Item 7. Management’s Discussion and Analysis
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the financial condition and results of operations should be read in conjunction with the consolidated financial statements and the accompanying notes and information contained in other sections included elsewhere in this annual report, particularly, “Risk Factors,” and “Business.” This discussion and analysis is based on the beliefs of our management, as well as assumptions made by, and information currently available to our management. The statements in this discussion and analysis concerning expectations regarding our future performance, liquidity and capital resources, as well as other non-historical statements in this discussion and analysis, are forward-looking statements. See “Forward-Looking Statements.” These forward-looking statements are subject to numerous risks and uncertainties, including those described under “Risk Factors.” Our actual results could differ materially from those suggested or implied by any forward-looking statements.
Management’s discussion focuses on fiscal 2020 results compared to fiscal 2019. Fiscal year 2020 and 2019 were 52-week periods. For a discussion of fiscal 2019 results compared to fiscal 2018, refer to the Company’s Annual Report on Form 10-K for the year ended February 2, 2020.
Overview
We are a lifestyle brand of men’s and women’s casual wear, workwear and accessories sold primarily through our own omnichannel platform. We offer products nationwide through our website and catalog. In 2010, we initiated our omnichannel platform with the opening of our first store. Since then, we have expanded our retail presence, and as of January 31, 2021, we operated 62 retail stores and three outlet stores.
We offer a comprehensive line of innovative, durable and functional products, such as our Longtail T ® shirts, Buck Naked TM underwear, Fire Hose ® work pants and No-Yank™ Tank, which reflect our position as the Modern, Self-Reliant American Lifestyle brand. Our brand has a heritage in workwear that transcends tradesmen and appeals to a broad demographic for everyday and on-the-job use.
From our heritage as a catalog for those working in the building trades, Duluth Trading has become a widely recognized brand and proprietary line of innovative and functional apparel and gear. Over the last decade, we have created strong brand awareness, built a loyal customer base and generated robust sales momentum. We have done so by sticking to our roots of “there’s gotta be a better way” and through our relentless focus on providing our customers with quality, functional products.
A summary of our financial results is as follows:
Net sales in fiscal 2020 increased by 3.8% over the prior year to $638.8 million;
Net income in fiscal 2020 decreased compared to the prior year to $13.4 million;
Adjusted EBITDA in fiscal 2020 increased 6.8% over the prior year to $55.5 million; and
Cash flow from operations in Fiscal 2020 increased to $55.8 million and Free Cash Flow increased $60.9 million over the prior year to $38.5 million.
See “Reconciliation of Net Income to EBITDA and EBITDA to Adjusted EBITDA” section for a reconciliation of our net income to EBITDA and EBITDA to Adjusted EBITDA, both of which are non-U.S. GAAP financial measures. See also the information under the heading “Adjusted EBITDA” in the section “How We Assess the Performance of Our Business” for our definition of Adjusted EBITDA.
See “Free Cash Flow” section for a reconciliation of Net cash provided by operating activities to Free Cash Flow. See also the information under the heading “Free Cash Flow” in the section “How We Assess the Performance of Our Business” for our definition of Free Cash Flow.
With an emphasis on profitable growth we are pursuing several strategies, including building brand awareness to continue customer acquisition, continuing selective retail expansion, strengthening the core Men’s Duluth sub-brand and growing our Women’s Duluth sub-brand.
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We continue to grow our omnichannel distribution network which allows the consumer to interact with us through a consistent customer experience whether on the company website or at company stores. As we expand our distribution network, and in conjunction with assessing the similar nature of products sold, production process, distribution process, target customers and economic characteristics between our sales channels, we have determined that the historical structure of separate reporting segments for direct and retail was no longer representative of the way in which we manage our business. Therefore, as of February 3, 2020, we have updated our segment reporting to one reportable external segment, consistent with our omnichannel business approach.
Our management’s discussion and analysis includes market sales metrics for our stores, website and catalog sales. Market areas are determined by a third-party that divides the United States and Puerto Rico into 280 unique geographical areas. Our store market sales metrics include sales from our stores, website and catalog. Our non-store market sales metrics include sales from our website and catalog.
COVID-19
In March 2020, a novel strain of coronavirus (“COVID-19”) was declared a global pandemic by the World Health Organization. This pandemic has negatively affected the U.S. and global economies, disrupted global supply chains and financial markets, and led to significant travel and transportation restrictions, including mandatory business closures and orders to shelter in place.
The Company has focused on protecting the health and safety of our employees, customers and suppliers, working with our customers, landlords, suppliers and vendors to minimize potential disruptions and supporting our community, while managing our business in these unprecedented times. The Company took the following significant actions during the first fiscal quarter as a response to the pandemic:
Beginning March 20, 2020 temporarily closed all stores for a period of seven weeks;
Made operational changes to accommodate social distancing within our distribution centers;
Made work from home accommodations for corporate employees;
Amended our Credit Agreement to include an incremental delayed draw term loan of $20.5 million and amended the loan covenants to provide greater flexibility during peak borrowing periods in fiscal 2020;
Partnered with landlords, suppliers and vendors to materially reduce costs, extend payment terms and cancel merchandise receipts;
Initiated furloughs of varying lengths with benefits intact for 68% of salaried staff;
Began a six-month pay reduction for senior leadership ranging from 10 to 20 percent;
The Company’s Chief Executive Officer (“CEO”) agreed to temporarily forgo his base salary;
The Board of Directors agreed to forgo cash retainers for the second and third quarters;
Reduced planned capital spend levels by approximately 40% primarily by decreasing new store openings to four in fiscal 2020; and
Partnered with the American Red Cross to donate a portion of sales on key apparel items.
While the business environment and above actions have impacted our results for the fiscal year, our strong brand awareness and loyal customer base were evident by a continued surge in direct sales through the fourth fiscal quarter. As of June 15, 2020, all of our retail stores were re-opened in some capacity, but prolonged COVID-19 safety concerns did impact store traffic levels throughout the year, including during our peak selling season.
The ultimate impact of COVID-19 on our operational and financial performance still depends on future developments outside of our control, including the duration and spread of the pandemic and related actions taken by federal, state and local government officials, and international governments to prevent disease spread, and the availability, safety and efficiency of a vaccine. Given the uncertainty, we cannot reasonably estimate store traffic patterns and the prolonged impact on overall consumer demand. We continue to actively evaluate all federal, state and local regulations to ensure compliance with store operations.
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How We Assess the Performance of Our Business
In assessing the performance of our business, we consider a variety of financial and operating measures that affect our operating results.
Net Sales
Net sales reflect our sale of merchandise plus shipping and handling revenue collected from our customers, less returns and discounts. Direct-to-consumer sales are recognized upon shipment to a customer, while store sales are recognized at the point of sale. Although we did not do so in fiscal 2020, we also have historically used net sales as one of the key financial metrics in determining our annual bonus compensation for our employees.
Gross Profit
Gross profit is equal to our net sales less cost of goods sold. Gross profit as a percentage of our net sales is referred to as gross margin. Cost of goods sold includes the direct cost of purchased merchandise; inventory shrinkage; inventory adjustments due to obsolescence, including excess and slow-moving inventory and lower of cost and net realizable reserves; inbound freight; and freight from our distribution centers to our retail stores. The primary drivers of the costs of individual goods are raw material costs. Depreciation and amortization are excluded from gross profit. We expect gross profit to increase to the extent that we successfully grow our net sales. Given the size of our sales through our direct-to-consumer sales channel relative to our total net sales, shipping and handling revenue has had a significant impact on our gross profit and gross profit margin. Historically, this revenue has partially offset shipping and handling expense included in selling, general and administrative expenses. We have experienced declines in shipping and handling revenues, and this trend is expected to continue. Declines in shipping and handling revenues may have a material adverse effect on our gross profit and gross profit margin, as well as Adjusted EBITDA to the extent there are not commensurate declines, or if there are increases, in our shipping and handling expense. Our gross profit may not be comparable to other retailers, as we do not include distribution network and store occupancy expenses in calculating gross profit, but instead we include them in selling, general and administrative expenses.
Selling, General and Administrative Expenses
Selling, general and administrative expenses include all operating costs not included in cost of goods sold. These expenses include all payroll and payroll-related expenses and occupancy expenses related to our stores and to our operations at our headquarters, including utilities, depreciation and amortization. They also include marketing expense, which primarily includes television advertising, catalog production, mailing and print advertising costs, as well as all logistics costs associated with shipping product to our customers, consulting and software expenses and professional services fees. Selling, general and administrative expenses as a percentage of net sales is usually higher in lower-volume quarters and lower in higher-volume quarters because a portion of the costs are relatively fixed.
Our historical sales growth has been accompanied by increased selling, general and administrative expenses. The most significant components of these increases are advertising, marketing, rent/occupancy and payroll costs. While we expect these expenses to increase as we continue to open new stores, increase brand awareness and grow our organization to support our growing business, we believe these expenses will decrease as a percentage of sales over time. Our shipping and handling expenses increased during the second half of the year because of additional surcharges due to the strained distribution network.
Adjusted EBITDA
We believe Adjusted EBITDA is a useful measure of operating performance, as it provides a clearer picture of operating results by excluding the effects of financing and investing activities by eliminating the effects of interest and depreciation costs and eliminating expenses that are not reflective of underlying business performance. We use Adjusted EBITDA to facilitate a comparison of our operating performance on a consistent basis from period-to-period and to provide for a more complete understanding of factors and trends affecting our business.
We define Adjusted EBITDA as consolidated net income before depreciation and amortization, interest expense and provision for income taxes adjusted for the impact of certain items, including non-cash and other items we do not consider representative of our ongoing operating performance. We believe Adjusted EBITDA is less susceptible to variances in actual performance resulting from depreciation, amortization and other items. This non-GAAP measure may not be comparable to similarly titled measures used by other companies.
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Free Cash Flow
We believe Free Cash Flow is a useful measure of performance as an indication of our financial strength and provides additional perspective on our ability to efficiently use capital in executing our growth strategy. We use Free Cash Flow to facilitate a comparison of our operating performance on a consistent basis from period-to-period and our ability to generate cash.
We define Free Cash Flow as net cash provided by operating activities less purchase of property and equipment and capital contributions towards build-to-suit stores. This non-GAAP measure may not be comparable to similarly titled measures used by other companies.
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Results of Operations
The following table summarizes our consolidated results of operations for the periods indicated, both in dollars and as a percentage of net sales.
Fiscal Year Ended
January 31, 2021
February 2, 2020
(in thousands)
Net sales
638,783
615,624
Cost of goods sold (excluding depreciation and amortization)
307,257
287,475
Gross profit
331,526
328,149
Selling, general and administrative expenses
307,311
300,041
Operating income
24,215
28,108
Interest expense
6,263
4,471
Other income, net
65
291
Income before income taxes
18,017
23,928
Income tax expense
4,637
5,429
Net income
13,380
18,499
Less: Net loss attributable to noncontrolling interest
(197)
(422)
Net income attributable to controlling interest
$
13,577
$
18,921
Percentage of Net sales:
Net sales
100.0
%
100.0
%
Cost of goods sold (excluding depreciation and amortization)
48.1
%
46.7
%
Gross profit
51.9
%
53.3
%
Selling, general and administrative expenses
48.1
%
48.7
%
Operating income
3.8
%
4.6
%
Interest expense
1.0
%
0.7
%
Other income, net
—
%
0.0
%
Income before income taxes
2.8
%
3.9
%
Income tax expense
0.7
%
0.9
%
Net income
2.1
%
3.0
%
Less: Net loss attributable to noncontrolling interest
—
%
(0.1)
%
Net income attributable to controlling interest
2.1
%
3.1
%
Fiscal 2020 Compared to Fiscal 2019
Net Sales
Net sales increased $23.2 million, or 3.8%, to $638.8 million in fiscal 2020 compared to $615.6 million in fiscal 2019. The increase was due to an increase in non-store market sales partially offset by a decrease in store market sales.
Net sales in non-store markets increased $46.0 million, or 27.5%, to $213.1 million in fiscal 2020 compared to $167.1 million in fiscal 2019. The increase was driven by new buyer growth and effective digital advertising to promote Mother’s Day, Father’s Day, the Pink Buck Naked event, our Big Dam Birthday, online warehouse clearance and global sales events, coupled with extended free shipping offers. Store market sales decreased $20.0 million, or 4.6%, to $419.1 million in fiscal 2020 compared to $439.1 million in fiscal 2019. The decrease was driven by a decline of in-store market sales due to the temporary closure of all stores beginning on March 20, 2020 until they re-opened beginning the first week of May through the third week of June, as well as slower store traffic throughout the year due to the pandemic, partially offset by growth in online sales from both existing customers and new buyers.
Gross Profit
Gross profit increased $3.4 million, or 1.0%, to $331.5 million in fiscal 2020 compared to $328.1 million in fiscal 2019. As a percentage of net sales, gross margin decreased to 51.9% of net sales in fiscal 2020 compared to 53.3% of net sales in fiscal 2019. The decrease in gross margin rate was driven by promotional events, extending clearance events and sitewide sales events to continue moving inventory during the period of store closures and uncertainty in customer demand. The decrease was partially offset by reduced store delivery costs from lower store sales volumes and lower product returns.
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Selling, General and Administrative Expenses
Selling, general and administrative expenses increased $7.3 million, or 2.4%, to $307.3 million in fiscal 2020 compared to $300.0 million in fiscal 2019. Selling, general and administrative expenses as a percentage of net sales decreased in fiscal 2020 to 48.1% of net sales, compared to 48.7% of net sales for fiscal 2019. The positive leverage was primarily due to shifting to a more efficient digital marketing approach as customer purchasing patterns migrated to online.
The increase in selling, general and administrative expense was due to increased shipping costs to support website sales coupled with additional surcharges during our peak shopping season, higher retail overhead costs driven by new store growth, increased depreciation expense primarily associated with investments in technology, and increased incentive compensation. These increases were partially offset by reduced catalog spend and national TV advertising.
Interest Expense
Interest expense increased $1.8 million to $6.3 million in fiscal 2020 compared to $4.5 million in fiscal 2019. The increase in interest expense was primarily attributable to an increase in borrowings on our revolving line of credit and delayed draw term loan, particularly during the first six months of fiscal 2020 as compared to the same period in the prior year, and interest expense relating to two additional finance leases during fiscal 2020.
Income Taxes
Income tax expense was $4.6 million in fiscal 2020 compared to $5.4 million in fiscal 2019. Our effective tax rate related to controlling interest was 25.5% and 22.3% in fiscal 2020 and fiscal 2019, respectively.
Net Income Attributable to Controlling Interest
Net income attributable to controlling interest was $13.6 million in fiscal 2020 compared to $18.9 million in fiscal 2019, primarily due to the factors discussed above.
Non-GAAP Financial Measures
See the above section titled “How We Asses the Performance of Our Business,” for our definition of Adjusted EBITDA and Free Cash Flow.
Reconciliation of Net Income to EBITDA and EBITDA to Adjusted EBITDA
The following table represents reconciliations of net income to EBITDA and EBITDA to Adjusted EBITDA for the periods indicated below.
Fiscal Year Ended
January 31, 2021
February 2, 2020
(in thousands)
Net income
$
13,380
$
18,499
Depreciation and amortization
28,520
22,083
Amortization of internal-use software hosting
subscription implementation costs
229
—
Interest expense
6,263
4,471
Amortization of build-to-suit operating
leases capital contribution
794
784
Income tax expense
4,637
5,429
EBITDA (non-GAAP)
53,823
51,266
Stock based compensation
1,629
647
Adjusted EBITDA (non-GAAP)
$
55,452
$
51,913
As a result of the factors discussed above in the “Results of Operations” section, Adjusted EBITDA increased $3.5 million, or 6.8%, to $55.5 million in fiscal 2020 compared to $51.9 million in fiscal 2019. As a percentage of net sales, Adjusted EBITDA increased to 8.7% of net sales in fiscal 2020 compared to 8.4% of net sales in fiscal 2019.
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Free Cash Flow
The following table represents a reconciliation of Net cash provided by operating activities, the most comparable U.S. GAAP financial measure, to free cash flow.
Fiscal Year Ended
January 31, 2021
February 2, 2020
(in thousands)
Net cash provided by operating activities
$
50,751
$
8,347
Purchases of property and equipment
(11,743)
(24,435)
Capital contributions towards build-to-suit stores
(520)
(6,354)
Free Cash Flow (non-GAAP)
$
38,488
$
(22,442)
Free cash flow increased $60.9 million to $38.5 million in fiscal 2020 compared to $(22.4) million in fiscal 2019. The increase was primarily driven by moderating inventory levels back in line with net sales growth as well as reducing capital expenditures during fiscal 2020.
Liquidity and Capital Resources
General
Our business relies on cash from operating activities and a credit facility as our primary sources of liquidity. Our primary cash needs have been for inventory, marketing and advertising, payroll, store leases, capital expenditures associated with opening new stores, infrastructure and information technology. The most significant components of our working capital are cash, inventory, accounts payable and other current liabilities. At January 31, 2021 our working capital was $114.6 million, which includes cash of $47.2 million.
We spent $12.3 million in fiscal 2020 on capital expenditures, as well as, $4.1 million of additional investments in implementation costs to enhance the value of hosting arrangements, which are included in Prepaid expenses & other current assets on the Company’s Consolidated Balance Sheets. We expect to spend approximately $10.0 million in fiscal 2021 on capital expenditures, primarily due to investments in technology, as well as $5.0 million of additional investments in implementations costs to enhance the value of hosting arrangements. Due to the seasonality of our business, a significant amount of cash from operating activities is generated during the fourth quarter of our fiscal year. During the first three quarters of our fiscal year, we typically are net users of cash in our operating activities as we acquire inventory in anticipation of our peak selling season, which occurs in the fourth quarter of our fiscal year. We also use cash in our investing activities for capital expenditures throughout all four quarters of our fiscal year.
We believe that our cash flow from operating activities and the availability of cash under our credit facility will be sufficient to cover working capital requirements and anticipated capital expenditures for the foreseeable future.
Cash Flow Analysis
A summary of operating, investing and financing activities is shown in the following table.
Fiscal Year Ended
January 31, 2021
February 2, 2020
(in thousands)
Net cash provided by operating activities
$
50,751
$
8,347
Net cash used in investing activities
(12,132)
(30,687)
Net cash provided by financing activities
6,362
21,495
Increase (decrease) in cash, cash equivalents and restricted cash
$
44,981
$
(845)
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Net Cash Provided by Operating Activities
Operating activities consist primarily of net income adjusted for non-cash items that include depreciation and amortization, stock-based compensation and the effect of changes in assets and liabilities.
For fiscal 2020, net cash provided by operating activities was $50.8 million, which consisted of net income of $13.4 million, non-cash depreciation and amortization of $28.5 million and amortization of stock-based compensation of $1.6 million and cash provided by operating assets and liabilities of $7.2 million. The cash provided by operating assets and liabilities of $7.2 million primarily consisted of a $7.7 million increase in accrued expenses and deferred rent obligations due to $3.5 million of deferred payroll taxes afforded by the CARES Act, a $4.2 million increase in income tax payable, a $2.6 million decrease in prepaid expenses, offset by a $1.2 million increase in inventory, a $4.1 million increase in hosting software implementation costs and a $1.5 million decrease in trade accounts payable.
For fiscal 2019, net cash provided by operating activities was $8.3 million, which consisted of net income of $18.5 million, non-cash depreciation and amortization of $22.1 million and amortization of stock-based compensation of $0.6 million offset by deferred income taxes of $1.2 million and cash used in operating assets and liabilities of $31.7 million. The cash used in operating assets and liabilities of $31.7 million primarily consisted of a $50.2 million increase in inventory due to growth and supply of inventory for our new retail stores in the first quarter of fiscal 2019, which was partially offset by a $5.4 decrease in prepaid expenses, coupled with a $3.2 million increase in income taxes payable and a $7.6 million increase in trade accounts payable. The increase in trade accounts payable was primarily due to an increase in inventory and timing of payments.
Net Cash Used in Investing Activities
Investing activities consist primarily of capital expenditures for growth related to new stores and information technology.
For fiscal 2020, net cash used in investing activities was $12.1 million, primarily driven by capital expenditures of $11.7 million, due mainly to the opening of 4 new stores, as well as investments in information technology.
For fiscal 2019, net cash used in investing activities was $30.7 million, primarily driven by capital expenditures of $24.4 million, due mainly to the opening of 15 new stores, as well as investments in information technology and $6.3 million of capital contributions towards our build-to-suit stores.
Net Cash Provided by Financing Activities
Financing activities consist primarily of borrowings and payments related to our revolving line of credit and other long-term debts, as well as proceeds from finance lease obligations.
For fiscal 2020, net cash provided by financing activities was $6.4 million, primarily consisting of proceeds of $28.3 million, net from our term loan and payments of $19.3 million, net from our revolving line of credit to fund working capital.
For fiscal 2019, net cash provided by financing activities was $21.5 million, which included borrowings of $271.8 million on our revolving line of credit and $20.0 million on our delayed draw term loan to support our capital expenditures discussed above and working capital needs, offset by payments of $269.0 million on our revolving line of credit.
Credit Agreement
On May 17, 2018, we entered into a credit agreement (the “Credit Agreement”) which provides for borrowings of up to $80.0 million on a revolving line of credit and an additional $50.0 million in a delayed draw term loan. The $80.0 million revolving line of credit matures on May 17, 2023 and we had the option to draw in various amounts on the $50.0 million term loan through May 17, 2020, with a maturity on May 17, 2023. On April 30, 2020, the Credit Agreement was amended to include an incremental delayed draw term loan of $20.5 million that is available to draw upon before March 31, 2021, and matures on April 29, 2021, for a total credit facility of $150.5 million. As of and for the fiscal year ended January 31, 2021, no amount of the incremental delayed draw term loan was funded. See Note 4 “Debt and Credit Agreement,” included in this Annual Report on Form 10-K for further information.
As of and for the fiscal year ended January 31, 2021, we were in compliance with all financial and non-financial covenants.
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Contractual Obligations
We enter into long term contractual obligations and commitments in the normal course of business. As of January 31, 2021, our contractual cash obligations were as follows:
Maturing in:
2022
2024
2026
to
to
and
Total
2021
2023
2025
after
(in thousands)
Delayed draw term loan
48,250
2,500
45,750
—
—
VIE Debt (1)
29,154
623
1,461
1,778
25,292
Operating leases (2)
141,008
15,721
31,884
29,976
63,427
Finance leases (2)
61,135
4,575
9,136
9,902
37,522
Total
$
279,547
$
23,419
$
88,231
$
41,656
$
126,241
_____________________________
(1) Consists of debt based on the consolidation of the VIE, TRI. The TRI debt listed above includes financing fees which are a direct deduction from the carrying value of the related debt liability on the Company’s Consolidated Balance Sheets. See Note 4 “Debt and Credit Agreement,” included in this Annual Report on Form 10-K for further information.
(2) Our store leases generally have initial lease terms of 5-15 years and include renewal options and rent escalation provisions.
Off-Balance Sheet Arrangements
We are not a party to any off balance sheet arrangements, except for operating leases, as discussed in “Contractual Obligations” section above.
Critical Accounting Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and related notes, as well as the related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We evaluate our accounting policies, estimates, and judgments on an on-going basis. We base our estimates and judgments on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions and conditions and such differences could be material to the consolidated financial statements.
We evaluated the development and selection of our critical accounting estimates and believe that the following involve a higher degree of judgment or complexity and are most significant to reporting our results of operations and financial position, and are therefore discussed as critical.
Product Return Reserve
The Company currently estimates product return reserve using available industry data and its own historical sales information. The Company regularly assesses and adjusts the estimate of accrued sales returns by updating return rates for actual industry and company trends and projected costs. While returns have historically been within our expectations, future return rates may differ from those experienced in the past. Changes in these estimates can have a material impact on our financial statements. We believe the accounting estimate related to product returns is a critical accounting estimate because it requires us to make assumptions about future potential returns and changes in demand, both of which are highly uncertain.
Fair Value
The use of fair values is required in determining the carrying values of certain assets and liabilities, as well as for specific disclosures. In determining the fair value of financial instruments, market prices of the same or similar instruments are used whenever such prices are available. If observable market prices are unavailable or impracticable to obtain, we are required to make judgments about assumptions that market participants would use in estimating the fair value of the financial instrument.
Fair value is estimated using modeling techniques and incorporates assumptions about interest rates, duration, future expected cash flows, market conditions, risks inherent in a particular valuation technique and the risk of nonperformance. These assumptions are inherently subjective as they require material estimates, all of which may be susceptible to significant change. The models used to determine fair value adjustments are periodically evaluated by management for relevance under
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current facts and circumstances. We believe the accounting estimate related to the fair value of available-for-sale securities to be a critical accounting estimate because it requires us to make assumptions where observable market prices are unavailable.
Critical Accounting Policies
With respect to critical accounting policies, even a relatively minor variance between actual and expected experience can potentially have a materially favorable or unfavorable impact on subsequent results of operations. However, our historical results for the periods presented in the consolidated financial statements have not been materially impacted by such variances. More information on all of our significant accounting policies can be found in Note 2, “Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K.
Leases
The Company recognizes ROU assets and lease liabilities related to leases on the Company’s consolidated balance sheets. The Company determines if an arrangement is, or contains, a lease at inception. ROU assets represent the right to use an underlying asset for the lease term and lease liabilities reflect the obligation to make lease payments arising from the lease. At any given time during the lease term, the lease liability represents the present value of the remaining lease payments and the ROU asset is measured at the amount of the lease liability, adjusted for pre-paid rent, unamortized initial direct costs and the remaining balance of lease incentives received. Both the lease ROU asset and liability are reduced to zero at the end of the lease. See Note 3 “Leases,” of Notes to Consolidated Financial Statements included in this Annual Report on Form 10 - K.
Revenue Recognition
Revenue for merchandise that is shipped to our customers from our distribution centers and stores is recognized upon shipment following customer payment, which is when the customer obtains control of the product and has the ability to direct the use of the product, including, among other options, the ability to redirect the product to a different shipping destination. Store revenue is recognized at the point of sale. This represents the point at which the customer obtains control of the product and has the ability to direct the use of the product.
We recognize shipping and handling fees as revenue included in net sales when generated from a customer order upon shipment or at the point of sale. Costs of shipping and handling are included in selling, general and administrative expenses.
Sales tax collected is not recognized as revenue as it is ultimately remitted to governmental authorities.
We reserve for projected merchandise returns based on both historical and actual experience, as well as various other assumptions that we believe to be reasonable. Actual merchandise returns are monitored regularly and have not been materially different from the estimates recorded. Product returns often represent merchandise that can be resold. Amounts refunded to customers are generally made by issuing the same payment tender as used in the original purchase. Merchandise exchanges of the same product and price are not considered merchandise returns and are therefore excluded when calculating the sales returns reserve.
Inventories
Our inventories are composed of finished goods and are stated at the lower of cost or net realizable value, with cost determined using the first-in, first-out method. Net realizable value is defined as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.” The inventory value is adjusted periodically, if needed, to reflect current market conditions, which requires our judgments that may significantly affect the ending inventory valuation, as well as gross margin. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or market reserves) and estimates of inventory shrinkage. We adjust our inventory for obsolescence based on historical trends, aging reports, specific identification, current retail prices and our estimates of future retail sales prices.
Due to these factors, our obsolescence and shrinkage reserves contain uncertainties. Both estimates have calculations that require us to make assumptions and to apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. If actual observed obsolescence or periodic updates of our shrinkage estimates differ from our original estimates, we adjust our inventory reserves accordingly throughout the period. We do not believe that changes in the assumptions used in these estimates would have a significant effect on our net income or inventory balances. We have not made any material changes to our assumptions included in the calculations of the obsolescence and shrinkage reserves during the periods presented, nor have we recorded significant adjustments related to the physical inventory process.
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The reserve for inventory shrinkage is adjusted to reflect the trend of historical physical inventory count results. The Company performs its retail store physical inventory counts in July and the difference between actual and estimated shrinkage, recorded in Cost of goods sold, may cause fluctuations in second fiscal quarter results.
Long-Lived Assets
Long-lived assets, such as property and equipment are reviewed for impairment during the fourth quarter, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset, a product recall or an adverse action or an assessment by a regulator. If the sum of the estimated undiscounted future cash flows related to the asset is less than the carrying value, we recognize a loss equal to the difference between the carrying value and the fair value, usually determined by the estimated discounted cash flow analysis of the asset. Impairment charges are included in selling, general and administrative expenses.
We evaluate long-lived tangible assets at an individual store level, which is the lowest level at which independent cash flows can be identified. We evaluate corporate assets or other long-lived assets that are not store-specific at the consolidated level.
Since there is typically no active market for our long-lived tangible assets, we estimate fair values based on the expected future cash flows. We estimate future cash flows based on store-level historical results, current trends, and operating and cash flow projections. Our estimates are subject to uncertainty and may be affected by a number of factors outside our control, including general economic conditions and the competitive environment. While we believe our estimates and judgments about future cash flows are reasonable, future impairment charges may be required if the expected cash flow estimates, as projected, do not occur or if events change requiring us to revise our estimates.
Income Taxes
We account for income taxes and the related accounts using the liability method in accordance with ASC Topic 740, Income Taxes (“ASC 740”). Under this method, we accrue income taxes payable or refundable and recognize deferred tax assets and liabilities based on differences between U.S. GAAP and tax bases of assets and liabilities. We measure deferred tax assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to reverse, and recognize the effect of a change in enacted rates in the period of enactment.
We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. A valuation allowance is established if it is more likely than not that some portion or all of the deferred income tax asset will not be realized.
We establish assets and liabilities for uncertain tax positions taken or expected to be taken in income tax returns, using a more-likely-than-not recognition threshold. We recognize penalties and interest related to uncertain tax positions as income tax expense.
See Note 9 “Income Taxes,” of Notes to Consolidated Financial Statements included in this Annual Report on Form 10 - K.
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