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 2021 results compared to fiscal 2020. Fiscal year 2021 and 2020 were 52-week periods. For a discussion of fiscal 2020 results compared to fiscal 2019, refer to the Company’s Annual Report on Form 10-K for the year ended January 31, 2021.
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 30, 2022, 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 2021 increased by 9.4% over the prior year to $698.6 million;
Net income in fiscal 2021 increased 118.8% compared to the prior year to $29.7 million;
Adjusted EBITDA in fiscal 2021 increased 41.6% over the prior year to $77.4 million; and
Cash flow from operations in fiscal 2021 increased to $92.0 million and Free Cash Flow increased $43.1 million over the prior year to $81.6 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.
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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, catalog and orders placed through the call center.
COVID-19
Throughout fiscal 2021, the COVID-19 pandemic impacted our business results and operations. The disruption in the global supply chain due to transportation delays, container shortages and port congestion interrupted the flow of our inventory and added incremental expedited shipping costs. Despite these disruptions caused by the pandemic, we achieved record revenues for fiscal 2021, which increased 9.4% to $698.6 million, compared to fiscal 2020, with gross margin expansion creating net income of $29.7 million, a 118.8% increase over fiscal 2020.
Our direct business coupled with retail reemerging in fiscal 2021 fueled our growth through the year as we continued to navigate the pandemic. 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 efficacy 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.
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. Shipping and handling revenue is also reflected in our gross profit and gross profit margin. 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, rent/occupancy and payroll costs. While we expect these expenses to increase as we continue to increase brand awareness and invest in infrastructure 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 during our peak selling season.
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 30, 2022
January 31, 2021
(in thousands)
Net sales
698,584
638,783
Cost of goods sold (excluding depreciation and amortization)
321,260
307,257
Gross profit
377,324
331,526
Selling, general and administrative expenses
333,225
307,311
Operating income
44,099
24,215
Interest expense
4,717
6,263
Other income, net
55
65
Income before income taxes
39,437
18,017
Income tax expense
9,887
4,637
Net income
29,550
13,380
Less: Net loss attributable to noncontrolling interest
(152)
(197)
Net income attributable to controlling interest
$
29,702
$
13,577
Percentage of Net sales:
Net sales
100.0
%
100.0
%
Cost of goods sold (excluding depreciation and amortization)
46.0
%
48.1
%
Gross profit
54.0
%
51.9
%
Selling, general and administrative expenses
47.7
%
48.1
%
Operating income
6.3
%
3.8
%
Interest expense
0.7
%
1.0
%
Other income, net
—
%
—
%
Income before income taxes
5.6
%
2.8
%
Income tax expense
1.4
%
0.7
%
Net income
4.2
%
2.1
%
Less: Net loss attributable to noncontrolling interest
—
%
—
%
Net income attributable to controlling interest
4.2
%
2.1
%
Fiscal 2021 Compared to Fiscal 2020
Net Sales
Net sales increased $59.8 million, or 9.4%, to $698.6 million in fiscal 2021 compared to $638.8 million in fiscal 2020. The increase was due to an increase in store market sales partially offset by a decrease in non-store market sales.
Store market net sales increased $67.1 million, or 16.0%, to $486.2 million in fiscal 2021 compared to $419.1 million in fiscal 2020. The year-over-year sales difference was primarily driven by temporary store closures beginning on March 20, 2020 until they re-opened beginning in the first week of May through the third week of June, coupled with higher conversion as compared to the prior year. Net sales in non-store markets decreased $8.2 million, or 3.8%, to $206.2 million in fiscal 2021 compared to $214.4 million in fiscal 2020. The decrease was driven by extended free shipping and higher promotions in the prior year.
Gross Profit
Gross profit increased $45.8 million, or 13.8%, to $377.3 million in fiscal 2021 compared to $331.5 million in fiscal 2020. As a percentage of net sales, gross margin increased to 54.0% of net sales in fiscal 2021 compared to 51.9% of net sales in fiscal 2020. The increase in gross margin rate was driven by a higher mix of full price sales due to lower clearance inventory and fewer promotional events, as well as improved gross margin rates on both full price and clearance items. The year-over-year increase was partially offset by expenses associated with increased expedited freight costs in order to combat disruptions within the supply chain.
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Selling, General and Administrative Expenses
Selling, general and administrative expenses increased $25.9 million, or 8.4%, to $333.2 million in fiscal 2021 compared to $307.3 million in fiscal 2020. Selling, general and administrative expenses as a percentage of net sales decreased in fiscal 2021 to 47.7% of net sales, compared to 48.1% of net sales for fiscal 2020. The positive leverage was primarily due to shifting to a more efficient digital marketing approach, as well as lower shipping expenses driven in part by a shift in channel mix resulting from higher store traffic during the current year.
The increase in selling, general and administrative expense was primarily caused by increased wages due to Company retail locations being open for the full fiscal year, wage increases at both the stores and distribution centers, new headcount and merit increases, as well as increased depreciation expense associated with investments in technology.
Interest Expense
Interest expense decreased $1.6 million to $4.7 million in fiscal 2021 compared to $6.3 million in fiscal 2020. The decrease in interest expense was primarily attributable the full pay-down of Duluth Trading’s bank debt in fiscal 2021 compared to increased borrowings on the revolving line of credit and delayed draw term loan during fiscal 2020 due to uncertainties resulting from the COVID-19 pandemic.
Income Taxes
Income tax expense was $9.9 million in fiscal 2021 compared to $4.6 million in fiscal 2020. Our effective tax rate related to controlling interest was 25.0% and 25.5% in fiscal 2021 and fiscal 2020, respectively.
Net Income Attributable to Controlling Interest
Net income attributable to controlling interest was $29.7 million in fiscal 2021 compared to $13.6 million in fiscal 2020, primarily due to the factors discussed above.
Non-GAAP Financial Measures
See the above section titled “How We Assess 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 30, 2022
January 31, 2021
(in thousands)
Net income
$
29,550
$
13,380
Depreciation and amortization
29,225
28,520
Amortization of internal-use software hosting
subscription implementation costs
1,797
229
Interest expense
4,717
6,263
Income tax expense
9,887
4,637
EBITDA (non-GAAP)
75,176
53,029
Stock based compensation
2,198
1,629
Adjusted EBITDA (non-GAAP)
$
77,374
$
54,658
As a result of the factors discussed above in the “Results of Operations” section, Adjusted EBITDA increased $22.7 million, or 41.6%, to $77.4 million in fiscal 2021 compared to $54.7 million in fiscal 2020. As a percentage of net sales, Adjusted EBITDA increased to 11.1% of net sales in fiscal 2021 compared to 8.6% of net sales in fiscal 2020.
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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 30, 2022
January 31, 2021
(in thousands)
Net cash provided by operating activities
$
91,981
$
50,751
Purchases of property and equipment
(10,352)
(11,743)
Capital contributions towards build-to-suit stores
—
(520)
Free Cash Flow (non-GAAP)
$
81,629
$
38,488
Free cash flow increased $43.1 million to $81.6 million in fiscal 2021 compared to $38.5 million in fiscal 2020. The increase was primarily driven by higher net income and lower inventory levels associated with continued in-bound receipt delays.
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, and capital expenditures associated with infrastructure and information technology. The most significant components of our working capital are cash, inventory, accounts payable and other current liabilities. At January 30, 2022 our working capital was $106.5 million, which includes cash of $77.1 million.
We spent $10.4 million in fiscal 2021 on capital expenditures, as well as, $4.7 million of additional investments in software hosting implementation costs, which are included in Prepaid expenses & other current assets on the Company’s Consolidated Balance Sheets. We expect to spend approximately $57.0 million in fiscal 2022 on capital expenditures, primarily due to investments in logistics optimization, including the introduction of automated fulfillment centers. 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 30, 2022
January 31, 2021
(in thousands)
Net cash provided by operating activities
$
91,981
$
50,751
Net cash used in investing activities
(10,150)
(12,132)
Net cash (used in) provided by financing activities
(51,364)
6,362
Increase in cash and cash equivalents
$
30,467
$
44,981
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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 2021, net cash provided by operating activities was $92.0 million, which primarily consisted of net income of $29.6 million, non-cash depreciation and amortization of $29.2 million, amortization of stock-based compensation of $2.2 million and cash provided by operating assets and liabilities of $36.1 million. The cash provided by operating assets and liabilities of $36.1 million primarily consisted of a $26.4 million decrease in inventory, a $10.5 million increase in accounts payable, and a $9.9 million increase in accrued expenses, partially offset by a $4.7 million increase in hosting software implementation costs, a $3.2 million increase in receivables, and a decrease of $2.4 million in prepaid expenses.
For fiscal 2020, net cash provided by operating activities was $50.8 million, which primarily 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.
Net Cash Used in Investing Activities
Investing activities consist primarily of capital expenditures for growth related to a new distribution center and information technology.
For fiscal 2021, net cash used in investing activities was $10.2 million, primarily driven by capital expenditures of $10.4 million for a new distribution center and one new retail store, as well as investments in 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.
Net Cash (Used in) 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 payments on finance lease obligations.
For fiscal 2021, net cash used in financing activities was $51.4 million, primarily consisting of the full paydown of Duluth’s bank debt.
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.
Credit Agreement
On April 30, 2020, the Company’s credit agreement (the “Credit Agreement”) was amended to include an incremental DDTL of $20.5 million (the “Incremental DDTL”) that was available to draw upon before March 31, 2021, and matured on April 29, 2021, for a total credit facility of $150.5 million. The loan covenants were also amended to allow for greater flexibility during the Company’s peak borrowing periods in fiscal 2020. The interest rate applicable to the Revolver or DDTL was a fixed rate for a one-, two-, three- or six-month interest period equal to LIBOR (with a 1% floor) for such interest period plus a margin of 225 to 300 basis points, based upon the Company’s rent adjusted leverage. The interest rate applicable to the Incremental DDTL was also a fixed rate over the aforementioned interest periods equal to LIBOR (with a 1% floor) for such interest period plus a margin of 275 to 350 basis points.
On May 14, 2021, the Company terminated the Credit Agreement, and entered into a new credit agreement (the “New Credit Agreement”), which was treated as a modification for accounting purposes. The New Credit Agreement matures on May 14, 2026 and provides for borrowings of up to $150.0 million that are available under a revolving senior credit facility, with a $5.0 million sublimit for issuance of standby letters of credit, as well as a $10.0 million sublimit for swing line loans. At the Company’s option, the interest rate applicable to the revolving senior credit facility will be a floating rate equal to: (i) the Bloomberg Short-Term Bank Yield Index rate (“BSBY”) plus the applicable rate of 1.25% to 2.00% determined based on the Company’s rent adjusted leverage ratio, or (ii) the base rate plus the applicable rate of 0.25% to 1.00% based on the Company’s rent adjusted leverage ratio. The New Credit Agreement is secured by essentially all Company assets and requires the Company
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to maintain compliance with certain financial and non-financial covenants, including a maximum rent adjusted leverage ratio and a minimum fixed charge coverage ratio as defined in the New Credit Agreement
As of and for the fiscal year ended January 30, 2022, we were in compliance with all financial and non-financial covenants.
Contractual Obligations
In connection with our investing and operating activities, we have entered into certain contractual obligations. See Note 3 “Leases” of Notes to Consolidated Financial Statements for additional discussion of these obligations.
Off-Balance Sheet Arrangements
We are not a party to any significant off-balance sheet arrangements.
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 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.
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.
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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 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.
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, particularly in second fiscal quarter results.
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. No valuation allowance was recognized for the years ended January 30, 2022 or January 31, 2021.
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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