REX

Business Context and Reporting Period

Company: Rex Stores Corporation (REX American Resources Corp)

Filing Type: Form 10-Q (Quarterly Report)

Reporting Period: Three and six months ended July 31, 2004

Business Overview: Rex is a specialty retailer in the consumer electronics and appliance industry. As of July 31, 2004, the company operated 239 stores in 37 states, primarily under the "REX" trade name. The company also holds significant interests in synthetic fuel limited partnerships.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Net sales decreased 4.7% year-over-year for the six-month period, driven by a net reduction of 10 stores and a 3.6% decline in comparable store sales. The appliance category was negatively impacted by cooler temperatures reducing air conditioner demand.
• Profitability Increase: Despite lower sales, Net Income increased 16.9% to $7.4 million. This was primarily driven by a significant increase in income from synthetic fuel investments ($8.6 million vs. $6.2 million prior year) and a reduction in interest expense due to debt paydowns.
• Margin Compression: Gross profit margin declined from 30.1% to 28.8% due to lower sales of high-margin air conditioners and increased promotional activity.
• Debt Reduction: The company aggressively reduced debt, paying off approximately $23.5 million in mortgage debt, including an early termination of $21.6 million in mortgages for 42 locations. This incurred a one-time charge of $614,000.
• Cash Flow: Operating cash flow usage increased to $14.5 million, primarily due to a $39.4 million increase in merchandise inventory for seasonal needs.

Outlook, Risks, and Management Commentary

• Synthetic Fuel Investments: A major driver of current earnings is income from synthetic fuel partnerships (Colona and Somerset). The IRS audit of the Colona partnership was finalized in February 2004, releasing escrowed funds. However, a U.S. Senate Subcommittee has initiated an investigation into income tax credits involving synthetic fuel operations, posing a potential regulatory risk.
• Store Strategy: The company closed 9 stores in the first half of fiscal 2004 and opened none. Management is focusing on optimizing the store base, with 5 stores classified as discontinued operations resulting in a net loss of $261,000 for the six-month period.
• Capital Allocation: The company utilized cash to repurchase 420,400 shares of common stock for approximately $6.0 million. Approximately 700,000 shares remain authorized for repurchase under the current program.
• Liquidity: While cash balances decreased significantly from the beginning of the fiscal year ($29.0 million to $3.4 million), the company maintains a current ratio of 1.8 to 1. Management notes that interim results are not necessarily indicative of full-year results.

Investor Verification Checklist

• Synthetic Fuel Dependency: Verify the sustainability of earnings given that a significant portion of net income ($8.6 million) is derived from non-operating synthetic fuel investments rather than core retail operations.
• Regulatory Risk: Monitor the status of the U.S. Senate Subcommittee investigation into synthetic fuel tax credits, which could impact future tax benefits and investment income.
• Inventory Levels: Assess the $39.4 million increase in inventory against seasonal sales trends to ensure no obsolescence or markdown risks exist.
• Comparable Store Sales: Track the 3.6% decline in comparable store sales to determine if the trend reverses in the second half of the fiscal year.
• Debt Structure: Confirm the impact of the $21.6 million debt payoff on future interest savings versus the loss of leverage.