filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
62K characters. Original on sec.gov · Markdown
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. It also should be read in conjunction with the Cautionary Disclosure Regarding Forward-Looking Statements and the Risk Factors disclosures set forth in the Introduction and in Item 1A of this report, respectively.
Executive Overview
We are among the largest discount retailers in the United States by number of stores, with 16,368 stores located in 45 states as of February 28, 2020, with the greatest concentration of stores in the southern, southwestern, midwestern and eastern United States. We offer a broad selection of merchandise, including consumable products such as food, paper and cleaning products, health and beauty products and pet supplies, and non-consumable products such as seasonal merchandise, home decor and domestics, and basic apparel. Our merchandise includes national brands from leading manufacturers, as well as our own private brand selections with prices at substantial discounts to national brands. We offer our customers these national brand and private brand products at everyday low prices (typically $10 or less) in our convenient small-box locations.
We believe our convenient store formats, locations, and broad selection of high-quality products at compelling values have driven our substantial growth and financial success over the years and through a variety of economic cycles. We are mindful that the majority of our customers are value-conscious, and many have low and/or fixed incomes. As a result, we are intensely focused on helping our customers make the most of their spending dollars. Our core customers are often among the first to be affected by negative or uncertain economic conditions and among the last to feel the effects of improving economic conditions particularly when trends are inconsistent and of an uncertain duration. The primary macroeconomic factors that affect our core customers include the unemployment and underemployment rates, wage growth, changes in U.S. and global trade policy (including price increases from tariffs), and changes to certain government assistance programs, such as the Supplemental Nutrition Assistance Program. Additionally, our customers are impacted by increases in those expenses that generally comprise a large portion of their household budget, such as rent, healthcare and fuel prices. Finally, significant unseasonable or unusual weather patterns can impact customer shopping behaviors.
We remain committed to the following long-term operating priorities as we consistently strive to improve our performance while retaining our customer-centric focus: 1) driving profitable sales growth, 2) capturing growth opportunities, 3) enhancing our position as a low-cost operator, and 4) investing in our people as a competitive advantage.
We seek to drive profitable sales growth through initiatives aimed at increasing customer traffic and average transaction amount. As we work to provide everyday low prices and meet our customers’ affordability needs, we remain focused on enhancing our margins through effective category management, inventory shrink reduction initiatives, private brands penetration, distribution and transportation efficiencies, global sourcing, and pricing and markdown optimization. Several of our sales-driving initiatives are also designed to capture growth opportunities and are discussed in more detail below.
Historically, our sales of consumables, which tend to have lower gross margins, have been the key drivers of net sales and customer traffic, while sales of non-consumables, which tend to have higher gross margins, have contributed to more profitable sales growth and an increase in average transaction amount. Our sales mix has continued to shift slightly toward consumables, and, within consumables, slightly toward lower margin departments such as perishables. While we expect some sales mix challenges to persist, certain of our initiatives are intended to address these trends, although there can be no assurance we will be successful in reversing them.
We continue to make progress on and invest in certain strategic initiatives that we believe will help drive profitable sales growth and capture long-term growth opportunities. Such opportunities include leveraging existing and developing new digital tools and technology to provide our customers with additional shopping access points and even greater convenience. Additionally, our refreshed approach to our non-consumable product offerings has been implemented in approximately 2,400 stores as of the end of 2019. This merchandising strategy, which is continuing to evolve and help shape our approach to non-consumable categories throughout the chain, offers a new, differentiated and limited assortment that will change throughout the year. As we extend this initiative more broadly, as well as incorporate certain related merchandising efforts throughout our chain, our goal is to continue to improve the shopping experience while delivering exceptional value within key areas of our non-consumable categories.
We are continuing our rollout of the “DG Fresh” initiative, a self-distribution model for fresh and frozen products that is designed to enhance sales, reduce product costs, improve our in-stock position and enhance item assortment. We currently operate five DG Fresh distribution facilities, which served more than 6,000 stores as of February 28, 2020.
Tariffs on products from China, as applied to both our direct imports and domestic purchases, did not have a net material impact on our financial results in 2019. We believe we can mitigate the potential sales and margin impact of such increased tariffs on our financial results in 2020 through various sourcing, merchandising and pricing efforts. However, as noted above, changes in trade policy that result in higher prices for our customers may negatively impact their budgets, and consequently, their spending, and additional increases in tariff rates or expansion of products subject to tariffs may have a more significant impact on our future business. There can be no assurance we will be successful in our efforts to mitigate the impacts of existing or future tariffs in whole or in part, including but not limited to any impacts on customer spending.
We have limited insight into the extent to which our business may be impacted by the COVID-19 coronavirus outbreak, and there are many unknowns. While we currently expect delays in the receipt of certain goods in 2020 as a result of this outbreak, we do not currently anticipate a material impact to our financial results in 2020 due to these delays. Further delays in the receipt of goods, or other unanticipated impacts to our supply chain, including on direct imports or goods purchased domestically, our stores or our customers, could have a more significant impact on our future business (including sales), and we are continuing to monitor this evolving situation.
To support our other operating priorities, we remain focused on capturing growth opportunities. In 2019, we opened 975 new stores, remodeled 1,024 stores, and relocated 100 stores. For 2020, we plan to open approximately 1,000 new stores, remodel approximately 1,500 stores, and relocate approximately 80 stores for a total of 2,580 real estate projects.
We continue to innovate within our channel and are able to utilize the most productive of our various store formats based on the specific market opportunity. We expect that our traditional 7,300 square foot store format will continue to be the primary store layout for new stores in 2020. We expect approximately 1,125 of the planned 1,500 remodels in 2020 to use a higher-cooler-count store format that enables us to offer an increased selection of perishable items, with the traditional store format the primary store layout for the remainder of the real estate projects. Additionally, the majority of both new stores and remodels will incorporate higher-capacity coolers. The acceleration of remodels in 2020 and the increased usage of the higher-cooler-count formats is expected to allow us to capture additional growth opportunities within our existing markets. In addition, our smaller format store (less than 6,000 square feet) is expected to allow us to capture growth opportunities in urban areas. We continue to incorporate lessons learned from our various store formats and layouts into our existing store base with a goal of driving increased customer traffic, average transaction amount, same-store sales and overall store productivity.
To support our new store growth and drive productivity, we have continued to make investments in our traditional distribution center network for non-refrigerated merchandise. We began shipping from our distribution centers in Longview, Texas and Amsterdam, New York in January 2019 and December 2019, respectively.
We have established a position as a low-cost operator, always seeking ways to reduce or control costs that do not affect our customers’ shopping experiences. We plan to continue enhancing this position over time while employing ongoing cost discipline to reduce certain expenses as a percentage of sales. Nonetheless, we seek to maintain flexibility to invest in the business as necessary to enhance our long-term profitability.
We also have launched “Fast Track”, an initiative aimed at further enhancing our convenience proposition and in-stock position as well as increasing labor productivity within our stores. The first phase of Fast Track involved sorting process optimization within our distribution centers, as well as increased shelf-ready packaging, to allow for greater store-level stocking efficiencies, followed by the second-phase pilot of a self-checkout option in a limited number of stores. We have completed the sorting process optimization at all of our non-refrigerated distribution centers. Additionally, we have launched the self-checkout pilot in a select number of stores. These and certain other strategic initiatives will require us to incur upfront expenses for which, in some respects, there may not be an immediate or acceptable return in terms of sales or enhanced profitability.
Certain of our operating expenses, such as wage rates and occupancy costs, have continued to increase in recent years, due primarily to market forces. While we expect these increases to persist, certain of our initiatives and plans are intended to help offset these challenges, although there can be no assurance we will be successful in mitigating them.
Our employees are a competitive advantage, and we proactively seek ways to continue investing in them. Our goal is to create an environment that attracts and retains talented personnel, particularly at the store level, because employees who are promoted from within our company generally have longer tenures and are greater contributors to improvements in our financial performance. We believe our investments in compensation and training for our store managers have contributed to improved customer experience scores, higher sales and improved turnover metrics.
To further enhance shareholder returns, we repurchased shares of our common stock and paid quarterly cash dividends throughout 2019. In 2020, we intend to continue our share repurchase activity, and to pay quarterly cash dividends, subject to Board discretion and approval.
We utilize key performance indicators (“KPIs”) in the management of our business. Our KPIs include same-store sales, average sales per square foot, and inventory turnover. Same-store sales are calculated based upon stores that were open at least 13 full fiscal months and remain open at the end of the reporting period. We include stores that have been remodeled, expanded or relocated in our same-store sales calculation. Changes in same-store sales are calculated based on the comparable 52 calendar weeks in the current and prior years. Net sales per square foot is calculated based on total sales for the preceding 12 months as of the ending date of the reporting period divided by the average selling square footage during the period, including the end of the fiscal year, the beginning of the fiscal year, and the end of each of our three interim fiscal quarters. Inventory turnover is calculated based on total cost of goods sold for the preceding four quarters divided by the average inventory balance as of the ending date of the reporting period, including the end of the fiscal year, the beginning of the fiscal year, and the end of each of our three interim fiscal quarters. Each of these measures is commonly used by investors in retail companies to measure the health of the business. We use these measures to maximize profitability and for decisions about the allocation of resources.
A continued focus on our four operating priorities as discussed above, coupled with strong cash flow management and share repurchases resulted in solid overall operating and financial performance in 2019 as
compared to 2018, as set forth below. Basis points, as referred to below, are equal to 0.01% as a percentage of net sales.
| ● | Net sales in 2019 increased 8.3% over 2018. Sales in same-stores increased 3.9%, primarily due to increases in average transaction amount and customer traffic. Average sales per square foot in 2019 were $237 compared to $231 in 2018. |
|---|
| ● | Our gross profit rate increased by 14 basis points due primarily to higher initial markups on inventory purchases. |
|---|
| ● | SG&A increased by 9 basis points primarily reflecting our estimate for the settlement of certain legal matters. |
|---|
| ● | Operating profit increased 8.8% to $2.30 billion in 2019 compared to $2.12 billion in 2018. |
|---|
| ● | The increase in the effective income tax rate to 22.2% in 2019 from 21.1% in 2018 was due primarily to changes in state income tax laws and income tax benefits arising from the Tax Cuts and Jobs Act in 2018 that did not reoccur in 2019. |
|---|
| ● | We reported net income of $1.71 billion, or $6.64 per diluted share, for 2019 compared to net income of $1.59 billion, or $5.97 per diluted share, for 2018. |
|---|
| ● | We generated approximately $2.24 billion of cash flows from operating activities in 2019, an increase of 4.4% compared to 2018. |
|---|
| ● | Inventory turnover was 4.4 times, and inventories increased 7.8% on a per store basis compared to 2018. |
|---|
| ● | We repurchased approximately 8.3 million shares of our outstanding common stock for $1.2 billion. |
|---|
Readers should refer to the detailed discussion of our operating results below for additional comments on financial performance in the current year as compared with the prior years presented.
Results of Operations
Accounting Periods. The following text contains references to years 2019, 2018, and 2017, which represent fiscal years ended January 31, 2020, February 1, 2019, and February 2, 2018, respectively. Our fiscal year ends on the Friday closest to January 31. Fiscal years 2019, 2018 and 2017 were each 52-week accounting periods.
Seasonality. The nature of our business is somewhat seasonal. Primarily because of sales of Christmas-related merchandise, operating profit in our fourth quarter (November, December and January) has historically been higher than operating profit achieved in each of the first three quarters of the fiscal year. Expenses, and to a greater extent operating profit, vary by quarter. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods.
The following table contains results of operations data for fiscal years 2019, 2018 and 2017, and the dollar and percentage variances among those years.
| | | | | | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | | | | | | | | | | 2019 vs. 2018 | 2018 vs. 2017 | | |||||||
| (amounts in millions, except | | | | | | | Amount | % | Amount | % | | |||||||||
| per share amounts) | | 2019 | | 2018 | | 2017 | | Change | | Change | Change | | Change | | ||||||
| Net sales by category: | | | | | | | | | | | | | | | | | | | | |
| Consumables | | $ | 21,635.9 | | $ | 19,865.1 | | $ | 18,054.8 | | $ | 1,770.8 | | 8.9 | % | $ | 1,810.3 | | 10.0 | % |
| % of net sales | | 77.96 | % | 77.52 | % | 76.92 | % | | | | | | | | | | ||||
| Seasonal | | 3,258.9 | | 3,050.3 | | 2,837.3 | | 208.6 | | 6.8 | | 213.0 | | 7.5 | | |||||
| % of net sales | | 11.74 | % | 11.90 | % | 12.09 | % | | | | | | | | | | ||||
| Home products | | 1,611.9 | | 1,506.1 | | 1,400.6 | | 105.8 | | 7.0 | | 105.4 | | 7.5 | | |||||
| % of net sales | | 5.81 | % | 5.88 | % | 5.97 | % | | | | | | | | | | ||||
| Apparel | | 1,247.3 | | 1,203.6 | | 1,178.3 | | 43.7 | | 3.6 | | 25.4 | | 2.2 | | |||||
| % of net sales | | 4.49 | % | 4.70 | % | 5.02 | % | | | | | | | | | | ||||
| Net sales | | $ | 27,754.0 | | $ | 25,625.0 | | $ | 23,471.0 | | $ | 2,128.9 | | 8.3 | % | $ | 2,154.1 | | 9.2 | % |
| Cost of goods sold | | 19,264.9 | | 17,821.2 | | 16,249.6 | | 1,443.7 | | 8.1 | | 1,571.6 | | 9.7 | | |||||
| % of net sales | | 69.41 | % | 69.55 | % | 69.23 | % | | | | | | | | | | ||||
| Gross profit | | 8,489.1 | | 7,803.9 | | 7,221.4 | | 685.2 | | 8.8 | | 582.5 | | 8.1 | | |||||
| % of net sales | | 30.59 | % | 30.45 | % | 30.77 | % | | | | | | | | | | ||||
| Selling, general and administrative expenses | | 6,186.8 | | 5,687.6 | | 5,213.5 | | 499.2 | | 8.8 | | 474.0 | | 9.1 | | |||||
| % of net sales | | 22.29 | % | 22.20 | % | 22.21 | % | | | | | | | | | | ||||
| Operating profit | | 2,302.3 | | 2,116.3 | | 2,007.8 | | 186.0 | | 8.8 | | 108.5 | | 5.4 | | |||||
| % of net sales | | 8.30 | % | 8.26 | % | 8.55 | % | | | | | | | | | | ||||
| Interest expense | | 100.6 | | 99.9 | | 97.0 | | 0.7 | | 0.7 | | 2.8 | | 2.9 | | |||||
| % of net sales | | 0.36 | % | 0.39 | % | 0.41 | % | | | | | | | | | | ||||
| Other (income) expense | | — | | 1.0 | | 3.5 | | (1.0) | | — | | (2.5) | | — | | |||||
| % of net sales | | 0.00 | % | 0.00 | % | 0.01 | % | | | | | | | | | | ||||
| Income before income taxes | | 2,201.7 | | 2,015.4 | | 1,907.3 | | 186.3 | | 9.2 | | 108.1 | | 5.7 | | |||||
| % of net sales | | 7.93 | % | 7.87 | % | 8.13 | % | | | | | | | | | | ||||
| Income tax expense | | 489.2 | | 425.9 | | 368.3 | | 63.2 | | 14.8 | | 57.6 | | 15.6 | | |||||
| % of net sales | | 1.76 | % | 1.66 | % | 1.57 | % | | | | | | | | | | ||||
| Net income | | $ | 1,712.6 | | $ | 1,589.5 | | $ | 1,539.0 | | $ | 123.1 | | 7.7 | % | $ | 50.5 | | 3.3 | % |
| % of net sales | | 6.17 | % | 6.20 | % | 6.56 | % | | | | | | | | | | ||||
| Diluted earnings per share | | $ | 6.64 | | $ | 5.97 | | $ | 5.63 | | $ | 0.67 | | 11.2 | % | $ | 0.34 | | 6.0 | % |
Net Sales. The net sales increase in 2019 reflects a same-store sales increase of 3.9% compared to 2018. In 2019, our 15,209 same-stores accounted for sales of $26.4 billion. The increase in same-store sales primarily reflects an increase in average transaction amount and customer traffic compared to 2018. The increase in average transaction amount was driven by higher average item retail prices. Same-store sales in 2019 increased in each of the consumables, seasonal and home products and apparel categories, compared to 2018. The 2019 net sales increase was positively affected by new stores, modestly offset by sales from closed stores.
The net sales increase in 2018 reflects a same-store sales increase of 3.2% compared to 2017. In 2018, our 14,283 same-stores accounted for sales of $23.9 billion. The increase in same-store sales primarily reflects an increase in average transaction amount relative to 2017. The increase in average transaction amount was driven by higher average item retail prices and to a lesser extent, an increase in average items per transaction, while customer traffic was essentially unchanged. Same-store sales in 2018 increased in the consumables, seasonal and home products categories, and declined in the apparel category, compared to 2017. Same-store sales results in 2018 for the three non-consumables categories, when aggregated, were positive. The 2018 net sales increase was positively affected by new stores, modestly offset by sales from closed stores.
Of our four major merchandise categories, the consumables category, which generally has a lower gross profit rate than the other three categories, is our largest category and has continued to become a larger percentage
of our total sales. Because of the impact of sales mix on gross profit, we continually review our merchandise mix and strive to adjust it when appropriate.
Gross Profit. In 2019, gross profit increased by 8.8%, and as a percentage of net sales increased by 14 basis points to 30.6% compared to 2018. Higher initial markups on inventory purchases and a lower LIFO provision contributed to the increase in the gross profit rate. These factors were partially offset by increased distribution and transportation costs, a greater proportion of sales of consumables, which generally have a lower gross profit rate than our other product categories, and sales of lower margin products comprising a higher proportion of consumables sales, as well as a higher rate of inventory shrinkage.
In 2018, gross profit increased by 8.1%, and as a percentage of net sales decreased by 32 basis points to 30.5% compared to 2017. Higher markdowns, a greater proportion of sales of consumables, which generally have a lower gross profit rate than our other product categories, and sales of lower margin products comprising a higher proportion of consumables sales, as well as increases in transportation costs and an increased LIFO provision reduced the gross profit rate. These factors were partially offset by an improved rate of inventory shrinkage and higher initial markups on inventory purchases.
SG&A. SG&A as a percentage of sales was 22.3% in 2019 compared to 22.2% in 2018, an increase of 9 basis points. We recorded expenses of $31.0 million in 2019 reflecting our estimate for the settlement of significant legal matters discussed in Note 7 to the consolidated financial statements. SG&A in 2019 included a decrease of approximately $22.8 million in hurricane and other disaster-related expenses compared to 2018 as well as an increase in retail labor costs at a rate less than the increase in net sales.
SG&A as a percentage of sales decreased by 1 basis point, rounding to 22.2% in both 2018 and 2017. The 2018 amounts reflect a reduction in repairs and maintenance expenses which were offset by occupancy costs and depreciation expenses, each of which increased at a rate greater than the increase in net sales. The 2018 amounts reflect an increase in hurricane and other disaster-related expenses of approximately $14.3 million compared to 2017. The 2017 amounts include costs of $24.0 million related to the closure of 35 underperforming stores, primarily expenses for remaining lease liabilities.
Interest Expense. Interest expense increased $0.7 million to $100.6 million in 2019 compared to 2018, and increased $2.8 million to $99.9 million in 2018 compared to 2017. See the detailed discussion under “Liquidity and Capital Resources” regarding the financing of various long-term obligations.
We had consolidated outstanding variable-rate debt of $430.1 million and $373.3 million as of January 31, 2020 and February 1, 2019, respectively, and the remainder of our outstanding indebtedness as of each of those dates was fixed rate debt.
Other (income) expense. Other (income) expense in 2018 reflects expenses associated with the voluntary prepayment of our senior unsecured term loan facility, and in 2017 reflects expenses associated with the issuance and refinancing of long-term debt.
Income Taxes. The effective income tax rate for 2019 was 22.2% compared to a rate of 21.1% for 2018 which represents a net increase of 1.1 percentage points. The effective income tax rate was higher in 2019 primarily due to an increase in income taxes resulting from changes in state income tax laws and a federal income tax benefit arising from the Tax Cuts and Jobs Act (the “TCJA”) in 2018 that did not reoccur in 2019.
The effective income tax rate for 2018 was 21.1% compared to a rate of 19.3% for 2017 which represents a net increase of 1.8 percentage points. The effective income tax rate was higher in 2018 primarily due to the one-time remeasurement of the federal portion of our deferred tax assets and liabilities at 21% in 2017, which was offset by the reduction in the current federal tax rate from 33.7% in 2017 to 21% in 2018.
Our 2017 provision for income taxes reflected an estimate due to the changes in the federal income tax law arising from the TCJA, signed into law on December 22, 2017. The provisional tax benefit consisted of $310.8 million related to the one-time remeasurement of the federal portion of our deferred tax assets and liabilities at the 21% rate and $24.2 million related to the reduced statutory tax rate of 33.7%, compared to 35% in prior years. Subsequent to the signing of the TCJA, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which allowed companies to record provisional amounts during a measurement period not to extend beyond one year after the enactment date while the accounting impact is still under analysis. In 2018, we concluded our analysis of the accounting impact of the TCJA pursuant to SAB 118 and recorded immaterial adjustments related to our 2017 provision for income taxes.
Off Balance Sheet Arrangements
We are not party to any material off balance sheet arrangements.
Effects of Inflation
In 2019 and 2018, we experienced increases in product costs due in part to tariffs on certain items imported from China. We experienced minimal overall commodity cost inflation or deflation in 2017.
Liquidity and Capital Resources
Current Financial Condition and Recent Developments
During the past three years, we have generated an aggregate of approximately $6.2 billion in cash flows from operating activities and incurred approximately $2.2 billion in capital expenditures. During that period, we expanded the number of stores we operate by 2,958, representing growth of approximately 22%, and we remodeled or relocated 3,053 stores, or approximately 23% of the stores we operated as of the beginning of the three-year period. In 2020, we intend to continue our current strategy of pursuing store growth, remodels and relocations.
At January 31, 2020, we had a $1.25 billion unsecured revolving credit agreement (the “Revolving Facility”), $2.5 billion aggregate principal amount of senior notes, and a commercial paper program that may provide borrowing availability of up to $1.0 billion. At January 31, 2020, we had total consolidated outstanding debt (including the current portion of long-term obligations) of $2.9 billion, which includes commercial paper borrowings (“CP Notes”) and senior notes, all of which are described in greater detail below. Our borrowing availability under the Revolving Facility may be effectively limited by our CP Notes as further described below. The information contained in Note 5 to the consolidated financial statements contained in Part II, Item 8 of this report is incorporated herein by reference.
We believe our cash flow from operations, and our existing cash balances, combined with availability under the Revolving Facility, CP Notes and access to the debt markets, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, capital spending and anticipated dividend payments for a period that includes the next twelve months as well as the next several years. However, our ability to maintain sufficient liquidity may be affected by numerous factors, many of which are outside of our control. Depending on our liquidity levels, conditions in the capital markets and other factors, we may from time to time consider the issuance of debt, equity or other securities, the proceeds of which could provide additional liquidity for our operations.
For fiscal 2020, we anticipate potential combined borrowings under the Revolving Facility and CP Notes to be a maximum of approximately $800 million outstanding at any one time, including any anticipated borrowings to fund repurchases of common stock.
Revolving Credit Facility
On September 10, 2019, we entered into the Revolving Facility consisting of a $1.25 billion senior unsecured revolving credit facility of which up to $175.0 million is available for the issuance of letters of credit and which is scheduled to mature on September 10, 2024.
Borrowings under the Revolving Facility bear interest at a rate equal to an applicable interest rate margin plus, at our option, either (a) LIBOR or (b) a base rate (which is usually equal to the prime rate). The applicable interest rate margin for borrowings as of January 31, 2020 was 1.015% for LIBOR borrowings and 0.015% for base-rate borrowings. We must also pay a facility fee, payable on any used and unused commitment amounts of the Revolving Facility, and customary fees on letters of credit issued under the Revolving Facility. As of January 31, 2020, the facility fee rate was 0.11%. The applicable interest rate margins for borrowings, the facility fees and the letter of credit fees under the Revolving Facility are subject to adjustment from time to time based on our long-term senior unsecured debt ratings.
The Revolving Facility contains a number of customary affirmative and negative covenants that, among other things, restrict, subject to certain exceptions, our (including our subsidiaries’) ability to: incur additional liens; sell all or substantially all of our assets; consummate certain fundamental changes or change in our lines of business; and incur additional subsidiary indebtedness. The Revolving Facility also contains financial covenants that require the maintenance of a minimum fixed charge coverage ratio and a maximum leverage ratio. As of January 31, 2020, we were in compliance with all such covenants. The Revolving Facility also contains customary events of default.
As of January 31, 2020, under the Revolving Facility, we had no outstanding borrowings, outstanding letters of credit of $5.4 million, and borrowing availability of $1.24 billion that, due to our intention to maintain borrowing availability related to the commercial paper program described below, could contribute incremental liquidity of $638.4 million at January 31, 2020. In addition, as of January 31, 2020 we had outstanding letters of credit of $41.4 million which were issued pursuant to separate agreements.
Commercial Paper
As of January 31, 2020, our consolidated balance sheet reflected outstanding unsecured CP Notes of $425.2 million classified as long-term obligations due to our intent and ability to refinance these obligations as long-term debt. An additional $181.0 million of outstanding CP Notes were held by a wholly-owned subsidiary and are therefore not reflected on the consolidated balance sheet. Under this program, we may issue the CP Notes from time to time in an aggregate amount not to exceed $1.0 billion outstanding at any time. The CP Notes may have maturities of up to 364 days from the date of issue and rank equal in right of payment with all of our other unsecured and unsubordinated indebtedness. We intend to maintain available commitments under the Revolving Facility in an amount at least equal to the amount of CP Notes outstanding at any time. As of January 31, 2020, the consolidated outstanding CP Notes had a weighted average borrowing rate of 1.7%.
Senior Notes
In April 2013 we issued $900.0 million aggregate principal amount of 3.25% senior notes due 2023 (the “2023 Senior Notes”) at a discount of $2.4 million, which are scheduled to mature on April 15, 2023. In October 2015 we issued $500.0 million aggregate principal amount of 4.150% senior notes due 2025 (the “2025 Senior Notes”) at a discount of $0.8 million, which are scheduled to mature on November 1, 2025. In April 2017 we issued $600.0 million aggregate principal amount of 3.875% senior notes due 2027 (the “2027 Senior Notes”) at a discount of $0.4 million, which are scheduled to mature on April 15, 2027. In April 2018 we issued $500.0 million aggregate principal amount of 4.125% senior notes due 2028 (the “2028 Senior Notes”) at a discount of $0.5 million, which are scheduled to mature on May 1, 2028. Collectively, the 2023 Senior Notes, 2025 Senior Notes, 2027 Senior Notes and 2028 Senior Notes comprise the “Senior Notes”, each of which were issued pursuant to an indenture as supplemented and amended by supplemental indentures relating to each series of Senior Notes (as so
supplemented and amended, the “Senior Indenture”). Interest on the 2023 Senior Notes and the 2027 Senior Notes is payable in cash on April 15 and October 15 of each year. Interest on the 2025 and 2028 Senior Notes is payable in cash on May 1 and November 1 of each year.
We may redeem some or all of the Senior Notes at any time at redemption prices set forth in the Senior Indenture. Upon the occurrence of a change of control triggering event, which is defined in the Senior Indenture, each holder of our Senior Notes has the right to require us to repurchase some or all of such holder’s Senior Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to, but excluding, the repurchase date.
The Senior Indenture contains covenants limiting, among other things, our ability (subject to certain exceptions) to consolidate, merge, or sell or otherwise dispose of all or substantially all of our assets; and our ability and the ability of our subsidiaries to incur or guarantee indebtedness secured by liens on any shares of voting stock of significant subsidiaries.
The Senior Indenture also provides for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on our Senior Notes to become or to be declared due and payable, as applicable.
Rating Agencies
Our senior unsecured debt is rated “Baa2,” by Moody’s with a stable outlook and “BBB” by Standard & Poor’s with a stable outlook, and our commercial paper program is rated “P-2” by Moody’s and “A-2” by Standard and Poor’s. Our current credit ratings, as well as future rating agency actions, could (i) impact our ability to finance our operations on satisfactory terms; (ii) affect our financing costs; and (iii) affect our insurance premiums and collateral requirements necessary for our self-insured programs. There can be no assurance that we will maintain or improve our current credit ratings.
Contractual Obligations
The following table summarizes our significant contractual obligations and commercial commitments as of January 31, 2020 (in thousands):
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Payments Due by Period | ||||||||||||||
| Contractual obligations | Total | < 1 year | 1 - 3 years | 3 - 5 years | 5+ years | |||||||||||
| Long-term debt obligations | | $ | 2,930,095 | | $ | 425,755 | | $ | 1,190 | | $ | 901,300 | | $ | 1,601,850 | |
| Interest(a) | | 558,518 | | 101,257 | | 187,873 | | 135,422 | | 133,966 | | |||||
| Self-insurance liabilities(b) | | 238,254 | | 106,911 | | | 85,160 | | | 29,370 | | | 16,813 | | ||
| Operating lease obligations(c) | | 10,770,814 | | 1,313,935 | | | 2,465,113 | | | 2,185,022 | | | 4,806,744 | | ||
| Subtotal | | $ | 14,497,681 | | $ | 1,947,858 | | $ | 2,739,336 | | $ | 3,251,114 | | $ | 6,559,373 | |
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Commitments Expiring by Period | ||||||||||||||
| Commercial commitments(d) | Total | < 1 year | 1 - 3 years | 3 - 5 years | 5+ years | |||||||||||
| Letters of credit | | $ | 13,405 | | $ | 13,405 | | $ | — | | $ | — | | $ | — | |
| Purchase obligations(e) | | 790,215 | | 790,215 | | — | | — | | — | | |||||
| Subtotal | | $ | 803,620 | | $ | 803,620 | | $ | — | | $ | — | | $ | — | |
| Total contractual obligations and commercial commitments(f) | | $ | 15,301,301 | | $ | 2,751,478 | | $ | 2,739,336 | | $ | 3,251,114 | | $ | 6,559,373 | |
| (a) | Represents obligations for interest payments on long-term debt and includes projected interest on variable rate long-term debt using 2019 year end rates and balances. Variable rate long-term debt includes the Revolving Facility (although such facility had a balance of zero as of January 31, 2020), the CP Notes (which had a |
|---|
| balance of $425.2 million as of January 31, 2020, which amount is net of $181 million held by a wholly-owned subsidiary), and the balance of an outstanding tax increment financing of $4.9 million. |
|---|
| (b) | We retain a significant portion of the risk for our workers’ compensation, employee health, general liability, property loss, automobile, and third-party landlord claims exposures. As these obligations do not have scheduled maturities, these amounts represent undiscounted estimates based upon actuarial assumptions. Substantially all amounts are reflected on an undiscounted basis in our consolidated balance sheets. |
|---|
| (c) | Commercial commitments include information technology license and support agreements, supplies, fixtures, letters of credit for import merchandise, and other inventory purchase obligations. |
|---|
| (d) | Purchase obligations include legally binding agreements for software licenses and support, supplies, fixtures, and merchandise purchases (excluding such purchases subject to letters of credit). |
|---|
| (e) | We have potential payment obligations associated with uncertain tax positions that are not reflected in these totals. We are currently unable to make reasonably reliable estimates of the period of cash settlement with the taxing authorities for the $5.1 million of reserves for uncertain tax positions. |
|---|
Share Repurchase Program
Our existing common stock repurchase program had a total remaining authorization of approximately $1.1 billion at January 31, 2020. Under the authorization, purchases may be made in the open market or in privately negotiated transactions from time to time subject to market and other conditions. The authorization has no expiration date and may be modified or terminated from time to time at the discretion of our Board of Directors. For more detail about our share repurchase program, see Note 11 to the consolidated financial statements.
Other Considerations
On March 11, 2020, the Board of Directors declared a quarterly cash dividend of $0.36 per share which is payable on or before April 21, 2020 to shareholders of record of our common stock on April 7, 2020. We paid quarterly cash dividends of $0.32 per share in 2019. Although the Board currently expects to continue regular quarterly cash dividends, the declaration and amount of future cash dividends are subject to the Board’s sole discretion and will depend upon, among other factors, our results of operations, cash requirements, financial condition, contractual restrictions and other factors that our Board may deem relevant in its sole discretion.
Our inventory balance represented approximately 55% of our total assets exclusive of goodwill, operating lease assets, and other intangible assets as of January 31, 2020. Our ability to effectively manage our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year. Inventory purchases are often somewhat seasonal in nature, such as the purchase of warm-weather or Christmas-related merchandise. Efficient management of our inventory has been and continues to be an area of focus for us.
As described in Note 7 to the consolidated financial statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments. Adverse developments in those actions could materially and adversely affect our liquidity.
Cash Flows
Cash flows from operating activities. Cash flows from operating activities were $2.24 billion in 2019, which represents a $94.4 million increase compared to 2018. Changes in accounts payable resulted in a $428.6 million increase in 2019 compared to a $375.2 million increase in 2018, due primarily to the timing of receipts and payments which was partially impacted by certain changes in payment terms. In addition, net income increased by $123.1 million in 2019 over 2018. These items were offset by changes in merchandise inventories
which resulted in a $578.8 million decrease in 2019 as compared to a decrease of $521.3 million in 2018. Changes in income taxes in 2019 compared to 2018 are primarily due to the timing of payments for income taxes.
Cash flows from operating activities were $2.1 billion in 2018, which represents a $341.4 million increase compared to 2017. Changes in accounts payable resulted in a $375.2 million increase in 2018 compared to a $427.9 million increase in 2017, due primarily to the timing of receipts and payments which was partially impacted by certain changes in payment terms. In addition, net income increased by $50.5 million in 2018 over 2017. These items were offset by changes in merchandise inventories which resulted in a $521.3 million decrease in 2018 as compared to a decrease of $348.4 million in 2017. Changes in income taxes in 2018 compared to 2017 are primarily due to the reduction in the federal income tax rate to 21% from 35% and the timing of payments for income taxes.
On an ongoing basis, we closely monitor and manage our inventory balances, and they may fluctuate from period to period based on new store openings, the timing of purchases, and other factors. Merchandise inventories increased by 14% in 2019, by 14% in 2018 and by 11% in 2017. Inventory levels in the consumables category increased by $371.9 million, or 14%, in 2019, by $320.9 million, or 14%, in 2018, and by $322.9 million, or 16% in 2017. The seasonal category increased by $127.3 million, or 17%, in 2019, by $108.4 million, or 17%, in 2018, and by $14.9 million, or 2%, in 2017. The home products category increased by $82.8 million, or 23%, in 2019, by $24.0 million, or 7%, in 2018, and by $10.6 million, or 3%, in 2017. The apparel category decreased by $2.1 million, or 1%, in 2019, and increased by $34.7 million, or 10%, in 2018, and by $1.9 million, or 1%, in 2017.
Cash flows from investing activities. Significant components of property and equipment purchases in 2019 included the following approximate amounts: $338 million for improvements, upgrades, remodels and relocations of existing stores; $217 million for distribution and transportation-related projects; $149 million for new leased stores, primarily for leasehold improvements, fixtures and equipment; and $59 million for information systems upgrades and technology-related projects. The timing of new, remodeled and relocated store openings along with other factors may affect the relationship between such openings and the related property and equipment purchases in any given period. During 2019, we opened 975 new stores and remodeled or relocated 1,124 stores.
Significant components of property and equipment purchases in 2018 included the following approximate amounts: $289 million for improvements, upgrades, remodels and relocations of existing stores; $242 million for distribution and transportation-related projects; $138 million for new leased stores, primarily for leasehold improvements, fixtures and equipment; and $47 million for information systems upgrades and technology-related projects. During 2018, we opened 900 new stores and remodeled or relocated 1,165 stores.
Significant components of property and equipment purchases in 2017 included the following approximate amounts: $231 million for improvements, upgrades, remodels and relocations of existing stores; $203 million for new leased stores, primarily for leasehold improvements, fixtures and equipment; $176 million for distribution and transportation-related projects; and $30 million for information systems upgrades and technology-related projects. During 2017, we opened 1,315 new stores and remodeled or relocated 764 stores.
Capital expenditures during 2020 are projected to be in the range of $925 million to $975 million. We anticipate funding 2020 capital requirements with a combination of some or all of the following: existing cash balances, cash flows from operations, availability under our Revolving Facility and/or the issuance of additional senior notes or CP Notes. We plan to continue to invest in store growth and development of approximately 1,000 new stores and approximately 1,580 stores to be remodeled or relocated. Capital expenditures in 2020 are anticipated to support our store growth as well as our remodel and relocation initiatives, including capital outlays for leasehold improvements, fixtures and equipment; the construction of new stores; costs to support and enhance our supply chain initiatives including new and existing distribution center facilities and our private fleet; technology initiatives; as well as routine and ongoing capital requirements.
Cash flows from financing activities. In 2019, we had a net increase in consolidated commercial paper borrowings of $58.3 million and had no borrowings or repayments under the Revolving Facility. We repurchased 8.3 million outstanding shares of our common stock in 2019 at a total cost of $1.2 billion, and paid cash dividends of $327.6 million.
In 2018, we had net proceeds from the issuance of the 2028 Senior Notes of $499.5 million, redeemed the 2018 Senior Notes for $400.0 million, and made a principal payment on the Term Facility of $175.0 million. We had a net decrease in consolidated commercial paper borrowings in 2018 of $63.3 million and had no borrowings or repayments under the Revolving Facility. We repurchased 9.9 million outstanding shares of our common stock in 2018 at a total cost of $1.0 billion, and paid cash dividends of $306.5 million.
In 2017, we had net proceeds from the issuance of the 2027 Senior Notes of $599.6 million, redeemed the 2017 Senior Notes for $500.0 million, and made a principal payment on the Term Facility of $250.0 million. We had a net decrease in consolidated commercial paper borrowings in 2017 of $60.3 million and had no borrowings or repayments under the Revolving Facility. We repurchased 7.1 million outstanding shares of our common stock in 2017 at a total cost of $579.7 million, and paid cash dividends of $282.9 million.
Accounting Standards
In January 2017, the FASB issued amendments to existing guidance related to the subsequent measurement of goodwill. These amendments modify the concept of impairment from the condition that exists when the carrying amount of goodwill exceeds its implied fair value to the condition that exists when the carrying amount of a reporting unit exceeds its fair value. Subsequent to adoption, an entity will perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. This guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2019, and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The amendments should be applied on a prospective basis. An entity is required to disclose the nature of and reason for the change in accounting principle upon transition. We do not anticipate a material effect on our consolidated results of operations, financial position or cash flows to result from the adoption of this guidance.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) requires management to make estimates and assumptions that affect reported amounts and related disclosures. In addition to the estimates presented below, there are other items within our financial statements that require estimation, but are not deemed critical as defined below. We believe these estimates are reasonable and appropriate. However, if actual experience differs from the assumptions and other considerations used, the resulting changes could have a material effect on the financial statements taken as a whole.
Management believes the following policies and estimates are critical because they involve significant judgments, assumptions, and estimates. Management has discussed the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed the disclosures presented below relating to those policies and estimates. See Note 1 to the consolidated financial statements for a detailed discussion of our principal accounting policies.
Merchandise Inventories. Merchandise inventories are stated at the lower of cost or market (“LCM”) with cost determined using the retail last in, first out (“LIFO”) method. We use the retail inventory method (“RIM”) to calculate gross profit and the resulting valuation of inventories at cost, which are computed utilizing a calculated cost-to-retail inventory ratio at an inventory department level. We apply the RIM to these departments, which are groups of products that are fairly uniform in terms of cost, selling price relationship and turnover. The
RIM will result in valuing inventories at LCM if permanent markdowns are currently taken as a reduction of the retail value of inventories. Inherent in the RIM calculation are certain management judgments and estimates that may impact the ending inventory valuation at cost, as well as the gross profit recognized. These judgments include ensuring departments consist of similar products, recording estimated shrinkage between physical inventories, and timely recording of markdowns needed to sell inventory.
We perform an annual LIFO analysis whereby all merchandise units are considered for inclusion in the index formulation. An actual valuation of inventory under the LIFO method is made at the end of each year based on the inventory levels and costs at that time. In contrast, interim LIFO calculations are based on management’s annual estimates of sales, the rate of inflation or deflation, and year-end inventory levels. We also perform analyses for determining obsolete inventory, adjusting inventory on a quarterly basis to an LCM value based on various management assumptions including estimated below cost markdowns not yet recorded, but required to liquidate such inventory in future periods.
Factors considered in the determination of markdowns include current and anticipated demand based on changes in competitors’ practices, consumer preferences, consumer spending, significant weather events and unseasonable weather patterns. Certain of these factors are outside of our control and may result in greater than estimated markdowns to entice consumer purchases of excess inventory. The amount and timing of markdowns may vary significantly from year to year.
We perform physical inventories in virtually all of our stores on an annual basis. We calculate our shrink provision based on actual physical inventory results during the fiscal period and an accrual for estimated shrink occurring subsequent to a physical inventory through the end of the fiscal reporting period. This accrual is calculated as a percentage of sales at each retail store, at a department level, based on the store’s most recent historical shrink rate. To the extent that subsequent physical inventories yield different results than the estimated accrual, our effective shrink rate for a given reporting period will include the impact of adjusting to the actual results.
We believe our estimates and assumptions related to the application of the RIM results in a merchandise inventory valuation that reasonably approximates cost on a consistent basis.
Impairment of Long-lived Assets. Impairment of long-lived assets results when the carrying value of the assets exceeds the estimated undiscounted future cash flows generated by the assets. Our estimate of undiscounted future store cash flows is based upon historical operations of the stores and estimates of future profitability which encompasses many factors that are subject to variability and are difficult to predict. If our estimates of future cash flows are not materially accurate, our impairment analysis could be impacted accordingly. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s estimated fair value. The fair value is estimated based primarily upon projected future cash flows (discounted at our credit adjusted risk-free rate) or other reasonable estimates of fair market value. Although not currently anticipated, changes in these estimates, assumptions or projections could materially affect the determination of fair value or impairment.
Insurance Liabilities. We retain a significant portion of the risk for our workers’ compensation, employee health, general liability, property loss, automobile and third-party landlord claim exposures. These represent significant costs primarily due to our large employee base and number of stores. Provisions are made for these liabilities on an undiscounted basis. Certain of these liabilities are based on actual claim data and estimates of incurred but not reported claims developed using actuarial methodologies based on historical claim trends, which have been and are anticipated to continue to be materially accurate. If future claim trends deviate from recent historical patterns, or other unanticipated events affect the number and significance of future claims, we may be required to record additional expenses or expense reductions, which could be material to our future financial results.
Contingent Liabilities – Income Taxes. Income tax reserves are determined using the methodology established by accounting standards relating to uncertainty in income taxes. These standards require companies to assess each income tax position taken using a two-step process. A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities. If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position. Uncertain tax positions require determinations and liabilities to be estimated based on provisions of the tax law which may be subject to change or varying interpretation. If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to our future financial results.
Lease Accounting. We adopted new accounting guidance related to leases as of February 2, 2019, using the modified retrospective approach. Under this approach, existing leases were recorded at the adoption date, and comparative periods were not restated and are presented under previously existing guidance. Adoption of the leasing standard resulted in right of use operating lease assets and operating lease liabilities of approximately $8.0 billion each as of February 2, 2019. Significant judgments and estimates were utilized in calculating these initial balances, including the determination of appropriate lease discount rates.
Many of our stores are subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of up to 15 years with multiple renewal options. We also have stores subject to shorter-term leases and many of these leases have renewal options. Certain of our stores have provisions for contingent rentals based upon a percentage of defined sales volume. We recognize contingent rental expense when the achievement of specified sales targets is considered probable. We record single lease expense on a straight-line basis over the lease term including any option periods that are reasonably certain to be renewed, commencing on the date that we take physical possession of the property from the landlord which normally includes a period prior to store opening to make necessary leasehold improvements and install store fixtures. When a lease contains a predetermined fixed escalation of the minimum rent, the related lease expense is recognized on a straight-line basis. Tenant allowances, to the extent received, are recorded as a reduction of the right of use asset. Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.
Share-Based Payments. Our stock option awards are valued on an individual grant basis using the Black-Scholes-Merton closed form option pricing model. We believe that this model fairly estimates the value of our stock option awards. The application of this valuation model involves assumptions that are judgmental in the valuation of stock options, which affects compensation expense related to these options. These assumptions include the term that the options are expected to be outstanding, the historical volatility of our stock price, applicable interest rates and the dividend yield of our stock. Other factors involving judgments that affect the expensing of share-based payments include estimated forfeiture rates of share-based awards. Historically, these estimates have been materially accurate; however, if our estimates differ materially from actual experience, we may be required to record additional expense or reductions of expense, which could be material to our future financial results.
Fair Value Measurements. Accounting standards for the measurement of fair value of assets and liabilities establish a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). Therefore, Level 3 inputs are typically based on an entity’s own assumptions, as there is little, if any, related market activity, and thus require the use of significant judgment and estimates. Currently, we have no assets or liabilities that are valued based solely on Level 3 inputs.
Our fair value measurements are primarily associated with our outstanding debt instruments. We use various valuation models in determining the values of these liabilities. We believe that in recent years these methodologies have produced materially accurate valuations.
Previous: Item 6. SELECTED FINANCIAL DATA · Next: Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK