J. Crew Group, Inc. Annual Report 1997

SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 __________ FORM 10-K FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (Mark One)[X] ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED, EFFECTIVE OCTOBER 7, 1996].For the fiscal year ended January 31, 1998 OR[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from __________ to __________ COMMISSION FILE NUMBER 333-42427 --------- J. CREW GROUP, INC. (Exact name of registrant as specified in its charter) New York 22-2894486 -------- ----------(State or other jurisdiction of (IRS Employerincorporation or organization) Identification No.) 770 BROADWAY, NEW YORK, NEW YORK 10003 (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (212) 209-2500 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered ------------------- ----------------------------------------- NONE NONE Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ______ No X ----- Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant's knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. [_] The common stock of the registrant is not publicly traded. Therefore,the aggregate market value is not readily determinable. Indicate by check mark whether the registrant has filed all documentsand reports required to be filed by Section 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a planconfirmed by a court. Yes _____ No _____ As of April 15, 1998, 60,745 shares of Common Stock, par value $.01 per share, were outstanding. DOCUMENTS INCORPORATED BY REFERENCE: NONE In connection with the Recapitalization (as defined below), J. Crew Group,Inc., a New York corporation ("Holdings"), organized J. Crew Operating Corp., aDelaware corporation ("Operating Corp"), and immediately prior to theconsummation of the Recapitalization, Holdings transferred substantially all ofits assets and liabilities to Operating Corp. Holdings' current operations are,and future operations are expected to be, limited to owning the stock of theOperating Corp. Holdings and its subsidiaries are collectively referred toherein as the "Company." References herein to fiscal years are to the fiscalyears of Holdings, which end on the Saturday closest to January 31 in thefollowing calendar year. Effective January 31, 1998, the Company changed itsfiscal year end from the Friday closest to January 31 to the Saturday closest toJanuary 31. Accordingly, fiscal years 1993, 1994, 1995, 1996 and 1997 ended onJanuary 28, 1994, February 3, 1995, February 2, 1996, January 31, 1997 andJanuary 31, 1998. All fiscal years for which financial information is includedhad 52 weeks, except fiscal 1994 which had 53 weeks. Certain statements in this Annual Report under the captions "Business","Selected Financial Data", Management's Discussion and Analysis of FinancialCondition and Results of Operations", Financial Statements and SupplementaryData" and elsewhere constitute "forward-looking statements" within the meaningof the Private Securities Litigation Reform Act of 1995. Such forward-lookingstatements involve known and unknown risks, uncertainties and other importantfactors that could cause the actual results, performance or achievements of theCompany, or industry results, to differ materially from any future results,performances or achievements expressed or implied by such forward-lookingstatements. The Company expressly disclaims any obligation or undertaking todisseminate any updates or revisions to any forward-looking statement containedherein to reflect any change in the Company's expectations with regard theretoor any change in events, conditions or circumstances on which any such statementis based. PART IITEM 1. BUSINESSGENERAL The Company is a leading mail order and store retailer of women's and men'sapparel, shoes and accessories operating primarily under the J. Crew(R) brandname. The Company has built a strong and widely recognized brand name known forits timeless styles at price points that the Company believes representexceptional product value. The J. Crew image has been built and reinforced overits 14-year history through the circulation of more than one-half billioncatalogs that use magazine-quality photography to portray a classic Americanperspective and aspirational lifestyle. Many of the original items introduced bythe Company in the early 1980s (such as the rollneck sweater, weathered chino,barn jacket and pocket tee) were instrumental in establishing the J. Crew brandand continue to be core product offerings. The Company has capitalized on thestrength of the J. Crew brand to provide customers with clothing to meet more oftheir lifestyle needs, including casual, career and sport. The J. Crew merchandising strategy emphasizes timeless styles and a broadassortment of high-quality products designed to provide customers with one-stopshopping opportunities at attractive prices. J. Crew catalogs and retail storesoffer a full line of men's and women's basic durables (casual weekend wear),sport, swimwear, accessories and shoes, as well as the more tailored men'ssportswear and women's "Classics" lines. Approximately 60% of the Company's J.Crew brand sales are derived from its core offerings of durables and sportclothing, the demand for which the Company believes is stable and resistant tochanging fashion trends. The Company believes that the J. Crew image andmerchandising strategy appeal to college-educated, professional and affluentcustomers who, in the Company's experience, have demonstrated strong brandloyalty and a tendency to make repeat purchases. J. Crew products are distributed exclusively through the Company's catalogand store distribution channels. The Company currently circulates over 76million J. Crew catalogs per annum and owns and operates 51 J. Crew retailstores and 42 J. Crew factory outlets. In addition, J. Crew products aredistributed through 67 free-standing and shop-in-shop stores in Japan under alicensing agreement with Itochu. 1 In addition to the Company's J. Crew operations, the Company operatesClifford & Wills ("C&W"), a mail order and factory store women's apparelbusiness that targets older, more conservative customers, and Popular Club Plan("PCP"), a direct selling catalog merchandiser of consumer branded goods througha "club" concept that provides credit sales to lower-income customers. The Company has five major operating divisions: J. Crew Mail Order, J. CrewRetail, J. Crew Factory Outlets, PCP and C&W. J. Crew Mail Order, J. CrewRetail and J. Crew Factory Outlets each operate under the J. Crew brand name. In1997, products sold under the J. Crew brand contributed $577.6 million inrevenues (including licensing revenues) or 69.3% of the Company's totalrevenues. J. Crew brand revenues in 1997 were comprised primarily of $264.8million (45.8%) from J. Crew Mail Order, $209.6 million (36.3%) from J. CrewRetail and $100.3 million (17.4%) from J. Crew Factory Outlets. In fiscal 1997,PCP and C&W contributed revenues of $184.4 million and $72.0 million,respectively, representing approximately 22.1% and 8.6%, respectively, of theCompany's total revenues.J. CREW BRANDMerchandising and Design Strategy The J. Crew merchandising strategy focuses on creating and delivering abroad assortment of high-quality products in timeless styles intended to providecustomers with one-stop shopping opportunities at attractive prices. Many of theoriginal items introduced by the Company in the early 1980s (such as therollneck sweater, weathered chino, barn jacket and pocket tee) were instrumentalin establishing the J. Crew brand, and continue to be core product offerings.The Company has capitalized on the strength of the J. Crew brand image toprovide its customers with clothing to meet more of their lifestyle needs,including casual, career and sport. Over time, the J. Crew merchandising strategy has evolved from providingunisex products to creating full lines of men's and women's clothing, shoes andaccessories. This has had the effect of increasing overall J. Crew brand salesvolume, and significantly increasing revenues from sales of women's apparel as apercentage of total J. Crew brand sales. The following table sets forth the J.Crew merchandise mix as a percentage of total J. Crew Mail Order and Retailrevenues for the years 1993 through 1997. (J. Crew brand sales statisticsthroughout this section exclude sales in J. Crew Factory Outlets.) FY 1993 FY 1994 FY 1995 FY 1996 FY 1997 ----------- ---------- ---------- ----------- ----------- Women's........ 42% 47% 53% 56% 59%Men's.......... 58 53 47 44 41 --- --- --- --- --- 100% 100% 100% 100% 100% === === === === === Every J. Crew product is designed by Emily Woods and her in-house designstaff of 15 designers to reflect a classic, clean aesthetic that is consistentwith the brand's American lifestyle image. Design teams are formed around J.Crew product lines and categories to develop concepts, themes and products foreach of the Company's J. Crew businesses. Members of the J. Crew technicaldesign team develop construction and fit specifications for every product toensure quality workmanship and consistency across product lines. These teamswork in close collaboration with the merchandising and production staff in orderto gain market and other input. Product merchandisers provide designers withmarket trend and other information at initial stages of the design process. J.Crew designers and merchants source globally for fabrics, yarns and finishingproducts to ensure quality and value, while manufacturing teams research anddevelop key vendors worldwide to identify and maintain the essentialcharacteristics for every style.J. Crew Mail Order Since its inception in 1983, J. Crew Mail Order has distinguished itselffrom other catalog retailers by its award-winning catalog, which utilizesmagazine-quality "real moment" pictures to depict an aspirational lifestyle 2 image. During fiscal 1997, J. Crew Mail Order distributed 33 catalog editionswith a combined circulation of more than 76 million, generating $264.8 millionin revenues or 45.8% of the Company's total J. Crew brand revenues. Circulation Strategy J. Crew Mail Order's circulation strategy focuses on continually improvingthe segmentation of customer files and the acquisition of additional customernames. In 1997, approximately 60% of J. Crew Mail Order revenues were fromcustomers in the 12-month buyer file (buyers who have made a purchase from anyJ. Crew catalog in the prior 12 months). Between 1993 and 1997 the J. Crew MailOrder 12-month buyer file grew at a compound annual growth rate of 10%. Customer Segmentation. In 1996, the Company began segmenting its customerfile and tailoring its catalog offerings to address the different product needsof its customer segments. To increase core catalog productivity and improve theeffectiveness of marginal and prospecting circulation, each customer segment isoffered different catalog editions. The Company currently circulates Base,Women's, Prospect and Sale catalogs to targeted customer segments, has recentlyintroduced a College catalog and intends to introduce a Swimwear catalog in1998. Descriptions of the Company's current catalogs follow: . Base Books. These catalogs contain the entire mail order product offeringand are sent primarily to 12-month buyers. . Women's Books. Introduced in the spring of 1996, the Women's books featurewomen's merchandise and are sent to buyers who purchase primarily women'smerchandise. These books represent an additional customer contact potentiallygenerating incremental revenue from women customers. . Prospect Books. Introduced in late 1995, these editions are abridgedversions of the Base Books and are sent to less active and prospective customersin order to cost-effectively reactivate old customers and acquire new customers. . Sale Books. These catalogs contain overstock merchandise to be sold atreduced prices without adversely affecting the J. Crew brand image. The following are descriptions of the recently introduced College book andthe Swimwear book planned for 1998: . College Books. College books present a merchandise mix (primarily men's andwomen's Durables, Sport and Swimwear) that is most often purchased by and forstudents. These catalogs consist of a new creative presentation involving alifestyle setting appealing to the youth market. The Company believes that thesenew catalogs will also be effective as prospecting vehicles: the page counts arerelatively low (68 pages) and the product lines offered are of above averageproductivity. . Swimwear Books. The Company plans to offer its full swimwear line togetherwith selected casual weekend clothing in a special catalog edition to be mailedto its most productive women customers as well as to prospective customers. TheCompany's analysis of buyer performance indicates that swimwear is the mostproductive category for existing buyers and the product classification mostfrequently purchased by first-time buyers. The Company believes that it circulates fewer and less-targeted catalogeditions than its competitors, and that segmentation will improve theproductivity (as measured by initial demand per page circulated) of itscirculation by: (i) increasing its offers to its most productive customers anddecreasing its offers to its less productive customers, and (ii) reducing boththe page count and number of mailings of its Base Books. For example, in 1996,the Company introduced the Women's catalog which to date has achieved 20% higherinitial 3 demand per page circulated than that of the Base Book. The overall effect ofincreased segmentation is expected to be an increase in books circulated (andcustomer contacts made) and a decrease in pages circulated. In 1997, totalcirculation increased to approximately 77 million from approximately 76 millionin 1996, primarily as a result of the introduction of Prospect and Women'scatalogs, while pages circulated were approximately 9.8 billion in 1996 and1997. From 1997 to 1998, the increased segmentation is expected to result in anapproximately 6% decrease in the number of catalogs circulated, and anapproximately 14% decrease in total pages circulated. Reductions in total pagescirculated should result in a decrease in paper and postage expenses and anincrease in productivity or sales per page circulated. Customer Acquisition and List Management. J. Crew Mail Order's nameacquisition programs are designed to attract new customers in a cost-effectivemanner. The Company acquires new names from various sources, including listrentals, exchanges with other catalog and credit card companies, "friends' name"card inserts and, recently, through J. Crew Retail stores which represent anincreasingly significant resource in prospecting for new names. Names andaddresses of 25% to 30% of the customers making credit card purchases at J. CrewRetail stores are automatically captured at the point of sale. Customers arealso asked to fill out cards at the cash register when they make purchases. Inaddition, the Company is exploring the feasibility of placing telephones in itsJ. Crew Retail stores with direct access to the J. Crew Mail Order telemarketingcenter to allow customers in the stores to order catalog-specific or out-of-stock items. The Company believes that circulation planning based on more sophisticatedstatistical circulation models will increase the effectiveness of catalogmailings and maximize the productivity of its buyer file. As a result, theCompany is testing increasingly sophisticated statistical circulation planningmodels to improve its ability to predict customer purchase behavior based on awide range of variables. The Company plans to use these analyses to enhance itscirculation efficiencies. Catalog Creation and Production The Company is distinguished from other catalog retailers by its award-winning catalog, which utilizes magazine-quality "real moment" pictures todepict an aspirational lifestyle image. All creative work on the catalogs iscoordinated by J. Crew personnel to maintain and reinforce the J. Crew brandimage. Photography is executed both on location and in studios, and creativedesign and copy writing are executed on a desk-top publishing system. Digitalimages are transmitted directly to outside printers, thereby reducing lead timesand improving reproduction quality. The Company believes that appropriate pagepresentation of its merchandise stimulates demand and therefore places greatemphasis on page layout. J. Crew Mail Order does not have long-term contracts with paper mills and,instead, purchases paper from paper mills at a two and one-half month specifiedrate. Projected paper requirements are communicated on an annual basis to papermills to ensure the availability of an adequate supply. Management believes thatthe Company's long-standing relationships with a number of the largest coatedpaper mills in the United States allow it to purchase paper at favorable pricescommensurate with the Company's size and payment terms. Telemarketing and Customer Service J. Crew Mail Order's primary telemarketing and fulfillment facilities arelocated in Lynchburg, Virginia. Telemarketing operations are open 24 hours aday, seven days a week and handled over 7 million calls in fiscal 1997. Ordersfor merchandise may be received by telephone, facsimile, mail and the Company'swebsite, although orders through the toll-free telephone service accounted for90% of orders in fiscal 1997. The telemarketing center is staffed by a total of900 full-time telemarketing associates, and up to 2,500 associates during peakperiods, who are trained to assist customers in determining the customer'scorrect size and to describe merchandise fabric, texture and function. Eachtelemarketing associate utilizes a terminal with access to an IBM mainframecomputer which houses complete and up-to-date product and order information. Thefulfillment operations are designed to process and ship customer orders in aquick and cost-effective manner. Orders placed before 9:00 p.m. are shipped thefollowing day. Same-day shipping is available for orders placed before noon.During non-peak periods, approximately 11,000 packages are shipped daily, andduring peak periods, 25,000 daily. 4 J. Crew Retail An important aspect of the Company's business strategy is an expansionprogram designed to reach new and existing customers through the opening of J.Crew Retail stores. In addition to generating sales of J. Crew products, J. CrewRetail stores help set and reinforce the J. Crew brand image. The stores aredesigned in-house and fixtured to create a distinctive J. Crew environment andstore associates are trained to maintain high standards of visual presentationand customer service. The result is a complete statement of J. Crew's timelessAmerican style, classic design and attractive product value. During fiscal 1997,J. Crew Retail generated revenues of $209.6 million, representing 36.3% of theCompany's total J. Crew brand revenues. The Company believes that J. Crew Retail derives significant benefits fromthe concurrent operation of J. Crew Mail Order. The broad circulation of J. Crewcatalogs performs an advertising function, enhancing the visibility and exposureof the brand, aiding the expansion of the retail concept and increasing theprofitability of the stores. J. Crew Retail maintains a uniform appearance throughout its store base, interms of merchandise display and location on the selling floor. Store managersreceive detailed store plans that dictate fixture and merchandise placement toensure uniform execution of the merchandising strategy at the store level.Standardization of store design and merchandise presentation also maximizesusage and productivity of selling space and lowers the cost of store furnishingsallowing J. Crew Retail to cost-effectively open new stores and refurbishexisting ones. Store Economics The Company believes that its J. Crew Retail stores are among the mostproductive in its industry segment. All of the Company's J. Crew Retail storesare profitable and have generated positive store contribution within the first12 months of opening. J. Crew Retail stores that were open during all of fiscal1997 averaged $4.5 million per store in sales, produced sales per gross squarefoot of approximately $518 and generated store contribution margins ofapproximately 23.4%. The Company believes that these results compare favorablyto the average among retailers that the Company believes to be its primarycompetitors. J. Crew Retail stores have an average size of 8,400 gross squarefeet. The Company's historical average cost for leasehold improvements,furniture and fixtures for new stores was approximately $950,000 per store,after giving effect to construction allowances. The Company anticipates that thecost of these improvements will increase as it targets more urban, high-trafficareas for its stores. Average pre-opening costs per store, which are expensed asincurred, were $87,000. In addition, working capital requirements, consistingalmost entirely of inventory purchases, averaged approximately $550,000 perstore. Current Stores As of January 31, 1998 J. Crew Retail operated 51 retail stores nationwide,having expanded from 18 stores in 1993. The Company intends to open 12 to 15stores in fiscal 1998. The stores are located in upscale shopping malls and inretail areas within major metropolitan markets that have an established higher-end retail business. 5 The table below highlights certain information regarding J. Crew Retailstores opened through fiscal 1997. AVERAGE STORES STORES ------------ ---------- ---------- TOTAL STORE TOTAL STORES OPEN OPENED CLOSED STORES AT ---------- ------------ ------------ ---------- ---------- ---------- SQUARE SQUARE AT BEGINNING DURING DURING END OF ---------- ------------ ------------ ---------- ---------- ---------- FOOTAGE FOOTAGE AT OF FISCAL FISCAL FISCAL FISCAL ---------- ------------ YEAR YEAR YEAR YEAR (000'S) END OF YEAR ------------ ---------- ---------- ---------- ---------- ------------ 1993.............. 18 10 -- 28 226 8,0711994.............. 28 1 -- 29 235 8,1031995.............. 29 2 -- 31 266 8,5811996.............. 31 8 -- 39 338 8,6671997.............. 39 12 -- 51 428 8,392 New Store Expansion J. Crew Retail plans to increase the number of stores in operation by 12 to20 stores annually, resulting in approximately 100 stores in operation by theend of fiscal 2000. The retail expansion plan will initially focus on markets inwhich J. Crew Mail Order has been successful and, more generally, in areaswithin major metropolitan markets with affluent and well educated populations.The Company will continue to cluster stores in markets which provide thegreatest sales potential, such as New York, New Jersey, Massachusetts,California and Florida. Historically, new stores have cost the Company anaverage of $1.5 million in building and working capital expenditures and haveexperienced a pay-back period of approximately 20 months. The Company believes,with a base of 51 stores, its markets are underpenetrated relative to itscompetitors and enough suitable locations exist nationwide to accommodate itsexpansion plan.J. Crew Factory Outlets The Company extends its reach to additional consumer groups through its 42J. Crew Factory Outlets. Offering J. Crew products at an average of 30% belowfull retail prices, J. Crew Factory Outlets target value-oriented consumers. Thefactory outlet stores also serve to liquidate excess, irregular or out-of-seasonJ. Crew products outside of the Company's two primary distribution channels.During fiscal 1997, J. Crew Factory Outlets generated revenues of $100.3million, representing 17.4% of the Company's total J. Crew brand revenues. J. Crew Factory Outlets offer selections of J. Crew menswear andwomenswear. Ranging in size from 3,800 to 10,000 square feet with an average of6,500 square feet, the stores are generally located in major outlet centers in25 states across the United States. The Company believes that the outlet stores,which are designed in-house, maintain fixturing, visual presentation and servicestandards superior to those typically associated with outlet stores.POPULAR CLUB PLAN PCP is a direct selling catalog business offering a broad range ofdepartment store merchandise on proprietary, in-house credit plans to the lowerand lower-middle income market. PCP markets its catalog products primarily ineleven states in the northeastern United States. PCP offers two distinct productcategories: Home Store (53% of 1997 sales) and Ready-to-Wear (47% of 1997sales). Home Store products include textiles, home furnishings, housewares andelectronics. Ready-to-Wear includes men's and women's sportswear, coats,lingerie, juniors, accessories, jewelry, shoes, children's wear, infants,special size and swimwear. During fiscal 1997, Popular Club Plan's annualcirculation of 7 million catalogs generated revenues of $184.4 million,representing 22.1% of total Company revenues. PCP markets products through an extensive network of over 100,000 localindependent sales representatives ("Secretaries"), using a unique combination ofmail order and direct selling methods. In contrast to a retail store salesassociate, a Secretary is a lead shopper who solicits his or her own circle offriends, relatives, and co-workers to shop from the catalog. Secretaries arecompensated through commission reward credits which can be redeemed for freemerchandise. This provides them with both a sales and collection incentive. AllSecretary 6 applicants are screened and scored with proprietary behavior models inconjunction with national credit bureau information. Only 60% of applicants areset up as new accounts. PCP offers customers a 22-week payment plan and a 44-week payment plan forpayment of merchandise ordered from PCP. Sales through these proprietary creditproducts accounted for 96.8% of PCP revenues in 1997. PCP performs ongoingcredit analysis on each Secretary and his or her club. Although Secretaries donot guarantee payment of members they recruit, reward credits of clubSecretaries may be withheld to offset poor credit performance. PCP monitorscollections through its approximately 70-person credit and collectiondepartment. While the primary dunning process is done through club Secretaries,if an individual is delinquent more than ten weeks, credit collectors will alsotake on the responsibility of contacting the customer directly. Over the lastfive years, PCP's annual credit losses have averaged approximately 4% of netcredit sales.CLIFFORD & WILLS C&W is a direct mail order and factory store business which offers a broadrange of women's updated apparel covering career to casual as well asaccessories and shoes. The typical customer is a 36 to 55 year old upper-moderate to better-priced women's apparel customer, parallel to that of a full-price department store. The brand is positioned to offer bridge level clothing at prices which are20% to 30% below the prices offered in better departments of department stores,thereby satisfying the target customer's desire for updated apparel at acompelling price advantage. The Company also operates nine C&W outlet stores inPennsylvania, Florida, Wisconsin, Indiana, Texas, Georgia and Connecticut.During 1997, C&W had revenues of $72.0 million representing 8.6% of totalCompany revenues.SOURCING, PRODUCTION AND QUALITY The Company maintains separate merchandising, design, manufacturing andquality assurance teams for the production of J. Crew and C&W merchandise. TheCompany's products are designed exclusively by in-house design and productdevelopment teams which support each line and class of product. These teamsprovide individual attention and expertise to every style, ensuring that thesestyles fit the respective J. Crew and C&W brand images. PCP primarily purchasesmerchandise from manufacturers and distributors. The Company's merchandise is produced for the Company by a variety ofmanufacturers, both domestically and outside the United States. The Company doesnot own or operate any manufacturing facilities, instead contracting with thirdparty vendors for the production of its products. Manufacturing teams researchand develop products and source from vendors across 38 countries to identify andmaintain essential quality and value for every product. In 1997, approximately60% of the Company's J. Crew brand products were sourced in the Far East, 20%were sourced domestically and 20% were from Europe and other regions. PCP andC&W source the majority of their products through domestic vendors. Rarely doesthe Company represent the majority of any one vendor's business and no onevendor supplies more than 10% of the Company's merchandise. The Company employs independent buying agents to conduct in-line and finalquality inspections at each manufacturing site. Random inspections of allincoming J. Crew and C&W merchandise at the Lynchburg and Asheville distributionfacilities further assure that the Company's products are of a consistently highquality. PCP primarily sells consumer goods which have been subjected to themanufacturer's own quality control processes prior to receipt by PCP. Due to the high concentration of foreign suppliers of J. Crew brandmerchandise, the Company estimates 10-month lead times for its products.Currently, the Company must make commitments on its piece goods eight to ninemonths prior to the issuance of the respective catalog and must decide on SKUcolor buys within six months of issuance. The Company is working to establish,either through the use of more domestic vendors or through strategicpartnerships, a core group of long-term suppliers that provide quicker responsetimes. The Company believes that the implementation of shorter lead times willimprove fill rates, reduce the overall complexity in 7 inventory management and improve its ability to more accurately forecast demand,all of which should provide substantial savings to the Company.DISTRIBUTION The Company operates three main telemarketing and distribution facilitiesfor its operations. Order fulfillment for J. Crew Mail Order and C&W takes placeat the 406,500 square foot telemarketing and distribution center located inLynchburg, Virginia. The Lynchburg facility processes approximately 3.8 millionorders per year and employs approximately 1,800 full- and part-time employeesduring its peak season. The 192,500 square foot telemarketing and distribution facility inAsheville, North Carolina was recently converted into the main distributioncenter to service the retail and outlet store operations and also houses a J.Crew Mail Order telemarketing center. This facility employs approximately 700full- and part-time employees during its non-peak season and an additional 1,100employees during the peak holiday season. PCP conducts its fulfillmentoperations from a 369,000 square foot distribution facility located in Edison,New Jersey. The Edison facility employs approximately 300 and 600 full- andpart-time employees during the non-peak and peak seasons, respectively. Each fulfillment center is designed to process and ship customer orders ina quick and cost-efficient manner. Same-day shipping is available for ordersplaced before noon; and orders placed before 9:00 p.m. are shipped the followingday. The Company ships merchandise via the UPS, the United States Postal Serviceand FedEx. To enhance efficiency, each facility is fully equipped with a highlyadvanced telephone system, an automated warehouse locator system and aninventory bar coding system.MANAGEMENT INFORMATION SYSTEMS The Company's management information systems are designed to provide, amongother things, comprehensive order processing, production, accounting andmanagement information for the marketing, manufacturing, importing anddistribution functions of the Company's business. The Company has installedsophisticated point-of-sale registers in its J. Crew Retail and Factory Outletstores that enable it to track inventory from store receipt to final sale on areal-time basis. The Company believes its merchandising and financial system,coupled with its point-of-sale registers and software programs, allow for rapidstock replenishment, concise merchandise planning and real-time inventoryaccounting practices. J. Crew Mail Order and C&W share the same managementinformation system and each of the Company's business units has its owninformation system that is customized to the needs of that particular business. The Company's telephone and telemarketing systems, warehouse packagesorting systems, automated warehouse locators and inventory bar coding systemsutilize advanced technology. These systems have provided the Company with anumber of benefits in the form of enhanced customer service, improvedoperational efficiency and increased management control and reporting. TheCompany's IBM 3990 system stores data, such as customer list segmentation andanalyses of market trends, and rapidly transfers the information throughout theCompany. In addition, the Company's real-time inventory computer systems provideinventory management on a per SKU basis and allow for a more efficientfulfillment process. J. Crew's management information systems also produce dailyand weekly sales and performance reports.TRADEMARKS AND INTERNATIONAL LICENSING J. Crew International, Inc., an indirect subsidiary of Holdings, currentlyowns all of the trademarks for the J. Crew name that the Company holds in theUnited States and internationally, as well as its international licensingcontracts with third parties. Trademarks related to the J. Crew name areregistered in the United States Patent and Trademark Office. The Company derives revenues from the international licensing of itstrademarks in the J. Crew name and the know-how it has developed. The Companyhas entered into a licensing agreement with Itochu in Japan which 8 gives the Company the right to receive payments of percentage royalty fees inexchange for the exclusive right to use the Company's trademarks in Japan. In1997, licensee sales at retail stores in Japan were approximately $95 millionthrough 67 free-standing and shop-in-shop stores. Under the license agreementthe Company retains a high degree of control over the manufacture, design,marketing and sale of merchandise under the J. Crew trademarks. This agreementexpires in January, 2003. The Company believes there is significant growth potential in internationalmarkets as the Company can leverage off its base in Japan into other key Asianmarkets. The Company is in the process of exploring licensing agreementscovering Hong Kong, China, Singapore, Thailand and Malaysia. In 1997, licensingrevenues totaled $2.9 million.EMPLOYEES The Company focuses significant resources on the selection and training ofsales associates in both its mail order, retail and factory operations. Salesassociates are required to be familiar with the full range of merchandise of thebusiness in which they are working and have the ability to assist customers withmerchandise selection. Both retail and factory store management are compensatedin a combination of annual salary plus performance-based bonuses. Retail,telemarketing and factory associates are compensated on an hourly basis and mayearn team-based performance incentives. At January 31, 1998, the Company had approximately 6,200 associates, ofwhom approximately 4,200 were full-time associates and 2,000 were part-timeassociates. In addition, approximately 3,000 associates are hired on a seasonalbasis to meet demand during the peak holiday buying season. None of theassociates employed by J. Crew Mail Order, J. Crew Retail, J. Crew FactoryOutlets or C&W are represented by a union. Approximately 240 warehouse employeesat PCP are represented by the Teamsters under a collective bargaining agreementwhich expires in June 1999. The Company believes that its relationship with itsassociates is good.COMPETITION All aspects of the Company's businesses are highly competitive. The Companycompetes primarily with other catalog operations, specialty brand retailers,department stores, and mass merchandisers engaged in the retail sale of men'sand women's apparel, accessories, footwear and general merchandise. The Companybelieves that the principal bases upon which it competes are quality, design,efficient service, selection and price.THE RECAPITALIZATION On October 17, 1997, the recapitalization of Holdings (the"Recapitalization") was consummated pursuant to a Recapitalization Agreement,dated as of July 22, 1997, as amended as of October 17, 1997 (the"Recapitalization Agreement"), among Holdings, its shareholders and TPG PartnersII, L.P. ("TPG"). Pursuant to the Recapitalization Agreement, Holdings purchasedfrom its shareholders all outstanding shares of Holdings' capital stock, otherthan shares having an implied value of $11.1 million, almost all of whichcontinues to be held by Emily Woods, and which represented approximately 14.8%of the outstanding shares of common stock, par value $.01 per share, of Holdings("Common Stock") immediately following the transaction. In connection with the Recapitalization, Holdings organized Operating Corpand immediately prior to the consummation of the Recapitalization, Holdingstransferred substantially all of its assets and liabilities to Operating Corp.Holdings' current operations are, and future operations are expected to continueto be, limited to owning the stock of Operating Corp. Operating Corp repaidsubstantially all of the Company's funded debt obligations existing immediatelybefore the consummation of the Recapitalization. Cash funding requirements for the Recapitalization (which was consummatedon October 17, 1997) totalled $559.7 million (including $99.0 million inseasonal borrowings) and were satisfied through the purchase by TPG, certain ofits affiliates and other investors of an aggregate $188.9 million in Holdings'equity securities together with an aggregate $330.9 million in borrowings and$40.0 million in proceeds from the securitization of certain of the Company'saccounts receivable, as follows: (i) the purchase by TPG, certain of itsaffiliates and other 9 investors of shares of Common Stock (representing 85.2% of the outstandingshares) for $63.9 million; (ii) the purchase by TPG, certain of its affiliatesand other investors of $125.0 million in liquidation value of preferred stockissued by Holdings (the "Preferred Stock"); (iii) gross proceeds of $75.3million from the issuance and sale by Holdings of the 13-1/8% senior discountdebentures due 2008 (the "Senior Discount Debentures"); (iv) $150.0 million fromthe gross proceeds of the offering by Operating Corp of the 10 3/8% SeniorSubordinated Notes due 2007 (the "Senior Subordinated Notes"); (v) $40.0 millionin proceeds from the securitization of certain of the Company's accountsreceivable (the "Securitization"); (vi) $70.0 million of borrowings under asenior secured term loan facility among Operating Corp, Holdings and thefinancial institutions parties thereto (the "Term Loan Facility"); and (vii)$35.6 million of borrowings under a senior secured revolving credit facilityamong Operating Corp, Holdings and the financial institutions parties thereto(the "Revolving Credit Facility" and, together with the Term Loan Facility, the"Bank Facilities"). See Item 7. "Management's Discussion and Analysis ofFinancial Condition and Results of Operations--Liquidity and Capital Resources."ITEM 2. PROPERTIES The Company is headquartered in New York City, although PCP maintains aseparate main office in Garfield, New Jersey. Both the New York Cityheadquarters offices and PCP's Garfield office are leased from third parties.The Company owns two telemarketing and distribution facilities: a 406,500-square-foot telemarketing and distribution center for J. Crew and C&W mail order operations in Lynchburg, Virginia and a 192,500-square-footdistribution center in Asheville, North Carolina servicing the J. Crew Retailand J. Crew and C&W outlet store operations. The Company also leases from athird party a 369,000-square-foot distribution facility located in Edison, NewJersey dedicated to PCP's fulfillment operations. As of January 31, 1998, the Company operated 102 retail and factory outletstores. All of the retail and factory outlet stores are leased from thirdparties, and the leases in most cases have terms of 10 to 12 years, notincluding renewal options. As a general matter, the leases contain standardprovisions concerning the payment of rent, events of default and the rights andobligations of each party. Rent due under the leases is comprised of annual baserent plus a contingent rent payment based on the store's sales in excess of aspecified threshold. Substantially all the leases are guaranteed by Holdings. The table below sets forth the number of stores by state operated by theCompany in the United States as of January 31, 1998: TOTAL ---------- RETAIL OUTLET NUMBER --------- --------------- ---------- STORES STORES(1) OF STORES --------- --------------- ---------- Alabama........................... -- 1 1Arizona........................... 1 -- 1California........................ 8 3 11Colorado.......................... 1 2 3Connecticut....................... 3 2 5Delaware.......................... -- 1 1Florida........................... 3 5 8Georgia........................... 1 3 4Illinois.......................... 4 -- 4Indiana........................... 1 3 4Kansas............................ -- 1 1Maine............................. -- 2 2Maryland.......................... 1 -- 1Massachusetts..................... 5 1 6Michigan.......................... 1 1 2Minnesota......................... 1 -- 1 10 Missouri.......................... 1 1 2New Hampshire..................... -- 2 2New Jersey........................ 2 1 3New Mexico........................ 1 -- 1New York.......................... 4 4 8North Carolina.................... 2 -- 2Ohio.............................. 2 -- 2Oregon............................ 1 -- 1Pennsylvania...................... 2 5 7South Carolina.................... -- 1 1Tennessee......................... -- 1 1Texas............................. 3 5 8Utah.............................. -- 1 1Vermont........................... -- 1 1Virginia.......................... 1 1 2Washington........................ 1 1 2Wisconsin......................... -- 2 2District of Columbia.............. 1 -- 1 -- -- --- Total........................ 51 51 102 == == ===- -----------------------------(1) Includes nine C&W outlet stores.ITEM 3. LEGAL PROCEEDINGS The Company is a defendant in several lawsuits arising in the ordinarycourse of business. Although the amount of any liability that could arise withrespect to any such lawsuit cannot be accurately predicted, in the opinion ofmanagement, the resolution of these matters is not expected to have a materialadverse effect on the financial position or results of operations of theCompany. A 1992 Supreme Court decision confirmed that the Commerce Clause of theUnited States Constitution prevents a state from requiring the collection of itsuse tax by a mail order company unless the company has a physical presence inthe state. However, there continues to be some uncertainty in this area due toinconsistent application of the Supreme Court decision by state and federalcourts. The Company attempts to conduct its operations in compliance with itsinterpretation of the applicable legal standard, but there can be no assurancethat this compliance will not be challenged. From time to time, various stateshave sought to require companies to begin collection of use taxes and/or paytaxes from previous sales. The Company has not received assessments from anystate in which it is not currently collecting sales taxes since the 1992 SupremeCourt decision. The Supreme Court decision also established that Congress has the power toenact legislation that would permit states to require collection of use taxes bymail order companies. Congress has from time to time considered proposals forsuch legislation. The Company anticipates that any legislative change, ifadopted, would be applied only on a prospective basis. 11 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On December 29, 1997, a Special Meeting of Shareholders of Holdings (the"Special Meeting") was held to consider (i) the approval and adoption of the J.Crew Group, Inc. 1997 Stock Option Plan (the "Stock Option Plan") and (ii) theapproval and ratification of the grant under the Stock Option Plan to EmilyWoods of options to purchase, in the aggregate, 2,461 shares of Common Stock.Of the 37,003,717 shares of Common Stock represented at the Special Meeting, allof such shares were voted in favor of each of the matters submitted to theshareholders. No shares of Common Stock were voted against, were withheld orabstained as to either of such matters. 12 PART IIITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY SECURITIES AND RELATED STOCKHOLDER MATTERS There is no established public market for any class of Holdings capitalstock. As of April 15, 1998, there were 32 shareholders of record of the CommonStock. See "Item 12. Security Ownership of Certain Beneficial Owners andManagement" for a discussion of the ownership of Holdings. Holdings has not paid cash dividends on its Common Stock and does notanticipate paying any such dividends in the foreseeable future. Each of the Bank Facilities and the indenture relating to the SeniorDiscount Debentures (the "Holdings Indenture") prohibits the payment ofdividends by Holdings on shares of Common Stock (other than dividends payablesolely in shares of capital stock of Holdings). Additionally, because Holdingsis a holding company, its ability to pay dividends is dependent upon the receiptof dividends from its direct and indirect subsidiaries. Each of the BankFacilities, the Holdings Indenture and the indenture relating to the SeniorSubordinated Notes contains covenants which impose substantial restrictions onOperating Corp's ability to make dividends or distributions to Holdings. In connection with the Recapitalization, on October 17, 1997, Holdings soldto TPG, certain of its affiliates and other investors (i) approximately 47,000shares of Common Stock (representing 85.2% of the then outstanding shares) for$63.9 million, (ii) 92,500 shares of Series A Preferred Stock, par value $0.01per share, of Holdings ("Series A Preferred Stock") for $92.5 million and (iii)32,500 shares of Series B Preferred Stock, par value $0.01 per share, ofHoldings ("Series B Preferred Stock") for $32.5 million. Holdings sold theCommon Stock, the Series A Preferred Stock and the Series B Preferred Stockdescribed in the foregoing sentence in transactions which did not involve anypublic offering in reliance upon Section 4(2) of the Securities Act of 1933, asamended. 13 ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated historical financial,operating, other and balance sheet data of Holdings. The selected incomestatement data and balance sheet data for each of the four fiscal years endedJanuary 31, 1997 are derived from the Consolidated Financial Statements ofHoldings, which have been audited by Deloitte & Touche LLP, independentauditors. The selected income statement data and balance sheet data for thefiscal year ended January 31, 1998 are derived from the Consolidated FinancialStatements of Holdings, which have been audited by KPMG Peat Marwick LLP,independent auditors. The data presented below should be read in conjunctionwith the Consolidated Financial Statements, including the related Notes thereto,included herein, the other financial information included herein, and"Management's Discussion and Analysis of Financial Condition and Results ofOperations." FISCAL YEAR ENDED ------------------------------------------------------------------ JANUARY 28, FEBRUARY 3, FEBRUARY 2, JANUARY 31, JANUARY 31, 1994 1995 1996 1997 1998 ----------- ----------- ----------- ----------- ---------- (dollars in thousands, except per square foot data) INCOME STATEMENT DATA:Revenues............................................ $646,972 $737,725 $745,909 $808,843 $ 834,031Cost of goods sold(a)............................... 354,889 394,073 399,668 428,719 465,168 -------- -------- -------- -------- --------- Gross profit..................................... 292,083 343,652 346,241 380,124 368,863Selling, general and administrative expenses........ 265,857 311,468 327,672 348,305 359,811 -------- -------- -------- -------- --------- Income from operations........................... 26,226 32,184 18,569 31,819 9,052Interest expense-net................................ 6,107 6,965 9,350 10,470 20,494Expenses incurred-Recapitalization.................. -- -- -- -- 20,707Provision (benefit) for income taxes................ 8,100 10,300 3,700 8,800 (5,262)Extraordinary items and cumulative effect ofaccounting changes.................................. -- -- 931 -- (4,500) -------- -------- --------- -------- ---------Net income (loss)................................... $ 12,019 $ 14,919 $ 6,450 $ 12,549 $ (31,387) ======== ======== ======== ======== ========= BALANCE SHEET DATA (AT PERIOD END): Cash and cash equivalents......................... $ 23,185 $ 18,255 $ 13,529 $ 7,132 $ 12,166 Working capital................................... 91,339 104,455 132,256 132,222 142,677 Total assets...................................... 287,233 324,795 355,249 410,821 421,878 Total debt and redeemable preferred stock......... 61,803 69,566 87,329 87,092 428,457 Stockholders' equity (deficit).................... 66,221 82,041 89,633 102,006 (201,642) OPERATING DATA:Revenues: J. Crew mail order................................ $199,954 $247,272 $274,653 $289,772 $ 264,853 J. Crew retail.................................... 108,650 135,726 134,959 167,957 209,559 J. Crew factory................................... 49,253 62,626 79,203 94,579 100,285 J. Crew licensing................................. 1,900 3,269 3,975 3,817 2,897 -------- -------- -------- -------- --------- Total J. Crew brand............................... 359,757 448,893 492,790 556,125 577,594 Other divisions(b)................................ 287,215 288,832 253,119 252,718 256,437 -------- -------- -------- -------- --------- Total........................................... $646,972 $737,725 $745,909 $808,843 $ 834,031 ======== ======== ======== ======== ========= J. Crew Mail Order: Number of catalogs circulated (in thousands)..... 62,547 61,187 67,519 76,087 76,994 Number of pages circulated (in millions)......... 6,965 8,277 10,198 9,827 9,830 J. Crew Retail: Sales per gross square foot...................... $ 559 $ 594 $ 533 $ 551 $ 518 Store contribution margin........................ 18.7% 22.7% 25.5% 25.4% 23.4% Number of stores open at end of period........... 28 29 31 39 51 Comparable store sales change(c)................. (8.0)% 6.9% (6.0)% 4.5% (6.6)% 14 FISCAL YEAR ENDED -------------------------------------------------------------- JANUARY 28, FEBRUARY 3, FEBRUARY 2, JANUARY 31, JANUARY 31, 1994 1995 1996 1997 1998 ---------- ---------- ---------- ---------- ---------- (dollars in thousands, except per square foot data) Depreciation and amortization..................... $ 6,786 $ 8,110 $10,272 $10,541 $15,255 Net capital expenditures(d) New store openings............................... 2,789 2,804 6,009 10,894 19,802 Other............................................ 8,297 10,663 8,631 11,587 11,565 ------- ------- ------- ------- ------- Total net capital expenditures................... 11,086 13,467 14,640 22,481 31,367(a) Includes buying and occupancy costs.(b) Includes revenues from the Company's PCP and C&W divisions and finance charge income from PCP installment sales.(c) Comparable store sales includes stores that have been opened for a full twelve month period.(d) Capital expenditures are net of proceeds from construction allowances.ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion summarizes the significant factors affecting theconsolidated operating results, financial condition and liquidity of the Companyduring the three-year period ended January 31, 1998. This discussion should beread in conjunction with the audited consolidated financial statements of theCompany for the three-year period ended January 31, 1998 and notes theretoincluded elsewhere in this Annual Report on Form 10-K.RESULTS OF OPERATIONS Consolidated statements of operations presented as a percentage of revenuesare as follows: FISCAL YEAR ENDED ------------------------------------ JANUARY 31 January 31 FEBRUARY 2 JANUARY 31 January 31 FEBRUARY 2 1998 1997 1996 ---------- ---------- ---------- Revenues......................................................................... 100.0% 100.0% 100.0%Cost of goods sold, including buying and occupancy costs......................... 55.8 53.0 53.6 ----- ----- -----Gross profit..................................................................... 44.2 47.0 46.4Selling, general and administrative expenses..................................... 43.1 43.1 43.9 ----- ----- -----Income from operations........................................................... 1.1 3.9 2.5Interest expense, net............................................................ (2.5) (1.3) (1.3)Expenses incurred-recapitalization............................................... (2.5) -- -- ----- ----- -----(Loss)/income before income taxes, extraordinary items and cumulative effect of accounting changes.............................................................. (3.9) 2.6 1.2Benefit/(provision) for income taxes............................................. 0.6 (1.0) (.5) ----- ----- -----(Loss)/income before extraordinary items and cumulative effect of accounting changes......................................................................... (3.3)% 1.6% 0.7% ===== ===== =====Fiscal 1997 Compared to Fiscal 1996 Revenues Revenues increased 3.1% to $834.0 million in the fiscal year ended January31, 1998 from $808.8 million in the fiscal year ended January 31, 1997, as aresult of increased revenues of J. Crew Retail stores. The increased revenues ofJ. Crew Retail stores were offset by a decrease in J. Crew Mail Order revenues.J. Crew Retail revenues increased by 24.8% to $209.6 million in the fiscal yearended January 31, 1998 from $168.0 million in the fiscal year ended January 31,1997. The increase in J. Crew Retail store revenues was the result of theopening of 12 new stores in fiscal 1997, which offset a decline of 6.6% incomparable store sales. 15 J. Crew Mail Order revenues decreased by 8.6% to $264.8 million in thefiscal year ended January 31, 1998 from $289.8 million in the fiscal year endedJanuary 31, 1997. The percentage of the Company's total revenues derived fromJ. Crew Mail Order decreased to 31.8% in the fiscal year ended January 31, 1998from 35.8% in the fiscal year ended January 31, 1997. The decrease in J. CrewMail Order revenues was primarily due to weak performance in menswear sales andunseasonably warm weather on the east coast during the fall season. The UPSstrike also contributed to the decrease in J. Crew Mail Order revenues. Grosssales were down 19% from July 18, 1997 to the end of the UPS strike on August23, 1997 compared to the same period in the prior year. The number of catalogsmailed was approximately 77 million in fiscal 1997 compared to 76 million infiscal 1996. J. Crew Retail revenues increased by 24.8% to $209.6 million in the fiscalyear ended January 31, 1998 from $168.0 million in the fiscal year ended January31, 1997. The percentage of the Company's total revenue derived from its J.Crew Retail stores increased to 25.1% in the fiscal year ended January 31, 1998from 20.8% in the fiscal year ended January 31, 1997. The increase in J. CrewRetail revenues is the result of opening 12 new stores in the fiscal year endedJanuary 31, 1998. Comparable stores sales decreased 6.6% as the result of theopening of new stores in proximity to existing store locations, weak performancein menswear sales and unseasonably warm weather in the second half of the yearwhich contributed to a decrease in the sales of fall and winter clothing. J. Crew Factory Outlet revenues increased by 6.1% to $100.3 million in thefiscal year ended January 31, 1998 from $94.5 million in the fiscal year endedJanuary 31, 1997. The percentage of the Company's total revenue derived from J.Crew Factory Outlet remained at approximately 12%. J. Crew Factory storescomparable store sales increased by 2.0% in the fiscal year ended January 31,1998. The comparable store sales increase was principally due to the overallimprovement in store merchandising under the direction of a new factory outletmerchandising vice president. J. Crew Factory Outlet opened three new storesand closed one store in fiscal 1997. PCP revenues increased by 3.8% to $184.4 million in the fiscal year endedJanuary 31, 1998 compared to $177.7 million in the fiscal year ended January 31,1997. The percentage of the Company's total revenues derived from PCP remainedat approximately 22.0%. The number of catalogs mailed remained at the sameapproximate level of 7 million and the number of selling agents remainedunchanged at approximately 106,000 during fiscal 1997 and 1996. The increase insales in fiscal 1997 over fiscal 1996 was attributable to better performance inready-to-wear apparel and specifically in new branded merchandise. C&W revenues decreased 4.0% to $72.0 million in the fiscal year endedJanuary 31, 1998 from $75.0 million in the fiscal year ended January 31, 1997.The percentage of the Company's revenue derived from C&W decreased to 8.6% inthe fiscal year ended January 31, 1998 from 9.3% in the fiscal year endedJanuary 31, 1997. The number of catalogs mailed increased to approximately 40million in the fiscal year ended January 31, 1998 from approximately 38 millionin the fiscal year ended January 31, 1997. The decrease in sales was the resultof the effect of the UPS strike, the unseasonably warm weather in the secondhalf of the fiscal year effecting the sales of fall and winter clothing and alower response from the Company's sale catalogs compared to the prior year. Gross Profit Gross profit as a percentage of revenues was 44.2% for the fiscal yearended January 31, 1998 compared to 47.0% in the fiscal year ended January 31,1997. Half of the decrease in gross profit was primarily the result ofsignificant promotional discounting in the November and December Holidaycatalogs in J. Crew Mail Order and the other half of the decrease was the resultof an increase in J. Crew Retail buying and occupancy costs, reflecting thehigher costs associated with opening new stores in urban areas such as New YorkCity. Selling, General and Administrative Expenses Selling, general and administrative expenses as a percentage of revenueswas 43.1% in the fiscal year ended January 31, 1998 and the fiscal year endedJanuary 31, 1997. As a percentage of revenues general and administrativeexpenses increased by 1.2%, primarily as a result of a higher expense ratio dueto the decrease in J. Crew Mail Order revenues and the decline in comparablestore sales in J. Crew Retail. Catalog circulation costs (consisting primarilyof paper, postage and printing) expenses decreased by 1.2% primarily as a resultof decreased paper costs. Absolute dollar amounts of selling, general andadministrative expenses increased to $359.8 million in fiscal 1997 from $348.3million in fiscal 1996, primarily reflecting volume related costs. 16 Interest Expense Interest expense increased to $20.5 million or 2.5% of revenues in thefiscal year ended January 31, 1998 from $10.5 million or 1.3% of revenues in thefiscal year ended January 31, 1997. This increase in interest expense was dueto the issuance by Holdings of the Senior Discount Debentures of $75.3 millionwhich contributed approximately $2.9 million in increased interest, the issuanceby Operating Corp of the Senior Subordinated Notes of $150 million whichcontributed approximately $4.6 million in increased interest and the Term LoanFacility of $70 million which contributed approximately $1.8 million inincreased interest. These borrowings were required to fund the Recapitalization.The increase was partially offset by a decrease in the interest expense relatedto the $85.0 million of senior indebtedness which was retired in October 1997.Borrowings under the Revolving Credit Facility required to fund inventories andcapital expenditures contributed $1.9 million in increased interest. Recapitalization Expenses The recapitalization expenses of $20.7 million consisted of managementbonuses of $12.2 million, a financial advisory fee paid to TPG of $5.6 million,legal and accounting fees of $1.4 million, a consulting fee of $1.0 million andother expenses of $0.5 million. The Company's results of operations werenegatively impacted by these recapitalization expenses. The loss before incometaxes and extraordinary item of $32.1 million for the fiscal year ended January31, 1998 includes the $20.7 million of non-recurring recapitalization expenses,the majority of which were paid before January 31, 1998.Fiscal 1996 Compared to Fiscal 1995 Revenues Revenues increased 8.4% to $808.8 million in fiscal 1996 from $745.9million in fiscal 1995, as the result of increased sales of J. Crew brandmerchandise. J. Crew brand revenues increased 12.8% to $556.1 million in fiscal1996 from $492.8 million in fiscal 1995. Other divisions contributed $252.7million in revenues in fiscal 1996 as compared to $253.1 million in fiscal 1995. J. Crew Mail Order revenues increased 5.5% to $289.8 million in fiscal 1996from $274.6 million in fiscal 1995. The percentage of the Company's totalrevenues derived from J. Crew Mail Order decreased to 35.8% in fiscal 1996 from36.8% in fiscal 1995. The increase in J. Crew Mail Order revenues principallyresulted from the introduction of the Women's Book and the related increase inoverall J. Crew catalog circulation to approximately 76 million in 1996 fromapproximately 68 million in 1995. J. Crew Retail revenues increased by 24.4% to $168.0 million in fiscal 1996from $135.0 million in fiscal 1995. The percentage of the Company's totalrevenues derived from its J. Crew Retail stores increased to 20.8% in 1996 from18.1% in 1995. The increase in revenues was principally the result of theopening of eight new stores and a 4.5% increase in comparable store sales infiscal 1996. The increase in comparable store sales was principally due tostrong performance in the J. Crew womenswear lines, including Durables, Classicsand Collection. J. Crew Factory Outlet revenues increased by 19.3% to $94.5 million infiscal 1996 from $79.2 million in fiscal 1995. The percentage of the Company'stotal revenues derived from its J. Crew Factory Outlet stores increased to 11.7%in fiscal 1996 from 10.6% in fiscal 1995. The increase in J. Crew Factory Outletrevenues was the result of a 7.0% increase in comparable store sales and salesof the 12 new stores opened in fiscal 1995 that were opened for a full fiscalyear in 1996. During fiscal 1996, J. Crew Factory Outlets opened three storesand closed four stores. Similar to J. Crew Retail, the increase in comparablestore sales for J. Crew Factory Outlets was principally due to strongperformance in the J. Crew womenswear lines. PCP revenues decreased by 2.4% to $177.7 million in fiscal 1996 from $182.1million in fiscal 1995. The percentage of the Company's total revenues derivedfrom PCP decreased to 22.0% in fiscal 1996 from 24.4% in fiscal 1995. Thedecrease in revenues primarily resulted from competitive discounting in thenortheastern market which was partially offset by revenues from the introductionof brand-name apparel. During fiscal 1996, the number 17 of catalogs mailed remained flat at approximately seven million and the numberof selling agents remained unchanged at approximately 106,000. C&W revenues increased by 5.6% to $75.0 million in fiscal 1996 from $71.0million in fiscal 1995. The percentage of the Company's revenues derived fromC&W decreased slightly to 9.3% in fiscal 1996 from 9.5% in fiscal 1995. Theincrease in C&W revenues during fiscal 1996 reflected: (i) the return to itsoriginal merchandising strategy of providing conservative career-orientedclothing, and (ii) the introduction of a value pricing strategy. In addition,the Company reduced the catalog circulation of C&W in fiscal 1996 to 38 millionfrom 40 million in fiscal 1995. Gross Profit Gross profit increased to 47.0% of revenues in 1996 as compared to 46.4% ofrevenues in 1995. This increase primarily resulted from an increase inmerchandise margins in J. Crew Mail Order. Selling, General and Administrative Expenses Selling, general and administrative expenses decreased to 43.1% of revenuesin fiscal 1996 from 43.9% of revenues in 1995. The decline in selling, generaland administrative expenses as a percentage of revenues principally reflects adecrease in catalog circulation costs (consisting primarily of paper, postageand printing). These costs declined to 15.9% of revenues in fiscal 1996 from16.9% of revenues in fiscal 1995, principally as a result of a decrease in papercosts to 3.2% of revenues in fiscal 1996 from 3.9% of revenues in fiscal 1995,and a decrease in number of pages circulated by J. Crew Mail Order from 10.2billion in fiscal 1995 to 9.8 billion in fiscal 1996 as a result of the J. CrewMail Order customer segmentation strategy. Circulation at C&W also decreased.This decrease was partially offset by an increase in general and administrativeexpenses related to payroll for new J. Crew retail stores opened during theperiod. Absolute dollar amounts of selling, general and administrative expensesincreased to $348.3 million in fiscal 1996 from $327.7 million in fiscal 1995,primarily reflecting volume related costs. Interest Expense Interest expense increased to $10.5 million or 1.3% of revenues in fiscal1996 from $9.4 million or 1.3% of revenues in fiscal 1995. This increase wasdue primarily to higher average borrowings under the revolving credit agreementthen in effect.LIQUIDITY AND CAPITAL RESOURCESHistorical The Company's primary cash needs have been for opening new stores,warehouse expansion and working capital. The Company's sources of liquidity havebeen cash flow from operations, proceeds from the private placement of long-termdebt and borrowings under a revolving credit facility. In April 1997, the Company entered into a bank credit facility (the"Retired Bank Credit Facility") with a group of twelve banks with MorganGuaranty Trust Company of New York as agent. The Retired Bank Credit Facilityprovided for commitments in an aggregate amount of up to $200.0 million of whichup to $120.0 million was available for direct borrowings. The Retired BankCredit Facility replaced the Company's previous revolving credit agreement whichprovided for commitments in an aggregate amount of up to $125.0 million, ofwhich up to $75.0 million was available for direct borrowings. Borrowings underthe Retired Bank Credit Facility were unsecured and bore interest, at theCompany's option, at the base rate (defined as the higher of the bank's primerate or the Federal Funds rate plus 0.5%) or the London Interbank Offering Rate("LIBOR") plus 0.625%. The Retired Bank Credit Facility was to expire on April17, 2000. There were no borrowings outstanding under the Company's revolvingcredit agreements at January 31, 1997 and February 2, 1996. Average borrowingsunder the Company's revolving credit agreements were $25.5 million and $31.2million for the years ended on February 2, 1996 and 18 January 31, 1997, respectively. Outstanding letters of credit issued tofacilitate international merchandise purchases were $25.9 million and $37.8million on February 2, 1996 and January 31, 1997, respectively. Borrowings under the Retired Bank Credit Facility on October 17, 1997,prior to the Recapitalization, were $99.0 million. Average borrowings under thecredit agreement were $68.8 million for the period ended on October 17, 1997. In June 1995, the Company issued $85.0 million of the senior notes (the"Retired Senior Notes") to institutional investors in a private placement. AtOctober 17, 1997, the Retired Senior Notes were retired by the Company at a costof $93.1 million that included accrued interest on the Retired Senior Notes anda make-whole premium. Net cash provided by (used in) operating activities was $16.5 million and($7.8) million for fiscal years 1996 and 1995. The improvement in cash flowfrom operations in 1996 was primarily attributable to the increase in net incomeand the timing of income tax payments/refunds for fiscal years 1996 and 1995. Net capital expenditures totaled $22.5 million and $14.6 million in fiscalyears 1996 and 1995. Capital expenditures included the opening of eight J. CrewRetail stores and three J. Crew Factory Outlet stores in fiscal 1996, two J.Crew Retail stores and 12 J. Crew Factory Outlet stores in fiscal 1995. Net cash provided by (used in) financing activities totaled ($0.4) millionand $17.8 million in fiscal years 1996 and 1995. In fiscal 1995, the Companyborrowed $85.0 million in private placement debt of which $67.0 million was usedto repay then outstanding long-term debt.After the Recapitalization Since consummating the Recapitalization, the Company's primary sources ofliquidity have been cash flow from operations and borrowings under the RevolvingCredit Facility. The Company's primary uses of cash have been debt servicerequirements, capital expenditures and working capital. The Company expects thatongoing requirements for debt service, capital expenditures and working capitalwill be funded from operating cash flow and borrowings under the RevolvingCredit Facility. The Company has incurred substantial indebtedness in connection with theRecapitalization. After giving effect to the Recapitalization and applicationof the proceeds of the Senior Discount Debentures, the issuance by Holdings ofshares of the Preferred Stock, the issuance by Holdings of shares of CommonStock and the distribution by Operating Corp to Holdings of the net proceeds ofthe issuance of the Senior Subordinated Notes, the Securitization of certainreceivables and borrowings under the Bank Facilities (less the repayment of theRetired Bank Credit Facility, the Retired Senior Notes and other indebtednessand transaction expenses), the Company had $298.2 million of indebtednessoutstanding and $201.7 million of stockholders' deficit, in each case as ofJanuary 31, 1998. The Company's significant debt service obligations followingthe Recapitalization could, under certain circumstances, have materialconsequences to security holders of the Company. Concurrent with the Recapitalization, Operating Corp issued the SeniorSubordinated Notes for $150.0 million in gross proceeds, entered into the TermLoan Facility and the Revolving Credit Facility and consummated theSecuritization. The Term Loan Facility is a single tranche term loan in theaggregate principal amount of $70.0 million. The Revolving Credit Facilityprovides revolving loans in an aggregate amount of up to $200.0 million. Uponclosing of the Recapitalization, Operating Corp borrowed the full amountavailable under the Term Loan Facility and approximately $35.6 million under theRevolving Credit Facility. Borrowings under the Revolving Credit Facility wereused to partially refinance seasonal borrowings outstanding under the RetiredBank Credit Facility. The amount remaining available under the Revolving CreditFacility is available to fund the working capital requirements of OperatingCorp. The Securitization generated approximately $40 million in proceeds.Proceeds to Operating Corp from the issuance of the Senior Subordinated Notes,the Securitization and from initial borrowings under the Bank Facilities, lessthe repayment of the Retired Bank Credit Facility, the Retired Senior Notes andother indebtedness and transaction expenses, were distributed to Holdings tofinance the Recapitalization 19 and the fees and expenses in connection therewith (the "Operating CorpDistribution"). To provide additional financing to fund the Recapitalization,Holdings raised $264.2 million through (i) the sale to TPG Partners, itsaffiliates and other investors of 46,853 shares of Common Stock (representing85.2% of the outstanding shares) for $63.9 million, (ii) gross proceeds of $75.3million from the issuance of the Senior Discount Debentures and (iii) theissuance of $125.0 million in liquidation value of the Preferred Stock. The proceeds of the Senior Subordinated Notes, the Securitization, theSenior Discount Debentures, the Preferred Stock, the purchase of Common Stock byTPG, its affiliates and other investors and the initial borrowings under theBank Facilities were used to repurchase from the former shareholders of Holdingsof all outstanding shares of Holdings' capital stock (other than shares ofCommon Stock having an implied value of $11.1 million, almost all of whichcontinues to be held by Emily Woods, and which represented approximately 14.8%of the shares of Common Stock immediately following the transaction), torefinance outstanding indebtedness of Holdings and to pay fees and expensesincurred in connection with the Recapitalization. Borrowings under the Bank Facilities bear interest at a rate per annumequal (at Operating Corp's option) to a margin over either a base rate or LIBOR.The Bank Facilities will mature on October 17, 2003. Operating Corp'sobligations under the Bank Facilities are guaranteed by each of Operating Corp'sdirect and indirect subsidiaries. The Bank Facilities and the guarantees thereofare secured by substantially all assets of Holdings and its direct and indirectsubsidiaries (other than any receivables subsidiary) and a pledge of the capitalstock of Operating Corp and all direct and indirect subsidiaries of Holdings,subject to certain limitations with respect to foreign subsidiaries. The BankFacilities contain customary covenants and events of default, includingsubstantial restrictions on Operating Corp's ability to make dividends ordistributions to Holdings. Simultaneously with the consummation of the Recapitalization, the Companyentered into an agreement with certain financial institutions to establish arevolving securitization facility in which the initial transaction was thesecuritization of approximately $40 million of PCP consumer loan installmentreceivables. The Securitization involved the transfer of receivables to a trustin exchange for cash and subordinated interests in the pool of receivables, andthe subsequent sale by the trust of certificates of beneficial interest to thirdparty investors. Although the Company remains obligated to repurchasereceivables in the event of return of the related merchandise and under certainother limited circumstances, the Company has no obligation to reimburse thetrust or the purchasers of beneficial interests for credit losses. The trust isheld by PCP Receivables Corp. ("Receivables Sub"), a special-purpose, bankruptcyremote subsidiary ("SPV") established by PCP. At January 31, 1998, the SPV hadnet assets of approximately $16.8 million. The SPV is not a guarantor of theSenior Subordinated Notes or the Bank Facilities. The initial securitization andsubsequent sales of accounts receivable were accounted for as a sale ofreceivables, and resulted in a gain of approximately $1.5 million for the periodended January 31, 1998. The Senior Subordinated Notes are guaranteed by each subsidiary ofOperating Corp (other than Receivables Sub) but are not guaranteed by Holdings.The Senior Subordinated Notes mature in 2007. Interest on the SeniorSubordinated Notes is payable semi-annually in cash. The Senior SubordinatedNotes contain customary covenants and events of default, including covenantsthat limit the ability of Operating Corp and its subsidiaries to incur debt, paydividends and make certain investments. The Preferred Stock bears cumulative dividends at the rate of 14.50% perannum (payable quarterly) for all periods ending on or prior to October 17, 2009and 16.50% per annum thereafter. Dividends compound to the extent not paid incash. Subject to restrictions imposed by the Senior Subordinated Notes, the BankFacilities, the Senior Discount Debentures and other documents relating to theCompany's indebtedness, Holdings may redeem the Preferred Stock at any time, atthe then-applicable redemption price and, in certain circumstances (includingthe occurrence of a change of control of Holdings), may be required torepurchase shares of Preferred Stock at liquidation value plus accumulated andunpaid dividends to the date of repurchase. The Senior Discount Debentures mature on October 15, 2008. Cash interestdoes not accrue on the Senior Discount Debentures prior to October 15, 2002.Thereafter, interest on the Senior Discount Debentures will be payablesemiannually in cash. 20 There were no borrowings outstanding under the Revolving Credit Facility atJanuary 31, 1998. Average borrowings under the Revolving Credit Facility were$19.5 million from October 17, 1997 through January 31, 1998 and letters ofcredit outstanding as of January 31, 1998 were $20.1 million. In the fiscal year ended January 31, 1998, net cash used in operatingactivities was $7.4 million compared to $16.5 million net cash provided in thefiscal year ended January 31, 1997. This increase in the net cash used resultedprimarily from the net loss of $31.4 million and a decrease in accounts payableof $37.7 million, which were partially offset by proceeds from the sale ofaccounts receivable of $46.0 million. The capital expenditures, net of construction allowances, during fiscal1997 were $31.4 million, primarily to fund the opening of 12 retail stores andthe relocation of the Company's headquarters office in New York City. Capitalexpenditures are expected to be $40 million in fiscal 1998, primarily for 15 J.Crew Retail stores, and will be funded from internally generated cash flows andby borrowing from available financing sources. Management believes that cash flow from operations and availability underthe Revolving Credit Facility will provide adequate funds for the Company'sworking capital needs, planned capital expenditures and debt service obligationsthrough fiscal 1998. The Company's ability to fund its operations and makeplanned capital expenditures, to make scheduled debt payments, to refinanceindebtedness and to remain in compliance with all of the financial covenantsunder its debt agreements depends on its future operating performance and cashflow, which in turn, are subject to prevailing economic conditions and tofinancial, business and other factors, some of which are beyond its control.THE YEAR 2000 ISSUE The effect of Year 2000 issues on the Company's operations are beingaddressed by the Company's Information Technology Department. A plan has beendeveloped which identifies the systems and related programs which must beupgraded and a timetable has been established for the completion of theseupgrades. This plan contemplates the use of internal programming resources, outsideconsulting services, system upgrades from existing vendors and the replacementof existing packages with packages that are Year 2000 compliant. The designedplan estimates that the Company will be in compliance with Year 2000 issues bythe Fall of 1999. The estimated cost of the Year 2000 upgrade is not expected to be materialto the Company.RECENT ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards (SFAS) No. 131, Disclosures about Segments of anEnterprise and Related Information, which will be effective for financialstatements beginning after December 15, 1997. SFAS No. 131 redefines howoperating segments are determined and requires expanded quantitative andqualitative disclosures relating to a company's operating segments. IMPACT OF INFLATION The Company's results of operations and financial condition are presentedbased upon historical cost. While it is difficult to accurately measure theimpact of inflation due to the imprecise nature of the estimates required, theCompany believes that the effects of inflation, if any, on its results ofoperations and financial condition have been minor. However, there can be noassurance that during a period of significant inflation, the Company's resultsof operations would not be adversely affected. 21 SEASONALITY The Company's retail and mail order businesses experience two distinctselling seasons, spring and fall. The spring season is comprised of the firstand second quarters, and the fall season is comprised of the third and fourthquarters. J. Crew Retail stores, J. Crew Factory Outlet stores, C&W Factorystores and PCP are stronger in the third and fourth quarters and the J. Crew andC&W Mail Order businesses are strongest in the fourth quarter. In addition, theCompany's working capital requirements fluctuate throughout the year, increasingsubstantially in September and October in anticipation of the holiday seasoninventory requirements. The Company funds its working capital requirementsprimarily through a revolving credit facility, which historically has been paiddown in full at the end of the Company's fiscal year.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's principal market risk relates to interest rate sensitivitywhich is the risk that future changes in interest rates will reduce net incomeor the net assets of the Company. The Company's variable rate debt consists ofborrowings under the Revolving Credit Facility and the $70 million Term LoanFacility. In order to manage this interest rate risk, the Company entered intoan interest rate swap agreement in October 1997 for $70 million notionalprincipal amount. This agreement which has a term of three years, converts theinterest rate on $70 million of debt to a fixed rate of 6.23%. If thisinterest rate swap agreement was settled on January 31, 1998, the Company wouldbe required to pay an additioinal $935,000. The Company enters into letters of credit to facilitate the international purchase of merchandise. The letters of credit are primarily denominated in U.S.dollars. Outstanding letters of credit at January 31, 1998 were approximately$20.1 million. Furthermore, the Company has a licensing agreement in Japan which provides for a royalty payment based on sales of J. Crew merchandise as denominated in yen. The Company has from time to time entered into forward foreign exchange contracts to minimize this risk. At January 31, 1998, there were no forward foreign exchange contracts outstanding. A 10% change in the dollar-yen exchange rate would have an effect on net income of approximately $200,000, which amount is not material.ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements are set forth herein commencing on page F-1 of this Report.ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES Not applicable. 22 PART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTDIRECTORS AND EXECUTIVE OFFICERS The following table sets forth the name, age and position of individualswho are serving as directors of Holdings and executive officers of the Company.Each director of Holdings will hold office until the next annual meeting ofshareholders or until his or her successor has been elected and qualified.Officers of Holdings are elected by the Boards of Directors and serve at thediscretion of such Board.NAME Age Position- ---- --- -------- Emily Woods.................. 37 Director; Chairman of the Board--J. Crew Group, Inc. and J. Crew Operating Corp; President--J. Crew Inc.Howard Socol................. 52 Chief Executive Officer--J. Crew Group, Inc. and J. Crew Operating Corp.Barry Erdos.................. 54 Chief Operating Officer--J. Crew Operating Corp.David Bonderman.............. 54 Director--J. Crew Group, Inc.Richard W. Boyce............. 43 Director--J. Crew Group, Inc.James G. Coulter............. 38 Director--J. Crew Group, Inc.Matthew E. Rubel............. 39 President--Popular Club Plan, Inc.Trudy Sullivan............... 46 President--C&W Outlet, Inc. and Clifford & Wills, Inc.Nicholas Lamberti............ 55 Vice President--Corporate Controller--J. Crew Operating Corp. and J. Crew Group, Inc.EMILY WOODSCHAIRMAN--J. CREW GROUP, INC. AND J. CREW OPERATING CORP.; PRESIDENT--J. CREW INC. Ms. Woods became Chairman of the Board of Directors of Holdings uponconsummation of the Recapitalization. Ms. Woods is also a director and Chairman of the Board of Operating Corp and the President of J. Crew Inc., a wholly ownedsubsidiary of Operating Corp. Ms. Woods co-founded the J. Crew brand in 1983 andis currently its designer. Ms. Woods has also served as Chief Executive Officerand Vice-Chairman of Holdings and as Chief Executive Officer of Operating Corp.HOWARD SOCOLCHIEF EXECUTIVE OFFICER--J. CREW GROUP, INC. AND J. CREW OPERATING CORP. Mr. Socol became Chief Executive Officer of Holdings on February 24, 1998.Mr. Socol is also currently the Chief Executive Officer of Operating Corp.From 1969 to 1997 Mr. Socol served in various management positions at Burdine's,a division of Federated Department Stores, Inc., becoming President in 1981 andChairman and Chief Executive Officer in 1984, a position he held until hisretirement in 1997.BARRY ERDOSCHIEF OPERATING OFFICER--J. CREW OPERATING CORP. Mr. Erdos became Chief Operating Officer of Operating Corp on April 17,1998. From 1997 to 1998 Mr. Erdos was Executive Vice President - Chief FinancialOfficer of Express, a division of The Limited, Inc., and from 1988 to 1997 Mr.Erdos was employed in various executive positions at The Limited, Inc.,including Executive Vice President, Henri Bendel, from 1988-1993, VicePresident, Corporate Controller, The Limited, Inc., from 1993-1995, andExecutive Vice President and Chief Financial Officer, Lane Bryant, from 1995-1997.DAVID BONDERMANDIRECTOR--J. CREW GROUP, INC. Mr. Bonderman became a director of Holdings upon consummation of theRecapitalization. Mr. Bonderman is also currently serving as a director ofOperating Corp. Mr. Bonderman is a principal and founding partner of TPG. Priorto forming TPG, Mr. Bonderman was Chief Operating Officer and Chief InvestmentOfficer 23 of Keystone Inc. ("Keystone"), the private investment firm, from 1983 to August1992. Mr. Bonderman serves on the Boards of Directors of Continental Airlines,Inc., Bell & Howell Company, Virgin Entertainment, Beringer Wine Estates, Inc.,Denbury Resources, Inc., Ducati Motor Holdings, S.p.A., Washington Mutual, Inc.,Ryanair, Ltd., and Credicom Asia, N.V. Mr. Bonderman also serves in generalpartner advisory board roles for Acadia Partners, L.P., Newbridge InvestmentPartners, L.P., Newbridge Latin America, L.P. and Aqua International, L.P.JAMES G. COULTERDIRECTOR--J. CREW GROUP, INC. Mr. Coulter became a director of Holdings upon consummation of theRecapitalization. Mr. Coulter is also currently serving as a director ofOperating Corp. Mr. Coulter is a principal and founding partner of TPG. Prior toforming TPG, Mr. Coulter was a Vice President of Keystone from 1986 to 1992. Mr.Coulter serves on the Boards of Directors of America West Airlines, Inc., VirginEntertainment, Beringer Wine Estates, Inc. and Paradyne Partners, L.P. and wasformerly on the Board of Directors of Allied Waste Industries Inc. andContinental Airlines, Inc.RICHARD W. BOYCEDIRECTOR--J. CREW GROUP, INC. Mr. Boyce became a director of Holdings upon consummation of theRecapitalization. Mr. Boyce is also currently serving as a director of OperatingCorp, C&W Outlet, Inc., Clifford & Wills, Inc., J. Crew Retail, J. Crew FactoryOutlet, J. Crew, Inc., J. Crew International, Inc., J. Crew Services, Inc. andPopular Club Plan, Inc., each of which is a wholly owned subsidiary of OperatingCorp. Mr. Boyce is the President of CAF, Inc., a management consulting firmwhich advises various companies controlled by TPG. Prior to founding CAF, Inc.in 1997, Mr. Boyce served as Senior Vice President of Operations for Pepsi-ColaNorth America ("PCNA") from 1996 to 1997, and Chief Financial Officer of PCNAfrom 1994 to 1996. From 1992 to 1994, Mr. Boyce served as Senior Vice President-Strategic Planning for PepsiCo. Prior to joining PepsiCo., Mr. Boyce was aDirector at the management consulting firm of Bain & Company where he wasemployed from 1980 to 1992.MATTHEW E. RUBELPRESIDENT--POPULAR CLUB PLAN, INC. Mr. Rubel joined the Company in September 1994 as the President of PCP.Prior to joining the Company, Mr. Rubel served as the President, CEO, and amember of the Board of Directors at Pepe Jeans USA in 1994, and from 1987 to1993, he was the President of Specialty Division at Revlon, Inc. From 1984 to1987, Mr. Rubel served as an Executive Vice President of Murjani Internationaland from 1980 to 1984, he was employed by Bonwit Teller.NICHOLAS LAMBERTIVICE PRESIDENT - CORPORATE CONTROLLER--J. CREW OPERATING CORP. Mr. Lamberti joined the Company in January 1991 as Vice President -Corporate Controller. Prior to joining the Company, Mr. Lamberti was withDeloitte & Touche from 1966 to 1991. 24 ITEM 11. EXECUTIVE COMPENSATION The following table sets forth compensation paid by the Company for fiscalyears 1995, 1996 and 1997 to each individual serving as its chief executiveofficer during fiscal 1997 and to each of the four other most highly compensatedexecutive officers of the Company as of the end of fiscal 1997. LONG-TERM COMPENSATION ------------------------------ OTHER ANNUAL RESTRICTED ALL OTHER FISCAL SALARY BONUS COMP. STOCK COMP.NAME AND PRINCIPAL POSITIONS YEAR ($) ($) ($) AWARD(S) ($)- ------------------------------------------ -------- -------- ------- -------------- ---------- --------- Arthur Cinader (1)........................ 1997 480,668 -- -- -- -- Chief Executive Officer 1996 307,692 -- -- -- -- 1995 700,000 107,800 -- -- -- Emily Woods (2)........................... 1997 700,000 -- -- -- 10,000,000(3)Chief Executive Officer 1996 700,000 -- -- -- -- 1995 700,000 188,700 1,079,713(4) $1,139,000 -- David DeMattei(5)......................... 1997 521,623 200,000 397,000 President, J. Crew Retail 1996 475,771 100,000 -- -- -- 1995 352,661 100,000 -- -- -- Matthew Rubel............................. 1997 465,787 130,800 -- -- 300,000(3) President, Popular Club Plan 1996 422,418 150,000 -- -- -- 1995 391,346 50,000 -- -- -- Michael P. McHugh(6)...................... 1997 290,587 50,000 -- -- 300,000(3) VP, Finance 1996 252,555 100,000 -- -- -- 1995 203,846 30,000 -- -- -- Trudy Sullivan............................ 1997 300,000 207,000 -- -- 50,000(3) President, Clifford & Wills 1996 300,000 10,000 -- -- -- 1995 28,846 50,000 -- -- --- ----------------------(1) Mr. Cinader was replaced as Chief Executive Officer on October 17, 1997.(2) Ms. Woods became Chief Executive Officer on October 17, 1997.(3) This amount was paid as a bonus in connection with the consummation of the Recapitalization.(4) This amount was paid as reimbursement for income taxes incurred as a result of the grant of Common Stock.(5) Mr. DeMattei resigned from the Company as of April 14, 1998.(6) Mr. McHugh resigned from the Company as of April 7, 1998. 25 - ------------------------------------------------------------------------------------------------------------------------------------ OPTION/SAR GRANTS IN LAST FISCAL YEAR- ------------------------------------------------------------------------------------------------------------------------------------ Individual Grants - ------------------------------------------------------------------------------------------------------------------------------------ Percent Of Total Number Of Securities Options/SARs Underlying Granted To Name Option/SARs Employees In Exercise Of Base Expiration (a) Granted (#) Fiscal Year Price ($/Sh) Date (b) (c) (d) (e) - ------------------------------------------------------------------------------------------------------------------------------ Arthur Cinader............................... -- -- -- -- --------------------------------------------------------------------------------- Emily Woods.................................. 1,641 41.7% 1,363.64 10/17/08 --------------------------------------------------------------------------------- Emily Woods.................................. 164 4.2% 1,704.55 10/17/08 --------------------------------------------------------------------------------- Emily Woods.................................. 164 4.2% 2,130.69 10/17/08 --------------------------------------------------------------------------------- Emily Woods.................................. 164 4.2% 2,663.33 10/17/08 --------------------------------------------------------------------------------- Emily Woods.................................. 164 4.2% 3,329.19 10/17/08 --------------------------------------------------------------------------------- Emily Woods.................................. 164 4.2% 4,161.56 10/17/08 --------------------------------------------------------------------------------- David DeMattei............................... 626 15.9% 1,363.64 1/31/09 --------------------------------------------------------------------------------- Matthew Rubel................................ 188 4.8% 1,363.64 1/31/09 --------------------------------------------------------------------------------- Michael P. McHugh............................ -- -- -- -- --------------------------------------------------------------------------------- Trudy Sullivan............................... 63 1.6% 1,363.64 1/31/09 - ------------------------------------------------------------------------------------------------------------------------------ Potential Realizable Value At Assumed Annual Rates Of Stock Price Appreciation For Option Term ------------------------------------------- Name 5% ($) 10% ($) (a) (f) (g) - ---------------------------------------------------------------------------------------- Arthur Cinader............................... -- -- ------------------------------------------- Emily Woods.................................. 857.59 2,173.29 ------------------------------------------- Emily Woods.................................. 516.68 1,832.38 ------------------------------------------- Emily Woods.................................. 90.54 1,406.24 ------------------------------------------- Emily Woods.................................. 0 873.60 ------------------------------------------- Emily Woods.................................. 0 207.74 ------------------------------------------- Emily Woods.................................. 0 0 ------------------------------------------- David DeMattei............................... 190.33 1,110.79 ------------------------------------------- Matthew Rubel................................ 190.33 1,110.79 ------------------------------------------- Michael P. McHugh............................ -- -- ------------------------------------------- Trudy Sullivan............................... 190.33 1,110.79- ---------------------------------------------------------------------------------------- AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION VALUES Number of Securities Underlying Unexercised Options At Fiscal Year End(1) (#)Name Exercisable/Unexercisable- ---- -------------------------Arthur Cinader --Emily Woods.............................................. 0/2,461 David DeMattei........................................... 62.6/563.4 Matthew Rubel............................................ 18.8/169.2 Michael McHugh........................................... -- Trudy Sullivan........................................... 6.3/56.7 (1) Represents options granted pursuant to the J. Crew Group, Inc. Stock Option Plan with respect to shares of Common Stock. Although there is no established public market for shares of the Common Stock, the Company's management believes that all options granted under such plan were out-of- money as of the end of fiscal year 1997. 26 EMPLOYMENT AGREEMENTS AND OTHER COMPENSATION ARRANGEMENTS On October 17, 1997, Holdings and Operating Corp (the "Employers") and Ms.Woods entered into an employment agreement, which provides that, for a period offive years commencing on the closing of the Recapitalization, she will serve asChairman of the Board of Directors of Holdings. The employment agreement provides for an annual base salary of $1.0 million, and provides an annualtarget bonus of up to $1.0 million based on achievement of earnings objectivesto be determined each year. The employment agreement also provided for the grantof 3,308 shares of Common Stock (the "Woods Restricted Shares"), of which 393vested immediately upon the grant thereof, which occurred as of April 1, 1998.Of the remaining Woods Restricted Shares, 972 shares will vest on each of thethird and fourth anniversaries of the Recapitalization and 971 shares will veston the fifth anniversary of the Recapitalization. In connection with the grantof the Woods Restricted Shares, the Employers agreed to pay Ms. Woods an amountequal to the federal, state and local income and payroll taxes incurred by Ms.Woods in 1998 as a result of the grant of the Woods Restricted Shares and anyfederal, state and local income and payroll taxes incurred as a result of suchpayment. Ms. Woods is also entitled to various executive benefits andperquisites under the employment agreement. In connection with the Recapitalization, Ms. Woods retained shares ofCommon Stock representing approximately 14.8% of the total outstanding shares ofCommon Stock determined immediately after the closing of the Recapitalization,such retention effected using an implied purchase price for the retained sharesequal to the price that TPG paid for shares of Common Stock in connection withthe Recapitalization (the "TPG Price"). Ms. Woods also purchased approximately$3.0 million of Preferred Stock issued in connection with the Recapitalization. Under the J. Crew Group Inc. Stock Option Plan (the "Option Plan"),Holdings has granted Ms. Woods an option to purchase 1,641 shares of CommonStock at an exercise price equal to the TPG Price, 20% of which shall becomeexercisable following the end of each of fiscal years 1998 through 2002,provided that the Company attains certain earnings targets; however, allunvested options shall become exercisable (i) if Ms. Woods' employment isterminated by Holdings without cause, by Ms. Woods for good reason or by reasonof death or disability, (ii) in the event of a change in control of Holdings, or(iii) if Ms. Woods is still employed by Holdings, on the seventh anniversary ofthe closing of the Recapitalization. Also under the Option Plan, Holdings has granted Ms. Woods the option topurchase 820 shares of Common Stock. Under this option, Ms. Woods has the rightto exercise 20% of the option after each of the first through the fifthanniversaries of the grant date at an exercise price equal to 125%, 156.25%,195.31%, 244.14% and 305.18% of the TPG Price, respectively. The exercise ofthis option may require Ms. Woods to purchase a proportional amount of PreferredStock issued in connection with the Recapitalization. In addition, all optionsshall become exercisable (i) if Ms. Woods' employment is terminated by Holdingswithout cause, by Ms. Woods for good reason or by reason of her death ordisability or (ii) in the event of a change in control of Holdings. All options granted to Ms. Woods are generally governed by and subject tothe Option Plan described below. The shares of Common Stock acquired by Ms. Woods pursuant to the foregoingare subject to a shareholders' agreement providing for certain transferrestrictions, registration rights and customary tag-along and drag-along rights. On February 24, 1998, the Employers and Mr. Socol entered into anemployment agreement (the "Socol Employment Agreement"), which provides that,for a period of four years commencing on February 24, 1998, he will serve asChief Executive Officer of Holdings and as Chief Executive Officer of OperatingCorp. The Employers also agreed to cause Mr. Socol to be elected as a member ofthe Board of Directors of Holdings. The employment agreement provides for anannual base salary of $1.0 million (subject to an increase to $1.2 million inany fiscal year following a fiscal year in which the Company's EBITDA (asdefined) equals or exceeds $75 million), and provides an annual target bonus ofup to 100 percent of his annual base salary based on achievement of earningsobjectives to be determined each year provided that, with respect to fiscal year1998, the bonus will be at least $500,000 regardless of whether the bonusobjectives are achieved. The employment agreement also 27 provided for the payment of a signing bonus of $1.5 million and the grant of2,437 shares of Common Stock (the "Socol Restricted Shares"). The SocolRestricted Shares were issued to Mr. Socol as of March 20, 1998 and twenty-fivepercent of such Socol Restricted Shares will vest on each of the first throughfourth anniversaries of the execution of the Socol Employment Agreement. Inconnection with the grant of the Socol Restricted Shares, if Mr. Socol makes anelection to include in gross income on the date of the grant the value of theSocol Restricted Shares on such date pursuant to Section 83(b) of the InternalRevenue Code of 1986, as amended, the Employers will pay Mr. Socol an amountequal to the federal, state and local income and payroll taxes incurred by Mr.Socol as a result of the grant of the Socol Restricted Shares and any federal,state and local income and payroll taxes incurred as a result of such payment.Mr. Socol is also entitled to various executive benefits and perquisites underthe employment agreement. Operating Corp has entered into an employment agreement with Mr. Rubel,dated January 27, 1998. The employment agreement provides that Mr. Rubel willbe employed as president of PCP with an annual salary of $475,000. Theagreement also provides that Mr. Rubel is eligible for performance-based annualbonus if certain performance objectives are satisfied. The agreement providesMr. Rubel with various executive benefits and perquisites. In the event of asale of the common stock or assets of PCP while Mr. Rubel is employed, theagreement provides Mr. Rubel with the opportunity to earn an additional bonusbased on the "gain" on the sale (as defined in the agreement). Finally, theagreement provides for continuation of salary and medical benefits for a periodof one year if Mr. Rubel's employment is terminated without cause (as defined inthe agreement) and otherwise will provide that Mr. Rubel's relationship with theOperating Corp and Holdings is one of employment at will. Mr. Rubel has alsoreceived an option to purchase 188 shares of Common Stock granted pursuant tothe Option Plan.1997 STOCK OPTION PLAN Holdings has adopted the Option Plan in order to promote the interests ofthe Company and its shareholders by providing the Company's key employees andconsultants with an appropriate incentive to encourage them to continue in theemploy of the Company and to improve the growth and profitability of theCompany. Under the Option Plan, the Board of Directors of Holdings has theauthority to administer the Option Plan and to grant options to purchase sharesof Common Stock to certain key employees and consultants of the Company. Theshareholders of Holdings have authorized up to an aggregate of 7,388 shares ofCommon Stock for issuance of options under the Option Plan, of which the Boardof Directors of Holdings has reserved 4,744 shares for issuance under the OptionPlan. As of April 15, 1998, the Board of Directors of Holdings has grantedoptions which are outstanding under the Option Plan to purchase an aggregate of3,308 shares of Common Stock (including the 2,461 shares underlying the optionsgranted to Ms. Woods and the 188 shares underlying the option granted to Mr.Rubel as described above). The options granted under the Option Plan may besubject to various vesting conditions, including, under some circumstances, theachievement of certain performance objectives. All shares of Common Stockacquired by key employees or consultants pursuant to the foregoing shall besubject to a shareholders' agreement providing for certain transferrestrictions, registration rights and customary tag-along and drag-along rights.Director Compensation Holdings does not currently have any arrangement pursuant to which its directors are compensated for services provided as directors. 28 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the information regarding the beneficialownership of the Common Stock as of April 15, 1998 for each person that is knownto Holdings to be the beneficial owner of 5% or more of the Common Stock. Theholders listed have sole voting power and investment power over the shares heldby them, except as indicated by the notes following the table. (a) (b) (c) (d) Name and Address Amount and Nature of Percent ofTitle of Class of Beneficial Owner Beneficial Ownership (1) Class - ----------------------------------------------------------------------------------------- Common Stock TPG Partners II, L.P. 37,003.717 shares (2) 66.8% 201 Main Street, Suite 2420 Fort Worth, TX 76102 Common Stock Emily Woods 8,410.883 shares (3) 15.2% J. Crew Group, Inc. 770 Broadway New York, NY 10003(1) As of April 15, 1998, there were 55,393 shares of Common Stock outstanding (excluding 5,352 shares of Common Stock which have not vested and are held in custody by the Company until the vesting thereof) and there were options to purchase 84.7 shares of Common Stock which were exercisable within 60 days.(2) These shares of Common Stock are held by TPG Partners and the following affiliates of TPG Partners (collectively, "TPG"): TPG Parallel II L.P. and TPG Investors II, L.P.(3) Excludes 2,915 shares of Common Stock which have not vested and are held in custody by the Company until the vesting thereof. 29 The following table sets forth the information regarding the beneficialownership of each class of equity securities of Holdings as of April 15, 1998for (i) each director, (ii) each of the executive officers of Holdingsidentified in the table set forth under Item 11. "Executive Compensation" and(iii) all directors and all such executive officers of Holdings as a group. Theholders listed have sole voting power and investment power over the shares heldby them, except as indicated by the notes following the table.(a) (b) (c) (d)Title of Class Name of Beneficial Owner Amount and Nature of Percent of Beneficial Ownership (1) Class- ----------------------------------------------------------------------------------------------------------------------- Common Stock David Bonderman 37,003.717 shares (2) 66.8%Common Stock Richard W. Boyce -- -- Common Stock James G. Coulter 37,003.717 shares (2) 66.8%Common Stock Emily Woods 8,410.883 shares 15.2%Common Stock Matthew Rubel 18.800 shares (3) 0.0%Common Stock Trudy Sullivan 6.300 shares (4) 0.0%Common Stock All Directors and specified 45,438.700 shares (2) (5) 82.0% Officers as a GroupSeries A Preferred Stock Emily Woods 2,978.505 shares 3.22%Series A Preferred Stock All Directors and Officers as a 2,978.505 shares 3.22% Group(1) As of April 15, 1998, there were 55,393 shares of Common Stock outstanding (excluding 5,352 shares of Common Stock which have not vested and are held in custody by the Company until the vesting thereof) and there were options to purchase 84.7 shares of Common Stock which were exercisable within 60 days. As of April 15, 1998, there were outstanding 92,500 shares of Series A Preferred Stock of Holdings and 32,500 shares of Series B Preferred Stock of Holdings.(2) Attributes ownership of the shares owned by TPG to Messrs. Bonderman and Coulter, who are partners of TPG. Each of Messrs. Bonderman and Coulter disclaim beneficial ownership of the shares owned by TPG.(3) Includes 18.8 shares of Common Stock issuable upon exercise of options which were exercisable within 60 days.(4) Includes 6.3 shares of Common Stock issuable upon exercise of options which were exercisable within 60 days.(5) Includes an aggregate of 25.1 shares of Common Stock issuable upon exercise of options which were exercisable within 60 days. Operating Corp is a wholly owned subsidiary of Holdings. Holdings does nothave any material assets other than the stock of Operating Corp. 30 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS As part of arrangements made prior to the negotiation and execution of theRecapitalization Agreement, Holdings agreed to make bonus payments to certain ofits executive officers upon consummation of any merger, acquisition,recapitalization or other transaction resulting in a change of control ofHoldings. Thus, Holdings made bonus payments in the amount of (i) $10.0 millionto Emily Woods, (ii) $0.3 million to Matthew Rubel, (iii) $0.3 million toMichael McHugh and (iv) $1.2 million to other employees. In addition, effective on the closing of the Recapitalization, the Companyand Arthur Cinader entered into an Employment/Consulting and Non-CompeteAgreement, under which Mr. Cinader agreed to serve as an employee and/orconsultant for twelve months following the closing of the Recapitalization.Under the agreement, Mr. Cinader agreed, for a period of five years from theclosing of the Recapitalization, not to compete, directly or indirectly, inassociation with or as a stockholder, director, officer, consultant, employee,partner, joint venturer, member or otherwise through any person or entity workfor, act as a consultant to, or own any interest in, any competitor of theCompany or its affiliates. In consideration of Mr. Cinader's non-compete,employment and consulting undertakings, the Company paid Mr. Cinader a total of$4.2 million. In addition, during this five-year period, Mr. Cinader is entitledto coverage under the Company's health and welfare plans. In connection with the Recapitalization, the Company paid TPG a financialadvisory fee in the amount of $5.6 million. Holdings and its subsidiaries also entered into a tax sharing agreementproviding (among other things) that each of the subsidiaries will reimburseHoldings for its share of income taxes determined as if such subsidiary hadfiled its tax returns separately from Holdings. 31 PART IVITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K(a) 1. Financial Statements The following financial statements of J. Crew Group, Inc. and subsidiaries are included in Item 8: (i) Report of KPMG Peat Marwick LLP, Independent Auditors (ii) Report of Deloitte & Touche LLP, Independent Auditors (iii) Consolidated Balance Sheets - January 31, 1998 and 1997 (iv) Consolidated Statements of Operations - Years ended January 31, 1998 and 1997 and February 2, 1996 (v) Consolidated Statements of Changes in Stockholders' Equity (Deficit) -Years ended January 31, 1998 and 1997 and February 2, 1996 (vi) Consolidated Statements of Cash Flows - Years ended January 31, 1998 and 1997 and February 2, 1996 (vii) Notes to consolidated financial statements 2. Financial Statements Schedules Schedule II Valuation and Qualifying Accounts is set forth herein commencing on page F-[25] of this Report. 3. Exhibits The exhibits listed on the accompanying Exhibit Index are incorporated by reference herein and filed as part of this report.(b) Reports on Form 8-K No reports on Form 8-K have been filed by registrant during the last quarter of the period covered by this report.(c) Exhibits See Item 14(a)3 above.(d) Financial Statement Schedules See Item 14(a)1 and 14(a)2 above. 32 J. CREW GROUP, INC. AND SUBSIDIARIES Consolidated Financial Statements January 31, 1998 and 1997 (With Independent Auditors' Report Thereon) F-1 INDEPENDENT AUDITORS' REPORT The Board of Directors and StockholdersJ. Crew Group, Inc. and Subsidiaries:We have audited the accompanying consolidated balance sheet of J. Crew Group,Inc. and subsidiaries (the "Company") as of January 31, 1998 and the relatedconsolidated statements of operations, cash flows and changes in stockholders'equity (deficit) for the fiscal year then ended. In connection with our audit ofthe consolidated financial statements, we also have audited the financialstatement schedule for the fiscal year ended January 31, 1998 as listed in theaccompanying index. These consolidated financial statements and financialstatement schedule are the responsibility of the Company's management. Ourresponsibility is to express an opinion on these consolidated financialstatements and financial statement schedule based on our audit.We conducted our audit in accordance with generally accepted auditing standards.Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.In our opinion, such consolidated financial statements present fairly, in allmaterial respects, the financial position of the Company as of January 31, 1998and the results of its operations and cash flows for the fiscal year then endedin conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule for the fiscal year ended January 31, 1998, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.KPMG Peat Marwick LLPApril 13, 1998New York, New York F-2 INDEPENDENT AUDITORS' REPORTTo the Board of Directors and Stockholders ofJ. Crew Group, Inc. We have audited the accompanying consolidated balance sheet of J. Crew Group, Inc. and subsidiaries as of January 31, 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the two fiscal years in the period ended January 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a)2. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express anopinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of J. Crew Group, Inc. and subsidiaries as of January 31, 1997, and the results of their operations and their cash flows for each of the two fiscal years in the period ended January 31, 1997 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule when considered in relation tothe basic consolidated financial statements taken as a whole, presents fairly inall material respects the information set forth therein. As discussed in Note 16 to the consolidated financial statements, in 1995, the Company changed its method of accounting for catalog costs to conform with the provisions of Statement of Position 93-7, "Reporting on Advertising Costs," and changed its method of accounting for merchandise inventories.Deloitte & Touche LLPNew York, New YorkMarch 31, 1997 F-3 J. CREW GROUP, INC. AND SUBSIDIARIES Consolidated Balance Sheets January 31 --------------------ASSETS 1998 1997 ---------- -------- (in thousands) Current assets: Cash and cash equivalents $ 12,166 7,132 Accounts receivable (net of allowance for doubtful accounts of $5,438 and $4,357) 16,834 58,079 Merchandise inventories 202,763 197,657 Prepaid expenses and other current assets 62,399 58,318 --------- ------- Total current assets 294,162 321,186 --------- ------- Property and equipment - at cost: Land 1,460 1,405 Buildings and improvements 11,167 11,167 Furniture, fixtures and equipment 47,673 43,537 Leasehold improvements 101,407 75,378 Construction in progress 4,569 4,063 --------- ------- 166,276 135,550 Less accumulated depreciation and amortization 55,613 49,121 --------- ------- 110,663 86,429 --------- -------Other assets 17,053 3,206 --------- ------- Total assets $ 421,878 410,821 ========= ======= LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY Current liabilities: Accounts payable 65,553 103,279 Other current liabilities 77,700 62,938 Deferred income taxes 7,981 12,555 Federal and state income taxes payable 251 9,955 Current portion of long-term debt -- 237 --------- ------- Total current liabilities 151,485 188,964 --------- -------Long-term debt 298,161 86,855 --------- -------Deferred credits and other long-term liabilities 43,578 32,996 --------- -------Redeemable preferred stock 130,296 -- Stockholders' (deficit) equity (201,642) 102,006 --------- ------- Total liabilities and stockholders' (deficit) equity $ 421,878 410,821 ========= ======= See accompanying notes to consolidated financial statements. F-4 J. CREW GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Operations Years ended ------------------------------- January 31 February 2 ------------------ ----------- 1998 1997 1996 -------- -------- ----------- (in thousands) Net sales $ 822,840 795,931 732,580Other revenues 11,191 12,912 13,329 ------- ------- ------- Revenues 834,031 808,843 745,909 Cost of goods sold, including buying and occupancy costs 465,168 428,719 399,668 ------- ------- ------- Gross profit 368,863 380,124 346,241 Selling, general and administrative expenses 359,811 348,305 327,672 ------- ------- ------- Income from operations 9,052 31,819 18,569 Interest expense - net 20,494 10,470 9,350Expenses incurred in connection with the recapitalization 20,707 -- -- ------- ------- ------- (Loss) income before income taxes, extraordinary item and cumulative effect of accounting changes (32,149) 21,349 9,219 (Benefit) provision for income taxes (5,262) 8,800 3,700 ------- ------- ---------- (Loss) income before extraordinary item and cumulative effect of accounting changes (26,887) 12,549 5,519 Extraordinary item - loss on early retirement of debt (net of income tax benefit of $3,127 and $1,200) (4,500) -- (1,679) Cumulative effect of accounting changes (net of income taxes of $1,800) -- -- 2,610 ------- ------- ------- Net (loss) income $ (31,387) 12,549 6,450 ======= ======= =======See accompanying notes to consolidated financial statements. F-5 J. CREW GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended --------------------------------- January 31 February 2 -------------------- ----------- 1998 1997 1996 ----- ----- ----- (in thousands) Cash flows from operating activities: Net (loss)/income $ (31,387) 12,549 6,450 Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: Loss on early retirement of debt 7,627 -- -- Depreciation and amortization 15,255 10,541 10,272 Amortization of deferred financing costs 958 401 1,186 Noncash interest expense 2,904 -- -- Deferred income taxes (5,010) (1,184) 10,131 Provision for losses on accounts receivable 7,343 6,945 7,277 Noncash compensation expense 150 -- 1,142 Changes in operating assets and liabilities: Accounts receivable (12,098) (6,744) (7,708) Sale of accounts receivable 46,000 -- -- Merchandise inventories (5,106) (49,602) (10,417) Prepaid expenses and other current assets (4,081) (4,007) (12,444) Other assets (587) (375) (2,031) Accounts payable (37,726) 31,864 6,318 Other liabilities 17,577 3,439 (5,351) Federal and state income taxes payable (9,268) 12,670 (12,674) --------- ------- ------- Net cash (used in) provided by operating activities (7,449) 16,497 (7,849) --------- ------- -------Cash flows from investing activities: Capital expenditures (43,134) (27,462) (18,466) Proceeds from construction allowances 11,767 4,981 3,826 --------- ------- ------- Net cash used in investing activities (31,367) (22,481) (14,640) --------- ------- ------- Cash flows from financing activities: Issuance of long-term debt 295,257 -- 85,000 Repayment of long-term debt (92,863) (237) (67,237) Costs incurred in connection with the issuance of debt (16,429) -- -- Proceeds from the issuance of common stock 63,891 -- -- Proceeds from the issuance of redeemable preferred stock 125,000 -- -- Repurchase and retirement of capital stock (316,688) -- -- Costs incurred in connection with the repurchase of capital stock (14,318) -- -- Dividends paid -- (176) -- --------- ------- ------- Net cash provided by (used in) financing activities 43,850 (413) 17,763 --------- ------- -------Increase (decrease) in cash and cash equivalents 5,034 (6,397) (4,726) Cash and cash equivalents at beginning of year 7,132 13,529 18,255 --------- ------- -------Cash and cash equivalents at end of year $ 12,166 7,132 13,529 ======= ======= ====== Supplementary cash flow information: Income taxes paid (refunded) $ 5,180 (3,600) 7,000 ======= ======= ====== Interest paid $ 12,655 9,880 9,601 ======= ======= ====== Noncash financing activities: Dividends on redeemable preferred stock $ 5,296 -- -- ======= ======= ====== See accompanying notes to consolidated financial statements. F-6 J. CREW GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity (Deficit) Years ended January 31, 1998 and 1997 and February 2, 1996 (in thousands, except shares) 6% noncumulative 8% cumulative preferred stock preferred stock Common stock -------------------- ------------------- -------------------- Shares Amount Shares Amount Shares Amount ------ ------ ------ ------ ------ ------Balance at February 3, 1995 15,794 $ 1,579 5,000 $ 500 262,912 $ 263 Net income -- -- -- -- -- -- Issuance of 2,898 shares of common stock from treasury under stock bonus agreement -- -- -- -- -- -- ------ ------ ------ ------ ------ ------Balance at February 2, 1996 15,794 1,579 5,000 500 262,912 263 Net income -- -- -- -- -- -- Dividends -- -- -- -- -- -- ------ ------ ------ ------ ------ ------Balance at January 31, 1997 15,794 1,579 5,000 500 262,912 263 Net loss -- -- -- -- -- -- Repurchase and retirement of capital stock (15,794) (1,579) (5,000) (500) (262,912) (263) Costs incurred in connection with the repurchase of capital stock -- -- -- -- -- -- Issuance of 55,000 shares of common stock -- -- -- -- 55,000 1 Preferred stock dividends -- -- -- -- -- -- Issuance of common stock pursuant to grant of restricted stock -- -- -- -- 3,308 -- Amortization of restricted stock -- -- -- -- -- -- ------ ------ ------ ------ ------ ------Balance at January 31, 1998 -- $ -- -- $ -- 58,308 $ 1 ====== ====== ====== ====== ====== ====== Deferred Total Additional compen- stockholders' paid-in Retained Treasury sation (deficit) capital earnings stock expense equity ------- --------- -------- -------- -------- Balance at February 3, 1995 2,993 83,027 (6,321) -- 82,041 Net income -- 6,450 -- -- 6,450 Issuance of 2,898 shares of common stock from treasury under stock bonus agreement 717 -- 425 -- 1,142 ------- --------- -------- -------- --------Balance at February 2, 1996 3,710 89,477 (5,896) -- 89,633 Net income -- 12,549 -- -- 12,549 Dividends -- (176) -- -- (176) ------- --------- -------- -------- --------Balance at January 31, 1997 3,710 101,850 (5,896) -- 102,006 Net loss -- (31,387) -- -- (31,387) Repurchase and retirement of capital stock (3,161) (317,081) 5,896 -- (316,688) Costs incurred in connection with the repurchase of capital stock -- (14,318) -- -- (14,318) Issuance of 55,000 shares of common stock 63,890 -- -- -- 63,891 Preferred stock dividends -- (5,296) -- -- (5,296)Issuance of common stock pursuant to grant of restricted stock 4,500 -- -- (4,500) -- Amortization of restricted stock -- -- -- 150 150 ------- --------- -------- -------- --------Balance at January 31, 1998 68,939 (266,232) -- (4,350) (201,642) ======= ========= ======== ======== ======== See accompanying notes to consolidated financial statements. F-7 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years ended January 31, 1998 and 1997 and February 2, 1996(1) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of J. Crew Group, Inc. ("Holdings") and its wholly-owned subsidiaries (collectively, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. (B) BUSINESS The Company, which operates in one business segment, designs, contracts for the manufacture of, markets and distributes men's, women's and children's apparel, accessories and home furnishings. The Company's products are marketed through catalogs and retail stores primarily in the United States. The Company is also party to a licensing agreement which grants the licensee exclusive rights to use the Company's trademarks in connection with the manufacture and sale of products in Japan. The license agreement provides for payments based on a specified percentage of net sales. The Company is subject to seasonal fluctuations in its merchandise sales and results of operations. The Company expects its sales and operating results generally to be lower in the first and second quarters than in the third and fourth quarters (which include the back-to-school and holiday seasons) of each fiscal year. A significant amount of the Company's products are produced in the Far East through arrangements with independent contractors. As a result, the Company's operations could be adversely affected by political instability resulting in the disruption of trade from the countries in which these contractors are located or by the imposition of additional duties or regulations relating to imports or by the contractor's inability to meet the Company's production requirements. (C) FISCAL YEAR The Company's fiscal year ends on the Saturday closest to January 31. The fiscal years 1997, 1996 and 1995 ended on January 31, 1998 (52 weeks), January 31, 1997 (52 weeks) and February 2, 1996 (52 weeks). Effective January 31, 1998 the Company changed its fiscal year-end from the Friday closest to January 31, to the Saturday closest to January 31. The effect of this change on the results of operations was not material. (D) CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments, with maturities of 90 days or less when purchased, to be cash equivalents. Cash equivalents, which were $1,902,000 and $1,968,000 at January 31, 1998 and 1997, are stated at cost, which approximates market value. F-8 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(1), CONTINUED (E) ACCOUNTS RECEIVABLE Accounts receivable consists of installment receivables resulting from the sale of merchandise of Popular Club Plan, Inc., a subsidiary of the Company. Concentrations of credit risk with respect to trade accounts receivable are limited due to the large number of customers comprising the accounts receivable base. Finance charge income (including the gain on sale of receivables (see Note 4)), which is included in other revenues, for the fiscal years 1997, 1996 and 1995 was $8,294,000, $9,095,000 and $9,354,000. (F) MERCHANDISE INVENTORIES Merchandise inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market. The Company capitalizes certain design, purchasing and warehousing costs into inventory. (See Note 16) (G) CATALOG COSTS Catalog costs, which primarily consist of catalog production and mailing costs, are capitalized and amortized over the expected future revenue stream, which extends up to five months from the date catalogs are mailed. The Company accounts for catalog costs in accordance with the AICPA Statement of Position ("SOP") 93-7, "Reporting on Advertising Costs." SOP 93-7 requires that the amortization of capitalized advertising costs be the amount computed using the ratio that current period revenues for the catalog cost pool bear to the total of current and estimated future period revenues for that catalog cost pool. Deferred catalog costs, included in prepaid expenses and other current assets, as of January 31, 1998 and 1997 were $39,227,000 and $41,191,000. Catalog costs, which are reflected in selling and administrative expenses, for the fiscal years 1997, 1996 and 1995 were $131,103,000, $135,633,000 and $132,566,000 (See Note 16). (H) PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Buildings and improvements are depreciated by the straight-line method over the estimated useful lives of the respective assets of twenty years. Furniture, fixtures and equipment are depreciated by the straight-line method over the estimated useful lives of the respective assets, ranging from three to ten years. Leasehold improvements are amortized over the shorter of their useful lives or related lease terms. The Company receives construction allowances upon entering into certain store leases. These construction allowances are recorded as deferred credits and are amortized over the term of the related lease. F-9 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(1), CONTINUED (I) OTHER ASSETS Other assets consist primarily of debt issuance costs of $14,865,000 and $1,250,000 at January 31, 1998 and 1997, which are amortized over the term of the related debt agreements. (J) INCOME TAXES The provision for income taxes includes taxes currently payable and deferred taxes resulting from the tax effects of temporary differences between the financial statement and tax bases of assets and liabilities, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." (K) REVENUE RECOGNITION Revenue is recognized when merchandise is shipped to customers. The Company accrues a sales return allowance in accordance with its return policy for estimated returns of merchandise subsequent to the balance sheet date that relate to sales prior to the balance sheet date. (L) STORE PREOPENING COST Costs associated with the opening of new retail and outlet stores are expensed as incurred. (M) DERIVATIVE FINANCIAL INSTRUMENTS Derivative financial instruments are used by the Company to manage its interest rate and foreign currency exposures. The Company does not hold derivative financial instruments for trading or speculative purposes. For interest rate swap agreements, the net interest paid is recorded as interest expense on a current basis. Gains or losses resulting from market fluctuations are not recognized. The Company from time to time enters into forward foreign exchange contracts as hedges relating to identifiable currency positions to reduce the risk from exchange rate fluctuations. Gains and losses on these contracts are deferred and recognized as adjustments to the bases of those assets. Such gains and losses were not material for the fiscal years ended January 31, 1998 and 1997. F-10 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(1), CONTINUED (N) USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (O) IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF In March 1995, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of." SFAS No. 121 requires that long-lived assets and certain identifiable intangibles to be held and used by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an assets may not be recoverable, and is effective for fiscal years beginning after December 15, 1995. The adoption of SFAS No. 121 did not have an effect on the Company's financial position or results of operations. (P) STOCK BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require, companies to record compensation cost for stock-based employee compensation at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). In accordance with APB No. 25, compensation expense is not recorded for options granted if the option price is equal to the fair market price at the date of grant. The adoption of SFAS No. 123 during 1997, for disclosure purposes, was immaterial to the financial statements. F-11 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(2) RECAPITALIZATION TRANSACTION During 1997 the Company entered into a recapitalization transaction (the "Recapitalization"). In October 1997, Holdings purchased from the existing shareholders for an aggregate purchase price of approximately $316,688,000 all of the outstanding shares of Holdings' capital stock, other than a certain number of shares of Holdings' common stock held by existing shareholders which represented 14.8% of the outstanding shares of Holdings' common stock immediately following consummation of the Recapitalization. The purchase of such outstanding shares of capital stock was financed in part by (a) issuing to TPG Partners II, L.P. ("TPG"), its affiliates and other investors shares of common stock of Holdings for approximately $63,891,000 and shares of preferred stock of Holdings for $125,000,000 and (b) consummating the debt and securitization transactions described in Notes 4, 5 and 6. In connection with the Recapitalization, the Company repaid substantially all of its preexisting debt obligations immediately before the consummation of the Recapitalization. Expenses incurred in connection with the recapitalization consisted of: Management bonuses $ 12,163,000 TPG financial advisory fee 5,550,000 Legal and accounting fees 1,454,000 Consulting fee 1,000,000 Other 540,000 ---------- Total $ 20,707,000 ========== (3) OTHER CURRENT LIABILITIES Other current liabilities consist of: January 31, ------------------------- 1998 1997 ---------- ---------- Customer liabilities $ 18,572,000 22,968,000Accrued catalog and marketing costs 12,504,000 10,734,000Taxes, other than income taxes 9,067,000 9,093,000Accrued interest 4,998,000 889,000Reserve for sales returns 3,529,000 2,406,000Other 29,030,000 16,848,000 ----------- ---------- $ 77,700,000 62,938,000 =========== ========== F-12 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(4) SALE OF ACCOUNTS RECEIVABLE In October 1997, the Company entered into an agreement to securitize certain customer installment receivables of Popular Club Plan, Inc. on a revolving basis. This securitization involves the transfer of receivables through a special purpose, bankruptcy remote subsidiary to a trust in exchange for cash and subordinated certificates representing undivided interests in the pool of installment accounts receivable and the subsequent sale by the trust of certificates of beneficial interest to third party investors. The Company has no obligation to reimburse the trust or the purchasers of beneficial interests for credit losses. The transactions have been accounted for as a sale in accordance with the provisions of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." At January 31, 1998, $46,000,000 of accounts receivable had been sold. The sale of receivables resulted in a gain on sale of $1,472,000 during the year ended January 31, 1998, which is included in other revenues. Included in the gain on sale is the discount on sale of accounts receivable which is comprised of the interest, discount and administrative and other fees paid or accrued to the purchasers of the accounts receivables sold. The discount approximates the prevailing short-term London Inter Bank Offered Rate (LIBOR) plus a credit spread and administrative fees. The interest rate (including administrative fees) applicable to receivables sold as of January 31, 1998 was 7.125%. Under SFAS No. 125, no servicing asset or liability is recorded as fees charged are expected to cover related expenses.(5) LONG-TERM DEBT January 31, ----------------------- 1998 1997 ----------- ---------- Senior notes due December 15, 2004 (Note 2) $ -- 85,000,000 Industrial Development Revenue Bond, bearing interest at 73.33% of prime rate (8.25% at January 31, 1997) (Note 2) -- 2,092,000 Term loan (a) 70,000,000 -- 10-3/8% senior subordinated notes (b) 150,000,000 13-1/8% senior discount debentures (c) 78,161,000 -- ----------- ---------- 298,161,000 87,092,000 Less payments due within one year __ (237,000) ----------- ---------- Total $298,161,000 86,855,000 =========== ========== (a) The $70.0 million term loan is subject to the same interest rates and security terms as the Revolving Credit Agreement (see Note 6). The term loan is repayable in quarterly installments of $4.0 million from February 2001 through November 2001 and $6.75 million from February 2002 through November 2003. F-13 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(5), CONTINUED (b) The senior subordinated notes are unsecured general obligations of J. Crew Operating Corp., a subsidiary of Holdings, and are subordinated in right of payment to all senior debt. Interest on the notes accrues at the rate of 10-3/8% per annum and is payable semi-annually in arrears on April 15 and October 15. The notes mature on October 15, 2007 and may be redeemed at the option of the issuer subsequent to October 15, 2002 at prices ranging from 105.188% in 2002 to 100% in 2005 and thereafter. (c) The senior discount debentures were issued in aggregate principal amount of $142.0 million at maturity and mature on October 15, 2008. These debentures are senior unsecured obligations of Holdings. Cash interest will not accrue prior to October 15, 2002 and the principal amount of the debentures will accrete at a rate of 13-1/8% per annum and will be payable in arrears on April 15, and October 15 of each year. The senior discount debentures may be redeemed at the option of Holdings on or after October 15, 2002 at prices ranging from 106.563%, to 100% in 2005 and thereafter. The maturities of long-term debt required during the next five years are: Fiscal year Amount ----------- ------ 1998 $ -- 1999 -- 2000 -- 2001 16,000,000 2002 27,000,000(6) LINES OF CREDIT On October 17, 1997, in connection with the Recapitalization, the Company entered into a syndicated revolving credit agreement of up to $200.0 million (the "Revolving Credit Agreement") with a group of banks, with The Chase Manhattan Bank as administrative and collateral agent (the "Administrative Agent"), and Donaldson, Lufkin & Jenrette Securities Corporation as syndication agent. Borrowings may be utilized to fund the working capital requirements of the Company's subsidiaries, including issuance of stand-by and trade letters of credit and bankers' acceptances. F-14 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(6), CONTINUED Borrowings are secured by a perfected first priority security interest in all assets (except for the accounts receivable of Popular Club Plan, Inc.) of the Company's direct and indirect, domestic, and to the extent no adverse tax consequences would result, foreign subsidiaries and bear interest, at the Company's option, at a base rate equal to the Administrative Agent's Eurodollar rate plus an applicable margin or an alternate base rate equal to the highest of the Administrative Agent's prime rate, a certificate of deposit rate plus 1% or the Federal Funds effective rate plus one-half of 1% plus, in each case, an applicable margin. The Revolving Credit Agreement matures on October 17, 2003. The Revolving Credit Agreement replaced the Company's previous revolving credit agreement which provided for commitments in an aggregate amount of up to $200.0 million, of which up to $120.0 million was available for direct borrowings. During fiscal 1997, 1996 and 1995, maximum borrowings under revolving credit agreements were $104,000,000, $55,000,000 and $49,000,000 and average borrowings were $54,300,000, $31,200,000 and $25,500,000. There were no borrowings outstanding under the Company's revolving credit agreements at January 31, 1998 and 1997. Outstanding letters of credit established to facilitate international merchandise purchases at January 31, 1998 and 1997 amounted to $20,143,000 and $37,800,000. The provisions of the Revolving Credit Agreement require that the Company maintain certain levels of (i) consolidated net worth, (ii), leverage ratio, (iii) interest coverage ratio and (iv) inventory coverage ratio and provide for limitations on capital expenditures, sale and leaseback transactions, liens, investments, sales of assets and indebtedness.(7) COMMON STOCK The restated certificate of incorporation authorizes Holdings to issue up to 100,000,000 shares of common stock; par value $.01 per share. In connection with the Recapitalization, Holdings issued 55,000 shares of common stock, all of which was outstanding at January 31, 1998. F-15 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(8) REDEEMABLE PREFERRED STOCK The restated certificate of incorporation authorizes Holdings to issue up to: (a) 1,000,000 shares of Series A cumulative preferred stock; par value $.01 per share; and (b) 1,000,000 shares of Series B cumulative preferred stock; par value $.01 per share. In connection with the Recapitalization, Holdings issued 92,500 shares of Series A Preferred Stock and 32,500 shares of Series B Preferred Stock, all of which was outstanding at January 31, 1998. The Preferred Stock accumulates dividends at the rate of 14.5% per annum (payable quarterly) for periods ending on or prior to October 17, 2009. Dividends compound to the extent not paid in cash. On October 17, 2009, Holdings is required to redeem the Series B Preferred Stock and to pay all accumulated but unpaid dividends on the Series A Preferred Stock. Thereafter, the Series A Preferred Stock will accumulate dividends at the rate of 16.5% per annum. Subject to restrictions imposed by certain indebtedness of the Company, Holdings may redeem shares of the Preferred Stock at any time at redemption prices ranging from 103% of liquidation value plus accumulated and unpaid dividends at October 17, 1997 to 100% of liquidation value plus accumulated and unpaid dividends at October 17, 2000 and thereafter. In certain circumstances (including a change of control of Holdings), subject to restrictions imposed by certain indebtedness of the Company, Holdings may be required to repurchase shares of the Preferred Stock at liquidation value plus accumulated and unpaid dividends. Accumulated but unpaid dividends amounted to $5,296,000 at January 31, 1998 and were recorded as an increase to redeemable preferred stock and a reduction of retained earnings. F-16 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(9) COMMITMENTS AND CONTINGENCIES (A) OPERATING LEASES As of January 31, 1998, the Company was obligated under various long-term operating leases for retail and outlet stores, warehouses, office space and equipment requiring minimum annual rentals. These operating leases expire on varying dates to 2012. At January 31, 1998 aggregate minimum rentals in future periods are as follows: Fiscal Year Amount ----------- ----------- 1998 $ 33,578,000 1999 33,504,000 2000 30,656,000 2001 27,924,000 2002 26,375,000 Thereafter 130,935,000 Certain of these leases include renewal options and escalation clauses and provide for contingent rentals based upon sales and require the lessee to pay taxes, insurance and other occupancy costs. Rent expense for fiscal 1997, 1996 and 1995 was $35,753,000, $29,852,000 and $27,366,000, including contingent rent based on store sales of $2,877,000, $2,850,000 and $2,197,000. (B) EMPLOYMENT AGREEMENTS The Company is party to employment agreements with certain executives which provide for compensation and certain other benefits. The agreements also provide for severance payments under certain circumstances. (C) LITIGATION The Company is involved in various legal proceedings, both as plaintiff and as defendant, which are routine litigations incidental to the conduct of its business. The Company believes that the ultimate resolution of these matters will not have a material effect on its financial position. (10) EMPLOYEE BENEFIT PLAN The Company has a thrift/savings plan pursuant to Section 401 of the Internal Revenue Code whereby all eligible employees may contribute up to 15% of their annual base salaries subject to certain limitations. The Company's contribution is based on a percentage formula set forth in the plan agreement. Company contributions to the thrift/savings plan for fiscal 1997, 1996 and 1995 were $1,780,000, $1,680,000 and $1,478,000. F-17 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(11) LICENSE AGREEMENT The Company has a licensing agreement through January 2003 with Itochu, a Japanese trading company. The agreement permits Itochu to distribute J. Crew merchandise in Japan. The Company earns royalty payments under the agreement based on the sales of its merchandise. Royalty income, which is included in other revenues, for fiscal 1997, 1996 and 1995 was $2,897,000, $3,817,000 and $3,975,000.(12) INTEREST EXPENSE - NET Interest expense, net consists of the following: Fiscal Year ------------------------------------ 1997 1996 1995 ----------- ----------- ---------- Interest expense $ 20,636,000 10,613,000 9,548,000 Interest income (142,000) (143,000) (198,000) ---------- ---------- --------- Interest expense, net $ 20,494,000 10,470,000 9,350,000 ========== ========== ========= (13) FINANCIAL INSTRUMENTS The following disclosure about the fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments." The fair value of the Company's long- term debt, including current portion, is estimated to be approximately, $275,290,000 and $89,100,000 at January 31, 1998 and 1997, respectively, and is based on dealer quotes or quoted market prices of the same or similar instruments or management's estimate of the present value of future cash flows discounted at the current market rate for financial instruments with similar characteristics and maturity. The carrying amounts of long-term debt were $298,161,000 and $87,092,000 at January 31, 1998 and 1997. The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable, accounts payable and other current liabilities approximate fair value because of the short-term maturity of those financial instruments. The estimates presented herein are not necessarily indicative of amounts the Company could realize in a current market exchange. In October 1997 the Company entered into an interest rate swap agreement for $70 million notional amount, which effectively converted the interest rate on its $70 million term loan from a variable rate to a fixed rate of 6.23% through October 2000. If this agreement was settled on January 31, 1998, the Company would be required to pay $935,000. F-18 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(13), CONTINUED At January 31, 1997, the Company had a forward foreign exchange contract outstanding with J. P. Morgan to deliver 235 million yen on March 31, 1997. This contract was a hedge relating to foreign licensing revenues. The fair value of this contract approximated carrying value due to its short-term maturity. There were no outstanding foreign exchange contracts at January 31, 1998. The Company is exposed to credit losses in the event of nonperformance by the counterparties to these contracts, but it does not expect any counterparties to fail to meet their obligation given their high-credit rating.(14) INCOME TAXES The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes". This statement requires the use of the liability method of accounting for income taxes. Under the liability method, deferred taxes are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The (benefit) provision for income taxes consists of: 1997 1996 1995 ----------- --------- ----------- Current: Foreign $ 309,000 400,000 -- Federal (866,000) 8,984,000 (5,131,000) State and local 305,000 600,000 500,000 ---------- --------- ---------- (252,000) 9,984,000 (4,631,000) Deferred - Federal and state and local (5,010,000) (1,184,000) 8,331,000 ----------- ---------- --------- Income taxes before tax effect of extraordinary items and cumulative effect of accounting changes (5,262,000) 8,800,000 3,700,000 Extraordinary item - current - Federal and state and local (3,127,000) -- (1,200,000) Cumulative effect of accounting changes - deferred -- -- 1,800,000 ----------- ---------- --------- Total (benefit) provision for income taxes $ (8,389,000) 8,800,000 4,300,000 ========== ========= ========== F-19 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(14), CONTINUED A reconciliation between the provision for income taxes based on the U.S. Federal statutory rate and the Company's effective rate is as follows: 1997 1996 1995 -------- ----------- ------------ Federal income tax rate (35.0)% 35.0% 35.0% Foreign 0.8 0.9 -- State and local income taxes, net of Federal benefit (1.8) 5.3 5.1 Nondeductible expenses 14.9 -- -- -------- ---------- ----------- Effective tax rate (21.1) % 41.2% 40.1% ======== ========== =========== The tax effect of temporary differences which give rise to deferred tax assets and liabilities are: January 31 1998 1997 ---------- ----------- Deferred tax assets: Allowance for doubtful accounts $ 2,118,000 1,769,000 Net operating loss carryforwards 4,074,000 1,300,000 Difference in book and tax basis for property and equipment 2,277,000 2,212,000 Other 2,601,000 943,000 ---------- ----------- 11,070,000 6,224,000 Deferred tax liabilities: Prepaid catalog expenses and other prepaid expenses (19,051,000) (18,779,000) ---------- ----------- Net deferred income taxes $ (7,981,000) (12,555,000) ========== =========== Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets. At January 31, 1998, the Company had Federal income tax loss carryforwards of approximately $2,860,000 which expire in 2012. The Company also had state and local income tax loss carryforwards of varying amounts. F-20 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(15) EXTRAORDINARY ITEMS In June 1995, the Company prepaid $58 million principal amount of senior notes and recorded an extraordinary loss of $1,679,000 (net of an income tax benefit of $1,200,000), consisting of the write-off of deferred financing costs and redemption premiums related to the early retirement of debt. In October 1997, the Company prepaid $85 million principal amount of senior notes and recorded an extraordinary loss of $4,500,000 (net of an income tax benefit of $3,127,000) consisting of the write-off of deferred financing costs and redemption premiums related to the early retirement of debt.(16) ACCOUNTING CHANGES Effective February 4, 1995, the Company changed its method of accounting for catalog costs to conform with the provisions of the SOP 93-7. SOP 93-7 requires that the amortization of capitalized advertising costs should be the amount computed using the ratio that current period revenues for the catalog cost pool bear to the total of current and estimated future period revenues for that catalog cost pool. Prior to fiscal 1995, such costs were amortized on a straight-line basis over the estimated productive life of the catalog. The cumulative effect of applying this change in accounting on prior periods was a decrease in net income of $1,600,000 (net of an income tax benefit of $ 1,000,000). Effective February 4, 1995, the Company modified its inventory accounting practices to include the capitalization of certain design, purchasing and warehousing costs. Prior to this change, these costs were charged to expense in the period incurred rather than in the period in which the inventories were sold. The Company believes this change is preferable because it provides a better matching of revenues and costs and improves the comparability of operating results and financial position with those of other companies. The cumulative effect of applying this change in accounting on prior periods was an increase in net income of $4,210,000 (net of income taxes of $2,800,000).(17) COMMON STOCK The J. Crew Group, Inc. Stock Option Plan (the "Option Plan") was adopted by the Company in 1997. Under the terms of the Option Plan, an aggregate of 7,388 shares are available for grant to certain key employees or consultants. During 1997, 3,934 shares were granted under the Option Plan at an exercise price per share of $1,364 for 3,114 shares, $1,705 for 164 shares, $2,131 for 164 shares, $2,664 for 164 shares, $3,330 for 164 shares and $4,162 for 164 shares. F-21 J. CREW GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued(17), CONTINUED The options have a term of ten years and become exercisable over a period of five years. At January 31, 1998, 147 shares were exercisable. Options granted under the Option Plan are subject to various conditions, including under some circumstances, the achievement of certain performance objectives.(18) EMPLOYEE RESTRICTED STOCK Under the terms of an employment agreement with a key executive 3,308 shares of restricted stock were awarded on January 1, 1998. These shares will vest from January 1, 1998 through October 17, 2002. Deferred compensation of $4.5 million will be charged to expense over the vesting period. F-22 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS ($ IN THOUSANDS) additions beginning charged to cost charged to other balance and expenses accounts ------------- --------------- ---------------- Allowance for doubtful accounts - ------------------------------- (deducted from accounts receivable) fiscal year ended: January 31, 1998 $4,357 $7,343 ___ January 31, 1997 4,824 6,945 ___ February 2, 1996 6,518 7,277 ___ (a) accounts deemed to be uncollectible Inventory impairment reserve - ---------------------------- (deducted from inventories) fiscal year ended: January 31, 1998 $3,289 $1,111(b) ___ January 31, 1997 5,226 (1,937)(b) ___ February 2, 1996 9,074 (3,848)(b) ___ Allowance for sales returns - ---------------------------(included in other current liabilities) - ---------------------------------------fiscal year ended: January 31, 1998 $2,406 $1,123(b) ___ January 31, 1998 $2,406 $1,123(b) ___ January 31, 1997 2,384 22(b) ___ February 2, 1996 1,935 449(b) ___ deductions ending balance ---------- -------------- Allowance for doubtful accounts - ------------------------------- (deducted from accounts receivable) fiscal year ended: January 31, 1998 $ (6,262)(a) $5,438 January 31, 1997 (7,412)(a) 4,357 February 2, 1996 (8,971)(a) 4,824 (a) accounts deemed to be uncollectible Inventory impairment reserve - ---------------------------- (deducted from inventories) fiscal year ended: January 31, 1998 ___ $4,400 January 31, 1997 ___ 3,289 February 2, 1996 ___ 5,226 Allowance for sales returns - --------------------------- (included in other current liabilities) - --------------------------------------- fiscal year ended: January 31, 1998 ___ $3,529 January 31, 1997 ___ 2,406 February 2, 1996 ___ 2,384 (b) The inventory impairment reserve and allowance for sales returns are evaluated at the end of each fiscal quarter and adjusted (plus or minus) based on the quarterly evaluation. During each period inventory write-downs and sales returns are charged to the statement of operations as incurred. F-23 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.J. CREW GROUP, INC.By: /s/ Emily Woods Date: May 1, 1998 ---------------------------------------- Emily Woods Chairman of the Board Pursuant to the requirements of the Securities and Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ Emily Woods- --------------------------------------------------- Chairman of the Board May 1, 1998 Emily Woods /s/ Nicholas Lamberti- --------------------------------------------------- Vice President -- Corporate Controller May 1, 1998 Nicholas Lamberti S-1 EXHIBIT INDEX EXHIBIT No. Description --- ----------- 2.1 Recapitalization Agreement, dated as of July 22, 1997 between TPG Partners II, L.P. and J. Crew Group, Inc. (the "Recapitalization Agreement") (incorporated by reference to Exhibit 2.1 to Registrant's Form S-4 Registration Statement, File No. 333-42427, filed December 16, 1997 (the "Registration Statement")) NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Recapitalization Agreement. 2.2 Amendment to Recapitalization Agreement, dated as of October 17, 1997 between TPG Partners II, L.P. and J. Crew Group, Inc. (the "Amendment") (incorporated by reference to Exhibit 2.2 to the Registration Statement) NOTE: Pursuant to the provisions of paragraph (b)(2) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of any schedule to the Amendment. 3.1 Restated Certificate of Incorporation of J. Crew Group, Inc. (incorporated by reference to Exhibit 3.1 to the Registration Statement) 3.2 By-laws of J. Crew Group, Inc. (incorporated by reference to Exhibit 3.2 to the Registration Statement) 4.1 Indenture, dated as of October 17, 1997, between J. Crew Group, Inc., as issuer, and State Street Bank and Trust Company, as trustee, relating to the Debentures (the "Indenture") (incorporated by reference to Exhibit 4.3 to the Registration Statement) 4.2 Credit Agreement, dated as of October 17, 1997, among J. Crew Group, Inc., J. Crew Operating Corp., the Lenders Party thereto, the Chase Manhattan Bank, as Administrative Agent, and Donaldson, Lufkin & Jenrette Securities Corporation, as Syndication Agent (incorporated by reference to Exhibit 4.5 to Amendment No. 1 to the Registration Statement, filed February 6, 1998 (the "Amendment No. 1")) 4.3 Guarantee Agreement dated as of October 17, among J. Crew Group, Inc., the subsidiary guarantors of J. Crew Operating Corp. that are signatories thereto and The Chase Manhattan Bank (incorporated by reference to Exhibit 4.6 to the Registration Statement) 4.4 Indemnity, Subrogation and Contribution Agreement dated as of October 17, 1997, among J. Crew Operating Corp., the subsidiary guarantors of J. Crew Operating Corp. that are signatories thereto and The Chase Manhattan Bank (incorporated by reference to Exhibit 4.7 to the Registration Statement) X-1 EXHIBIT No. Description --- ----------- 4.5 Pledge Agreement, dated as of October 17, among J. Crew Operating Corp., J. Crew Group, Inc., the subsidiary guarantors of J. Crew Operating Corp. that are signatories thereto and The Chase Manhattan Bank (incorporated by reference to Exhibit 4.8 to the Registration Statement) 4.6 Security Agreement, dated as of October 17, among J. Crew Operating Corp., J. Crew Group, Inc., the subsidiary guarantors of J. Crew Operating Corp. that are signatories thereto and The Chase Manhattan Bank (incorporated by reference to Exhibit 4.9 to the Registration Statement) 4.7 Registration Rights Agreement, dated as of October 17, 1997 by and among J. Crew Group, Inc., Donaldson, Lufkin & Jenrette Securities Corporation and Chase Securities Inc. (incorporated by reference to Exhibit 4.10 to the Registration Statement) NOTE: Pursuant to the provisions of paragraph (b)(4)(iii) of Item 601 of Regulation S-K, the Registrant hereby undertakes to furnish to the Commission upon request copies of the instruments pursuant to which various entities hold long-term debt of the Company or its parent or subsidiaries, none of which instruments govern indebtedness exceeding 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. 10.1 Employment Agreement, dated October 17, 1997, among J. Crew Group, Inc., J. Crew Operating Corp., TPG Partners II, L.P. (only with respect to Section 2(c) therein) and Emily Woods (the "Woods Employement Agreement") (incorporated by reference to Exhibit 10.1 to the Registration Statement) 10.2 J. Crew Operating Corp. Senior Executive Bonus Plan (included as Exhibit A to the Woods Employment Agreement filed as Exhibit 10.1) 10.3 Stock Option Grant Agreement, made as of October 17, 1997 between J. Crew Group, Inc. and Emily Woods (time based) (incorporated by reference to Exhibit 10.3 to the Registration Statement) 10.4 Stock Option Grant Agreement, made as of October 17, 1997 between J. Crew Group, Inc. and Emily Woods (performance based) (incorporated by reference to Exhibit 10.4 to the Registration Statement) 10.5 Letter Agreement between Matthew Rubel and J. Crew Group, Inc. (incorporated by reference to Exhibit 10.5 to Amendment No. 2 to the Registration Statement, filed February 26, 1998) X-2 EXHIBIT No. Description --- ----------- 10.6 Employment Agreement, dated February 24, 1998, among J. Crew Group, Inc., J. Crew Operating Corp., TPG Partners II, L.P. (only with respect to Section 7 therein) and Howard Socol 10.7 Stockholders' Agreement, dated as of October 17, 1997, among J. Crew Group, Inc. and the Stockholder signatories thereto (incorporated by reference to Exhibit 4.1 to the Registration Statement) 10.8 Stockholders' Agreement, dated as of October 17, 1997, among J. Crew Group, Inc., TPG Partners II, L.P. and Emily Woods (included as Exhibit B to the Woods Employment Agreement filed as Exhibit 10.1) 10.9 J. Crew Group, Inc. 1997 Stock Option Plan (incorporated by reference to Exhibit 10.13 to the Registration Statement) 10.10 Contract Carrier Agreement, between J. Crew Group, Inc. and United Parcel Service, Inc. (incorporated by reference to Exhibit 10.6 to the Registration Statement) 10.11 Custom Pricing Agreement, made November 15, 1996 between Federal Express Corporation and J Crew Group, Inc. (incorporated by reference to Exhibit 10.7 to the Registration Statement) 10.12 Lease dated as of October 21, 1981 between Vornado, Inc. and Popular Services, Inc. (incorporated by reference to Exhibit 10.8 to the Registration Statement) 10.13 Agreement of Sublease dated November 4, 1993 between Revlon Holdings Inc., as Sublessor, and Popular Club Plan, Inc., as Sublessee (incorporated by reference to Exhibit 10.9 to the Registration Statement) 10.14 Letter Agreement dated July 29, 1996 between World Color and Clifford & Wills, Inc. (incorporated by reference to Exhibit 10.10 to the Registration Statement) 10.15 Agreement dated August 14, 1997 between R.R. Donnelley & Sons Company and J. Crew Inc. (incorporated by reference to Exhibit 10.11 to the Registration Statement) 10.16 Letter Agreement, dated April 17, 1998, betweem J. Crew Operating Corp. and Barry Erdos 21.1 Subsidiaries of J. Crew Group, Inc. (incorporated by reference to Exhibit 21.1 to the Amendment No. 1) 27.1 Financial Data Schedule X-3 EXHIBIT 10.6 EMPLOYMENT AGREEMENT -------------------- AGREEMENT, dated this 24th day of February, 1998 (the "Agreement"),among J. Crew Group, Inc., a New York Corporation (the "Parent") and itsoperating subsidiary J. Crew Operating Corp. (the "Subsidiary" and collectivelywith the Parent, the "Employer"), with offices at 770 Broadway, New York, NewYork, TPG Partners II, L.P. ("TPG II") (only with respect to Section 7 herein)and Howard Socol (the "Employee"). 1. Employment, Duties, Authority and Agreements. -------------------------------------------- (a) The Employer hereby agrees to cause the Employee to be elected asa member of the Board of Directors of the Parent and to employ the Employee asChief Executive Officer of the Parent and the Subsidiary and the Employee herebyaccepts such positions and agrees to serve the Parent and the Subsidiary in suchcapacities during the employment period fixed by Section 3 hereof (the"Employment Period"). The Employee shall report solely and directly to theBoard of Directors of the Parent (the "Board") and to the Executive Committee ofthe Board. The Employee will have such duties, responsibilities and authorityas are customary for chief executive officers of catalogue and specialtyretailing, including direct authority over those divisions as shown on theorganizational chart attached hereto as Exhibit C. During the EmploymentPeriod, the Employee shall be subject to, and shall act in substantialaccordance with, all reasonable instructions and directions of the Board and allapplicable reasonable policies and rules thereof as are consistent with theabove title, duties, responsibilities and authority. (b) During the Employment Period and as long as the Employer shallnot be in default of a material obligation hereunder, excluding any periods ofvacation and sick leave to which the Employee is entitled, the Employee shalldevote his full working time, energy and attention to the performance of hisduties and responsibilities hereunder and shall faithfully and diligentlyendeavor to promote the business and best interests of the Employer. (c) During the Employment Period and so long as the Employer shallnot be in default of a material obligation hereunder, the Employee may not,without the prior written consent of the Board, operate, participate in themanagement, operations or control of, or act as an employee, officer,consultant, agent or representative of, any type of business or service (otherthan as an employee of the Employer), provided that it shall not be a violationof the foregoing for the Employee to (i) act or serve as a director, trustee orcommittee member of any civic or charitable organization and (ii) manage hispersonal, financial and legal affairs, so long as such activities (described inclauses (i) and (ii)) do not interfere with the performance of his duties andresponsibilities to the Employer as provided hereunder. 2. Compensation. ------------ (a) As compensation for the agreements made by the Employee hereinand the performance by the Employee of his obligations hereunder, during theEmployment Period, the Employer shall pay the Employee, not less than once amonth pursuant to the Employer's normal and customary payroll procedures, a basesalary at the rate of $1,000,000 per annum (the "Base Salary"), provided thatsuch base salary shall increase to $1,200,000 per annum in any fiscal yearfollowing a fiscal year in which the Employer's EBITDA (as reflected on theEmployer's audited financial statements) equals or exceeds $75 million. TheBase Salary may also be increased further in the absolute discretion of theBoard. (b) In addition to the Base Salary, during the Employment Period theEmployee shall have an opportunity to earn an annual bonus (the "Bonus") inaccordance with the terms of the J. Crew Operating Corp. Senior Executive BonusPlan for Howard Socol attached hereto as Exhibit A (the "Bonus Plan"), providedthat, with respect to the fiscal year beginning in 1998, the Employee's Bonusunder the Bonus Plan shall be at least $500,000, regardless of whether theperformance objectives under the Bonus Plan are achieved. (c) As soon as practicable after the Effective Date (as defined inSection 3 below) but in no event later than ten (10) days after the EffectiveDate, the Employer will pay the Employee $1,500,000 (the "Signing Bonus"),provided that the Employee will be required to pay back the entire Signing Bonusin the event he voluntarily terminates his employment hereunder prior to thefirst anniversary of the Effective Date, and to the extent the Employee fails topay back any portion of the Signing Bonus as provided herein, the Employer shallhave the right to offset any other payments provided hereunder by such amount. (d) On the Effective Date (as defined in Section 3 below), theEmployer shall grant the Employee restricted shares of common stock of theParent representing, as of the Effective Date, 3.75% of the total outstandingcommon stock of the Parent including all issued or awarded options to purchase,or other equity securities convertible to, shares of common stock of the Parent(the "Restricted Shares"). Twenty-five percent of the Restricted Shares shallvest and become non-forfeitable on each of the first through the fourthanniversaries of the Effective Date, provided that the Employee is stillemployed by the Employer on such anniversary. Notwithstanding the foregoing, inthe event that the Employee's employment hereunder is terminated by the Employerwithout Cause, any portion of the Restricted Shares not previously forfeitedwhich would have vested within two years of the date of such termination shallimmediately vest and become non-forfeitable on such date of termination and, inthe event of a Change in Control (as defined below), all or any portion of theRestricted Shares not previously forfeited shall immediately vest and becomenon-forfeitable on the date such Change in Control occurs. If the EmploymentPeriod terminates for any other reason, the Restricted Shares which have notvested and become non-forfeitable on such date of termination shall be forfeitedby the Employee and returned to the Employer. Notwithstanding anything to thecontrary in the Stockholders' Agreement, the certificates representing theRestricted Shares shall be held in 2 custody by the Employer until the vesting thereof and shall not be transferreduntil such shares become vested as provided herein. All cash, securities andother property paid or otherwise distributed with respect to the RestrictedShares which have not vested shall be held in custody by the Employer and shallbe subject to the same vesting, forfeiture and distribution rules describedabove with respect to the Restricted Shares related thereto. In addition, theEmployee shall be entitled to direct the Employer as to the manner in which theRestricted Shares held in custody by the Employer shall be voted. (e) The term "Change in Control" shall mean the occurrence of any ofthe following events: (i) any sale, lease, exchange or other transfer (in onetransaction or a series of related transactions) of all or substantially all ofthe assets of the Parent or Subsidiary to any Person or group of related personsfor purposes of Section 13(d) of the Securities Exchange Act of 1934 (a"Group"), together with any affiliates thereof other than to TPG II; (ii) theapproval by the holders of capital stock of the Parent or Subsidiary of any planor proposal for the liquidation or dissolution of the Parent or Subsidiary, asthe case may be; (iii) (A) any Person or Group (other than TPG II) shall becomethe owner, directly or indirectly, beneficially or of record, of sharesrepresenting more than 40% of the aggregate voting power of the issued andoutstanding stock entitled to vote in the election of directors, managers ortrustees (the "Voting Stock") of the Parent or Subsidiary and (B) TPG IIbeneficially owns, directly or indirectly, in the aggregate a lesser percentageof the Voting Stock of the Parent or Subsidiary than such other Person or Group;(iv) the replacement of a majority of the Board of Directors of the Parent orSubsidiary over a two-year period from the directors who constituted the Boardof Directors of the Parent or Subsidiary, as the case may be, at the beginningof such period, and such replacement shall not have been approved by a vote ofat least a majority of the Board of Directors of the Parent or Subsidiary, asthe case may be, then still in office who either were members of such Board ofDirectors at the beginning of such period or whose election as a member of suchBoard of Directors was previously so approved or who were nominated by, ordesignees of, TPG II; (v) any Person or Group other than TPG II shall haveacquired the power to elect a majority of the members of the Board of Directorsof the Parent; or (vi) a merger or consolidation of the Parent with anotherentity in which holders of the common stock of the Parent immediately prior tothe consummation of the transaction hold, directly or indirectly, immediatelyfollowing the consummation of the transaction, 50% or less of the common equityinterest in the surviving corporation in such transaction. For purposes of theAgreement, "Person" shall mean an individual, partnership, corporation, limitedliability company, unincorporated organization, trust or joint venture, or agovernmental agency or political subdivision thereof. (f) In connection with the grant of the Restricted Shares, theEmployee shall make an election within thirty days of the Effective Date, toinclude in gross income on the date of the grant the value of the RestrictedShares on such date pursuant to Section 83(b) (the "Section 83(b) Election") ofthe Internal Revenue Code of 1986, as amended. Upon notification from theEmployee that the Section 83(b) Election has been made, the Employer shall paythe appropriate depository an amount equal to the Employee's federal, state andlocal income and payroll tax withholding obligations with respect to (i) thevalue of the Restricted Shares (the 3 "Restricted Share Value"), which value shall be mutually agreed upon by theparties, and (ii) the income required to be recognized by the Employee as aresult of the payment by the Employer of such withholding obligations, in eachcase based on withholding rates determined by the Employer in compliance withapplicable law, provided that with respect to the Employee's federal income tax,the withholding rate shall be thirty-six percent (36%) (such sum paid by theEmployer hereinafter referred to as the "Withholding Amount"). At least thirtydays before the Employee's due date for 1998 Federal income taxes (withoutconsideration for any extensions filed thereto), the Employee shall provide acertificate to the Employer in which the Employee shall represent to theEmployer the Employee's highest marginal income tax rate applicable to hisactual income with respect to each of his federal, state and local income taxesfor 1998. The "Stock Gross-Up Payment" shall be determined by an accounting firmmutually agreed upon by the parties (whose expenses will be paid by theEmployer) and shall equal an amount such that, after payment of all federal,state and local income and payroll taxes ("Taxes") on the Stock Gross-UpPayment, the Employee will retain an amount sufficient to pay all Taxes that heis required to pay as a result of the grant of the Restricted Shares and theSection 83(b) Election. The calculation of the amount of the Stock Gross-UpPayment shall (i) take into account any marginal deduction with respect to theEmployee's Federal income tax liability for state and local income taxes paidwith respect to the grant of Restricted Shares and the Stock Gross-Up Payment towhich the Employee will be entitled, and (ii) notwithstanding the time of yearin which any payments are made hereunder by the Employer, be based on payrolltaxes on income in excess of $100,000. The determination of the accounting firmshall be final and binding upon the Employee and the Employer. After theaccounting firm notifies the Employer of the amount of the Stock Gross-UpPayment and no later than fifteen days prior to the Employee's due date for his1998 Federal income taxes (without consideration for any extensions filedthereto), the Employer shall pay the Employee the excess, if any, of the StockGross-Up Payment over the Withholding Amount or the Employee shall pay theEmployer the excess, if any, of the Withholding Amount over the Stock Gross-UpPayment, as applicable. (g) All shares of common stock of the Parent acquired by the Employeeunder this Agreement or otherwise shall be subject to the Stockholders'Agreement attached hereto as Exhibit B. (h) During the Employment Period, the Employee shall be entitled tothe following benefits and perquisites: (i) medical and dental benefits (including for the employee's spouse) paid 100% by the Employer; (ii) life insurance equal to two (2) times Base Salary; (iii) long-term disability plan providing a disability benefit equal to two-thirds of Base Salary in the event of permanent disability to the extent such insurance is reasonably available in the market; 4 (iv) a car and driver provided by the Employer; (v) reimbursement of reasonable personal counseling services not to exceed $12,000 per year; (vi) the provision of J. Crew Brand clothing (including for the Employee's spouse and children); and (i) During the Employment Period: (i) except as specificallyprovided herein, the Employee shall be entitled to participate in all savingsand retirement plans, practices, policies and programs of the Employer and whichare made available generally to other executive officers of the Employer and(ii) except as specifically provided herein, the Employee and/or the Employee'sfamily, as the case may be, shall be eligible for participation in, and shallreceive all benefits under, all welfare benefit plans, practices, policies andprograms provided by the Employer and its affiliated companies which are madeavailable generally to other executive officers of the Employer (for theavoidance of doubt, such plans, practices, policies or programs shall notinclude any plan, practice, policy or program which provides benefits in thenature of severance or continuation pay). (j) During the Employment Period, the Employee shall be entitled topaid vacation of at least four weeks per year. The ability to carry forwardvacation time shall be subject to the Employer's vacation policy applicablegenerally to executive officers of the Employer as in effect from time to time. (k) With respect to the Employee's relocation from Florida to the NewYork area, the Employer will provide the following payments or reimbursements ofexpenses and relocation benefits: (i) Until the Employee obtains a permanent residence in the New York area but no longer than six (6) months after the Effective Date, the Employer will provide the Employee with weekly first class air travel between New York and Florida for both the Employee and his spouse and the Employer will provide the Employee with the use of a furnished apartment reasonably acceptable to the Employee in the New York area; (ii) After the Employee's current residence in Florida (the "Florida Residence") has been listed on a multiple listing service covering the area in which the Florida Residence is located ("Local Area") or with a reputable real estate broker in the Local Area for a four-month period, the Employer will retain three independent third- party real estate appraisers to appraise the Florida Residence. The average of the three appraisals obtained by the Employer shall be referred to herein as the "Appraised Value." If the Florida Residence has not been sold following such four-month period, the Employer will either, (A) purchase or cause another entity to purchase the Florida Residence for the Appraised Value or 5 (B) if the Employee sells the Florida Residence to an independent third-party purchaser for less than the Appraised Value in a transaction approved by the Employer, pay the Employee an amount equal to the excess of (x) the Appraised Value over (y) the proceeds received by the Employee as a result of such sale; (iii) the Employer will reimburse the Employee for the closing costs including reasonable brokerage fees and expenses incurred by the Employee with respect to the sale of the Florida Residence and incurred within six months of the Effective Date by the Employee with respect to his lease or purchase of a new residence in the New York area, excluding the purchase price for such residence and any mortgage points. (l) The Employer shall promptly reimburse the Employee for allreasonable business expenses upon the presentation of statements of suchexpenses in accordance with the Employer's policies and procedures now in forceor as such policies and procedures may be modified with respect to all seniorexecutive officers of the Employer. 3. Employment Period. ----------------- The Employment Period shall commence on the date hereof (the"Effective Date") and shall terminate on the day preceding the fourthanniversary of the Effective Date (the "Scheduled Termination Date"); provided, -------- however, that the Employee's employment hereunder may be terminated during the- ------- Employment Period prior to the Scheduled Termination Date upon the earliest tooccur of the following events (at which time the Employment Period shall beterminated): (a) Death. The Employee's employment hereunder shall terminate uponhis death. (b) Disability. The Employer shall be entitled to terminate theEmployee's employment hereunder for "Disability" if, as a result of theEmployee's incapacity due to physical or mental illness, the Employee shall havebeen unable to perform his duties hereunder for a period of six (6) consecutivemonths or for 180 days within any 365-day period, and within 30 days afterNotice of Termination (as defined in Section 4 below) for Disability is givenfollowing such 6-month or 180/365-day period, as the case may be, the Employeeshall not have returned to the performance of his duties on a full-time basis. (c) Cause. The Employer may terminate the Employee's employmenthereunder for Cause. For purposes of this Agreement, the term "Cause" shallmean: (i) a willful and material violation by the Employee of either Section1(c) or 12 of this Agreement; (ii) the willful failure by the Employee tosubstantially perform the duties reasonably assigned to him within the scope ofthe Employee's duties and authority as stated in Section 1(a) hereunder (otherthan as a result of physical or mental illness or injury), after the Boarddelivers to the Employee a written demand for substantial performance thatspecifically identifies the manner in which the 6 Employee has not substantially performed the Employee's duties and provides theEmployee ten (10) days to begin to substantially perform, provided that theEmployer shall not have the right to terminate the Employee's employmenthereunder for Cause if the Employee begins to substantially perform within suchten-day period; (iii) the Employee's willful misconduct, willful waste ofcorporate assets or gross negligence which in any such event substantially andmaterially injures the Employer; or (iv) the indictment of the Employee for afelony or other serious crime involving moral turpitude. If, subsequent to theEmployee's termination of employment hereunder for other than Cause, it isdiscovered that the Employee's employment could have been terminated for Causedue to a subsequent conviction of the Employee for a criminal offense againstthe Employer, the Employee's employment shall, at the election of the Employer,be deemed to have been terminated for Cause retroactively to the date the eventsgiving rise to Cause occurred. (d) Without Cause. The Employer may terminate the Employee'semployment hereunder without Cause. (e) Voluntarily. The Employee may voluntarily terminate hisemployment hereunder, provided that the Employee provides the Employer withnotice of his intent to terminate his employment at least three months inadvance of the Date of Termination (as defined in Section 4 below). TheEmployee and the Employer shall mutually agree on the time, method and contentof any public announcement regarding the Employee's termination of employmenthereunder and neither the Employee nor the Employer shall make any publicstatements which are inconsistent with the information mutually agreed upon bythe Employer and the Employee and the parties hereto shall cooperate with eachother in refuting any public statements made by other persons, which areinconsistent with the information mutually agreed upon between the Employee andEmployer as described above. 4. Termination Procedure. --------------------- (a) Notice of Termination. Any termination of the Employee'semployment by the Employer or by the Employee during the Employment Period(other than termination pursuant to Section 3(a)) shall be communicated bywritten "Notice of Termination" to the other party hereto in accordance withSection 13(a). For purposes of this Agreement, a Notice of Termination shallmean a notice which shall indicate the specific termination provision in thisAgreement relied upon and shall set forth in reasonable detail the facts andcircumstances claimed to provide a basis for termination of the Employee'semployment under the provision so indicated and shall attach any prior noticesrequired under Section 3. (b) Date of Termination. "Date of Termination" shall mean (i) if theEmployee's employment is terminated by his death, the date of his death, (ii) ifthe Employee's employment is terminated pursuant to Section 3(b), thirty (30)days after Notice of Termination, (iii) if the Employee voluntarily terminateshis employment, the date specified in the notice given pursuant to Section 3(e)herein and (iv) if the Employee's employment is terminated for any other reason, 7 the date on which a Notice of Termination is given or any later date (withinthirty (30) days, or any alternative time period agreed upon by the parties,after the giving of such notice) set forth in such Notice of Termination. 5. Termination Payments. -------------------- (a) Without Cause. In the event of the termination of the Employee'semployment during the Employment Period by the Employer without Cause, theEmployee shall be entitled to a payment, within thirty (30) days following theDate of Termination, of (i) the Employee's Base Salary through the Date ofTermination (to the extent not theretofore paid) and any unreimbursed expensespursuant to Section 2(h), (k) and (l) herein (the "Accrued Obligations"), (ii)any earned but unpaid Bonus in respect of a Bonus Period ending prior to orcoincident with the Date of Termination and (iii) a lump-sum payment equal totwo (2) times Base Salary (as in effect on the Date of Termination). TheEmployee shall also be entitled to a payment, as soon as practicable after theend of the fiscal year in which the Date of Termination occurs, of the Bonuspayable in accordance with the Bonus Plan attached as Exhibit A hereto, if any,calculated as if the Employee had been employed by the Employer through the endof such fiscal year. The payments provided in this Section 5(a) are conditionedupon and subject to the Employee executing a valid general release and waiver,waiving all claims the Employee may have against the Employer, its affiliates,directors, officers and employees. The Employer shall have no additionalobligations under this Agreement. (b) Cause. If the Employee's employment is terminated during theEmployment Period by the Employer for Cause, the Employer shall pay to theEmployee or to his estate in the event of his death, within thirty (30) days ofthe Date of Termination, (i) the Accrued Obligations and (ii) any earned butunpaid Bonus in respect of a Bonus Period ending prior to the Date ofTermination, but only if the event constituting Cause occurs after thetermination of such Bonus Period. The Employer shall have no additionalobligations under this Agreement. (c) Voluntary, Death or Disability. If the Employee's employment isterminated by the Employee or as a result of his death or Disability, theEmployer shall pay to the Employee or to his estate in the event of his death,within thirty (30) days of the Date of Termination, (i) the Accrued Obligationsand (ii) any earned but unpaid Bonus in respect of a Bonus Period ending priorto or coincident with the Date of Termination. In addition, with respect to atermination of the Employee's employment hereunder as a result of death orDisability, the Employer shall pay the Employee a pro-rata bonus in respect ofthe year in which such termination occurs determined pursuant to Section 3 ofthe Bonus Plan as if the Employee's Date of Termination was the ScheduledTermination Date. The Employer shall have no additional obligations under thisAgreement. 8 6. Change in Control. ----------------- Within the one-year period immediately following a Change in Control(as defined in Section 2(e) herein), the Employee may voluntarily terminate hisemployment hereunder and such termination will be deemed a termination withoutCause by the Employer entitling the Employee to the payments described inSection 5(a) herein. 7. Bankruptcy Proceeding; TPG II Guarantee. --------------------------------------- In the event the Employer files a petition for relief under the U.S.Bankruptcy Code, TPG II will guarantee the Employee's Base Salary for the one-year period immediately following the date of such filing provided that theEmployee continues to be employed with the Employer unless the Employee'sfailure to remain employed is the result of the Employer terminating hisemployment hereunder without Cause. 8. Non-exclusivity of Rights. ------------------------- Any vested benefits and other amounts that the Employee is otherwiseentitled to receive under any employee benefit plan, policy, practice or programof the Employer or any of its affiliated companies shall be payable inaccordance with such employee benefit plan, policy, practice or program as thecase may be, except as explicitly modified by this Agreement. 9. Full Settlement. ---------------- The Employer's obligation to make the payments provided for in, andotherwise to perform its obligations under, this Agreement shall not be affectedby any set off, counterclaim, recoupment, defense or other claim, right oraction that the Employer may have against the Employee or others; provided thatthis provision shall not apply (i) with respect to any debt owed by the Employeeto the Employer or any of its affiliates, (ii) with respect to the Employee'sobligations, if applicable, under Section 2(c) hereof or (iii) in the event theEmployee's employment is terminated by the Employer for Cause. 10. Legal Fees. ----------- (a) The Employer shall reimburse the Employee for reasonableattorneys' fees and expenses and other reasonable fees incurred in connectionwith the preparation of this Agreement not to exceed $20,000. (b) In the event of any contest or dispute between the Employer andthe Employee with respect to this Agreement or the Employee's employmenthereunder, each of the parties shall be responsible for their respective legalfees and expenses. 9 11. Indemnification. --------------- (a) The Employer agrees to defend, indemnify and hold the Employeeharmless for all claims asserted against and liabilities incurred by theEmployee as a result of any action taken by the Employee's former employer anddirectly related to the Employee's employment hereunder, provided that theEmployee fully cooperates with the Employer in defending or participating in anysuch action. This Section 11(a) shall survive any termination of the Employee'semployment hereunder including the termination of the Employment Period. (b) The Employee hereby represents to the Employer that he will notutilize or disclose any confidential information obtained by the Employee inconnection with his former employment with respect to his duties andresponsibilities hereunder. 12. Non-Solicitation. ---------------- (a) During the Employment Period and so long as the Employer is notin default of a material obligation hereunder, the Employee agrees not to offeremployment to any employee of the Employer or any of its affiliates for otherthan employment by the Employer or attempt to induce any such employee to leavethe employ of the Employer or any subsidiaries of the Employer and the Employeefurther agrees not to solicit any clients or suppliers of the Employer to dobusiness with any competing business of the Employer. (b) The parties hereto hereby declare that it is impossible tomeasure in money the damages which will accrue to the Employer by reason of afailure by the Employee to perform any of his obligations under this Section 12.Accordingly, if the Employer institutes any action or proceeding to enforce theprovisions hereof, to the extent permitted by applicable law, the Employeehereby waives the claim or defense that the Employer has an adequate remedy atlaw, and the Employee shall not urge in any such action or proceeding thedefense that any such remedy exists at law. 13. Miscellaneous. ------------- (a) Any notice or other communication required or permitted underthis Agreement shall be effective only if it is in writing and deliveredpersonally or sent by registered or certified mail, postage prepaid, addressedas follows (or if it is sent through any other method agreed upon by theparties): If to the Employer: J. Crew Group, Inc. 770 Broadway Fourth Floor New York, NY 10003 10 Attention: Board of Directors and Secretary with a copy to: Paul Shim, Esq. Cleary, Gottlieb, Steen & Hamilton One Liberty Plaza New York, NY 10006 If to the Employee: Mr. Howard Socol 11 Tahiti Beach Road Coral Gables, FL 33143 with a copy to: Stephen N. Lipton, Esq. Goldberg, Young & Gravenhorst, P.A. 1630 North Federal Highway P.O. Box 23800 Fort Lauderdale, Florida 33307or to such other address as any party hereto may designate by notice to theothers, and shall be deemed to have been given upon receipt. (b) This Agreement and all Exhibits hereto, including the Bonus Planand the Stockholders' Agreement dated as of February 24, 1998 by and between theEmployee and the Parent, constitute the entire agreement among the partieshereto with respect to the Employee's Employment, and supersedes and is in fullsubstitution for any and all prior understandings or agreements with respect tothe Employee's Employment. (c) This Agreement may be amended only by an instrument in writingsigned by the parties hereto, and any provision hereof may be waived only by aninstrument in writing signed by the party or parties against whom or whichenforcement of such waiver is sought. The failure of any party hereto at anytime to require the performance by any other party hereto of any provisionhereof shall in no way affect the full right to require such performance at anytime thereafter, nor shall the waiver by any party hereto of a breach of anyprovision hereof be taken or held to be a waiver of any succeeding breach ofsuch provision or a waiver of the provision itself or a waiver of any otherprovision of this Agreement. (d) (i) This Agreement is binding on and is for the benefit of theparties hereto and their respective successors, heirs, executors, administratorsand other legal representatives. 11 Neither this Agreement nor any right or obligation hereunder may be assigned bythe Employer or by the Employee. (ii) The Employer shall require any successor (whether direct orindirect, by purchase, merger, consolidation or otherwise) to all orsubstantially all of the business and/or assets of the Employer expressly toassume and agree to perform this Agreement in the same manner and to the sameextent that the Employer would have been required to perform it if no suchsuccession had taken place. As used in the Agreement, "the Employer" shall meanboth the Employer as defined above and any such successor that assumes andagrees to perform this Agreement, by operation of law or otherwise. (e) If any provision of this Agreement or portion thereof is sobroad, in scope or duration, so as to be unenforceable, such provision orportion thereof shall be interpreted to be only so broad as is enforceable. (f) The Employer may withhold from any amounts payable to theEmployee hereunder all federal, state, city or other taxes that the Employer mayreasonably determine are required to be withheld pursuant to any applicable lawor regulation. (g) This Agreement shall be governed by and construed in accordancewith the laws of the State of NEW YORK, without reference to its principles ofconflicts of law. (h) This Agreement may be executed in several counterparts, each ofwhich shall be deemed an original, but all of which shall constitute one and thesame instrument. (i) The headings in this Agreement are inserted for convenience ofreference only and shall not be a part of or control or affect the meaning ofany provision hereof. (j) Exhibit A hereto shall be subject to the provision of paragraphs(a), (c), (d), (f), (g) and (i) of this Section 13. 12 IN WITNESS WHEREOF, the parties have executed this Agreement, exceptthat TPG II is only a party to this Agreement with respect to its obligationsunder Section 7 hereof, as of the date first written above. J. CREW GROUP, INC. /s/ ------------------------------ Name: Title: J. CREW OPERATING CORP. /s/ ------------------------------ Name: Title: TPG Partners II, L.P. /s/ ------------------------------ Name: Title: /s/ ------------------------------ Howard Socol 13 EXHIBIT A- --------- J. CREW OPERATING CORP. SENIOR EXECUTIVE BONUS PLAN FOR HOWARD SOCOL 1. Definitions; References ----------------------- As used herein, the following terms shall have the meanings indicated below.Capitalized terms used in this Plan but not defined herein shall have themeanings assigned to them in the Employment Agreement. (a) "Annual EBITDA Performance Objective" shall mean the EBITDA performance ----------------------------------- objectives determined pursuant to Section 2(a) herein for each Bonus Period. (b) "Bonus," with respect to any Bonus Period, shall mean the cash bonus ----- earned pursuant to Section 2(b) hereof with respect to such Bonus Period. (c) "Bonus Period" shall mean each fiscal year of the Employer during which ------------ this Plan is in effect, provided that the initial Bonus Period shall be theperiod commencing on the Effective Date of the Employment Agreement and endingon the last day of the fiscal year ending in January 1999. (d) "EBITDA" shall mean, for any period, the consolidated earnings (losses) ------ of the Employer before extraordinary items and the cumulative effect ofaccounting changes, as determined by the Employer in accordance with GAAP, andbefore interest (expense or income), taxes, depreciation, amortization, non-cashgains and losses from sales of assets other than in the ordinary course ofbusiness and Valuation Adjustments. For purposes of clarification indetermining EBITDA, consolidated earnings shall not be reduced by compensationexpenses attributable to this Plan but shall be reduced (or with respect tolosses, increased), by compensation expenses attributable to any othercompensation plan, program or arrangement of the Employer or any of itsaffiliates, to the extent such expenses are recorded in accordance with GAAP. (e) "Employer" shall mean J. Crew Operating Corp. and the subsidiaries with -------- which its financial accounts are required to be consolidated under GAAP. (f) "Employment Agreement" shall mean the Employment Agreement dated February -------------------- 24, 1998, between Howard Socol, J. Crew Group, Inc., J. Crew Operating Corp.and, for certain purposes, TPG Partners II, L.P. (g) "GAAP" shall mean the U.S. generally accepted accounting principles. ---- (h) "Participant" shall mean Howard Socol. ----------- (i) "Payment Date," with respect to a Bonus Period, shall mean the date on ------------ which a Bonus is paid with respect to such Bonus Period, but shall not be laterthan the last date on which a Bonus earned with respect to such Bonus Period maybe paid pursuant to Section 2(c) hereof. (j) "Plan" shall mean this J. Crew Group, Inc. Senior Executive Bonus Plan ---- for Howard Socol. (k) "Target Bonus" shall mean 100% of Participant's annual Base Salary, ------------ provided that, with respect to the initial Bonus Period, the Target Bonus shallbe equal to the product of 100% of Participant's annual Base Salary multipliedby a fraction, the numerator of which is the number of whole days from andincluding the Effective Date to and including the last day of such Bonus Period,and the denominator of which is 365. (l) "Valuation Adjustments" shall mean that amount of non-cash expense --------------------- charged against earnings for any period resulting from the application ofaccounting for business combinations in accordance with Accounting PrinciplesBoard Opinion #16. These charges may include, but are not limited to, amountssuch as inventory revaluations, property, plant and equipment revaluations,goodwill amortization and finance fee amortization.2. Determination and Payment of Bonus Amounts ------------------------------------------ (a) The Board will determine the Annual EBITDA Performance Objectives withinsixty (60) days after the beginning of each Bonus Period and will notify theParticipant thereof. The parties intend that the financial assumptions thatwill form the starting point for the determination of the EBITDA PerformanceObjectives are the assumptions determined by the Board for executives of theEmployer generally but that the final determination is intended to reflectchanges in capitalization, prior performance of the Employer and any otherrelevant business and financial criteria. (b) The amount of the Bonus earned by the Participant for each Bonus Periodshall be determined pursuant to the table set forth below. In the event thatthe EBITDA of the Employer with respect to a Bonus Period is between 90% and100% of the Annual EBITDA Performance Objective with respect to such BonusPeriod, the amount of the Bonus earned by the Participant for such Bonus Periodshall be determined on the basis of straight line interpolation based on amountsset forth in such table. 2 If EBITDA with respect to a then the Bonus earned with respect to Bonus Period equals: such Bonus Period shall be:=============================================================================================== Less than 90% of the Annual EBITDA ZeroPerformance Objective with respect to suchBonus Period- -----------------------------------------------------------------------------------------------90% of the Annual EBITDA Performance 50% of the Target Bonus with respect to suchObjective with respect to such Bonus Period Bonus Period- -----------------------------------------------------------------------------------------------100% of the Annual EBITDA Performance 100% of the Target Bonus with respect to suchObjective with respect to such Bonus Period Bonus Period- ----------------------------------------------------------------------------------------------- (c) As soon as practical after the end of each Bonus Period, the Employershall determine the EBITDA for such Bonus Period and cause such determination tobe audited by the Company's independent auditors. The Employer shall pay theBonus, if any, to the Participant not later than thirty (30) business days afterthe Employer has received an opinion of its independent auditors concerning theamount of EBITDA, but in no event later than 120 days after the end of suchBonus Period.3. Effect of Termination of Employment ----------------------------------- In the event the Participant's employment with the Employer terminates on theScheduled Termination Date, the Participant shall be entitled to a Bonus withrespect to the Bonus Period in which such Scheduled Termination Date occurs,equal to the product of (A) the amount of Bonus to which the Participant wouldhave been entitled had he remained employed until the end of such Bonus Period,multiplied by (B) a fraction, the numerator of which is the number of whole daysfrom the first day of the Bonus Period up to and including the ScheduledTermination Date, and the denominator of which is 365. In the event theParticipant's employment with the Employer terminates pursuant to circumstancesentitling the Participant to severance payments under Section 5(a) of theEmployment Agreement, the Participant shall be entitled to a Bonus with respectto the Bonus Period in which such Date of Termination occurs, equal to theamount of Bonus to which the Participant would have been entitled had heremained employed until the end of such Bonus Period, provided that theParticipant executes a valid general release and waiver in connection with suchtermination. 3 EXHIBIT 10.6 STOCKHOLDERS' AGREEMENT STOCKHOLDERS' AGREEMENT (this "Agreement"), dated as of February 24, --------- 1998, between J. Crew Group, Inc. (the "Company"), TPG Partners II, L.P. ("TPG") ------- --- and Howard Socol (the "Stockholder"). ----------- WHEREAS, the Stockholder is an employee of the Company and in suchcapacity was granted restricted shares of common stock ("Common Stock") of theCompany (the "Restricted Shares"), pursuant to the employment agreement, dated ----------------- February 24, 1998, between Howard Socol, J. Crew Group, Inc., J. Crew OperatingCorp. and, for certain purposes, TPG Partners II, L.P. (the "Employment ----------Agreement");- --------- WHEREAS, as a condition to the issuance of Restricted Shares of CommonStock, the Stockholder is required under the Employment Agreement to executethis Agreement; and WHEREAS, the Stockholder and the Company desire to enter thisAgreement and to have this Agreement apply to the shares to be issued pursuantto the Employment Agreement and to any shares of Common Stock acquired after thedate hereof by the Stockholder from whatever source, subject to any futureagreement between the Company and the Stockholder to the contrary (in theaggregate, the "Shares"). ------ NOW THEREFORE, in consideration of the premises hereinafter set forth,and other good and valuable consideration, the receipt of which is herebyacknowledged, the parties hereto agree as follows. 1. Investment. The Stockholder represents that the Shares are being ---------- acquired for investment and not with a view toward the distribution thereof. 2. Issuance of Shares. The Company hereby represents to the ------------------ Stockholder that there are no agreements or arrangements other than thisStockholders' Agreement which would prohibit the issuance of, or restrict theStockholder's ability to transfer, the Restricted Shares. The Stockholderacknowledges and agrees that the certificate for the Shares shall bear thefollowing legends (except that the second paragraph of this legend shall not berequired after the Shares have been registered and except that the firstparagraph of this legend shall not be required after the termination of thisAgreement): The shares represented by this certificate are subject to the terms and conditions of a Stockholders' Agreement dated as of February 24, 1998 and may not be sold, transferred, hypothecated, assigned or encumbered, except as may be permitted by the aforesaid Agreement. A copy of the Stockholders' Agreement may be obtained from the Secretary of the Company. The shares represented by this certificate have not been registered under the Securities Act of 1933. The shares have been acquired for investment and may not be sold, transferred, pledged or hypothecated in the absence of an effective registration statement for the shares under the Securities Act of 1933 or an opinion of counsel for the Company that registration is not required under said Act. Upon the termination of this Agreement, or upon registration of theShares under the Securities Act of 1933 (the "Securities Act"), the Stockholder -------------- shall have the right to exchange any Shares containing the above legend (i) inthe case of the registration of the Shares, for Shares legended only with thefirst paragraph described above and (ii) in the case of the termination of thisAgreement, for Shares legended only with the second paragraph described above. 3. Transfer of Shares; Call Rights. ------------------------------- (a) The Stockholder agrees that he will not cause or permit the Sharesor his interest in the Shares to be sold, transferred, hypothecated, assigned orencumbered except as expressly permitted by this Section 3; provided, however, -------- ------- that the Shares or any such interest may be transferred (i) on the Stockholder'sdeath by bequest or inheritance to the Stockholder's executors, administrators,testamentary trustees, legatees or beneficiaries, (ii) to a trust orcustodianship the beneficiaries of which may include only the Stockholder, theStockholder's spouse, or the Stockholder's lineal descendants (by blood oradoption) and (iii) in accordance with Section 4 of this Agreement, subject inany such case to the agreement by each transferee (other than the Company) inwriting to be bound by the terms of this Agreement and provided in any such casethat no such transfer that would cause the Company to be required to registerthe Common Stock under Section 12(g) of the Securities Exchange Act of 1934, asamended (the "Exchange Act"), shall be permitted. ------------ (b) The Company (or its designated assignee) shall have the right,during the one-hundred-twenty-day period (x) immediately following thetermination of the Employee's employment with the Company for any reason inrespect of Shares acquired by the Stockholder prior to such termination and (y)immediately following the date of the acquisition of any Shares acquired by theStockholder following the termination of the Employee's employment for anyreason, to purchase from the Stockholder, and upon the exercise of such rightthe Stockholder shall sell to the Company (or its designated assignee), all orany portion of the Shares held by the Stockholder as of the date as of whichsuch right, is exercised at a per Share price equal to the Fair Market Value ofa share of Common Stock determined as of the date as of which such right isexercised. The Company (or its designated assignee) shall exercise such right bydelivering to the Stockholder a written notice specifying its intent to purchaseShares held by the Stockholder, the date as of which such right is to beexercised and the number of Shares to be purchased. Such purchase and saleshall occur on such date as the Company (or its designated assignee) 2 shall specify which date shall not be later than ninety (90) days after thefiscal quarter-end immediately following the date as of which the Company'sright is exercised. (c) For purposes of this Agreement, "Fair Market Value" shall mean, as ----------------- of any date: (1) prior to the existence of a Public Market (as defined in Section 5 herein) for the Common Stock, the quotient obtained by dividing (i) the excess of (x) the product of (A) 9 (as such number may be changed as provided below, the "Multiple") and (B) EBITDA (as defined in Exhibit A -------- of the Employment Agreement) for the twelve month period ending on the fiscal quarter-end immediately preceding such date over (y) the sum of (I) the weighted arithmetic average indebtedness (net of all cash and cash equivalents) during such period of the Company and its consolidated direct and indirect wholly-owned subsidiaries and (II) for each less than wholly- owned direct or indirect subsidiary of the Company the earnings of which are either consolidated with those of the Company or accounted for on an equity basis, the weighted arithmetic average indebtedness (net of all cash and cash equivalents) during such period of such subsidiary multiplied by the proportion of the total earnings (determined on the same basis as, and excluding the same items as in the determination of, EBITDA) of such subsidiary included in EBITDA (excluding earnings attributable to dividends received from such subsidiary), by (ii) the total number of shares of Common Stock on the last day of such period, determined on a fully diluted basis. For purposes of determining the indebtedness of an entity, all preferred stock of the entity, other than preferred stock convertible into Common Stock, shall be considered indebtedness in the amount of the liquidation value thereof plus accumulated but unpaid dividends thereon. Notwithstanding the foregoing provisions of this paragraph (1), for the ten (10) day period immediately following the occurrence of a Change in Control (as defined in the Employment Agreement), Fair Market Value shall not be less than the price per share, if any, paid to any member of the Initial Ownership Group or the public tender offer price paid in connection with such Change in Control. The Committee shall review the Multiple then in effect following the audit of the Company's financial statements each fiscal year, and shall make such increases or decreases in the Multiple as shall be determined by the Committee in good faith to reflect market conditions and Company performance. (2) on which a Public Market (as defined in Section 5 herein) for the Common Stock exists, (i) the average of the high and low sales prices during the ten (10) trading days immediately preceding such day of a share of Common Stock as reported on the principal securities exchange on which shares of Common Stock are then listed or admitted to trading or (ii) if not so reported, the average of the closing bid and ask prices during the ten (10) trading days immediately preceding such day as reported on the National Association of Securities Dealers Automated Quotation System (which shall include the NASDAQ National Market or the NASDAQ Small Cap Market) or (iii) if not so reported, as furnished by any member of the National Association of Securities 3 Dealers, Inc. selected by the Committee. The Fair Market Value of a share of Common Stock as of any such date on which the applicable exchange or inter-dealer quotation system through which trading in the Common Stock regularly occurs is closed shall be the Fair Market Value determined pursuant to the preceding sentence as of the immediately preceding date on which the Common Stock is traded, a bid and ask price is reported or a trading price is reported by any member of NASD selected by the Committee. In the event that the price of a share of Common Stock shall not be so reported or furnished, the Fair Market Value shall be determined by the Committee in good faith to reflect the fair market value of a share of Common Stock. 4. Certain Rights. -------------- (a) Drag Along Rights. If TPG desires to sell all or substantially ----------------- all of its shares of Common Stock to a good faith independent purchaser (a"Purchaser") (other than any other investment partnership, limited liability- ---------- company or other entity established for investment purposes and controlled bythe principals of TPG or any of its affiliates and other than any employees ofTPG or any of its affiliates, hereinafter referred to as a "Permitted ---------Transferee") and said Purchaser desires to acquire all or substantially all ofthe issued and outstanding shares of Common Stock (or all or substantially allof the assets of the Company) upon such terms and conditions as agreed to withTPG, the Stockholder agrees to sell all of his Shares to said Purchaser (or tovote all of his Shares in favor of any merger or other transaction which wouldeffect a sale of such shares of Common Stock or assets of the Company) at thesame price per share of Common Stock and pursuant to the same terms andconditions with respect to payment for the shares of Common Stock as agreed toby TPG. In such case, TPG shall give written notice of such sale to theStockholder at least 30 days prior to the consummation of such sale, settingforth (i) the consideration to be received by the holders of shares of CommonStock, (ii) the identity of the Purchaser, (iii) any other material items andconditions of the proposed transfer and (iv) the date of the proposed transfer. (b) Tag Along Rights. (i) Subject to paragraph ( iv) of this Section ---------------- 4(b), if TPG or its affiliates proposes to transfer any of its shares of CommonStock to a Purchaser (other than a Permitted Transferee), then TPG or suchPermitted Transferee (hereinafter referred to as a "Selling Stockholder") shall ------------------- give written notice of such proposed transfer to the Stockholder (the "Selling -------Stockholder's Notice") at least 30 days prior to the consummation of such- -------------------- proposed transfer, and shall provide notice to all other stockholders of theCompany to whom TPG has granted similar "tag-along" rights (such stockholderstogether with the Stockholder, referred to herein as the "Other Stockholders") ------------------ setting forth (A) the number of shares of Common Stock offered, (B) theconsideration to be received by such Selling Stockholder, (C) the identity ofthe Purchaser, (D) any other material items and conditions of the proposedtransfer and (E) the date of the proposed transfer. (ii) Upon delivery of the Selling Stockholder's Notice, theStockholder may elect to sell up to the sum of (A) the Pro Rata Portion (ashereinafter defined) and (B) the Excess Pro 4 Rata Portion (as hereinafter defined) of his Shares, at the same price per shareof Common Stock and pursuant to the same terms and conditions with respect topayment for the shares of Common Stock as agreed to by the Selling Stockholder,by sending written notice to the Selling Stockholder within 15 days of the dateof the Selling Stockholder's Notice, indicating his election to sell up to thesum of the Pro Rata Portion plus the Excess Pro Rata Portion of his Shares inthe same transaction. Following such 15 day period, the Selling Stockholder andeach Other Stockholder shall be permitted to sell to the Purchaser on the termsand conditions set forth in the Selling Stockholder's Notice the sum of (X) thePro Rata Portion and (Y) the Excess Pro Rata Portion of its Shares. (iii) For purposes of Section 4(b) and 4(c) hereof, "Pro Rata --------Portion" shall mean, with respect to shares of Common Stock held by theStockholder or Selling Stockholder, as the case may be, a number equal to theproduct of (x) the total number of such shares then owned by the Stockholder orthe Selling Stockholder, as the case may be, and (y) a fraction, the numeratorof which shall be the total number of such shares proposed to be sold to thePurchaser as set forth in the Selling Stockholder's Notice or initially proposedto be registered by the Selling Stockholder, as the case may be, and thedenominator of which shall be the total number of such shares then outstanding(including such shares proposed to be sold or registered by the SellingStockholder); provided, however, that any fraction of a share resulting fromsuch calculation shall be disregarded for purposes of determining the Pro RataPortion. For purposes of Sections 4(b) and 4(c), "Excess Pro Rata Portion" ----------------------- shall mean, with respect to shares of Common Stock held by the Stockholder orthe Selling Stockholder, as the case may be, a number equal to the product of(x) the number of Non-Elected Shares (as defined below) and (y) a fraction, thenumerator of which shall be such Stockholder's Pro Rata Portion with respect tosuch shares, and the denominator of which shall be the sum of (1) the aggregatePro Rata Portions with respect to the shares of Common Stock of all of the OtherStockholders that have elected to exercise in full their rights to sell theirPro Rata Portion of shares of Common Stock, and (2) the Selling Stockholder'sPro Rata Portion of shares of Common Stock (the aggregate amount of suchdenominator is hereinafter referred to as the "Elected Shares"). For purposes -------------- of this Agreement, "Non-Elected Shares" shall mean the excess, if any, of the ------------------ total number of shares of Common Stock, proposed to be sold to a Purchaser asset forth in a Selling Stockholder's Notice or initially proposed to beregistered by the Selling Stockholder, as the case may be, less the amount ofElected Shares. (iv) Notwithstanding anything to the contrary contained herein, theprovisions of this Section 4(b) shall not apply to any sale or transfer by TPGof shares of Common Stock unless and until TPG, after giving effect to theproposed sale or transfer, shall have sold or transferred in the aggregate(other than to Permitted Transferees) shares of Common Stock, representing 7.5%of shares of Common Stock owned by TPG on the date hereof. (c) Piggyback Registration Rights. ----------------------------- 5 (i) Notice to Stockholder. If the Company determines that it will --------------------- file a registration statement under the Securities Act, other than aregistration statement on Form S-4 or Form S-8 or any successor form, for anoffering which includes shares of Common Stock held by TPG or its affiliates(hereinafter in this paragraph (c) of Section 4 referred to as a "Selling -------Stockholder"), then the Company shall give prompt written notice to the- ----------- Stockholder that such filing is expected to be made (but in no event less than30 days nor more than 60 days in advance of filing such registration statement),the jurisdiction or jurisdictions in which such offering is expected to be made,and the underwriter or underwriters (if any) that the Company (or the personrequesting such registration) intends to designate for such offering. If theCompany, within 15 days after giving such notice, receives a written request forregistration of any Shares from the Stockholder, then the Company shall includein the same registration statement the number of Shares to be sold by theStockholder as shall have been specified in his request, except that theStockholder shall not be permitted to register more than the Pro Rata Portionplus the Excess Pro Rata portion of his Shares. The Company shall bear all costsof preparing and filing the registration statement, and shall indemnify and holdharmless, to the extent customary and reasonable, pursuant to indemnificationand contribution provisions to be entered into by the Company at the time offiling of the registration statement, the seller of any shares of Common Stockcovered by such registration statement. Notwithstanding anything herein to the contrary, the Company, on priornotice to the participating Stockholder, may abandon its intention to file aregistration statement under this Section 4(c) at any time prior to such filing. (ii) Allocation. If the managing underwriter shall inform the Company ---------- in writing that the number of shares of Common Stock requested to be included insuch registration exceeds the number which can be sold in (or during the timeof) such offering within a price range acceptable to TPG, then the Company shallinclude in such registration such number of shares of Common Stock which theCompany is so advised can be sold in (or during the time of) such offering. Allholders of shares of Common Stock proposing to sell shares of Common Stock shallshare pro rata in the number of shares of Common Stock to be excluded from suchoffering, such sharing to be based on the respective numbers of shares of CommonStock as to which registration has been requested by such holders. (iii) Permitted Transfer. Notwithstanding anything to the contrary ------------------ contained herein, sales of Shares pursuant to a registration statement filed bythe Company may be made without compliance with any other provision of thisAgreement. 5. Termination. This Agreement shall terminate immediately following ----------- the existence of a Public Market for the Common Stock except that (i) therequirements contained in Section 2 hereof shall survive the termination of thisAgreement and (ii) the provisions contained in Section 3 hereof shall continuewith respect to each Share during such period of time, if any, as theStockholder is precluded from selling such Shares pursuant to Rule 144 of theSecurities Act. For this purpose, a "Public Market" for the Common Stock shall ------------- be deemed to exist if the 6 Common Stock is registered under Section 12(b) or 12(g) of the Exchange Act andtrading regularly occurs in such Common Stock in, on or through the facilitiesof securities exchanges and/or inter-dealer quotation systems in the UnitedStates (within the meaning of Section 902(n) of the Securities Act) or anydesignated offshore securities market (within the meaning of Rule 902(a) of theSecurities Act). 6. Distributions With Respect To Shares. As used herein, the term ------------------------------------ "Shares" includes securities of any kind whatsoever distributed with respect to- ------- the Common Stock acquired by the Stockholder pursuant to the Option Plan or anysuch securities resulting from a stock split or consolidation involving suchCommon Stock. 7. Amendment; Assignment. This Agreement may be amended, superseded, --------------------- canceled, renewed or extended, and the terms hereof may be waived, only by awritten instrument signed by authorized representatives of the parties or, inthe case of a waiver, by an authorized representative of the party waivingcompliance. No such written instrument shall be effective unless it expresslyrecites that it is intended to amend, supersede, cancel, renew or extend thisAgreement or to waive compliance with one or more of the terms hereof, as thecase may be. Except for the Stockholder's right to assign his or her rightsunder Section 3(a) or the Company's right to assign its rights under Section3(b), no party to this Agreement may assign any of its rights or obligationsunder this Agreement without the prior written consent of the other partieshereto. 8. Notices. All notices and other communications hereunder shall be ------- in writing, shall be deemed to have been given if delivered in person or bycertified mail, return receipt requested, and shall be deemed to have been givenwhen personally delivered or three (3) days after mailing to the followingaddress: If to the Stockholder: Mr. Howard Socol 11 Tahiti Beach Road Coral Gables FL 33143 If to the Company: J. Crew Group, Inc. 770 Broadway Fourth Floor New York, NY 10003 Attention: Board of Directors and Secretary If to TPG: 7 TPG Partners II, L.P. 600 California Street Suite 1850 San Francisco, CA 94108 Attention: Jonathan Coslet or to such other address as any party may have furnished to the othersin writing in accordance herewith, except that notices of change of addressshall only be effective upon receipt. 9. Counterparts. This Agreement may be executed in two or more ------------ counterparts, each of which shall be deemed to be an original, but each of whichtogether shall constitute one and the same document. 10. Governing Law. This Agreement shall be governed by and construed ------------- in accordance with the laws of the State of NEW YORK, without reference to itsprinciples of conflicts of law. 11. Binding Effect. This Agreement shall be binding upon, inure to -------------- the benefit of, and be enforceable by the heirs, personal representatives,successors and permitted assigns of the parties hereto. Nothing expressed orreferred to in this Agreement is intended or shall be construed to give anyperson other than the parties to this Agreement, or their respective heirs,personal representatives, successors or assigns, any legal or equitable rights,remedy or claim under or in respect of this Agreement or any provision containedherein. 12. Entire Agreement. This Agreement along with the Employment ---------------- Agreement constitutes the entire agreement between the parties hereto withrespect to the subject matter hereof. 13. Severability. If any term, provision, covenant or restriction of ------------ this Agreement, is held by a court of competent jurisdiction to be invalid, voidor unenforceable, the remainder of the terms, provisions, covenants andrestrictions of this Agreement shall remain in full force and effect and shallin no way be affected, impaired or invalidated. 14. Miscellaneous. The headings contained in this Agreement are for ------------- reference purposes only and shall not affect in any way the meaning orinterpretation of this Agreement. * * * * * * 8 IN WITNESS WHEREOF, the parties hereto have caused this Agreement tobe duly executed as of the day and year first above written. ___________________________ Howard Socol J. CREW GROUP, INC. _____________________________ By: Title: TPG PARTNERS II, L.P. _____________________________ By: Title: 9 EXHIBIT 10-16 LETTER AGREEMENT April 28, 1998Mr. Barry Erdos2111 Park Hill DriveColumbus, OH 43209Dear Barry: Pursuant to our recent discussions regarding your employment with J.Crew Operating Corporation (the "Company"), we thought it would be useful to layout the terms and conditions of our agreement in this letter agreement("Agreement") for both parties to sign.1. EMPLOYMENT. (A) The Company hereby agrees to employ you as Chief Operating Officer ofthe Company and you hereby agree to serve the Company in such capacity duringthe "Employment Period" (as defined below). You will report to the ChiefExecutive Officer of the Company. Your principal work location will be the NewYork metropolitan area, but you will be required to travel to the extentnecessary to perform your duties and responsibilities. (B) You shall devote your full business time and energy, attention, skillsand ability to the performance of your duties and responsibilities as providedhereunder on an exclusive basis, shall faithfully and diligently endeavor topromote the business and best interests of the Company.2. EMPLOYMENT PERIOD. (A) The "Employment Period" shall commence on April 13, 1998 (the"Effective Date") and shall terminate upon the earliest to occur of (i) thethird anniversary of the Effective Date, (ii) your death or Disability (as suchterm is defined in the Company's Long-Term Disability Plan), (iii) voluntarytermination of employment by you, (iv) termination of employment by the Companyother than for Cause, death or Disability or (v) termination of employment bythe Company for Cause. (B) Upon termination of the Employment Period, you shall be entitled to anyearned but unpaid Base Salary (as defined in Section 3(a) below) as of the dateof termination. In addition, you will be entitled to the following payments: (i) if such termination is pursuant to subsection (ii) of Section 2(a) hereof, you or your estate, as the case may be, will be entitled to (A) payment of any Annual Bonus earned but not yet paid with respect to the fiscal year ended before the date of termination of employment and (B) a pro-rata portion of your Annual Bonus (the "Pro-Rata Bonus") with respect to the fiscal year in which such termination occurs equal to the product of (x) the Annual Bonus determined as if you worked through the end of the fiscal year, multiplied by (y) a ------------- fraction, the numerator of which is the number of full months worked by you during such fiscal year and the denominator of which is twelve (12); or (ii) if such termination is pursuant to subsection (iv) of Section 2(a) hereof, you shall be entitled to (A) continuation of Base Salary as in effect immediately prior to such termination for a period of twelve (12) months after the date of termination, (B) payment of any Annual Bonus earned but not yet paid with respect to the fiscal year ended before the date of termination of employment, (C) payment of the Pro-Rata Bonus with respect to the fiscal year in which such termination occurs determined in accordance with subsection (i) of this section 2(b), provided that, in the event such termination occurs prior to the end of the fiscal year beginning in 1998, you shall be entitled to the Guaranteed Bonus (described in Section 3(b) hereof) instead of the Pro-Rata Bonus, and (D) if your employment is terminated prior to payment of the Second-Half Signing Bonus (described in Section 3(c) hereof), the Company will pay you such Second- Half Signing Bonus. All the payments provided herein are conditioned upon and subject to your compliance with the Restrictive Covenants provided in Section 4 hereof and your execution of a general release and waiver, waiving all claims you may have against the Company except for claims which may arise as a result of the Company's failure to meet its obligations after the date of such waiver.Except as provided in this Section 2(b), no further compensation shall be dueupon your termination of employment. (C) For purposes of this Agreement, "Cause" shall mean (i) the commissionof a felony, (ii) willful misconduct or gross negligence in connection with theperformance of your duties as an employee of the Company, (iii) a materialbreach of this Agreement, (iv) a fraudulent act or omission by you adverse tothe reputation of the Company or any affiliate, and (v) the disclosure by you ofany Confidential Information (as defined in Section 4(b) hereof) to persons notauthorized to know same. If subsequent to your termination of employment, it isdiscovered that your employment could have been terminated for Cause by reasonof subsection (i) of this Section 2(c), your employment shall, at the electionof the Company, in its sole discretion, be deemed to have been terminated forCause.3. COMPENSATION AND BENEFITS. (A) During the Employment Period, your annual base salary shall be $600,000("Base Salary") and shall be paid pursuant to regular Company payroll practicesfor the senior executives of the Company. The Base Salary will be reviewedannually and may be increased but not decreased in the sole discretion of theCompany. (B) In addition to the Base Salary, in each fiscal year during theEmployment Period, you will have the opportunity to earn an annual bonus("Annual Bonus") of up to fifty percent (50%) of the Base Salary if the Companyachieves certain performance objectives (which will be 2 determined by the Company for each such fiscal year), provided that, withrespect to the fiscal year beginning in 1998, your Annual Bonus will be at least$150,000 (the "Guaranteed Bonus"), regardless of whether the performanceobjectives for such fiscal year are achieved. The Annual Bonus will be paid nolater than May 1 following the fiscal year for which it relates and, except asotherwise provided in Section 2(b) hereof, such Annual Bonus will be paid onlyif you are actively employed with the Company and not in breach of thisAgreement on such date of disbursement. (C) As soon as practicable after the Effective Date, but in no event laterthan ten (10) days thereafter, the Company will pay you $250,000 (the "First-Half Signing Bonus") as consideration for entering into this Agreement. Inaddition, on or as soon as practicable after the first anniversary of theEffective Date, the Company will pay you an additional $250,000 (the "Second-Half Signing Bonus"), provided that you are actively employed with the Companyand not in breach of this Agreement on such first anniversary. (D) As soon as practicable after the Effective Date, but in no event laterthan ten (10) days thereafter, the Company will provide you with a recourse loanin the amount of $300,000 (the "Loan"). Prior to receiving the Loan, you willbe required to execute a promissory note in favor of the Company which shallprovide the specific terms and conditions of the Loan. The promissory noteshall provide that (i) the principal amount of the loan will be $300,000, (ii)the rate of interest shall be 5.5% compounded semi-annually, (iii) you shallmake interest payments on each anniversary of the date such loan is made untilthe entire principal amount is paid and (iv) fifty percent of the principalamount of such loan shall be paid on each of the first and second anniversariesof the date the loan is made. At your discretion, you make interim interestpayments and may pay the principal amount on any portion thereof before thedates provided in the preceding sentence. The promissory note also will providethat the Company shall have the right to withhold all or any portion of anypayments owed to you, including without limitation the Second-Half Signing Bonusand Guaranteed Bonus as payment of all or any portion of the principal orinterest due under such promissory note. (E) As soon as practicable after the Effective Date and subject to approvalof the Board of Directors of J. Crew Group, Inc., the Company will grant you anoption (the "Option") to purchase the number of shares equal to approximatelyone percent (1%) of the total outstanding shares of common stock of J. CrewGroup, Inc. as of the Effective Date (rounded down to the nearest whole share)at an exercise price equal to $1,363.64 per share. Except as otherwise providedherein, the Option shall be governed by the terms and subject to the conditionsof the 1997 J. Crew Group Inc. Stock Option Plan (the "Option Plan"), includingthe requirements regarding the execution of a Stock Option Grant Agreement and aStockholders' Agreement. Ten percent (10%) of the Option will be immediatelyexercisable upon grant, ten percent (10%) of the Option will become exercisableon January 31, 1999 and twenty percent (20%) of the Option will becomeexercisable on each of January 31, 2000 through 2003, provided you are activelyemployed with the Company on such date. Any portion of the Option which has notyet become exercisable, shall become immediately exercisable upon the occurrenceof a Change in Control (as defined in the Option Plan). Subject to theprovisions of the Option Plan, with respect to the Option or any portion thereofwhich has not become 3 exercisable, the Option shall expire on the date your employment with theCompany is terminated for any reason, and with respect to any Option or anyportion thereof which has become exercisable, the Option shall expire on theearlier of: (i) 90 days after your termination of employment with the Companyother than for Cause, death or disability; (ii) one year after termination ofyour employment with the Company by reason of death or disability; (iii) thecommencement of business on the date your employment with the Company is, or isdeemed to have been, terminated for Cause; or (iv) the tenth anniversary of theEffective Date. (F) The Company will reimburse you for relocation expenses with respect toyour relocation from Ohio to New York not to exceed $420,000, provided thatrelocation expenses shall not include any loss incurred in connection with thesale of your primary residence located in Ohio. However, in the event that,after the primary Ohio residence has been listed on a multiple listing serviceor with a reputable real estate broker in the area for at least six months, youreceive an offer to purchase such residence from an unrelated third-partypurchaser for less than the amount that you originally paid for such residenceplus the amount of any capital expenditures not to exceed $80,000 which aresupported by documentation reasonably requested by the Company (the "OriginalPurchase Price"), and you intend to accept such offer, prior to accepting suchoffer you shall notify the Company and provide the Company with all reasonablyrequested details and documents regarding the offer, any previous offersreceived by you and any other relevant information regarding the residence. Atthat time, you agree to cooperate with the Company in determining the variousalternatives related to the disposition of the residence with a view towardeliminating any loss to you with respect to such disposition, including possiblyreimbursing you for the difference between the Original Purchase Price and theamount that you would receive in the proposed sale, provided that you do notagree to sell the residence for less than the Original Purchase Price withoutthe consent of the Company. It is understood that the term "loss" as used inthis Section 3(f) shall mean the excess, if any, of the Original Purchase Priceover the amount received in any sale of your primary Ohio residence. You agreethat you will use your reasonable best efforts to sell the residence for anamount in excess of the Original Purchase Price and to minimize all otherrelocation costs and will provide the Company with documentation reasonablyrequested by the Company with respect to any such reimbursement claims. (G) During the Employment Period, you will be entitled to participategenerally in the Company's benefit plans, except where specifically providedherein and except for any severance or other termination of employment plans.Currently, the Company's benefit package includes 3 weeks vacation, 3 personaldays, holidays, life insurance, medical insurance, long term disability, 401(k)tax deferred savings plan, a health flexible spending account, and the employeediscount. The Company reserves the right to change these benefits at any timein its sole discretion. (H) The Company will reimburse you for all reasonable business expensesupon the presentation of statements of such expenses in accordance with theCompany's policies and procedures now in force or as such policies andprocedures may be modified with respect to the senior executives of the Company.4. RESTRICTIVE COVENANTS. 4 (A) As additional consideration for the Company entering into thisAgreement and agreeing to make the salary continuation payments described inSection 2(a) hereof, you agree that during the Employment Period and for aperiod of twelve (12) months after the date on which the Employment Period isterminated, you shall not solicit, hire, or seek to influence the employmentdecisions of, any employee of the Company on behalf of any person or entityother than the Company. (B) You agree that, during the Employment Period and thereafter, you willhold in strict confidence any proprietary or Confidential Information related tothe Company. For purposes of this Agreement, the term "ConfidentialInformation" shall mean all information of the Company in whatever form which isnot generally known to the public, including without limitation, customer lists,trade practices, marketing techniques, pricing structures and practices,research, trade secrets, processes, systems, programs, methods, software,merchandising, planning, inventory and financial control, store design andstaffing. (C) You also agree that breach of the confidentiality or employee non-solicitation provisions provided in paragraphs (a) or (b) of this Section 4would cause the Company to suffer irreparable harm for which money damages wouldnot be an adequate remedy and therefore, if you breach any of the RestrictiveCovenants provided herein, the Company would be entitled to temporary andpermanent injunctive relief in any court of competent jurisdiction (without theneed to post any bond). (D) You agree not to disclose any information regarding the existence orsubstance of this Agreement to any third party, without the prior writtenconsent of the Company except as may be required by law, during any legalproceeding brought by you relating to this Agreement or with your professionaladvisers for purposes of discussing the subject matter hereof and, with respectto such professional advisers, you agree to inform them of your obligationshereunder and take all reasonable steps to ensure that such professionaladvisers do not disclose the existence or substance hereof. Further, you agreenot to directly or indirectly disparage or defame the Company or any of itsdirectors, officers or employees.5. REPRESENTATIONS. (A) Each party hereto represents and warrants to the other party heretothat (i) the execution, delivery and performance of such party of this Agreementhas been duly authorized by all necessary action on its part and does notcontravene or conflict with any provisions of any agreement or other instrumentto which it is party or by which it is bound or any applicable law, judgment,order, writ, injunction, decree, rule or regulation of any court, governmentalauthority, administrative agency or arbitrator, (ii) this Agreement is thelegal, valid and binding obligation of such party, enforceable against it inaccordance with its terms and (iii) there is no pending or threatened action orproceeding affecting such party before or by any court, governmental authority,administrative agency or arbitrator, which if adversely determined, wouldprevent such party from consummating the transactions contemplated hereby.6. MISCELLANEOUS. 5 (A) Any notice or other communication required or permitted under thisAgreement shall be effective only if it is in writing and delivered personallyor sent by registered or certified mail, postage prepaid, return receiptrequested and addressed as follows: If to the Company: J. Crew Operating Corp. 770 Broadway Twelfth Floor New York, NY Attention: Chief Executive Officer If to the Employee: Mr. Barry Erdos 2111 Park Hill Drive Columbus, OH 43209or to such other address as any party hereto may designate by notice to theother, and shall be deemed to have been given upon receipt. (B) This Agreement constitutes the entire agreement among you and theCompany with respect to your employment by the Company, and supersedes and is infull substitution for any and all prior understandings or agreements withrespect to your employment. (C) This Agreement shall inure to the benefit of and be an obligation ofthe Company's assigns and successors; however you may not assign your duties andobligations hereunder to any other party. (D) No provision of this Agreement may be amended or waived, unless suchamendment or waiver is specifically agreed to in writing and signed by you andan officer of the Company duly authorized to execute such amendment. (E) This Agreement and all amendments thereof shall, in all respects, begoverned by and construed and enforced in accordance with the internal laws(without regard to principles of conflicts of law) of the State of NEW YORK.Each party hereto hereby agrees to and accepts the exclusive jurisdiction of anycourt in New York County or the U.S. District Court for the Southern District ofNew York in that County in respect of any action or proceeding relating to thesubject matter hereof, expressly waiving any defense relating to jurisdiction orforum non conveniens, and consents to service of process by U.S. certified or- -------------------- registered mail in any action or proceeding with respect to this Agreement. (F) The Company shall be responsible for and shall pay the agency fees withrespect to Herbert Mines Associates, Inc. which arranged for and facilitatedyour employment with the Company hereunder. 6 (G) The Company shall reimburse you for reasonable attorneys' fees andexpenses and other reasonable fees incurred in connection with the preparationof this Agreement not to exceed $20,000. 7 If the terms of this letter Agreement meet with your approval, pleasesign and return one copy to me. Sincerely, /s/ Howard Socol Chief Executive Officer J. Crew Operating CorporationAgreed to and Accepted: /s/- -------------------------------------Barry Erdos Date 8

5THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THECONSOLIDATED BALANCE SHEET AT JANUARY 31, 1998 AND THE CONSOLIDATED STATEMENT OFOPERATIONS FOR THE YEAR ENDED JANUARY 31, 1998 AND IS QUALIFIED IN ITS ENTIRETYBY REFERENCE TO SUCH FINANCIAL STATEMENTS 1,000,000 12-MOS JAN-31-1998 JAN-31-1998 12 0 22 5 203 294 166 56 422 151 298 130 0 1 (202) 422 823 834 465 825 21 7 20 (32) (5) (27) 0 (5) 0 (31) 0 0

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J. Crew Group, Inc. Annual Report 1997

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J. Crew Group, Inc.
Annual Report 1997