    |    | 35,452                      |   | 23,799 |   | 70,824 |   |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Selling, general and administrative expenses:        |   |                      |    |                        |   |   |   |   |   |
| Operating expense                                    |   | 13,738                    |    | 21,025                      |   | 33,339 |   | 41,051 |   |
| Occupancy expense                                    |   | 12,468                    |    | 20,581                      |   | 28,646 |   | 40,967 |   |
| Marketing and advertising expense                    |   | 1,679                     |    | 2,065                       |   | 3,180 |   | 3,880 |   |
| General and administrative expense                   |   | 4,524                     |    | 6,109                       |   | 9,169 |   | 12,756 |   |
| Depreciation and amortization expense                |   | 1,988                     |    | 1,536                       |   | 4,492 |   | 3,025 |   |
| Store closing costs                                  |   | 371                       |    | —                      |   | 1,707 |   | — |   |
|                                                 |   | 34,768                    |    | 51,316                      |   | 80,533 |   | 101,679 |   |
| Operating loss                                       |   | (16,272                   | )       | (15,864                     | )      | (56,734 | ) | (30,855 | ) |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Reorganization items, net                            |   | (1,101                    | )       | —                      |   | 61,980 |   | — |   |
| Interest expense, net                                |   | (1,438                    | )       | (2,272                      | )      | (7,199 | ) | (4,387 | ) |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Loss before income taxes                             |   | (18,811                   | )       | (18,136                     | )      | (1,953 | ) | (35,242 | ) |
| Income tax provision                                 |   | 34                        |    | 29                          |   | 85 |   | 99 |   |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Net loss                                             |   | $                         | (18,845 | )                           | $      | (18,165 | ) | $ | (2,038 | ) | $ | (35,341 | ) |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Basic and diluted loss per share:                    |   |                      |    |                        |   |   |   |   |   |
| Net loss per share                                   |   | $                         | (4.05   | )                           | $      | (8.01 | ) | $ | (9.70 | ) | $ | (19.53 | ) |
|                                                 |   |                      |    |                        |   |   |   |   |   |
| Weighted average number of common shares outstanding |   | 5,152,064                 |    | 2,269,038                   |   | 3,954,912 |   | 1,814,142 |   |

 

See accompanying notes toconsolidated financial statements

 

4

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**FAO, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(unaudited)

(in 000’s)

 
|                                                                         |   | **Twenty-Six  Weeks Ended** |   |
|------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                         |   | **August 2,  2003**         |   | **August 3,  2002** |   |
|                                                                         |   |                        |   |   |   |
| Cash flows from operating activities:                                        |   |                        |   |   |   |
| Net loss                                                                     |   | $                           | (2,038 | ) | $ | (35,341 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                        |   |   |   |
| Depreciation and amortization                                                |   | 4,492                       |   | 3,025 |   |
| Deferred rent                                                                |   | 163                         |   | 932 |   |
| Amortization of debt issuance costs                                          |   | 211                         |   | 221 |   |
| Non-cash interest                                                            |   | 4,712                       |   | 134 |   |
| Gain on discharge of liabilities                                             |   | (65,283                     | )      | — |   |
| Change in assets and liabilities affecting operations                        |   | 38,291                      |   | (256 | ) |
|                                                                         |   |                        |   |   |   |
| Net cash used in operating activities                                        |   | (19,452                     | )      | (31,285 | ) |
|                                                                         |   |                        |   |   |   |
| Cash flows from investing activities:                                        |   |                        |   |   |   |
| Additions to property, fixtures and equipment                                |   | (1,223                      | )      | (2,532 | ) |
| Proceeds from fixture sales                                                  |   | 503                         |   | — |   |
| Purchase price adjustments                                                   |   | —                      |   | (1,117 | ) |
|                                                                         |   |                        |   |   |   |
| Net cash used in investing activities                                        |   | (720                        | )      | (3,649 | ) |
|                                                                         |   |                        |   |   |   |
| Cash flows from financing activities:                                        |   |                        |   |   |   |
| Net borrowings (payments) on revolving line of credit                        |   | (41,272                     | )      | 21,395 |   |
| Increase (decrease) in bank overdraft                                        |   | 6,797                       |   | (3,015 | ) |
| Payments on notes payable, Acquisition Obligations and Purchase Money  Notes |   | (666                        | )      | (5,503 | ) |
| Redemption of Mandatorily Redeemable Preferred Stock                         |   | —                      |   | (3,000 | ) |
| Net proceeds from sale of common stock                                       |   | —                      |   | 26,189 |   |
| Net proceeds from issuance of Preferred Stock                                |   | 31,070                      |   | — |   |
| Payments of financing costs                                                  |   | (1,599                      | )      | (458 | ) |
| Proceeds from exercise of stock options and warrants                         |   | —                      |   | 329 |   |
|                                                                         |   |                        |   |   |   |
| Net cash (used in) provided by financing activities                          |   | (5,670                      | )      | 35,937 |   |
|                                                                         |   |                        |   |   |   |
| Net (decrease) increase in cash and cash equivalents                         |   | (25,842                     | )      | 1,003 |   |
| Cash and cash equivalents at beginning of period                             |   | 26,107                      |   | 2,811 |   |
|                                                                         |   |                        |   |   |   |
| Cash and cash equivalents at end of period                                   |   | $                           | 265    |   | $ | 3,814 |   |

 

See accompanying notes toconsolidated financial statements

 

5

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FAO,INC.

NOTESTO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

NOTE 1:  Basis of FinancialStatement Presentation

 

The accompanying unaudited consolidated financial statementshave been prepared in accordance with the requirements for Form 10-Q andArticle 10 of Regulation S-X and, accordingly, certain informationand footnote disclosures normally included in the notes to the annualconsolidated financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted.  Reference is madeto the Annual Report on Form 10-K as of and for the year endedFebruary 1, 2003 for FAO, Inc. and Subsidiaries (referred to hereinas “FAO”, “we”, “us”, “our” and similar designations) as filed with theSecurities and Exchange Commission for additional disclosures including asummary of the Company’s accounting policies.

 

In the opinion of management, the consolidatedfinancial statements contain all adjustments, consisting of normal recurringadjustments, necessary to present fairly the consolidated financial position ofthe Company for the periods presented. Since the Company’s operations are seasonal, the interim operatingresults of the Company may not be indicative of operating results for the fullyear.

 

Certain prior year balances in the consolidatedfinancial statements have been reclassified to conform with the current yearpresentation.

 

NOTE 2:  Proceedings UnderChapter 11 of the Bankruptcy Code

 

Chapter 11 Reorganization

 

On January 13, 2003, we, together with our significantsubsidiaries (collectively, the “Filing Entities”), filed for protection underChapter 11 of the United States Bankruptcy Code in the United States BankruptcyCourt for the District of Delaware in case number 03-10119(LK).  During the pendency of the Chapter 11 cases,the Filing Entities continued to operate as debtors-in-possession under thejurisdiction of the Bankruptcy Court and in accordance with the applicableprovisions of the Bankruptcy Code and orders of the Bankruptcy Court.  Our First Amended Disclosure Statement withRespect to First Amended Joint Plan of Reorganization of FAO, Inc. and itsDebtor Subsidiaries was approved by the Bankruptcy Court on February 28,2003.  Our First Amended Joint Plan ofReorganization of FAO, Inc. and its Debtor Subsidiaries (“Plan ofReorganization”) was confirmed by the Bankruptcy Court on April 4, 2003, andbecame effective when we emerged from bankruptcy on April 23, 2003 (the“Effective Date”).  We decided to seekbankruptcy reorganization based upon a rapid decline in our liquidity resultingfrom reduced sales related to the events of September 11, 2001, a weak economicenvironment, a soft retail market, reduced travel and tourism, and restrainedconsumer spending at a time when we were continuing to integrate our FAOSchwarz®, Right Start® and Zany Brainy® operations, together with erosion ofvendor credit support and a more restrictive advance rate covenant imposed byour prior senior secured lenders.  Inparticular, certain of our store locations did not perform to expectations,affecting our overall operations.  Weutilized Chapter 11 to close most of the 111 stores we have closed, 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, convertible at $1.50 per common share, forgross proceeds of $30.0 million as of the Effective Date, and an additional1,850 shares for $1.85 million gross proceeds since the Effective Date andreplaced our former revolving credit facility with an asset based revolving$77.0 million Loan and Security Agreement (the “Loan Agreement”) withFleet Retail Finance Inc., as agent (the “Agent”), under which we areco-borrowers with our subsidiaries ZB Company, Inc. and FAO Schwarz, Inc.

 

6

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Pursuant to our Plan of Reorganization, we:

 

•             repaid the fullamount of our prior senior secured lenders' claims;

 

•             compromised $8.5million in Equipment Notes and accrued interest in exchange for (i) newconvertible Equipment Notes payable January 11, 2004 in the aggregate principalamount of $4.0 million (of which $314,000 was converted to 314 shares of ourClass J Convertible Preferred Stock, subsequently converted at $1.95 per commonshare into 160,959 shares of common stock in April and May of 2003 and $3.7million remained outstanding as of August 2, 2003), provided certain paymentsto our pre-bankruptcy unsecured creditors have been made, (ii) 4,542 shares ofour Class J Convertible Preferred Stock convertible into 2,329,025 shares ofour common stock (converted into 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;

 

•             compromisedapproximately $17.4 million in old Subsidiary Subordinated Notes in exchangefor (i) new Subsidiary Subordinated Notes in the aggregate principal amount of$9.9 million payable ratably in three annual installments in December 2006,2007 and 2008, (ii) $500,000 in cash payable on January 11, 2004 and (iii) 500shares of our Class I Convertible Preferred Stock convertible into 333,333shares of our common stock;

 

•             retained a notesecured by equipment in the aggregate outstanding principal amount ofapproximately $1.1 million;

 

•             compromised smallerclaims to a convenience amount of $100 or to the full amount of the claim,whichever is less; and

 

•             compromised ourremaining unsecured claims depending on the individual choices of our unsecuredcreditors to: (i) 38% of the allowed amount of the claim, payable as follows:5% on the Effective Date, 11% on December 22, 2003, 15% on December 22, 2004,and 7% on December 22, 2005; (ii) 21% of the allowed amount of the claim,payable as follows: 7% on the Effective Date, and 14% on December 22, 2003; or(iii) 35% of the allowed amount of the claim with cash payments representing28% payable as follows: 5% on the Effective Date, 8% on December 22, 2003, 9%on December 22, 2004, and 6% on December 22, 2005 and payment of equity for theremaining 7%. A portion of the cash payments due in December 2003 may bedeferred if we do not meet certain borrowing availability conditions ascalculated under our Loan Agreement.

 

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

 

(i)                                     Anestimated $16.8 million to holders of unsecured claims; $4.4 million on theEffective Date, approximately $9.4 million on December 22, 2003, approximately$2.0 million on December 22, 2004 and approximately $1.0 million on December22, 2005.  In the event excess availability under the Loan Agreement onDecember 18, 2003 is less than $37.0 million then the December 2003 paymentobligation will be deferred until December 22, 2004 pro rata, by the amount bywhich excess availability is less than $37.0 million; provided, however, in noevent may the December 2003 payment to holders of unsecured claims be less than$1.0 million.  In the event that excess availability under the LoanAgreement on December 18, 2004 is less than $40.0 million, then any deferredDecember 2003 payments to holders of unsecured claims will be deferred untilDecember 22, 2005 pro rata, by the amount by which the excess availability isless than $40.0 million; provided, however, in no event may the December 2004payment to holders of unsecured claims be less than (i) the amounts due tounsecured creditors on December 22, 2004, plus (ii) $1.0 million of thedeferred December 2003 payments.  Any payments deferred

 

7

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until December 22, 2005 shall be due and payable nolater than December 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 $37.0million.

 

(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 including December22, 2003 provided such payments have not been deferred.

 

(iii)                               $500,000on January 11, 2004 and $3.3 million on each of December 31, 2006, 2007 and2008 plus interest at a rate of 6% per annum through and including January 11,2005, at which time the first interest payment shall be made in cash withpayments made quarterly thereafter, to the holders of the new SubsidiarySubordinated Notes provided we are current with our payments to holders of thenew convertible Equipment Notes and unsecured claims and such payments have notbeen deferred.  $4.0 million of such amountswill be forgiven if we obtain the release of the holders of such notes from aguarantee on the lease for one of our FAO Schwarz stores.

 

Claims Resolution

 

Pursuant to the bankruptcy process, our claims agentreceived approximately 1,700 timely-filed proofs of claim totalingapproximately $450.0 million in the aggregate, exclusive of approximately 120proofs of claim filed by governmental agencies totaling approximately $4.0million in the aggregate.  The bar date(the final date for which claims could be filed timely) was March 31, 2003 formost claimants.  For governmentalagencies the bar date was July 13, 2003. For holders of canceled executory contracts and real property leases thebar date was 60 days from the date their contract or lease was rejected.

 

As is typical in reorganization cases, there aresignificant differences between amounts scheduled by us and claims filed bycreditors; these differences are being investigated and resolved in connectionwith the claims resolution process.  Theaggregate amount of claims filed with the Bankruptcy Court far exceeds ourestimate of ultimate liability.  Webelieve that many of these claims are duplicative, based upon contingenciesthat have not occurred, or otherwise are overstated, and are therefore invalid.  As of September 12, 2003, we have filed oneclaims objection totaling approximately $6.0 million and have identifiedapproximately $365.0 million of what we believe to be duplicative or otherwiseinvalid claims.  We intend to includethese in a claims objection to be filed with the Bankruptcy Court.  Additionally, approximately $13.0 million inclaims have been settled and initial payments on these claims have been madepursuant to the Plan of Reorganization. In light of the number of claims asserted against the Filing Entities,the claims resolution process is ongoing and may take considerable time tocomplete.  A number of significantclaims remain to be resolved. Accordingly, the ultimate number of and amount of allowed claims is notpresently known.

 

8

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NOTE 3:  Description of Businessand Significant Accounting Policies

 

We are a specialty retailer of high qualitydevelopmental, educational and care products for infants and children and highquality toys, games, books and multimedia products for children up to age 12conducted through the FAO Schwarz®, Right Start® and Zany Brainy® brands.  Our business expanded in the last two fiscalyears to include educational products, toys, games, books and multimediaproducts for children up to age 12 through the purchase of substantially all ofthe assets of Zany Brainy, Inc. and certain assets of upscale toy sellerF.A.O. Schwarz (now known as KBB Retail Assets Corp.).  Results for the twenty-six week period endedAugust 2, 2003 are not indicative of annual results in part because the firstthirteen weeks of the year ending January 31, 2004 (“Fiscal 2003”) reflectoperations while we were in bankruptcy that include store closings andinventory liquidation, the costs and expenses associated with our bankruptcycase as well as the one-time gains that occurred in connection with ouremergence from bankruptcy while the second quarter reflects operations while wewere working to rebuild inventories after emerging from bankruptcy.

 

On February 21, 2003, we executed a letter of intentwith Saks Incorporated with respect to the placement of licensed departments indepartment stores comprising the Saks Department Store Group (consisting ofBergner’s, Boston Store, Carson Pirie Scott, Herberger’s, McRae’s, Parisian,Proffitt’s and Younkers) (“Saks Boutiques”).  On April 23, 2003, weentered into a Departmental License Agreement documenting the first portion ofthe letter of intent and setting forth the terms of operation of testdepartments in selected Saks Department Store Group stores.  As of September 3, 2003, we have opened 16Saks Boutiques and six more are scheduled to be completed in September(including four in Saks Fifth Avenue Stores which are operated separately fromthe Saks Department Store Group stores). We expect to incur annual license fees under the Departmental LicenseAgreement of approximately $370,000 subject to increase based on a percentageof sales.  The test departments will beoperated for up to one year and, if the parties are satisfied with the results,additional departments may be placed in the remainder of Saks’ 244 departmentstores as the parties deem appropriate. The departments will consist of FAO Schwarz, Zany Brainy, The RightStart and FAO Schweetz® departments.  The letter of intent alsocontemplates that we will negotiate with Saks to expand the number ofdepartments and add temporary shops for the holiday season, develop a line ofapparel, 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.  At present the parties are installingseasonal shops in approximately 230 Saks Department Store Group stores and nineSaks Fifth Avenue Stores and are negotiating definitive agreements with respectto such seasonal shops allowing for operation for an extended period beyond theend of the upcoming holiday season.

 

Operating Results and Liquidity

 

We are primarily a toyretailer and expect to derive approximately 40% of our annual revenue duringour fourth quarter.  Historically, wehave incurred annual losses.   Ourbusiness is seasonal and we expect operating losses for the first threequarters of Fiscal 2003 though we currently expect to generate sufficientoperating income in the fourth quarter to offset such losses.  We believe that we will be able to maintainour operations and fund working capital and capital expenditures through Fiscal2003 with cash on hand at September 12, 2003, projected cash flow fromoperations and anticipated availability from the Loan Agreement.  We have supplemented our availability underour Loan Agreement with letters of credit that were cash collateralized by certainholders of our Class I Convertible Preferred Stock.  These letters of credit increased our availability by $11.0million through November 30, 2003 reducing to $6.0 million in additionalavailability thereafter until January 9, 2004. We may need to raise additional capital in an amount to be determinedfollowing the holiday season.  Our needsfor additional funding will depend upon several factors, including, but notlimited to, generating sufficient cash flow from operations, the expenses orincome from incorporating the Saks Boutiques and the Borders Initiative (seeNote 13) into our operations and our dependence on independent manufacturersand suppliers and their credit terms in order to maintain adequate inventoryin-stock levels.  There can be no assurancesthat we will achieve our business plan for generating cash flow due to theeconomic and operational risks we face, including our dependence on fourthquarter results and the other risks discussed in our Annual Report on Form10-K.  If additional

 

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capital is required to grow our business or execute our business plan,we may seek to raise additional equity or incur additional debt.  There can be no assurance given thatadequate funds will be available to us on acceptable terms or at all.

 

The Loan Agreementmatures April 22, 2006 and consists of (i) a standard revolving line ofcredit of up to $67.0 million under which borrowings bear interest, at ourelection, at an initial rate of 2.50% over the Agent’s calculated Eurodollar Rateor 0.50% over a base rate designated by Fleet National Bank (the “Bank”) fromtime to time, and (ii) an additional special term subline of$10.0 million under which borrowings bear interest at a rate of 15.5% perannum for the first year and thereafter at a rate of 11.25% over the base ratedesignated by the Bank.  The LoanAgreement currently allows us to borrow (A) so long as the special termsubline remains outstanding, up to 95% of the current appraised liquidationvalue of our eligible inventory from November 1 through August 14 and 102.5% ofcurrent appraised liquidation value of our eligible inventory from August 15through October 31, and (B) when the special term subline is no longer ineffect, 85% of the current appraised liquidation value of our eligibleinventory, less, in each case, reserves established by the Agent from time totime in its reasonable discretion for such items as a portion of outstandinggift certificates and merchandise credits, royalty obligations, two months renton certain store leases for which we have not received collateral accessagreements which are acceptable to the landlord and the Agent and anavailability block (initially set at $4.0 million which decreases betweenSeptember 7, 2003 and September 30, 2003 to $1.5 million and between October 1,2003 and October 31, 2003 to $500,000). Eligible inventory consists of inventory in which the Agent has a prior,perfected security interest less certain ineligible items.  The Loan Agreement also allows us to borrow85% of eligible credit card receivables, however, our lenders under the LoanAgreement currently are not permitting us to borrow against our credit cardreceivables until we reach a satisfactory agreement with them regarding theirsecurity interest in the receivables. The Loan Agreement contains a default clause triggered by a materialadverse change and a borrowing restriction based on material adverse changesoccurring since our February 1, 2003 balance sheet date after giving effect tothe Plan of Reorganization.  The LoanAgreement contains one financial covenant. This covenant requires that we maintain minimum excess availabilityunder the Loan Agreement of $5.0 million at all times.  In order to meet this covenant, we arepermitted to supplement our availability under the Loan Agreement by postingletters of credit for the benefit of the lenders under our Loan Agreement.  In connection with the issuance of our ClassI Convertible Preferred Stock, we obtained 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. This letter of credit (the “First Letter of Credit”) was posted on July9, 2003 and supplemented with a second letter of credit (the “Second Letter ofCredit” and collectively, the “Letters of Credit”) posted pursuant to anagreement as of August 27, 2003 with certain holders of our Class I ConvertiblePreferred Stock including those who posted the First Letter of Credit.  The First Letter of Credit will expire nolater than November 30, 2003, and is to expire undrawn so long as on such datewe are not in default under the Loan Agreement or would not be in default underthe Loan Agreement excluding from consideration for this purpose, any increasein availability as a result of the Letters of Credit.  We issued to the providers of the First Letter of Creditfive-year warrants to purchase 821,297 shares of our common stock with anexercise price of $1.50 per share and, if the First Letter of Credit is drawn,we are required to issue to the providers one-year notes in an aggregateprincipal amount equal to the stated amount of the letter of credit secured byour equipment and bearing interest at a rate of 10% per annum.  The fair value of the warrants was estimatedat $1.95 million on the date of issuance using the Black-Scholes pricing modelwith the following assumptions: risk-free interest rate 2.63%; expected life of5 years; dividend yield of 0% and expected volatility of 176.98%.  The value of the warrants is beingrecognized as interest expense through November 30, 2003, which is the term ofthe First Letter of Credit.  Interestexpense recognized in connection with the warrants during the thirteen weeksended August 2, 2003 was $390,000.  Ifsuch notes have not been repaid by November 30, 2003, we are further requiredto issue to the providers five-year warrants to purchase 1,099,460 shares ofour common stock with an exercise price of $1.50 per share.  If the Second Letter of Credit is drawn, weare required to issue demand notes bearing interest at the rate borne on thespecial term subline portion under the Loan Agreement and secured by a lien onall of our assets.  In connection withthe posting of the Second Letter of Credit we entered into a first amendment toour Loan Agreement (the “First Amendment to Loan Agreement”).  The First Amendment to Loan Agreement waiveda default with respect to the minimum excess availability covenant under theLoan Agreement and permitted us to use the Second Letter of Credit to satisfythat covenant.  The First Amendment toLoan Agreement also increases the minimum excess availability covenant minimumfrom $5.0 million to $10.0 million ten days prior to expiration of the SecondLetter of Credit continuing until either the Second Letter of Credit is fullydrawn and we have not made any payment on the notes we are required to issue in

 

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connection with such draws or we have received not less than $6.0million in net proceeds from new subordinated debt or equity financing on termsand conditions acceptable to the lenders under the Loan Agreement.

 

Based on the terms of the Loan Agreement, we haverecorded the outstanding borrowings under the $10.0 million term subline ($10.0million as of August 2, 2003) as long-term since the subline is payable inApril 2006.  Although the revolving lineof credit is scheduled to mature in April 2006, the outstanding borrowingsunder the $67.0 million revolving line of credit ($19.2 million as of August 2,2003) have been classified as current based on the provisions of EmergingIssues Task Force (“EITF”) Issue No. 95-22. EITF 95-22 requires borrowings under a loan agreement to be classifiedas a current liability when the loan agreement includes a provision for blockedaccounts to be instituted with the agent and an acceleration clause, such as amaterial adverse change default provision, even though there has not beennotice or cause for the acceleration. Our Loan Agreement has both provisions, andwe have recorded the outstanding borrowings under the $67.0 million revolvingline of credit in accordance with EITF 95-22, even though the defaultprovisions requiring an acceleration have not been and are not anticipated tobe invoked.

 

The amount available tous under our borrowing formula fluctuates primarily with our level of inventoryand the level of credit provided by our suppliers.  Additionally, availability is significantly affected by periodicchanges in the advance rates against our eligible inventory, which fluctuatefrom month to month (from a low of approximately 68% to a high of approximately90%) and are subject to adjustment by the Agent based on third party appraisalsof the liquidation value of our inventory and other discretionary considerations.  These appraisals are typically performed atleast quarterly at the request of the Agent and attempt to reflect the net cashthat could be realized by selling our inventory in a “going out of business”sale.  The time of year that such a saleis assumed to take place is significant to the valuation and consequently theresulting monthly advance rates can fluctuate substantially.  For example, advance rates typically arelowest in the first half of the year and begin to rise as the holiday seasonapproaches.  This increase in advancerates provides more availability as we begin to build our inventory levels tomeet holiday season demand.  As ofSeptember 12, 2003, the availability under the Loan Agreement was approximately$6.3 million, $1.3 million above the $5.0 million excess availabilitycovenant taking into account the Letters of Credit.

 

Stock Split

 

Effective on April 22, 2003, our common shares werereverse split into one share for every 15 shares outstanding.  The statedpar value of the common shares was not changed from its existing amount of$0.001 per share.  The number of authorized shares of common stockremained at 75 million.  All share and per share amounts have beenrestated to reflect the reverse stock split.

 

Bankruptcy Accounting

 

Since our Chapter 11 bankruptcy filing, we haveapplied the provisions of Statement of Position (“SOP”) 90-7.  SOP 90-7 does not significantly change theapplication of accounting principles generally accepted in the United States ofAmerica; however, it does require that the financial statements for periodsincluding and subsequent to the filing of a Chapter 11 petition distinguishtransactions and events that are directly associated with the reorganizationfrom the ongoing operations of the business. Based on the provisions of SOP 90-7, we are not eligible to applyfresh-start accounting.

 

Use of Estimates

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

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Seasonality

 

Operating results for the twenty-six week period endedAugust 2, 2003 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 ourannual revenue from, and achieve all of our annual profitability, if any, inour fourth quarter.

 

Vendor Incentives

 

For the thirteen and twenty-six week period endedAugust 2, 2003, we had marketing and advertising expenses of $1.7 million and$3.2 million, respectively, and no offsetting vendor incentives.  In addition, there were no offsets relatedto vendor incentives included in cost of goods sold for the thirteen andtwenty-six week period ended August 2, 2003.

 

For the thirteen and twenty-six week periods endedAugust 3, 2002, we had marketing and advertising expenses of $2.1 million and$3.9 million, respectively, which is net of $1.9 million and $3.3 million,respectively, in vendor incentives. Cost of goods sold for the thirteen and twenty-six week periods endedAugust 3, 2002 included an offset of $1.2 million and $1.7 million, respectively,of vendor incentives.

 

Revenue Recognition

 

Sales are generated in our Retail segment and ourDirect to customer segment.  Retail sales are recorded when the customertakes possession of the merchandise and tenders payment.  Direct tocustomer sales are recorded at the time the goods are received by thecustomer.  Historically, damaged goods have not been significant.  We permit returns so long as the goods arereturned in saleable condition, within 60 days and accompanied by areceipt.  Appropriate sales returnreserves are maintained and are estimated based on historical rates andadjusted for current conditions.

 

Stock-Based Compensation

 

The Company applies the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations to account for awards of stock-basedcompensation granted to employees and directors.  Accordingly, compensation expense is recorded for options awardedto employees and directors to the extent that the exercise prices are less thanthe fair market value of the common stock on the date of grant when the numberof options and the exercise price are fixed. The difference between the fair value of the common stock and theexercise price of the stock option is recorded as deferred compensation, whichis charged to expense over the vesting period of the underlying stock option ona straight-line basis.  In the periods reported, we have not issued anyoptions with an exercise price that was less than the fair market value of thecommon stock on the date of grant.

 

We have adopted the disclosure requirements ofStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accountingfor Stock-Based Compensation.”  In accordance with the provisions ofSFAS No. 123, we apply APB Opinion No. 25 and related interpretationsin accounting for our plans and do not recognize compensation expense for ourstock-based compensation plans based on the fair market value method prescribedby SFAS No. 123.  Based on the additional disclosure requirementsunder SFAS No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure,” the following table is a reconciliation of net loss and net lossper share had we adopted the fair value recognition provisions of SFAS No. 123.

 

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|                                                                                                                    |   | **Thirteen weeks ended** |    | **Twenty-six weeks ended** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|----------------------------|--------|
| **(in 000’s,  except for share and per share data)**                                                               |   | **August 2,   2003**     |    | **August 3,   2002**       |   | **August 2,   2003** |   | **August 3,   2002** |   |
|                                                                                                                    |   |                     |    |                       |   |   |   |   |   |
| Net loss applicable to common stockholders, as reported (see Note 5)                                                    |   | $                        | (20,854 | )                          | $      | (18,165 | ) | $ | (38,365 | ) | $ | (35,341 | ) |
| Deduct:  Total stock-based  employee compensation expense determined under fair value based method for  all awards |   | —                   |    | (105                       | )      | — |   | (172 | ) |
| Pro forma net  loss applicable to common stockholders                                                                   |   | $                        | (20,854 | )                          | $      | (18,270 | ) | $ | (38,365 | ) | $ | (35,513 | ) |
| Basic  and diluted net loss per share:                                                                                  |   |                     |    |                       |   |   |   |   |   |
| As reported                                                                                                             |   | $                        | (4.05   | )                          | $      | (8.01 | ) | $ | (9.70 | ) | $ | (19.53 | ) |
| Pro forma                                                                                                               |   | $                        | (4.05   | )                          | $      | (8.05 | ) | $ | (9.70 | ) | $ | (19.58 | ) |

 

Upon emergence frombankruptcy, all of our then outstanding option awards were cancelled.  As of August 2, 2003, there are nooutstanding options.

 

NOTE 4:  Reorganization Items, Net

 

Reorganization items, net represents amountsrecognized and incurred as a direct result of our Chapter 11 filing andemergence and are presented separately in our Consolidated Statement ofOperations.  Such items consist of thefollowing:

 

|                                    |   | **Thirteen Weeks Ended** |   | **Twenty-Six Weeks Ended** |   |
|-----------------------------------------|--------|--------------------------|--------|----------------------------|--------|
| **(in 000’s)**                     |   | **August 2, 2003**       |   |
|                                    |   |                     |   |                       |   |
| Gain (loss) on discharge of liabilities |   | $                        | (1,027 | )                          | $      | 65,283 |   |
| Severance and retention expense         |   | (47                      | )      | (1,105                     | )      |
| Gain on sale of leases                  |   | 74                       |   | 3,005                      |   |
| Professional fees                       |   | (101                     | )      | (5,203                     | )      |
|                                    |   | $                        | (1,101 | )                          | $      | 61,980 |   |

 

A summary of the activity related to the severance andretention reserve is as follows:

 

| **(in 000’s)**       |   | **As of  August 2, 2003** |   |
|---------------------------|--------|---------------------------|--------|
| Balance, February 1, 2003 |   | $                         | 1,192  |   |
| Additional provision      |   | 1,105                     |   |
| Cash payments             |   | (2,296                    | )      |
| Balance, August 2, 2003   |   | $                         | 1      |   |

 

NOTE 5:  Per Share Data

 

Basic per share data is computed by dividing our lossavailable to common stockholders by the weighted average number of our commonshares outstanding.  Diluted per sharedata is computed by dividing our net income or loss adjusted for costsassociated with dilutive securities by the weighted average number of sharesoutstanding plus any potential dilution that could occur if securities or othercontracts to issue common stock were exercised or converted into common stockin each period, unless the impact would be antidilutive.

 

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|                                                                  |   | **Thirteen weeks ended** |    | **Twenty-six weeks ended** |   |
|-----------------------------------------------------------------------|--------|--------------------------|---------|----------------------------|--------|
| **(in 000’s,  except for share and  per share data)**            |   | **August 2,  2003**      |    | **August 3,  2002**        |   | **August 2,  2003** |   | **August 3,  2002** |   |
|                                                                  |   |                     |    |                       |   |   |   |   |   |
| Net loss                                                              |   | $                        | (18,845 | )                          | $      | (18,165 | ) | $ | (2,038 | ) | $ | (35,341 | ) |
| Less:                                                                 |   |                     |    |                       |   |   |   |   |   |
| Preferred stock accretion                                             |   | —                   |    | —                     |   | — |   | (90 | ) |
| Preferred stock dividends                                             |   | (475                     | )       | —                     |   | (530 | ) | — |   |
| Beneficial conversion feature on Class I and Class  J Preferred Stock |   | (1,534                   | )       | —                     |   | (35,797 | ) | — |   |
| Basic and diluted loss available to common stockholders               |   | $                        | (20,854 | )                          | $      | (18,165 | ) | $ | (38,365 | ) | $ | (35,431 | ) |
| Weighted average common shares, basic and diluted                     |   | 5,152,064                |    | 2,269,038                  |   | 3,954,912 |   | 1,814,142 |   |
| Loss per share, basic and diluted                                     |   | $                        | (4.05   | )                          | $      | (8.01 | ) | $ | (9.70 | ) | $ | (19.53 | ) |

 

Certain of our securities were not included in thecomputation of diluted loss per share for the thirteen and twenty-six weekperiods because to do so would have been antidilutive for the periodspresented.  Such securities include:

 

|                     |   | **Common Stock  Equivalents at** |   |
|--------------------------|--------|----------------------------------|--------|
| **Securities**           |   | **August 2,  2003**              |   | **August 3,  2002** |   |
| Options                  |   | —                           |   | 369,534 |   |
| Class I Preferred Stock  |   | 21,566,666                       |   | — |   |
| Warrants                 |   | 931,297                          |   | 35,100 |   |
| Junior Convertible Notes |   | —                           |   | 228,438 |   |

 

Pursuant to our Plan of Reorganization all existingwarrants and options as of April 23, 2003 (other than 110,000 warrants issuedor repriced in compromise of claims) were cancelled.  An additional  821,297warrants were issued in connection with the First Letter of Credit.

 

NOTE 6:  Supplemental Disclosureof Cash Flow Information

 

Interest paid amounted to $2.3 million and $3.5million for the twenty-six week period ended August 2, 2003 and August 3, 2002,respectively.  Cash paid for incometaxes was $59,000 and $25,000 for the twenty-six week period ended August 2,2003 and August 3, 2002, respectively.

 

Changes in assets and liabilities which increased(decreased) cash provided by (used in) operating activities are as follows:

 
|                           |   | **Twenty-six weeks ended** |   |
|--------------------------------|--------|----------------------------|--------|
| **(in 000’s)**            |   | **August 2, 2003**         |   | **August 3, 2002** |   |
| Accounts and other receivables |   | $                          | 2,900  |   | $ | 5,735 |   |
| Merchandise inventories        |   | 44,912                     |   | (7,902 | ) |
| Other current assets           |   | (964                       | )      | (4,235 | ) |
| Other noncurrent assets        |   | 15                         |   | (776 | ) |
| Accounts payable               |   | (3,584                     | )      | 13,911 |   |
| Accrued expenses               |   | (3,993                     | )      | (1,344 | ) |
| Accrued salaries and wages     |   | (995                       | )      | (5,645 | ) |
|                           |   | $                          | 38,291 |   | $ | (256 | ) |

 

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Non-cash investing and financing activities:

 
|                                                    |   | **Twenty-six  weeks ended** |   |
|---------------------------------------------------------|--------|-----------------------------|--------|
| **(in 000’s)**                                     |   | **August 2,  2003**         |   | **August 3,  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  |   | 4,856                       |   | — |   |
| Preferred dividend  accretion                           |   | —                      |   | 90 |   |
| Class I Preferred  Stock dividends                      |   | 530                         |   | — |   |
|                                                         |        |                             |        |  |  |  |  |

 

NOTE 7:  Stockholders’ Equity(Deficit)

 

Preferred Stock

 

In April 2003, we sold 30,000 shares of our Class IConvertible Preferred Stock for gross proceeds of $30.0 million and anadditional 1,850 shares for $1.85 million of gross proceeds since the EffectiveDate.  In addition, we issued 500 sharesof Class I Convertible Preferred Stock in April 2003 in connection with thesettlement of certain outstanding debt obligations.  Class I Convertible Preferred Stock carries a cumulative dividendat a rate of 6% per annum payable semiannually on December 1 and June 1, withthe first payment commencing December 1, 2003. We have the option through December 2005 to pay the dividends throughthe issuance of additional Class I Convertible Preferred Stock shares atconversion prices based on the market price of our common stock.  The Class I Convertible Preferred Stockcarries a liquidation preference of $1,000 per share plus all accrued andunpaid dividends.  The Class I ConvertiblePreferred Stock is convertible into common stock at the rate of $1.50 pershare, subject to adjustment.  Werecorded cumulative dividends on the Class I Convertible Preferred Stock of$530,000 as of August 2, 2003.  Weincurred costs of $779,000 in connection with the sale of the Class IConvertible Preferred Stock.  The liquidationvalue per share of Class I Convertible Preferred Stock as of August 2, 2003 is$1,000.

 

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 were issued in connection with thePlan of Reorganization for $4.5 million of Equipment Notes and 314 shares wereissued from the exchange of $314,000  ofnew convertible Equipment Notes).  TheClass J Convertible Preferred Stock has terms similar to the Class IConvertible Preferred Stock except that the Class J Convertible Preferred Stockis convertible into common stock at the rate of $1.95 per share.  In April 2003, 4,816 shares of Class JConvertible Preferred Stock were converted into 2,469,473 shares of commonstock and the remaining 40 shares of Class J Convertible Preferred Stock wereconverted in May 2003 into 20,511 shares of common stock.

 

Beneficial Conversion Feature

 

Generally accepted accounting principles require thatwe recognize the difference between the negotiated conversion price of aninstrument and the actual closing price of the underlying common stock as abeneficial conversion feature and charge it to: a) a dividend in the case of anequity instrument; b) non-cash interest expense in the case of a debtinstrument; or c) non-cash compensation expense in the case of an employeestock option grant.  The interest andcompensation expense is to be amortized over the period, or periods, prior tothe related instruments becoming freely convertible (if the instruments arefreely convertible at any time the charge is immediate).  For the thirteen and twenty-six week periodsended August 2, 2003, we recorded the following amounts due to the existence ofbeneficial conversion features in various instruments that we issued:

 

15

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| **(in 000’s)**                 |   | **Thirteen Weeks** |   | **Twenty-Six Weeks** |   |
|-------------------------------------|--------|--------------------|--------|----------------------|--------|
| **Instrument**                      |   | **August 2, 2003** |   |
| Class I Convertible Preferred Stock |   | $                  | 1,534  |                 | $      | 31,534 |   |
| Class J Convertible Preferred Stock |   | —             |   | 4,263                |   |
| Total Preferred Stock               |   | 1,534              |   | 35,797               |   |
| Convertible Equipment Notes         |   | —             |   | 4,000                |   |
| Total                               |   | $                  | 1,534  |                 | $      | 39,797 |   |

 

The Convertible Equipment Notes with a principalamount of $4.0 million issued in connection with the Plan of Reorganization includeconversion rights for the holders to convert the outstanding principal balanceinto Class J Convertible Preferred Stock at a rate of $1,000 per share.  As noted above the Class J ConvertiblePreferred Stock is convertible into common stock at a rate of $1.95 pershare.  Based on these terms abeneficial conversion charge of $4.0 million was recorded as additionalinterest expense for the thirteen weeks ended May 3, 2003.

 

NOTE 8: Income Taxes

 

The Company has incurredoperating losses and generated a significant accumulated deficit through August2, 2003.  As a result of the reviewundertaken for the year ended February 1, 2003, we concluded that it wasappropriate to establish a full valuation allowance for our net deferred taxassets.  For the thirteen and twenty-sixweek periods ended August 2, 2003, we continued to record a full valuationallowance.  The provision for incometaxes for the thirteen and twenty-six week periods ended August 2, 2003 andAugust 3, 2002 is related to certain minimum state income and franchise taxes.

 

We have federal and state net operating losscarryforwards at August 2, 2003.  Thesecarryforwards will expire in fiscal years ending 2004 through 2023.  Management believes that an ownershipchange, as defined by the U.S. Internal Revenue Code, took place onMarch 26, 2002 and April 23, 2003 in connection with the conversion ofcertain preferred stock to common stock and in connection with the issuance ofequity in accordance with the bankruptcy Plan of Reorganization, respectively.  An ownership change has the effect oflimiting the amount of net operating loss carryforwards that can be used in anyone year, subject to limited carryforward periods.  In addition to the reduction or limitation of net operating losscarryforwards as a result of certain ownership changes, restructuring ofcertain debt pursuant to the bankruptcy Plan of Reorganization caused asignificant amount of net operating loss carryforwards to be eliminated.

 

We have determined that the estimated federal netoperating loss carryforward as of April 23, 2003 was approximately $70.0million and that this carryforward is limited in use to approximately $7.0million per year based on the ownership change, as defined by the U.S. InternalRevenue Code, which took place.  Inaddition, we generated an additional federal net operating loss ofapproximately $18.0 million during the thirteen week period ended August 2,2003.

 

NOTE 9:  New AccountingPronouncements

 

In December 2002, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 148 which amends SFAS No. 123 to providealternative methods of transition for a voluntary change to the fair valuemethod of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require prominent disclosuresrelated to stock-based compensation in both annual and interim financialstatements.  The disclosuremodifications are required for fiscal years and interim periods ending afterDecember 15, 2002 and are included herein.

 

In March 2003, the EITF reached a consensus on EITFIssue No. 02-16, “Accounting by a Customer (Including a Reseller) forCertain Consideration Received from a Vendor.” EITF Issue No. 02-16 addresses the income statement classification ofcash consideration received by an entity, including a reseller, from a vendorand provides guidance regarding the timing of recognition of volumerebates.  We have adopted

 

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EITF Issue No. 02-16 as of January 1, 2003 and the adoption did nothave a material effect on our financial position or results of operations.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and HedgingActivities.”  SFAS No. 149 amends andclarifies the accounting for derivative instruments, including certainderivative instruments embedded in other contracts, and for hedging activitiesunder SFAS No. 133.  SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 and forhedging relationships designated after June 30, 2003.  The guidance should be applied prospectively.  The adoption of SFAS No. 149 did not have amaterial effect on our financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity.”  SFAS No. 150 clarifies theaccounting for certain financial instruments with characteristics of bothliabilities and equity and requires that those instruments be classified asliabilities in the statement of financial position.  Previously, many of those financial instruments were classifiedas equity.  SFAS No. 150 is effectivefor financial 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 expectthe adoption of SFAS No. 150 to have a material effect on our financial positionor results of operations.

 

NOTE 10:  Segment Information

 

At August 2, 2003 and August 3, 2002, we operated intwo reportable segments: Direct to customer, which includes online and catalogoperations, and Retail, which includes activities related to our retail stores.

 

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies.  We evaluate performance based on profit orloss from operations before income taxes.

 

We allocate costs for certain services provided by theRetail segment to the Direct to customer segment.

 

Our reportable segments have operations that offer thesame or similar products but have a different method of delivery to theircustomers.

 

Segment information for the thirteen and twenty-sixweek periods ended August 2, 2003, is as follows:

 
|                                  |   | **Thirteen-Weeks Ended** |   | **Twenty-Six Weeks Ended** |   |
|---------------------------------------|--------|--------------------------|--------|----------------------------|--------|
| **(in  000’s)**                  |   | **Direct to  customer**  |   | **Retail**                 |   | **Total** |   | **Direct to  customer** |   | **Retail** |   | **Total** |   |
| Net sales                             |   | $                        | 1,458  |                       | $      | 44,854 |   | $ | 46,312 |   | $ | 4,316 |   | $ | 114,812 |   | $ | 119,128 |   |
| Interest expense, net (1)             |   | 28                       |   | 1,410                      |   | 1,438 |   | 86 |   | 7,113 |   | 7,199 |   |
| Depreciation and amortization expense |   | 76                       |   | 1,912                      |   | 1,988 |   | 153 |   | 4,339 |   | 4,492 |   |
| Income (loss) before income taxes (2) |   | (1,307                   | )      | (17,504                    | )      | (18,811 | ) | 1,001 |   | (2,954 | ) | (1,953 | ) |
| Total assets                          |   | 7,171                    |   | 94,908                     |   | 102,079 |   | 7,171 |   | 94,908 |   | 102,079 |   |
| Fixed asset additions                 |   | —                   |   | 922                        |   | 922 |   | — |   | 1,223 |   | 1,223 |   |
|                                       |        |                          |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Interest expense, net for the twenty-six week period ended August 2,2003 includes a beneficial conversion charge of $4.0 million.  In addition, $390,000 is included ininterest expense for the thirteen and the twenty-six week period ended August2, 2003 related to the valuation of warrants issued during the fiscal quarterended August 2, 2003.  The $4.0 millionand the $390,000 were allocated entirely to the Retail segment.

 

17

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(2)          Income (loss) before income taxes for the thirteen and twenty-six weekperiod ended August 2, 2003 includes reorganization items totaling ($1.1)million and $62.0 million, respectively, recorded in relation to our emergencefrom bankruptcy.  Direct to customer andRetail operations were allocated $3.0 million and $59.0 million,respectively.  The $62.0 millionconsists primarily of a gain on discharge of liabilities of $65.3 million, netof other reorganization items (see Note 4).

 

Segment information for the thirteen and twenty-sixweek period ended August 3, 2002 is as follows:

 
|                                  |   | **Thirteen-Weeks Ended** |   | **Twenty-Six Weeks Ended** |   |
|---------------------------------------|--------|--------------------------|--------|----------------------------|--------|
| **(in  000’s)**                  |   | **Direct to  customer**  |   | **Retail**                 |   | **Total** |   | **Direct to  customer** |   | **Retail** |   | **Total** |   |
| Net sales                             |   | $                        | 2,192  |                       | $      | 87,808 |   | $ | 90,000 |   | $ | 5,145 |   | $ | 172,711 |   | $ | 177,856 |   |
| Interest expense, net                 |   | 41                       |   | 2,231                      |   | 2,272 |   | 47 |   | 4,340 |   | 4,387 |   |
| Depreciation and amortization expense |   | 103                      |   | 1,433                      |   | 1,536 |   | 127 |   | 2,898 |   | 3,025 |   |
| Loss before income taxes              |   | (941                     | )      | (17,195                    | )      | (18,136 | ) | (771 | ) | (34,471 | ) | (35,242 | ) |
| Total assets                          |   | 8,630                    |   | 181,848                    |   | 190,478 |   | 8,630 |   | 181,848 |   | 190,478 |   |
| Fixed asset additions                 |   | —                   |   | 1,752                      |   | 1,752 |   | — |   | 2,532 |   | 2,532 |   |
|                                       |        |                          |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

NOTE 11:  Related Party Transactions

 

We have a note receivable of $500,000 from ourChief Executive Officer.  The notereceivable bears interest at the same interest rate that we incur under ourprimary bank loan agreement.  The noteis collateralized by options to purchase shares of our common stock (if andwhen such options are issued) and proceeds from a split-dollar life insurancepolicy with respect to the officer and is due on the earlier of July 3, 2004,termination of employment or upon death. This note receivable, including interest receivable of $29,000, isincluded in accounts and other receivables in our Consolidated Balance Sheet asof August 2, 2003.

 

On April 23, 2003, our director Richard Kayne, ourchairman of the board of directors Fred Kayne and their affiliates purchasedClass I Convertible Preferred Stock convertible into 9,266,667 shares of ourcommon stock.

 

In connection with Hancock Park Capital II, L.P.’sinvestment in our Class I Preferred Stock, we have entered into a consultingagreement, which obligates us to pay them $150,000 for such services.

 

As discussed in Note 2, pursuant to our Plan ofReorganization, we compromised $8.5 million in Equipment Notes and accruedinterest held by Richard Kayne, Fred Kayne and Kayne Anderson InvestmentManagement, Inc.  In addition, asdiscussed in Note 2, pursuant to our Plan of Reorganization, we alsocompromised approximately $17.4 million in old Subsidiary Subordinated Notesheld by affiliates of Royal Vendex KBB, a beneficial owner of our outstandingcommon stock.

 

Fortune Fashions, a company of which Fred Kayne isPresident and Chairman of the Board, has sold and continues to sell embellishedclothing merchandise to us.  Fortune Fashions was a creditor in ourbankruptcy as a result of such sales and had the right to receive 10,463 sharesof our common stock in partial settlement of its claim of approximately$225,000.

 

As discussed in Note 3, we have executed a LicensingAgreement with Saks Incorporated.  SaksIncorporated has invested $5.0 million to purchase shares of our Class IConvertible Preferred Stock.

 

On April 30, 2003, the Board of Directors determinedto invite Mr. Leslie Biller, an investor in our Class I Convertible PreferredStock, to attend Board Meetings as a consultant.  Mr. Biller receivespayment for such consulting services at a rate equal to the rate paid toDirectors.

 

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On July 9, 2003, we issued five-year warrantsexercisable at $1.50 per share of Common Stock for 821,297 shares of our CommonStock to Fred Kayne, Richard Kayne, Kayne Anderson Capital Advisors, L.P.,Hancock Park Capital II, L.P., Woodacres LLC, Charles Norris and Leslie Biller,as trustee in connection such investors posting a $5.0 million letter of credit(see Note 3) for our benefit.  TheCompany paid a fee of $100,000 in connection with the issuance of this letterof credit.

 

On August 27, 2003, Fred Kayne, Richard Kayne, KayneAnderson Capital Advisors, L.P., Hancock Park Capital II, L.P., Woodacres LLC,Charles Norris, Leslie Biller, as trustee, Richard Atlas, as trustee, MarcStern, as trustee, and James Land, each a holder of our Class I ConvertiblePreferred Stock, caused a $6.0 million letter of credit (see Note 3) to beposted for our benefit.  The Companypaid a fee of $200,000 in connection with the issuance of this letter ofcredit.

 

NOTE 12:  Other Developments

 

Contingencies

 

We are a party to variouslegal actions arising in the ordinary course of business.  Management currently believes that theultimate outcome of these matters will not have a material adverse effect onour financial position or results of operations; however, management’s initialevaluation may prove inaccurate.

 

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 alleging various contract claims anddefenses.  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 on our business or operations, financial position or results of operations.

 

On February 19, 2003, Edward Steele filed a classaction claim against our directors Jerry R. Welch, Fred Kayne and Richard Kaynein United States District Court for the Eastern District of Pennsylvaniaclaiming violations of Sections 10(b) and 20(a) of the Securities Exchange Actof 1934 and Rule 10b-5 promulgated thereunder based on allegedmisrepresentations made by the defendants. Mr. Steele has filed a proof of claim on behalf of himself and othersfor $50.0 million in our bankruptcy case. On April 3, 2003, another case was filed in the same court, making thesame claims against the same defendants. The two cases have been consolidated. We have not been named as a defendant nor has there been any claim madefor indemnity though 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. An amended consolidated complaint was filed on August 4, 2003 whichadded certain claims related to our accounting and added our former ChiefFinancial Officer, Raymond Springer, as a defendant.  The defendants must respond to the amended complaint by October1, 2003.  In the thirteen week periodended August 2, 2003, we recorded a $250,000 charge for defense costspertaining to this securities class action litigation.  The $250,000 charge represents our insurancedeductible.  Management currently doesnot believe this claim will result in a material adverse effect on our businessor operations, financial position or results of operations; however, new issuesmay arise that could have such an effect or management’s initial evaluation mayprove 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 mattersfiled with 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 business or operations, financial position or results ofoperations; however, management’s initial evaluation may prove inaccurate.

 

19

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NOTE 13:  Subsequent Events

 

On August 14, 2003, weexecuted a letter of intent with Borders Group, Inc. with respect to managementby Borders of our book departments and extension of credit terms for thepurchase of books, the placement of boutiques selling merchandise under the FAOSchwarz and Zany Brainy brands in up to 25 Borders®stores and up to12 Waldenbooks® storesthrough August 31, 2004 and the opening of several kiosks selling FAO Schwarzand Zany Brainy branded merchandise (the “Borders Initiative”).  The letter of intent contemplates that thedefinitive agreements would be terminable at will upon specified notice.  The letter of intent also contemplates thatwe and Borders would explore other initiatives such as cross promotional opportunities,book development, special orders, cooperation overseas, cooperation in airportsand development of calendar departments in our stores.

 

As of August 27, 2003, Fred Kayne, Richard Kayne,Kayne Anderson Capital Advisors, L.P., Hancock Park Capital II, L.P., WoodacresLLC, Charles Norris, Leslie Biller, as trustee, Richard Atlas, as trustee, MarcStern, as trustee, and James Land, each a holder of our Class I ConvertiblePreferred Stock, caused a $6.0 million letter of credit to be posted for ourbenefit.  If the letter of credit is drawnupon, we will issue demand notes paying interest at the rate we pay to ourTranche B lenders under the Loan Agreement and secured by a lien on all of ourassets.

 

20

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ITEM 2.

MANAGEMENT’S DISCUSSIONAND ANALYSIS OF

FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

 

Forward-Looking Statements

 

This report contains “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933, asamended and Section 21E of the Securities Exchange Act of 1934, asamended.  The forward-looking statementsin this Quarterly Report are intended to be subject to the safe harborprotection provided by Sections 27A and 21E. These forward-looking statements are based on our current expectations,assumptions, estimates and projections about our company and our industry as ofthe date hereof.  When used in thisreport, the words “believes,” “anticipates,” “intends,” “expects” and similarexpressions are intended to identify such forward-looking statements withrespect to our financial condition, results of operations and business.  You will find these forward-lookingstatements at various places throughout this report and the documentsincorporated by reference, including amendments.  These forward-looking statements involve risks, uncertainties andassumptions.  Actual results may differmaterially from those expressed in these forward-looking statements.  You are cautioned not to unduly rely on anyforward-looking statements.  Weundertake no obligation to publicly release any revisions to theseforward-looking statements to reflect events or circumstances after the datehereof.  Further information onpotential factors that could materially affect our financial condition isincluded elsewhere in our Annual Report on Form 10-K under the heading“Risks” and in our filings with the Securities and Exchange Commission.

 

Overview

 

Part I, Item 2 of this report should be read inconjunction with Part II, Item 7 of our Annual Report on Form 10-K for the yearended February 1, 2003 (“Fiscal 2002”). The information contained herein is not a comprehensive discussion andanalysis of our financial condition and results of operations, but ratherupdates disclosures made in the earlier filing.

 

FAO, Inc. (formerly known as The Right Start, Inc.,and referred to herein as “FAO,” “we,” “us,” “our,” the “Company” and similardesignations) operates 142 retail stores (89 Zany Brainy stores, 38 Right Startstores, and 15 FAO Schwarz stores, the “goforward stores”) in 29 states throughoutthe United States as of September 12, 2003. In addition, we have opened 16 (11 of which were opened as of August 2,2003) licensed departments within the Saks Department Store Group (“SaksBoutiques”).  The stores’ product mixincludes a wide variety of items to meet the needs of infants, small childrenand their care givers and children through age 12 presented in three distinctformats identified by the brands FAO Schwarz, The Right Start and Zany Brainy.

 

On January 13, 2003, we, together with our significantsubsidiaries, filed for protection under Chapter 11 of the United StatesBankruptcy Code in the United States Bankruptcy Court for the District ofDelaware in case number 03-10119(LK). During the pendency of the Chapter 11 cases, we and our subsidiariescontinued to operate our businesses as debtors-in-possession under thejurisdiction of the Bankruptcy Court and in accordance with the applicableprovisions of the Bankruptcy Code and orders of the Bankruptcy Court.  The Bankruptcy Court approved our FirstAmended Disclosure Statement with Respect to First Amended Joint Plan ofReorganization of FAO, Inc. and its Debtor Subsidiaries on February 28,2003.  Our First Amended Joint Plan ofReorganization of FAO, Inc. and its Debtor Subsidiaries (“Plan ofReorganization”) was confirmed by the Bankruptcy Court on April 4, 2003, andbecame effective when we emerged from bankruptcy on April 23, 2003 (the“Effective Date”).  In addition, we sold 30,000 shares ofour Class I Convertible Preferred Stock, convertible at $1.50 per common share,for gross proceeds of $30.0 million as of the Effective Date, and an additional1,850 shares for $1.85 million gross proceeds since the Effective Date andreplaced our former revolving credit facility with an asset based revolving$77.0 million Loan and Security Agreement (the “Loan Agreement”) withFleet Retail Finance, Inc., as agent (the “Agent”) under which we areco-borrowers with our subsidiaries ZB Company, Inc. and FAO Schwarz, Inc.

 

21

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Effectiveon April 22, 2003, our common shares were reverse split into one share forevery 15 shares outstanding.  All share and per share amounts have beenrestated to reflect the reverse stock split.

 

Pursuant to our Plan of Reorganization, we:

 

•             repaid the fullamount of our prior senior secured lenders' claims;

 

•             compromised $8.5million in Equipment Notes and accrued interest in exchange for (i) newconvertible Equipment Notes payable January 11, 2004 in the aggregate principalamount of $4.0 million (of which $314,000 was converted at $1.95 per commonshare into 160,959 shares of common stock in April and May 2003 and $3.7million remained outstanding as of August 2, 2003), provided certain paymentsto our pre-bankruptcy unsecured creditors have been made, (ii) 4,542 shares ofour Class J Convertible Preferred Stock convertible into 2,329,025 shares ofour common stock (converted into 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;

 

•             compromisedapproximately $17.4 million in old Subsidiary Subordinated Notes in exchangefor (i) new Subsidiary Subordinated Notes in the aggregate principal amount of$9.9 million payable ratably in three annual installments in December 2006,2007 and 2008, (ii) $500,000 in cash payable on January 11, 2004 and (iii) 500shares of our Class I Convertible Preferred Stock convertible into 333,333shares of our common stock;

 

•             retained a notesecured by equipment in the aggregate outstanding principal amount ofapproximately $1.1 million;

 

•             compromised smallerclaims to a convenience amount of $100 or to the full amount of the claim,whichever is less; and

 

•             compromised ourremaining unsecured claims depending on the individual choices of our unsecuredcreditors to: (i) 38% of the allowed amount of the claim, payable as follows:5% on the Effective Date, 11% on December 22, 2003, 15% on December 22, 2004,and 7% on December 22, 2005; (ii) 21% of the allowed amount of the claim,payable as follows: 7% on the Effective Date, and 14% on December 22, 2003; or(iii) 35% of the allowed amount of the claim with cash payments representing28% payable as follows: 5% on the Effective Date, 8% on December 22, 2003, 9%on December 22, 2004, and 6% on December 22, 2005 and payment of equity for theremaining 7%.  The holders of unsecuredclaims received approximately 95,262 shares of our common stock.  A portion of the cash payments due inDecember 2003 may be deferred if we do not meet certain borrowing availabilityconditions in the Loan Agreement.

 

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The following tables setforth the statement of operations data for the thirteen week period endedAugust 2, 2003 and August 3, 2002:

 
|                                   |   | **Thirteen Weeks Ended** |    |
|----------------------------------------|--------|--------------------------|---------|
|                                   |   | **August 2, 2003**       |    |
| **(in  000’s)**                   |   | **Total Stores**         |    |   |   | **Goforward Stores** |   |   |   | **Closing Stores** |   |   |   |
| Retail net sales                       |   | $                        | 44,714  |   | 96.5 | % | $ | 41,670 |   | 96.3 | % | $ | 3,044 |   | 100.0 | % |
| Direct to customer net sales           |   | 1,221                    |    | 2.7 | % | 1,221 |   | 2.8 | % | — |   | 0.0 | % |
| Shipping and handling revenues         |   | 377                      |    | 0.8 | % | 377 |   | 0.9 | % | — |   | 0.0 | % |
| Net Sales                              |   | 46,312                   |    | 100.0 | % | 43,268 |   | 100.0 | % | 3,044 |   | 100.0 | % |
| Cost of goods sold                     |   | 27,471                   |    | 59.3 | % | 24,255 |   | 56.0 | % | 3,216 |   | 105.6 | % |
| Cost of shipping and handling          |   | 345                      |    | 0.7 | % | 337 |   | 0.8 | % | 8 |   | 0.3 | % |
| Gross profit                           |   | 18,496                   |    | 40.0 | % | 18,676 |   | 43.2 | % | (180 | ) | (6.0 | )% |
| Operating expense                      |   | 13,738                   |    | 29.7 | % | 13,093 |   | 30.2 | % | 645 |   | 21.2 | % |
| Occupancy expense                      |   | 12,468                   |    | 26.9 | % | 11,730 |   | 27.1 | % | 738 |   | 24.2 | % |
| Marketing and advertising expense      |   | 1,679                    |    | 3.6 | % | 1,679 |   | 3.9 | % | — |   | 0.0 | % |
| General and administrative expense     |   | 4,524                    |    | 9.8 | % | 4,524 |   | 10.5 | % | — |   | 0.0 | % |
| Depreciation and amortization expense  |   | 1,988                    |    | 4.3 | % | 1,323 |   | 3.1 | % | 665 |   | 21.8 | % |
| Store closing costs                    |   | 371                      |    | 0.8 | % | — |   | 0.0 | % | 371 |   | 12.2 | % |
|                                   |   | 34,768                   |    | 75.1 | % | 32,349 |   | 74.8 | % | 2,419 |   | 79.4 | % |
| Operating loss                         |   | (16,272                  | )       | (35.1 | )% | (13,673 | ) | (31.6 | )% | (2,599 | ) | (85.4 | )% |
|                                   |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Reorganization items, net              |   | (1,101                   | )       | (2.4 | )% | (1,101 | ) | (2.5 | )% | — |   | 0.0 | % |
| Interest expense, net                  |   | (1,438                   | )       | (3.1 | )% | (1,438 | ) | (3.3 | )% | — |   | 0.0 | % |
| Loss before income taxes               |   | (18,811                  | )       | (40.6 | )% | (16,212 | ) | (37.4 | )% | (2,599 | ) | (85.4 | )% |
| Income tax provision                   |   | 34                       |    | 0.1 | % | 34 |   | 0.1 | % | — |   | 0.0 | % |
| Net loss                               |   | $                        | (18,845 | ) | (40.7 | )% | $ | (16,246 | ) | (37.5 | )% | $ | (2,599 | ) | (85.4 | )% |
| Number of stores open at end of period |   | 153                      | *       |   |   |   |   |   |   |   |   |   |   |

 

23

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|                                   |   | **Thirteen Weeks Ended** |    |
|----------------------------------------|--------|--------------------------|---------|
|                                   |   | **August 3, 2002**       |    |
| **(in  000’s)**                   |   | **Total Stores**         |    |   |   | **Goforward Stores** |   |   |   | **Closing Stores** |   |   |   |
| Retail net sales                       |   | $                        | 87,808  |   | 97.6 | % | 56,796 |   | 96.3 | % | 31,012 |   | 100.0 | % |
| Direct to customer net sales           |   | 1,628                    |    | 1.8 | % | 1,628 |   | 2.8 | % | — |   | 0.0 | % |
| Shipping and handling revenues         |   | 564                      |    | 0.6 | % | 564 |   | 0.9 | % | — |   | 0.0 | % |
| Net Sales                              |   | 90,000                   |    | 100.0 | % | 58,988 |   | 100.0 | % | 31,012 |   | 100.0 | % |
| Cost of goods sold                     |   | 53,851                   |    | 59.8 | % | 34,604 |   | 58.6 | % | 19,247 |   | 62.1 | % |
| Cost of shipping and handling          |   | 697                      |    | 0.8 | % | 697 |   | 1.2 | % | — |   | 0.0 | % |
| Gross profit                           |   | 35,452                   |    | 39.4 | % | 23,687 |   | 40.2 | % | 11,765 |   | 37.9 | % |
| Operating expense                      |   | 21,025                   |    | 23.4 | % | 12,776 |   | 21.6 | % | 8,249 |   | 26.6 | % |
| Occupancy expense                      |   | 20,581                   |    | 22.9 | % | 12,264 |   | 20.8 | % | 8,317 |   | 26.8 | % |
| Marketing and advertising expense      |   | 2,065                    |    | 2.3 | % | 1,259 |   | 2.1 | % | 806 |   | 2.6 | % |
| General and administrative expense     |   | 6,109                    |    | 6.8 | % | 3,951 |   | 6.7 | % | 2,158 |   | 7.0 | % |
| Depreciation and amortization expense  |   | 1,536                    |    | 1.7 | % | 1,213 |   | 2.1 | % | 323 |   | 1.0 | % |
| Store closing costs                    |   | —                   |    | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % |
|                                   |   | 51,316                   |    | 57.0 | % | 31,463 |   | 53.3 | % | 19,853 |   | 64.0 | % |
| Operating loss                         |   | (15,864                  | )       | (17.6 | )% | (7,776 | ) | (13.1 | )% | (8,088 | ) | (26.1 | )% |
|                                   |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Reorganization items, net              |   | —                   |    | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % |
| Interest expense, net                  |   | (2,272                   | )       | (2.5 | )% | (2,272 | ) | (3.9 | )% | — |   | 0.0 | % |
| Loss before income taxes               |   | (18,136                  | )       | (20.1 | )% | (10,048 | ) | (17.0 | )% | (8,088 | ) | (26.1 | )% |
| Income tax provision                   |   | 29                       |    | 0.0 | % | 29 |   | 0.1 | % | — |   | 0.0 | % |
| Net loss                               |   | $                        | (18,165 | ) | (20.2 | )% | $ | (10,077 | ) | (17.1 | )% | $ | (8,088 | ) | (26.1 | )% |
| Number of stores open at end of period |   | 253                      |    |   |   |   |   |   |   |   |   |   |   |
|                                        |        |                          |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*  Number of stores includes 11 Saks Boutiques opened in the lasttwo weeks of July 2003.

 

Thirteen Weeks Ended August 2, 2003 Compared With August 3, 2002

 

*Retailnet sales.* Retail netsales for the thirteen week period ended August 2, 2003 decreased $43.1 million,or 49.1%, compared to the thirteen week period ended August 3, 2002.  Same store sales, defined as stores thathave been open for at least 14 full fiscal months, decreased 26.7% from $56.8million to $41.6 million in the thirteen week period ended August 2, 2003compared to the thirteen week period ended August 3, 2002.  Sales not attributable to same store salesamounted to approximately $3.0 million in the thirteen week period ended August2, 2003 of which approximately $3.0 million relates to stores that haveclosed.  Management believes that samestore sales were negatively impacted primarily by poor in-stock conditions dueto significantly reduced inventory receipts during the bankruptcy, along with agenerally sluggish retail environment. Other factors that may have caused reduced sales are customerperceptions of the quality of our services or goods as a result of ourclearance and cost-cutting efforts and factors discussed in our Annual Reporton Form 10-K.  We cannot assure you thatthese factors have been or will be overcome.

 

*Costof goods sold.* Costof goods sold consists primarily of the cost of products sold, inbound freightcosts, inventory shrinkage costs, and costs related to the distribution andwarehousing of our retail merchandise.  Grossmargin increased in the thirteen week period ended August 2, 2003 to 40.0% from39.4% in the thirteen week period ended August 3, 2002.  The increase in gross margin was due to a3.0% increase in selling margins in merchandising departments such as plush,candy, baby gifts and puzzles, a result of merchandising initiatives, and thereduction of discounted and discontinued product sold during the firstquarter.  These increases were offset byhigher distribution and freight costs. The closing stores' gross margin reflects $180,000 of allocateddistribution operating costs.

 

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Distribution and freight costs as a percentage of sales increased to8.9% compared to 8.0% in the comparable prior year period and shrink costs,damages and markdowns as a percentage of sales for the closed stores increased1.5% compared to the comparable prior year period.

 

*Operatingexpense.* Operatingexpense consists of store operating expenses, retail personnel costs and storepre-opening costs.  Operating expensewas $13.7 million in the thirteen week period ended August 2, 2003compared to $21.0 million for the thirteen week period ended August 3, 2002.  The decrease is primarily related to the 101stores closed since the end of Fiscal2002.  Operating expense for thegoforward stores and direct to customer businesses increased $0.3 million as aresult of increased expenses in the direct to customer businesses, retailadministration and preopening costs partially offset by improved operatingefficiencies in the gofoward stores.  Asa percentage of goforward net sales, these expenses increased 8.6%, primarilyas a result of lower sales volume. Pre-opening costs were $0.1 million for the thirteen week period endedAugust 2, 2003 compared to $29,000 for the thirteen week period ended August 3,2002.  The pre-opening costs for thethirteen week period ended August 2, 2003 related to costs associated with theopening of the Saks Boutiques.

 

*Occupancyexpense.* Occupancyexpense consists primarily of rent, real estate taxes, common area maintenanceand other miscellaneous expenses. Occupancy expense was $12.5 million for the thirteen week period endedAugust 2, 2003, a decrease of $8.1 million compared to the thirteen week periodended August 3, 2002.  This decrease isprimarily attributable to the 101 stores closed since the end of Fiscal2002.  Occupancy expense on thecomparable 142 goforward stores decreased $0.5 million due to reduced rentsresulting from negotiations with landlords during the bankruptcy.  Occupancy expense as a percentage of netsales for the goforward stores increased 6.3% to 27.1% from 20.8% as a resultof lower sales volume for the period.

 

*Marketingand advertising expense.* Marketing and advertising expense generally consists of printadvertising in national and regional publications, as well as promotionalmailings to our customers.  Marketingand advertising expense decreased $0.4 million comparing the thirteen week periodended August 2, 2003 to the thirteen week period ended August 3, 2002.  Marketing and advertising expense for thethirteen week period ended August 2, 2003 included approximately $0.7 millionrelated to new FAO Schwarz promotions targeting tourists.

 

*Generaland administrative expense.* General and administrative expense consists primarily of the costsrelated to management, accounting, merchandising, inventory management,professional service fees and other administrative support.  General and administrative expense decreased$1.6 million, or 25.9%, to $4.5 million in the thirteen week period endedAugust 2, 2003 compared to $6.1 million in the thirteen week period endedAugust 3, 2002.  This change isprimarily attributable to the consolidationof operations across all three brands in Fiscal 2002 as well as administrativestaff reductions which occurred in the last quarter of Fiscal 2002,which resulted in decreases of $0.5 million and $1.1 million,respectively.  As a percentage of netsales, general and administrative expense increased from 6.8% to 9.8% dueprimarily to lower sales volume in the thirteen week period ended August 2,2003 compared to the thirteen week period ended August 3, 2002.  Additionally, we recorded a $0.3 millioncharge in the thirteen week period ended August 2, 2003 for defense costspertaining to the securities class action litigation.  This $0.3 million charge represents our insurance deductible.

 

*Depreciationand amortization expense.* Depreciation and amortization expense during the thirteen weekperiod ended August 2, 2003 was $2.0 million ($0.9 million for the goforwardstores, $0.4 million for the corporate offices and warehouses and $0.7 millionfor the closed stores), an increase of $0.5 million, compared to the thirteenweek period ended August 3, 2002.  Theincrease is primarily attributable to the acceleration of depreciation due tostore closures, the addition of Right Start shops within the Zany Brainystores, the additional depreciation related to our west coast distributioncenter which opened in the second quarter of Fiscal 2002 and the conversion ofRight Start and FAO Schwarz point-of-sale and merchandising systems.

 

*Storeclosing costs. *Storeclosing costs consist primarily of costs associated with the impairment of

 

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assets related to the closed stores. For the thirteen week period ended August 2, 2003, store closing costswere $0.4 million.

 

*Reorganizationitems, net.* Reorganization items, net, totaling $1.1 million in the thirteenweek period ended August 2, 2003 consist primarily of a $1.0 million chargerecorded in connection with the compromise of liabilities.  See Note 4 in the footnotes to theConsolidated Financial Statements.

 

*Interestexpense, net.* Interest expense, net, decreased $0.8 million to $1.4 million forthe thirteen week period ended August 2, 2003 compared to $2.3 million for thethirteen week period ended August 3, 2002. The decrease is due to a lower outstanding balance on the line of creditin the current period compared to the comparative prior year period offsetpartially by a $0.4 million expense recorded in connection with the warrantsissued in connection with the First Letter of Credit.

 

*Taxprovision.*  Provisionfor income taxes is related to certain minimum state income and franchise taxesfor both of the thirteen week periods ended August 2, 2003 and August 3, 2002.

 

The following tables setforth the statement of operations data for the twenty-six week period endedAugust 2, 2003 and August 3, 2002:

 
|                                   |   | **Twenty-Six Weeks Ended** |    |
|----------------------------------------|--------|----------------------------|---------|
|                                   |   | **August 2, 2003**         |    |
| **(in  000’s)**                   |   | **Total Stores**           |    |   |   | **Goforward Stores** |   |   |   | **Closing Stores** |   |   |   |
| Retail net sales                       |   | $                          | 114,518 |   | 96.1 | % | $ | 87,775 |   | 95.0 | % | $ | 26,743 |   | 100.0 | % |
| Direct to customer net sales           |   | 3,614                      |    | 3.1 | % | 3,614 |   | 3.9 | % | — |   | 0.0 | % |
| Shipping and handling revenues         |   | 996                        |    | 0.8 | % | 990 |   | 1.1 | % | 6 |   | 0.0 | % |
| Net Sales                              |   | 119,128                    |    | 100.0 | % | 92,379 |   | 100.0 | % | 26,749 |   | 100.0 | % |
| Cost of goods sold                     |   | 94,258                     |    | 79.1 | % | 63,920 |   | 69.2 | % | 30,338 |   | 113.4 | % |
| Cost of shipping and handling          |   | 1,071                      |    | 0.9 | % | 1,024 |   | 1.1 | % | 47 |   | 0.2 | % |
| Gross profit                           |   | 23,799                     |    | 20.0 | % | 27,435 |   | 29.7 | % | (3,636 | ) | (13.6 | )% |
| Operating expense                      |   | 33,339                     |    | 28.0 | % | 24,306 |   | 26.3 | % | 9,033 |   | 33.8 | % |
| Occupancy expense                      |   | 28,646                     |    | 24.0 | % | 23,591 |   | 25.6 | % | 5,055 |   | 18.9 | % |
| Marketing and advertising expense      |   | 3,180                      |    | 2.7 | % | 2,672 |   | 2.9 | % | 508 |   | 1.9 | % |
| General and administrative expense     |   | 9,169                      |    | 7.7 | % | 9,169 |   | 9.9 | % | — |   | 0.0 | % |
| Depreciation and amortization expense  |   | 4,492                      |    | 3.8 | % | 2,805 |   | 3.0 | % | 1,687 |   | 6.3 | % |
| Store closing costs                    |   | 1,707                      |    | 1.4 | % | — |   | 0.0 | % | 1,707 |   | 6.4 | % |
|                                   |   | 80,533                     |    | 67.6 | % | 62,543 |   | 67.7 | % | 17,990 |   | 67.3 | % |
| Operating loss                         |   | (56,734                    | )       | (47.6 | )% | (35,108 | ) | (38.0 | )% | (21,626 | ) | (80.9 | )% |
|                                   |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Reorganization items, net              |   | 61,980                     |    | 52.0 | % | 61,980 |   | 67.1 | % | — |   | 0.0 | % |
| Interest expense, net                  |   | (7,199                     | )       | (6.0 | )% | (7,199 | ) | (7.8 | )% | — |   | 0.0 | % |
| Loss before income taxes               |   | (1,953                     | )       | (1.6 | )% | 19,673 |   | 21.3 | % | (21,626 | ) | (80.9 | )% |
| Income tax provision                   |   | 85                         |    | 0.1 | % | 85 |   | 0.1 | % | — |   | 0.0 | % |
| Net loss                               |   | $                          | (2,038  | ) | (1.7 | )% | $ | 19,588 |   | 21.2 | % | $ | (21,626 | ) | (80.9 | )% |
| Number of stores open at end of period |   | 153                        | *       |   |   |   |   |   |   |   |   |   |   |

 

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|                                   |   | **Twenty-Six Weeks Ended** |    |
|----------------------------------------|--------|----------------------------|---------|
|                                   |   | **August 3, 2002**         |    |
| **(in 000’s)**                    |   | **Total Stores**           |    |   |   | **Goforward Stores** |   |   |   | **Closing Stores** |   |   |   |
| Retail net sales                       |   | $                          | 172,711 |   | 97.1 | % | $ | 111,866 |   | 95.6 | % | $ | 60,845 |   | 100.0 | % |
| Direct to customer net sales           |   | 4,076                      |    | 2.3 | % | 4,076 |   | 3.5 | % | — |   | 0.0 | % |
| Shipping and handling revenues         |   | 1,069                      |    | 0.6 | % | 1,069 |   | 0.9 | % | — |   | 0.0 | % |
| Net Sales                              |   | 177,856                    |    | 100.0 | % | 117,011 |   | 100.0 | % | 60,845 |   | 100.0 | % |
| Cost of goods sold                     |   | 105,722                    |    | 59.8 | % | 68,612 |   | 58.6 | % | 37,110 |   | 61.0 | % |
| Cost of shipping and handling          |   | 1,310                      |    | 0.7 | % | 1,310 |   | 1.1 | % | — |   |   |   |
| Gross profit                           |   | 70,824                     |    | 39.8 | % | 47,089 |   | 40.3 | % | 23,735 |   | 39.0 | % |
| Operating expense                      |   | 41,051                     |    | 23.1 | % | 25,193 |   | 21.6 | % | 15,858 |   | 26.1 | % |
| Occupancy expense                      |   | 40,967                     |    | 23.0 | % | 24,361 |   | 20.8 | % | 16,606 |   | 27.3 | % |
| Marketing and advertising expense      |   | 3,880                      |    | 2.2 | % | 2,233 |   | 1.9 | % | 1,647 |   | 2.7 | % |
| General and administrative expense     |   | 12,756                     |    | 7.3 | % | 8,262 |   | 7.1 | % | 4,494 |   | 7.4 | % |
| Depreciation and amortization expense  |   | 3,025                      |    | 1.7 | % | 2,464 |   | 2.1 | % | 561 |   | 0.9 | % |
| Store closing costs                    |   | —                     |    | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % |
|                                   |   | 101,679                    |    | 57.2 | % | 62,513 |   | 53.5 | % | 39,166 |   | 64.4 | % |
| Operating loss                         |   | (30,855                    | )       | (17.3 | )% | (15,424 | ) | (13.2 | )% | (15,431 | ) | (25.4 | )% |
|                                   |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Reorganization items, net              |   | —                     |    | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % |
| Interest expense, net                  |   | (4,387                     | )       | (2.5 | )% | (4,387 | ) | (3.7 | )% | — |   | 0.0 | % |
| Loss before income taxes               |   | (35,242                    | )       | (19.8 | )% | (19,811 | ) | (16.9 | )% | (15,431 | ) | (25.4 | )% |
| Income tax provision                   |   | 99                         |    | 0.1 | % | 99 |   | 0.1 | % | — |   | 0.0 | % |
| Net loss                               |   | $                          | (35,341 | ) | (19.9 | )% | $ | (19,910 | ) | (17.0 | )% | $ | (15,431 | ) | (25.4 | )% |
| Number of stores open at end of period |   | 253                        |    |   |   |   |   |   |   |   |   |   |   |

 

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*  Number of stores includes 11 Saks Boutiques opened in the lasttwo weeks of July 2003.

 

Twenty-Six Weeks Ended August 2, 2003 Compared With August 3, 2002

 

*Retailnet sales.* Retail netsales for the twenty-six week period ended August 2, 2003 decreased $58.2million, or 33.7%, compared to the twenty-six week period ended August 3,2002.  Same store sales, defined asstores that have been open for at least 14 full fiscal months, decreased 21.8%to $86.8 million from $111.0 million in the twenty-six week period ended August2, 2003 compared to the twenty-six week period ended August 3, 2002.  Sales not attributable to same store salesamounted to $27.7 million in the twenty-six week period ended August 2, 2003 ofwhich $0.9 million relates to a new store opened during the twenty-six weekperiod ended August 3, 2002 and $26.8 million relates to stores that haveclosed.  Management believes that samestore sales for the twenty-six week period ended August 2, 2003 were negativelyimpacted primarily by poor in-stock conditions due to significantly reducedinventory receipts during the bankruptcy along with some cannibalization ofsales by our closing store liquidations and a generally sluggish retailenvironment.  The retail environment wasfurther impacted by global political uncertainty, and adverse weatherconditions, including severe winter weather in February 2003 and a delay in theonset of spring weather in much of the United States compared to lastyear.  In addition, during thebankruptcy, we took the opportunity to clear a substantial amount ofdiscontinued merchandise in our go-forward stores that generated approximately30% of total sales in the goforward stores, selling at discounts averaging 70%off retail price.  The clearance salesended on April 30, 2003.  We cannotassure you that our sales decreased solely due to lower in stock levels or thatsales will increase as we improve our stock levels.  Other factors that may have caused reduced sales are customerperceptions of the quality of our services or goods as a result of ourclearance and cost-cutting efforts and factors discussed in our Annual Reporton Form 10-K.  We cannot assure you thatthese factors have been overcome.

 

*Costof goods sold.* Costof goods sold consists primarily of the cost of products sold, inbound freight

 

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costs, inventory shrinkage costs, and costs related to the distributionand warehousing of our retail merchandise. Gross margin decreased in the twenty-six week period ended August 2,2003 to 20.0% from 39.8% in the twenty-six week period ended August 3, 2002.  The decrease is primarily attributable tothe liquidation sales in the closing stores and the impact of the clearancesales in the goforward stores which occurred in the thirteen week period endedMay 3, 2003.  The closing stores' grossmargin reflects $2.6 million in inventory shrinkage and approximately $1.0million in allocated distribution operating costs.  However, there has been an increase in gross margin since thefirst quarter of the year ending January 31, 2004 (“Fiscal 2003”) to 40.0% inthe thirteen week period ended August 2, 2003. The increase in the gross margin in the second quarter of Fiscal 2003was due primarily to the reduction of discounted and discontinued product soldduring the first quarter and a 3.0% increase in selling margins inmerchandising departments such as plush, which was candy, baby gifts andpuzzles, which was a result of merchandising initiatives.

 

*Operatingexpense.* Operatingexpense consists of store operating expenses, retail personnel costs and storepre-opening costs.  Operating expensewas $33.3 million in the twenty-six week period ended August 2, 2003compared to $41.1 million for the twenty-six week period ended August 3,2002.  The decrease is primarily relatedto the 101 stores closed since the end of Fiscal 2002.  Although operating expenses as a percentageof goforward sales increased 4.7% as a result of lower sales volume, operatingexpenses on the comparable 142 goforward stores decreased $0.9 million due toimproved operating efficiencies. Pre-opening costs were $0.1 million for the twenty-six week period endedAugust 2, 2003 compared to $0.2 million for the twenty-six week period endedAugust 3, 2002.  The pre-opening costsfor the twenty-six week period ended August 2, 2003 related to costs associatedwith the opening of the Saks Boutiques.

 

*Occupancyexpense.* Occupancyexpense consists primarily of rent, real estate taxes, common area maintenanceand other miscellaneous expenses. Occupancy expense was $28.6 million for the twenty-six week period endedAugust 2, 2003, a decrease of $12.3 million compared to the twenty-six weekperiod ended August 3, 2002.  Thisdecrease is primarily attributable to the 101 stores closed since the end ofthe first quarter of Fiscal 2002. Occupancy expense on the comparable 142 goforward stores decreased $0.8million due primarily to reduced rents resulting from negotiations withlandlords during the bankruptcy.

 

*Marketingand advertising expense.* Marketing and advertising expense generally consists of printadvertising in national and regional publications, as well as promotional mailingsto our customers.  Marketing andadvertising expense decreased $0.7 million comparing the twenty-six week periodended August 2, 2003 to the twenty-six week period ended August 3, 2002.  Marketing and advertising expense for thetwenty-six week period ended August 2, 2003 included approximately $0.7 millionrelated to new FAO Schwarz promotions targeting tourists.

 

*Generaland administrative expense.* General and administrative expense consists primarily of the costsrelated to management, financial, merchandising, inventory management,professional service fees and other administrative support.  General and administrative expense decreased$3.6 million, or 28.1%, to $9.2 million in the twenty-six week period endedAugust 2, 2003 compared to $12.8 million in the twenty-six week periodended August 3, 2002.  This change isprimarily attributable to the consolidationof operations across all three brands in Fiscal 2002 as well as administrativestaff reductions which occurred in the last quarter of Fiscal 2002,which resulted in decreases of $1.4 million and $2.2 million,respectively.  As a percentage of netsales, general and administrative expense increased from 7.3% to 7.7% dueprimarily to lower sales volume in the twenty-six week period ended August 2,2003 compared to the twenty-six week period ended August 3, 2002.  Additionally, we recorded a $0.3 millioncharge in the twenty-six week period ended August 2, 2003 for defense costspertaining to the securities class action litigation.  This $0.3 million charge represents our insurance deductible.

 

*Depreciationand amortization expense.* Depreciation and amortization expense during the twenty-six weekperiod ended August 2, 2003 was $4.5 million ($1.9 million on the goforwardstores, $0.9 million on the corporate offices and warehouses and $1.7 millionon the closed stores and closed warehouses), an increase of $1.5 million,compared to the twenty-six week period ended August 3, 2002.  The increase is primarily attributable tothe acceleration of depreciation due to store closures, the addition of RightStart shops within the Zany Brainy stores, the additional depreciation relatedto our west coast distribution center which opened in the second quarter ofFiscal 2002 and the conversion of Right Start and FAO Schwarz point-of-sale andmerchandising systems.

 

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*Storeclosing costs. *Storeclosing costs consist primarily of costs associated with the retention of athird party liquidation service to manage the store closings.  For the twenty-six week period ended August2, 2003, store closing costs were $1.7 million.

 

*Reorganizationitems, net.* Reorganization items, net, totaling $62.0 million in thetwenty-six week period ended August 2, 2003 consist of the $65.3 million gainrecorded in connection with the compromise of liabilities, a $3.0 million gainon the sale of certain leases offset partially by employee severance andprofessional fees.  These items wereincurred as a result of the Chapter 11 proceedings.  See Note 4 in the footnotes to the Consolidated FinancialStatements.

 

*Interestexpense, net.* Interest expense, net, increased $2.8 million to $7.2 million forthe twenty-six week period ended August 2, 2003 compared to $4.4 million forthe twenty-six week period ended August 3, 2002.  The increase is primarily due to the beneficial conversionfeature of $4.0 million recorded in connection with the new convertibleEquipment Notes and $0.4 million recorded in connection with the warrantsissued in connection with the First Letter of Credit offset partially by adecrease in interest expense related to the line of credit due to a loweroutstanding balance in the current period compared to the comparative prioryear period.

 

*Taxprovision.*  Provisionfor income taxes is related to certain minimum state income and franchise taxesfor both of the twenty-six week periods ended August 2, 2003 and August 3,2002.

 

Liquidity and Capital Resources

 

 We are primarily atoy retailer and expect to derive approximately 40% of our annual revenueduring our fourth quarter. Historically, we have incurred annual losses.  Our business is seasonal and we expect operating losses for thefirst three quarters of Fiscal 2003 though we currently expect to generatesufficient operating income in the fourth quarter to offset such losses.  We believe that we will be able to maintainour operations and fund working capital and capital expenditures through Fiscal2003 with cash on hand at September 12, 2003, projected cash flow from operationsand anticipated availability from the $77.0 million Loan and SecurityAgreement (the “Loan Agreement”) with Fleet Retail Finance, Inc., as agent (the“Agent”) under which we are co-borrowers with our subsidiaries ZB Company, Inc.and FAO Schwarz, Inc.  We havesupplemented our availability under our Loan Agreement with letters of creditthat were cash collateralized by certain holders of our Class I ConvertiblePreferred Stock.  These letters ofcredit increased our availability by $11.0 million through November 30, 2003reducing to $6.0 million in additional availability thereafter until January 9,2004.  We may need to raise additionalcapital in an amount to be determined following the holiday season.  Our needs for additional funding will dependupon several factors, including, but not limited to, generating sufficient cashflow from operations, the expenses or income from incorporating the SaksBoutiques and the Borders Initiative into our operations and our dependence onindependent manufacturers and suppliers and their credit terms in order tomaintain adequate inventory in-stock levels. There can be no assurances that we will achieve our business plan forgenerating cash flow due to the economic and operational risks we faceincluding our dependence on fourth quarter results and the other risksdiscussed in our Annual Report on Form 10-K. If additional capital is required to grow our business or execute ourbusiness plan, we may seek to raise additional equity or incur additionaldebt.  There can be no assurance giventhat adequate funds will be available to us on acceptable terms or at all.

 

The Loan Agreementmatures April 22, 2006 and consists of (i) a standard revolving line ofcredit of up to $67.0 million under which borrowings bear interest, at ourelection, at an initial rate of 2.50% over the Agent’s calculated EurodollarRate or 0.50% over a base rate designated by Fleet National Bank (the “Bank”)from time to time, and (ii) an additional special term subline of$10.0 million under which borrowings bear interest at a rate of 15.5% perannum for the first year and thereafter at a rate of 11.25% over the base ratedesignated by the Bank.  The LoanAgreement currently allows us to borrow (A) so long as the special termsubline remains outstanding, up to 95% of the current appraised liquidationvalue of our eligible inventory from November 1 through August 14 and 102.5% ofcurrent appraised liquidation value of our eligible inventory from August 15through October 31, and (B) when the special term subline is no

 

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longer in effect, 85% of the current appraised liquidation value of oureligible inventory, less, in each case, reserves established by the Agent fromtime to time in its reasonable discretion for such items as a portion ofoutstanding gift certificates and merchandise credits, royalty obligations, twomonths rent on certain store leases for which we have not received collateralaccess agreements which are acceptable to the landlord and the Agent and anavailability block (initially set at $4.0 million which decreases betweenSeptember 7, 2003 and September 30, 2003 to $1.5 million and between October 1,2003 and 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 Agreement also allows us to borrow85% of eligible credit card receivables, however, our lenders under the LoanAgreement currently are not permitting us to borrow against our credit cardreceivables until we reach a satisfactory agreement with them regarding theirsecurity interest in the receivables.   The Loan Agreement contains a default clause triggered by a materialadverse change and a borrowing restriction based on material adverse changesoccurring since our February 1, 2003 balance sheet date after giving effect tothe Plan of Reorganization.  The LoanAgreement contains one financial covenant. This covenant requires that we maintain minimum excess availabilityunder the Loan Agreement of $5.0 million at all times.  In order to meet this covenant, we arepermitted to supplement our availability under the Loan Agreement by postingletters of credit for the benefit of the lenders under our Loan Agreement.  In connection with the issuance of our ClassI Convertible Preferred Stock, we obtained 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. This letter of credit (the “First Letter of Credit”) was posted on July9, 2003 and supplemented with a second letter of credit (the “Second Letter ofCredit” and collectively, the “Letters of Credit”) posted pursuant to anagreement as of August 27, 2003 with certain holders of our Class I ConvertiblePreferred Stock including those who posted the First Letter of Credit.  The First Letter of Credit will expire nolater than November 30, 2003, and is to expire undrawn so long as on such datewe are not in default under the Loan Agreement or would not be in default underthe Loan Agreement excluding from consideration for this purpose, any increasein availability as a result of the Letters of Credit.  We issued to the providers of the First Letter of Creditfive-year warrants to purchase 821,297 shares of our common stock with anexercise price of $1.50 per share and, if the First Letter of Credit is drawn,we are required to issue to the providers one-year notes in an aggregateprincipal amount equal to the stated amount of the letter of credit secured byour equipment and bearing interest at a rate of 10% per annum.  The fair value of the warrants was estimatedat $1.95 million on the date of issuance using the Black-Scholes pricing modelwith the following assumptions: risk-free interest rate 2.63%; expected life of5 years; dividend yield of 0% and expected volatility of 176.98%.  The value of the warrants is beingrecognized as interest expense through November 30, 2003, which is the term ofthe First Letter of Credit.  Interestexpense recognized in connection with the warrants during the thirteen weeksended August 2, 2003 was $390,000.  Ifsuch notes have not been repaid by November 30, 2003, we are further requiredto issue to the providers five-year warrants to purchase 1,099,460 shares ofour common stock with an exercise price of $1.50 per share.  If the Second Letter of Credit is drawn, weare required to issue demand notes bearing interest at the rate borne on thespecial term subline portion under the Loan Agreement and secured by a lien onall of our assets.  In connection withthe posting of the Second Letter of Credit, we entered into a first amendmentto our Loan Agreement (the “First Amendment to Loan Agreement”).  The First Amendment to Loan Agreement waiveda default with respect to the minimum excess availability covenant under theLoan Agreement and permitted us to use the Second Letter of Credit to satisfythat covenant.  The First Amendment toLoan Agreement also increases the minimum excess availability covenant minimumfrom $5.0 million to $10.0 million ten days prior to expiration of the SecondLetter of Credit continuing until either the Second Letter of Credit is fullydrawn and we have not made any payment on the notes we are required to issue inconnection with such draws or we have received not less than $6.0 million innet proceeds from new subordinated debt or equity financing on terms andconditions acceptable to the lenders under the Loan Agreement.

 

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 and other discretionary considerations.  These appraisals are typically performed atleast quarterly at the request of the Agent and attempt to reflect the net cashthat could be realized by selling our inventory in a “going out of business”sale.  The time of year that such a saleis assumed to take place is significant to the valuation and consequently theresulting monthly advance rates can fluctuate substantially.  For example, advance

 

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rates typically are lowest in the first half of the year and begin torise as the holiday season approaches. This increase in advance rates provides more availability as we begin tobuild our inventory levels to meet holiday season demand.  As of September 12, 2003, the availabilityunder the Loan Agreement was approximately $6.3 million, $1.3 millionabove the $5.0 minimum excess availability covenant taking into account theLetters of Credit.

 

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 1,850shares for $1.85 million gross proceeds since the Effective Date.

 

Forthe twenty-six week period ended August 2, 2003,  $19.5 million in cash was used in our operating activitiescompared to $31.3 million used in operating activities for the same twenty-sixweek period of Fiscal 2002.  Cash used in operating activities in thetwenty-six week period ended August 2, 2003 was primarily from the liquidationand clearance of inventory offset by bankruptcy related expenses and forpayments made pursuant to our Plan of Reorganization.

 

Cash used in investing activities for the twenty-sixweek period ended August 2, 2003 was $0.7 million, primarily resulting from theinstallation of 24 Right Start stores in our existing Zany Brainy stores (“RSShops”), Right Start exterior building and pylon signage for our 83 Zany Brainystores with RS Shops and installation of 11 test departments in nine SaksBoutiques offset by the proceeds from the sale of closing stores’ property,fixtures and equipment.  Cash used ininvesting activities for the twenty-six week period ended August 3, 2002 of$3.6 million was primarily related to the conversion of Right Start and FAOSchwarz point-of-sale and merchandising systems, completing the construction ofthe Farmer’s Market FAO Schwarz store in Los Angeles and costs associated withthe acquisition of our FAO Schwarz brand assets in January 2002 and Zany Brainybrand assets in September 2001.

 

Cash used in financing activities for the twenty-sixweek period ended August 2, 2003 was $5.7 million.  The primary use offunds in financing activities for the twenty-six week period ended August 2,2003 was the payoff of the prior credit facility with the proceeds from thesale of Class I Convertible Preferred Stock, from the Loan Agreement executedupon emergence from bankruptcy and from cash accumulating in a cash collateralaccount during our bankruptcy.  In thetwenty-six week period ended August 2, 2003, we paid $1.6 million in financingcosts for the Loan Agreement.  Cash provided by financing activities forthe twenty-six week period ended August 3, 2002 was $35.9 million.  The primary source of funds from financingactivities for the Fiscal 2002 period were borrowings of $21.4 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 Schwarz, RightStart and Zany Brainy operations, pay $5.0 million in post-closing obligationsin connection with the acquisition of our Zany Brainy brand assets in September2001 and satisfy the redemption of $3.0 million of our Series A MandatorilyRedeemable Preferred Stock.

 

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

 

(i)                                     Anestimated $16.8 million to holders of unsecured claims; $4.4 million on theEffective Date, approximately $9.4 million on December 22, 2003, approximately$2.0 million on December 22, 2004 and approximately $1.0 million on December22, 2005.  In the event excess availability under the Loan Agreement onDecember 18, 2003 is less than $37.0 million then the December 2003 paymentobligation will be deferred until December 22, 2004 pro rata, by the amount bywhich excess availability is less than $37.0 million; provided, however, in noevent may the December 2003 payment to holders of unsecured claims be less than$1 million.  In the event that excess availability under the LoanAgreement on December 18, 2004 is less than $40.0 million, then any deferredDecember 2003 payments to holders of unsecured claims will be deferred untilDecember 22, 2005 pro rata, by the amount by which the excess availability is lessthan $40.0 million; provided, however, in no event may the December 2004payment to holders of unsecured

 

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claims be less than (i) the amounts due to unsecuredcreditors on December 22, 2004, plus (ii) $1.0 million of the deferred December2003 payments.  Any payments deferred until December 22, 2005 shall be dueand payable no later than December 22, 2005 irrespective of excess availabilityunder the Loan Agreement.  The deferrals will be applicable if, and onlyif, 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 including December22, 2003 provided such payments have not been deferred.

 

(iii)                               $500,000on January 11, 2004 and $3.3 million on each of December 31, 2006, 2007 and2008 plus interest at a rate of 6% per annum through and including January 11,2005, at which time the first interest payment shall be made in cash withpayments made quarterly thereafter, to the holders of the new SubsidiarySubordinated Notes provided we are current with our payments to holders of thenew convertible Equipment Notes and unsecured claims and such payments have notbeen deferred.  $4.0 million of suchamounts will be forgiven if we obtain the release of the holders of such notesfrom a guarantee on the lease for one of our FAO Schwarz stores.

 

We have completed the opening of 83 RS Shops.  We opened 24 RS Shops in the second quarterof Fiscal 2003 in addition to the 59 RS Shops which were open as of February 1,2003.  The capital outlay for a typicalRS Shop averages approximately $25,000. All 83 of the stores containing RS Shops will have new exterior signageand the typical capital outlay will be approximately $10,000 per store.  In addition to the RS Shops, on April 23,2003, we entered into a Departmental License Agreement with Saks DepartmentStore Group (consisting of Bergner’s, Boston Store, Carson Pirie Scott,Herberger’s, McRae’s, Parisian, Proffitt’s and Younkers) setting forth theterms of operation for 22 test departments in eleven stores (“SaksBoutiques”).  We expect to incur annuallicense fees under the Departmental License Agreement of approximately $370,000subject to increase based on a percentage of sales.  As of September 2003, we have installed 16 Saks Boutiques andhave scheduled six additional boutiques for installation (including four inSaks Fifth Avenue stores which are operated separately from the Saks DepartmentStore Group stores).  The capital outlayfor the remaining six Saks Boutiques is expected to be approximately$180,000.

 

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*CriticalAccounting Policies and Estimates*

 

Our consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States.  These generally acceptedaccounting principles require management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of net sales and expenses during the reporting period.

 

Our significant accounting policies were described inNote 1 of “Notes to Consolidated Financial Statements” contained in the AnnualReport on Form 10-K as filed for the fiscal year ended February 1, 2003. We believe that the following discussion addresses our critical accountingpolicies, which are those that are most important to the portrayal of ourfinancial condition and results of operations and require management’s mostdifficult, subjective and complex judgments, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain. If actual results were to differ significantly from estimates made, thereported results could be materially affected.  We are not, however,currently aware of any reasonably likely events or circumstances that webelieve would be reasonable likely to result in materially different results.

 

We believe that the following represents the areaswhere the most critical estimates and assumptions are used in the preparationof the financial statements.

 

Merchandise inventories: Merchandise inventoriesconsist of finished goods purchased for resale and are stated at the lower ofcost or market value.  Cost isdetermined on a weighted average basis. A periodic review of inventory levels and inventory turns is performedin order to determine if inventory is properly valued at the lower of cost ormarket.  Factors relating to current inventories such as future customerdemand, current analysis of merchandise based on receipt date and current andanticipated retail markdowns are analyzed to determine estimated net realizablevalues.  Criteria we used to quantify aging trends include merchandisereceived within the past 12 months, merchandise received more than sixmonths before with quantities on-hand in excess of 26 weeks of sales andmerchandise selling below cost.  A provision is recorded to reduce thecost of inventories to the estimated net realizable values, if required. Inventories as of August 2, 2003 and February 1, 2003 totaled $58.2 million and$103.1 million, respectively, representing 57.0% and 58.7% of total assets,respectively.  Given the significance of inventories to our consolidatedfinancial statements, the determination of net realizable values is consideredto be a critical accounting estimate.  Any significant unanticipatedchanges in the factors noted above could have a significant impact on the valueof our inventories and our reported operating results.

 

Long-lived assets: We periodically evaluate whetherevents and circumstances have occurred that indicate the remaining estimateduseful lives of long-lived assets may warrant revision or that the remainingbalance may not be recoverable.  Theselong-lived assets are recorded at cost and are amortized using thestraight-line method, which deducts equal amounts of costs over the lesser ofthe applicable store lease term or the estimated useful life of theasset.  Net property, fixtures and equipment as of August 2, 2003 andFebruary 1, 2003 totaled $22.6 million and $26.4 million, respectively,representing 22.1% and 15.0% of total assets, respectively.  When factorsindicate that an asset should be evaluated for possible impairment, we use anestimate of the asset’s undiscounted net cash flows over its remaining life inmeasuring whether the asset is recoverable.  If economic conditions aresubstantially different from our expectations, the carrying value of ourlong-lived assets may become impaired.  In the twenty-six week periodended August 2, 2003, we did not record any write-downs of long-lived assets,compared to $7.1 million recorded in Fiscal 2002.

 

Income taxes: We account for income taxes using anasset and liability approach under which deferred tax liabilities and assetsare recognized for the expected future tax consequences of net operating losscarryforwards and temporary differences between the carrying amounts and thetax bases of assets and liabilities.  Avaluation allowance is established against deferred tax assets when it is morelikely than not that all, or some portion, of such deferred tax assets may notbe realized.  We must assess the likelihood that our deferred tax assetswill be recovered from future taxable income.  As a result of the reviewundertaken for the year ended February 1, 2003, we concluded that it wasappropriate to establish a full

 

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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 inflation on the results of operationshas not been significant during our last three fiscal years.

 

Seasonality

 

Operating results for the twenty-six week period endedAugust 2, 2003 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 ourannual revenue from, and achieve all of our annual profitability, if any, inour fourth quarter.

 

New Accounting Requirements

 

In December 2002, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.148, “Accounting for Stock-Based Compensation-Transition and Disclosure” whichamends SFAS No. 123, “Accounting for Stock-Based Compensation,” to providealternative methods of transition for a voluntary change to the fair valuemethod of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 to require prominent disclosures inboth annual and interim financial statements. The disclosure modifications are required for fiscal years and interimperiods ending after December 31, 2002 and are included in the notes to ourconsolidated financial statements.

 

In March 2003, the Emerging Issues Task Force (“EITF”)reached a consensus on EITF Issue No. 02-16, “Accounting by a Customer(Including a Reseller) for Certain Consideration Received from a Vendor.”  EITF Issue No. 02-16 addresses the incomestatement classification of cash considerations received by an entity,including a reseller, from a vendor and provides guidance regarding the timingof recognition of volume rebates.  Wehave adopted EITF Issue No. 02-16 as of January 1, 2003 and the adoption didnot have a material effect on our financial position or results of operations.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and HedgingActivities”.  SFAS No. 149 amends andclarifies the accounting for derivative instruments, including certainderivative instruments embedded in other contracts, and for hedging activitiesunder SFAS No. 133.  SFAS No. 149 iseffective for contracts entered into or modified after June 30, 2003 and forhedging relationships designated after June 30, 2003.  The guidance should be applied prospectively.  The adoption of SFAS No. 149 did not have amaterial effect on our financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity”.  SFAS No. 150 clarifies theaccounting for certain financial instruments with characteristics of bothliabilities and equity and requires that those instruments be classified asliabilities in the statement of financial position.  Previously, many of those financial instruments were classifiedas equity.  SFAS No. 150 is effectivefor financial 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 expectthe adoption of SFAS No. 150 to have a material effect on our financialposition or results of operations.

 

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ITEM 3.                  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

In the ordinary course of operations, we face nosignificant market risk from derivative instruments.  Our purchase of imported products subjects us to a minimal amountof foreign currency risk.  Foreigncurrency risk is that risk associated with recurring transactions with foreigncompanies, such as purchases of goods from foreign vendors.  If the strength of foreign currenciesincreases compared to the United States dollar, the price of imported productscould increase.  We have no commitments,however, for future purchases with foreign vendors and, additionally, we havethe ability to source many products domestically in the event of significantimport price increases.

 

Part I, Item 3 of this report should be read inconjunction with Part II, Item 7A of our Annual Report on Form 10-K for theyear ended February 1, 2003.

 

See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations — Liquidity and Capital Resources” abovefor a discussion of our debt obligations, the interest rates of which arelinked to the Agent’s Eurodollar Rate or Base Rate.  For every $1 million in debt outstanding under the LoanAgreement, an increase of 0.25% in our interest rate would cost us anadditional $2,500 of interest expense per year.  We have not entered into any derivative financial instruments tomanage interest rate risk, currency risk or for speculative purposes and we arecurrently not evaluating the future use of these instruments.

 

ITEM 4.                  CONTROLS AND PROCEDURES

 

We maintain “disclosure controls and procedures,” assuch term is defined in Rules 13a-15e and 15d-15e of the Securities ExchangeAct of 1934, as amended (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed in our reports, pursuant to the ExchangeAct, is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Senior Vice President-Finance, as appropriate, to allow timelydecisions regarding the required disclosures.  In designing and evaluatingthe disclosure controls and procedures, management has recognized that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurances of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost benefit relationship of possible controls and procedures.

 

Our Chief Executive Officer and Senior VicePresident-Finance (our principal executive officer and principal accountingofficer, respectively) have evaluated the effectiveness of our “disclosurecontrols and procedures” as of the end of the period covered by this QuarterlyReport on Form 10-Q.  Based on their evaluation, the principal executiveofficer and principal financial officer concluded that our disclosure controlsand procedures are effective.  There were no significant changes in ourinternal controls or in other factors that could significantly affect thesecontrols subsequent to the date the controls were evaluated.

 

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 business or operations,financial position or results of operations, however, management’s initialevaluation may prove inaccurate.

 

Prior to our bankruptcy filing we negotiated asettlement of a suit with Oxygen Media, LLC (“Oxygen”) regarding a disputedterm sheet in which Oxygen alleged we and our former subsidiary,RightStart.com, owed Oxygen for advertising services.  The parties each had alleged fraud was committed by the otherparty as well as various contract claims and defenses.  Before the settlement agreement wasfinalized and executed, we filed for bankruptcy protection under Chapter11.  The settlement amount was

 

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confidential but immaterial to our business.  Oxygen has filed a claim in our Chapter 11 proceedings for $20.0million which we have disputed as unliquidated.  Management does not believe this claim will result in a materialadverse effect on our business or operations, financial position or results ofoperations.

 

On February 19, 2003, Edward Steele filed a classaction claim against our directors Jerry R. Welch, Fred Kayne and Richard Kaynein United States District Court for the Eastern District of Pennsylvaniaclaiming violations of Sections 10(b) and 20(a) of the Securities Exchange Actof 1934 and Rule 10b-5 promulgated thereunder based on allegedmisrepresentations made by the defendants. Mr. Steele has filed a proof of claim on behalf of himself and othersfor $50.0 million in our bankruptcy case. On April 3, 2003, another case was filed in the same court, making thesame claims against the same defendants. The two cases have been consolidated. We have not been named as a defendant nor has there been any claim madefor indemnity though the defendants did file proofs of claim on ourindemnification obligations set forth in our articles and bylaws.  Our directors and officers insurance carrierhas acknowledged coverage with a reservation of claims.  An amended consolidated complaint was filedon July 14, 2003 which added certain claims related to our accounting and addedour former Chief Financial Officer, Raymond Springer, as a defendant.  The defendants must respond to the amendedcomplaint by October 1, 2003. Management currently does not believe this claim will result in amaterial adverse effect on our business or operations, financial position orresults of operations; however, new issues may arise that could have such aneffect or management’s initial evaluation 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.  Changesin Securities and Use of Proceeds

 

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 1,850shares for $1.85 million in gross proceeds since the Effective Date.

 

Exceptfor 500 shares, our Class I Convertible Preferred Stock was sold underSection 4(2) of the Securities Act of 1933.  The proceeds of thisissuance were used to fund our emergence from bankruptcy.  Five hundred shares of the Class IConvertible Preferred Stock, convertible into 333,333 shares of our commonstock, were issued on the Effective Date in compromise of claims pursuant toSection 1145(a) of the Bankruptcy Code.  Holders of 20,166,667 shares ofour common stock to be issued on conversion of the Class I ConvertiblePreferred Stock and certain holders of common stock issued prior to ourbankruptcy filing who had registration rights prior to such filing, haveregistration rights with respect to such common stock.  The Class I Convertible Preferred Stock is senior onliquidation, dissolution or winding up and in the payment of dividends to ourcommon stock.  Holders of the Class IConvertible Preferred Stock vote with the holders of our common stock on an asconverted 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 4,542 shares of Class J Convertible PreferredStock issued in compromise of claims through our bankruptcy and since convertedinto 2,329,025shares of our common stock was issued pursuant to Section 4(2) ofthe Securities Act of 1933 or Section 1145(a) of the Bankruptcy Code andconverted pursuant to Section 3(a)(9) of the Securities Act of 1933 or Section1145(a) of the Bankruptcy Code.

 

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Thewarrants to purchase 110,000 shares of our common stock issued in compromise ofclaims through bankruptcy were issued pursuant to Section 4(2) of theSecurities Act of 1933 or Section 1145(a) of the Bankruptcy Code.

 

In connection with our emergence from bankruptcy, wecompromised Equipment Notes in exchange, in part, for new Equipment Notes in anaggregate principal amount of $4.0 million convertible into Class J ConvertiblePreferred Stock at $1,000 per share which convert to common stock at $1.95 pershare pursuant to Section 4(2) of the Securities Act of 1933. A portion of thenew Equipment Notes was converted into 314 shares of our Class I ConvertiblePreferred Stock and subsequently converted into160,959 shares of our commonstock pursuant to Section 3(a)(9) of the Securities Act of 1933 or 1145(a) ofthe Bankruptcy Code.

 

The warrants issued in connection with the posting ofthe First Letter of Credit were issued pursuant to Section 4(2) of theSecurities Act of 1933.

 

Item 6.    Exhibitsand Reports on Form 8-K

 

(a) Listing of Exhibits

 

**INDEXTO EXHIBITS**

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                           |
|---------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |   | First Amendment to Loan and  Security Agreement dated as of August 27, 2003 by and among FAO, Inc., FAO  Schwarz, Inc., ZB Company, Inc., The Right Start, Inc. and Targoff-RS, LLC,  the lenders listed therein and Fleet Retail Finance, Inc. as Agent. |
| 31.1                |   | Certificate of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                        |
| 31.2                |   | Certificate of Senior Vice  President-Finance pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
| 32.1                |   | 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.                                                                                                        |
| 32.2                |   | 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 were no reports filed by the Company on Form 8-K during thethirteen weeks ended August 2, 2003.

 

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SIGNATURES

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Company has duly caused this reportto be signed on its behalf by the undersigned and thereunto duly authorized.

 
|                           | FAO, INC.                              |
|--------------------------------|----------------------------------------|
|                           |                                   |
|                           |                                   |
| Date:  September 15, 2003 |                                   | /s/  Jerry R. Welch |
|                           | Jerry  R. Welch                        |
|                           | Chief  Executive Officer and President |
|                           |                                   |
| Date:  September 15, 2003 |                                   | /s/  Jerome A. Kollar |
|                           | Jerome  A. Kollar                      |
|                           | Senior  Vice President-Finance         |

 

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