Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, which reflect our current views with respect to, among other things, future events and financial performance. You can identify these forward-looking statements by the use of forward-looking words such as “outlook,” “believes,” “expects,” “plans,” “estimates,” or other comparable words. Any forward-looking statements contained in this Form 10-K are based upon our historical performance and on current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. Such forward-looking statements are subject to various risks and uncertainties, which include, without limitation: the impact of weakness in the economy; changes in the overall level of consumer spending; changes in the wholesale cost of our products; the possibility that we may be unable to compete effectively in our highly competitive markets; the possibility that our continued opening of new stores could strain our resources and have a material adverse effect on our business and financial performance; the possibility that new store openings and existing locations may be impacted by developer or co-tenant issues; the possibility that the capacity of our distribution and order fulfillment infrastructure may not be adequate to support our recent growth and expected future growth plans; the possibility of material disruptions to our information systems; weather conditions that could negatively impact sales; and other risk factors detailed in our public filings with the Securities and Exchange Commission (the “SEC”), including risk factors contained in Item 1A, “Risk Factors” of this Annual Report on Form 10-K for the year ended January 29, 2011. We assume no obligation to update any forward-looking statements as a result of new information, future events or developments. References in the following discussion to “we”, “us”, “our”, “the Company”, “Ulta” and similar references mean Ulta Salon, Cosmetics & Fragrance, Inc. unless otherwise expressly stated or the context otherwise requires.

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Overview

We were founded in 1990 as a discount beauty retailer at a time when prestige, mass and salon products were sold through separate distribution channels. After extensive research, we recognized an opportunity to better satisfy how a woman wanted to shop for beauty products, which led to what we believe to be our unique combination of beauty superstore and specialty store attributes. We believe our strategy provides us with the competitive advantages that have contributed to our strong financial performance.

We are currently the largest beauty retailer that provides one-stop shopping for prestige, mass and salon products and salon services in the United States. We combine the unique elements of a beauty superstore with the distinctive environment and experience of a specialty retailer. Key aspects of our beauty superstore strategy include our ability to offer our customers a broad selection of over 21,000 beauty products across the categories of cosmetics, fragrance, haircare, skincare, bath and body products and salon styling tools, as well as salon haircare products. We focus on delivering a compelling value proposition to our customers across all of our product categories. Our stores are conveniently located in high-traffic, primarily off-mall locations such as power centers and lifestyle centers with other destination retailers.

The continued growth of our business and any future increases in net sales, net income and cash flows is dependent on our ability to execute our growth strategy, including growing our store base, expanding our product, brand and service offerings, enhancing our loyalty program, broadening our marketing channels, expanding our e-commerce business and improving our profitability by leveraging our fixed costs. We believe that the steadily expanding U.S. beauty products and services industry, the shift in distribution of prestige beauty products from department stores to specialty retail stores, coupled with Ulta’s competitive strengths, positions us to capture additional market share in the industry through successful execution of our growth strategy.

Comparable store sales is a key metric that is monitored closely within the retail industry. Our comparable store sales have fluctuated in the past and we expect them to continue to fluctuate in the future. A variety of factors affect our comparable store sales, including general U.S. economic conditions, changes in merchandise strategy or mix, and timing and effectiveness of our marketing activities, among others. We do not expect our 11.0% fiscal 2010 comparable store sales increase to continue into the future. Our long-term annual comparable store sales increase target is 3% to 5%.

Over the long-term, our growth strategy is to increase total net sales through increases in our comparable store sales and by opening new stores. Gross profit as a percentage of net sales is expected to increase as a result of our ability to expand merchandise margin and leverage our supply chain infrastructure and fixed store costs with comparable store sales increases and operating efficiencies. We plan to continue to improve our operating results by leveraging our fixed costs and decreasing our selling, general and administrative expenses, as a percentage of our net sales.

Global economic conditions

The global economic crisis and resulting volatility and disruption to the capital and credit markets have had a significant, adverse impact on global economic conditions, resulting in recessionary pressures and declines in consumer confidence and economic growth. While economic conditions have begun to show signs of improvement, the recovery has proceeded at a sluggish rate and the retail environment has remained weak. As a result of market conditions, the cost and availability of credit has been and may continue to be adversely affected by decreased liquidity in credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide credit to businesses and consumers. While global credit and financial markets appear to be recovering from the extreme disruptions experienced over the past few years, uncertainty about continuing economic stability remains. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in the United States and international markets and economies and declines in business and consumer spending may adversely affect our liquidity and financial condition, and the liquidity and

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financial condition of our customers, including our ability to refinance maturing liabilities and access the capital markets to meet liquidity needs.

Current business trends

Our comparable store sales for first, second, third and fourth quarters of fiscal 2009 were -2.3%, -1.7%, 1.5% and 6.2%, respectively. Comparable store sales for the first, second, third and fourth quarters of fiscal 2010 were 10.8%, 10.8%, 12.2% and 10.4%, respectively. Fiscal 2010 two year comparable store sales for the respective quarters were 8.5%, 9.1%, 13.7%, and 16.6%, respectively. We believe the improvement in our comparable store sales trends is due to a combination of factors including effective marketing and merchandising programs as well as improved consumer sentiment and shopping patterns due to a general improvement in U.S. economic conditions compared to fiscal 2009 and 2008.

We do not expect the low double digit comparable store increases of fiscal 2010 to continue into the future. Our long-term annual net income growth target of 25% to 30% is based on comparable store sales increases of 3% to 5%.

Basis of presentation

The Company has determined its operating segments on the same basis that it uses to internally evaluate performance. We have combined our three operating segments: retail stores, salon services and e-commerce, into one reportable segment because they have a similar class of consumer, economic characteristics, nature of products and distribution methods.

Net sales include store and e-commerce merchandise sales as well as salon service revenue. We recognize merchandise revenue at the point of sale (POS) in our retail stores and the time of shipment in the case of Internet sales. Merchandise sales are recorded net of estimated returns. Salon service revenue is recognized at the time the service is provided. Gift card sales revenue is deferred until the customer redeems the gift card. Company coupons and other incentives are recorded as a reduction of net sales.

Comparable store sales reflect sales for stores beginning on the first day of the 14th month of operation. Therefore, a store is included in our comparable store base on the first day of the period after one year of operations plus the initial one month grand opening period. Non-comparable store sales include sales from new stores that have not yet completed their 13th month of operation and stores that were closed for part or all of the period in either year as a result of remodel activity. Remodeled stores are included in comparable store sales unless the store was closed for a portion of the current or prior period. E-commerce merchandise sales are excluded from comparable store sales. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales. As a result, data herein regarding our comparable store sales may not be comparable to similar data made available by our competitors or other retailers.

Comparable store sales is a critical measure that allows us to evaluate the performance of our store base as well as several other aspects of our overall strategy. Several factors could positively or negatively impact our comparable store sales results:

	•	the general national, regional and local economic conditions and corresponding impact on customer spending levels;
	•	the introduction of new products or brands;
	•	the location of new stores in existing store markets;
	•	competition;
	•	our ability to respond on a timely basis to changes in consumer preferences;
	•	the effectiveness of our various marketing activities; and
	•	the number of new stores opened and the impact on the average age of all of our comparable stores.

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Cost of sales includes:

	•	the cost of merchandise sold, including all vendor allowances, which are treated as a reduction of merchandise costs;
	•	warehousing and distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities, and insurance;
	•	store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses, and cleaning expenses;
	•	salon payroll and benefits;
	•	customer loyalty program expense; and
	•	shrink and inventory valuation reserves.

Our cost of sales may be negatively impacted as we open an increasing number of stores. Changes in our merchandise mix may also have an impact on cost of sales. This presentation of items included in cost of sales may not be comparable to the way in which our competitors or other retailers compute their cost of sales.

Selling, general and administrative expenses include:

	•	payroll, bonus and benefit costs for retail and corporate employees;
	•	advertising and marketing costs;
	•	occupancy costs related to our corporate office facilities;
	•	stock-based compensation expense;
	•	depreciation and amortization for all assets except those related to our retail and warehouse operations, which is included in cost of sales; and
	•	legal, finance, information systems and other corporate overhead costs.

This presentation of items in selling, general and administrative expenses may not be comparable to the way in which our competitors or other retailers compute their selling, general and administrative expenses.

Pre-opening expense includes non-capital expenditures during the period prior to store opening for new, remodeled and relocated stores including rent during the construction period for new and relocated stores, store set-up labor, management and employee training, and grand opening advertising.

Interest expense includes interest costs and unused facility fees associated with our credit facility, which is structured as an asset based lending instrument. Our interest expense will fluctuate based on the seasonal borrowing requirements associated with acquiring inventory in advance of key holiday selling periods and fluctuation in the variable interest rates we are charged on outstanding balances. Our credit facility is used to fund seasonal inventory needs and new and remodel store capital requirements in excess of our cash flow from operations. Our credit facility interest is based on a variable interest rate structure which can result in increased cost in periods of rising interest rates.

Income tax expense reflects the federal statutory tax rate and the weighted average state statutory tax rate for the states in which we operate stores.

Results of operations

Our fiscal years are the 52 or 53 week periods ending on the Saturday closest to January 31. The Company’s fiscal years ended January 29, 2011, January 30, 2010 and January 31, 2009 were 52 week years and are hereafter referred to as fiscal 2010, fiscal 2009 and fiscal 2008.

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As of January 29, 2011, we operated 389 stores across 40 states. The following tables present the components of our results of operations for the periods indicated:

		Fiscal Year Ended
		**January 29, **				**January 30, **				**January 31, **
		2011				2010				2009
		(In thousands, except number of stores)
Net sales		$	1,454,838			$	1,222,771			$	1,084,646
Cost of sales(1)			970,753				846,202				752,939
Gross profit			484,085				376,569				331,707
Selling, general and administrative expenses(1)			358,106				302,413				271,095
Pre-opening expenses			7,095				6,003				14,311
Operating income			118,884				68,153				46,301
Interest expense			755				2,202				3,943
Income before income taxes			118,129				65,951				42,358
Income tax expense			47,099				26,595				17,090
Net income		$	71,030			$	39,356			$	25,268
Other operating data:
Number of stores end of period			389				346				311
Comparable store sales increase			11.0	%			1.4	%			0.2	%

		Fiscal Year Ended
		**January 29, **				**January 30, **				**January 31, **
(Percentage of Net Sales)		2011				2010				2009
Net sales			100.0	%			100.0	%			100.0	%
Cost of sales			66.7	%			69.2	%			69.4	%
Gross profit			33.3	%			30.8	%			30.6	%
Selling, general and adminstrative expenses			24.6	%			24.7	%			25.0	%
Pre-opening expenses			0.5	%			0.5	%			1.3	%
Operating income			8.2	%			5.6	%			4.3	%
Interest expense			0.1	%			0.2	%			0.4	%
Income before income taxes			8.1	%			5.4	%			3.9	%
Income tax expense			3.2	%			2.2	%			1.6	%
Net income			4.9	%			3.2	%			2.3	%

(1)		The Company made reclassifications in the consolidated income statements for the fiscal years ended January 30, 2010 (fiscal 2009) and January 31, 2009 (fiscal 2008) to decrease cost of sales and increase selling, general and administrative expenses by $3,520 and $3,773, respectively, to conform to the fiscal 2010 presentation.

Fiscal year 2010 versus fiscal year 2009

Net sales

Net sales increased $232.0 million, or 19.0%, to $1,454.8 million in fiscal 2010 compared to $1,222.8 million in fiscal 2009. Salon service sales increased $9.8 million, or 12.8%, to $86.4 million compared to $76.6 million in fiscal 2009. The sales increases are due to the opening of 43 net new stores in 2010 and a 11.0% increase in comparable store sales which was primarily due to a 8.6% increase in store traffic. Non-comparable stores, which include stores opened in fiscal 2010 as well as stores opened in fiscal 2009 which

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have not yet turned comparable, contributed $102.3 million of the net sales increase while comparable stores contributed $129.7 million of the total net sales increase. We believe the improvement in our comparable store sales trends is due to a combination of factors including effective marketing and merchandise programs and the relatively lower comparable store sales level in the prior year. We also believe that overall consumer sentiment and shopping patterns improved in 2010 when compared to 2009 which may have contributed to our improving trends.

Gross profit

Gross profit increased $107.5 million, or 28.6%, to $484.1 million in fiscal 2010, compared to $376.6 million, in fiscal 2009. Gross profit as a percentage of net sales increased 250 basis points to 33.3% in fiscal 2010 compared to 30.8% in fiscal 2009. Gross profit in fiscal 2010 was impacted by:

	•	120 basis points of leverage in fixed store costs attributed to the impact of significantly higher sales levels in fiscal 2010;
	•	80 basis points improvement in merchandise margin due to improved promotional pricing and a shift in category mix towards higher margin product compared with fiscal 2009; and
	•	20 basis points of supply chain efficiencies on product handling automation, engineering efforts and higher sales volume.

Selling, general and administrative expenses

Selling, general and administrative (SG&A) expenses increased $55.7 million, or 18.4%, to $358.1 million in fiscal 2010 compared to $302.4 million in fiscal 2009. As a percentage of net sales, SG&A expenses decreased 10 basis points to 24.6% in fiscal 2010 compared to 24.7% in fiscal 2009. SG&A expense as a percentage of sales was primarily impacted by:

	•	40 basis points improvement in marketing expense leverage attributed to costs efficiencies and higher sales volume; offset by
	•	30 basis points deleverage due to the non-recurring executive compensation charge related to our newly appointed President and Chief Executive Officer.

Pre-opening expenses

Pre-opening expenses increased $1.1 million, or 18.2%, to $7.1 million in fiscal 2010 compared to $6.0 million in fiscal 2009. During fiscal 2010, we opened 47 new stores, remodeled 13 stores and relocated 5 stores. During fiscal 2009, we opened 37 new stores and remodeled 6 stores.

Interest expense

Interest expense decreased $1.4 million, or 65.7%, to $0.8 million in fiscal 2010 compared to $2.2 million in fiscal 2009. Fiscal 2010 interest expense represents fees associated with the credit facility. We did not utilize the credit facility in fiscal 2010.

Income tax expense

Income tax expense of $47.1 million in fiscal 2010 represents an effective tax rate of 39.9%, compared to fiscal 2009 tax expense of $26.6 million and an effective tax rate of 40.3%. The decrease in the effective tax rate in fiscal 2010 is primarily attributed to the large number of stock option exercises and share sales deemed to be disqualifying dispositions.

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Net income

Net income increased $31.6 million, or 80.5%, to $71.0 million in fiscal 2010 compared to $39.4 million in fiscal 2009. The increase in net income was primarily due to an increase in gross profit of $107.5 million, which was offset by a $55.7 million increase in SG&A expenses and a $20.5 million increase in income tax expense.

Fiscal year 2009 versus fiscal year 2008

Net sales

Net sales increased $138.2 million, or 12.7%, to $1,222.8 million in fiscal 2009 compared to $1,084.6 million in fiscal 2008. Salon service sales increased $1.6 million, or 2.1%, to $76.6 million compared to $75.0 million in fiscal 2008. The sales increases are due to the opening of 35 net new stores in 2009 and a 1.4% increase in comparable store sales which was primarily due to a 3.6% increase in store traffic. Non-comparable stores, which include stores opened in fiscal 2009 as well as stores opened in fiscal 2008 which have not yet turned comparable, contributed $123.3 million of the net sales increase while comparable stores contributed $14.9 million of the total net sales increase. Fiscal 2009 comparable store sales were positively affected by the 6.2% increase in comparable store sales in the fourth quarter. We believe the improvement in our comparable store sales trends is due to a combination of factors including our ability to better plan our marketing and merchandise programs for the challenging environment and the relatively lower comparable in the prior year fourth quarter period. We also believe that overall consumer sentiment and shopping patterns improved somewhat in the second half of 2009 which may have contributed to our improving trends when compared to 2008.

Gross profit

Gross profit increased $44.9 million, or 13.5%, to $376.6 million in fiscal 2009, compared to $331.7 million, in fiscal 2008. Gross profit as a percentage of net sales increased 20 basis points to 30.8% in fiscal 2009 compared to 30.6% in fiscal 2008. Gross profit in fiscal 2009 was impacted by:

	•	70 basis points improvement due to supply chain efficiencies including labor and freight; offset by
	•	40 basis points of deleverage of fixed store costs due to the impacts of our new store program; the level of fixed store costs deleverage improved during the course of fiscal 2009 as the rate of square footage growth slowed consistent with the decrease in our fiscal 2009 new store program as compared to fiscal 2008 and 2007.

Selling, general and administrative expenses

SG&A expenses increased $31.3 million, or 11.6%, to $302.4 million in fiscal 2009 compared to $271.1 million in fiscal 2008. As a percentage of net sales, SG&A expenses decreased 30 basis points to 24.7% in fiscal 2009 compared to 25.0% in fiscal 2008. SG&A expense as a percentage of sales was primarily impacted by:

	•	40 basis points improvement in variable store expense leverage attributed to cost management strategies;
	•	20 basis points improvement in marketing expense leverage attributed to improved cost efficiencies while total number of marketing impressions were maintained at historical levels; offset by
	•	40 basis points deleverage of general corporate overhead which is attributed to a 90 basis point, or $11.6 million, increase in incentive compensation compared to the prior year.

Pre-opening expenses

Pre-opening expenses decreased $8.3 million, or 58.1%, to $6.0 million in fiscal 2009 compared to $14.3 million in fiscal 2008. During fiscal 2009, we opened 37 new stores and remodeled 6 stores. During fiscal 2008, we opened 63 new stores and remodeled 8 stores.

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Interest expense

Interest expense decreased $1.7 million, or 44.2%, to $2.2 million in fiscal 2009 compared to $3.9 million in fiscal 2008 primarily due to a $45 million decrease in the weighted-average debt outstanding on our variable rate credit facility during fiscal 2009.

Income tax expense

Income tax expense of $26.6 million in fiscal 2009 represents an effective tax rate of 40.3%, compared to fiscal 2008 tax expense of $17.1 million which represents an effective tax rate of 40.3%.

Net income

Net income increased $14.1 million, or 55.8%, to $39.4 million in fiscal 2009 compared to $25.3 million in fiscal 2008. The increase in net income was primarily due to an increase in gross profit of $45.1 million and a $8.3 million decrease in pre-opening expenses, which were offset by a $31.6 million increase in selling, general and administrative expenses and a $9.5 million increase in income tax expense.

Liquidity and capital resources

Our primary cash needs are for capital expenditures for new, relocated and remodeled stores, increased merchandise inventories related to store expansion, and for continued improvement in our information technology systems.

Our primary sources of liquidity are cash flows from operations, including changes in working capital, and borrowings under our credit facility. The most significant component of our working capital is merchandise inventories reduced by related accounts payable and accrued expenses. Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day, or within several days of the related sale, while we typically have up to 30 days to pay our vendors.

Our working capital needs are greatest from August through November each year as a result of our inventory build-up during this period for the approaching holiday season. This is also the time of year when we are at maximum investment levels in our new store class and may not have collected all of the landlord allowances due to us as part of our lease agreements. Based on past performance and current expectations, we believe that cash generated from operations and borrowings under the credit facility will satisfy the Company’s working capital needs, capital expenditure needs, commitments, and other liquidity requirements through at least the next 12 months.

The following table presents a summary of our cash flows for fiscal years 2010, 2009 and 2008:

		Fiscal Year Ended
		**January 29, **				**January 30, **				**January 31, **
		2011				2010				2009
		(In thousands)
Net cash provided by operating activities		$	176,543			$	172,827			$	75,203
Net cash used in investing activities			(97,115	)			(68,105	)			(110,863	)
Net cash provided by (used in) financing activities			27,740				(104,343	)			35,509
Net increase (decrease) in cash and cash equivalents		$	107,168			$	379			$	(151	)

Operating activities

Operating activities consist of net income adjusted for certain non-cash items, including depreciation and amortization, non-cash stock-based compensation, realized gains or losses on disposal of property and equipment, and the effect of working capital changes.

Merchandise inventories were $218.5 million at January 29, 2011, compared to $206.9 million at January 30, 2010, representing an increase of $11.6 million. The increase is due to the addition of 43 net new stores opened since January 30, 2010, offset by a 6.1% decrease in average inventory per store driven by management initiatives focused on leveraging store and supply chain inventories. The reduction in inventories in fiscal 2010 did not affect our store in-stock levels or the customer experience.

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Income taxes were prepaid by $10.7 million at January 29, 2011, compared to an accrual of $10.8 million at January 30, 2010. The change in our year end tax position is primarily due to the combination of 2010 changes in Federal tax regulations which allowed accelerated or bonus depreciation of fixed assets and a large number of stock option exercises and share sales deemed to be disqualifying dispositions. The estimate related to bonus depreciation and the tax benefit related to stock option exercises were finalized during the fourth quarter fiscal 2010 and resulted in Federal income tax deductions which were significantly in excess of our year to-date estimated tax payments. We expect to apply the fiscal 2010 overpayments to our fiscal 2011 Federal income tax liabilities.

Accounts payable were $87.1 million at January 29, 2011, compared to $56.4 million at January 30, 2010, an increase of $30.7 million. The increase is attributed to a combination of a higher level of inventory purchases late in the fourth quarter of fiscal 2010 compared to the prior year on significantly higher comparable store sales trends, and changes in vendor payment terms.

Deferred rent liabilities were $134.6 million at January 29, 2011, an increase of $20.9 million compared to the prior year end. Deferred rent includes deferred construction allowances, future rental increases and rent holidays which are all recognized on a straight-line basis over their respective lease term. The increase is due to fiscal 2010 activity which includes 43 net new stores.

Investing activities

We have historically used cash primarily for new and remodeled stores as well as investments in information technology systems. Investment activities primarily related to capital expenditures were $97.1 million in fiscal 2010, compared to $68.1 million and $110.9 million in fiscal 2009 and 2008, respectively. Capital expenditures increased in fiscal 2010 compared to fiscal 2009 due to the increase in our 2010 new store program. During fiscal 2010 we opened 47 new stores, remodeled 13 stores and relocated 5 stores, compared to 37 new stores, 6 remodels and 1 relocation during fiscal 2009 and 63 new stores and a new distribution center during fiscal 2008.

Financing activities

Financing activities in fiscal 2010 consist of capital stock transactions, while financing activities in fiscal 2009 and 2008 consisted principally of draws and payments on our credit facility and capital stock transactions. The decrease in cash used in financing activities of $132.0 million in fiscal 2010 compared to fiscal 2009 is primarily the result of not utilizing the credit facility in fiscal 2010. The remaining difference is related to capital stock transactions.

We had no borrowings outstanding under our credit facility at the end of fiscal 2010. The zero outstanding borrowings position is due to a combination of factors including stronger than expected sales growth, overall performance of management initiatives including expense control as well as inventory and other working capital reductions, and a planned reduction in our fiscal 2009 and 2010 new store program.

Credit facility

Prior to August 31, 2010, the Company’s credit facility was with Bank of America National Association as administrative agent, Wachovia Capital Finance Corporation as collateral agent, and JP Morgan Chase Bank as documentation agent. We had no outstanding borrowings under the facility as of August 31, 2010.

On August 31, 2010, we terminated our credit facility with Bank of America and entered into a new credit facility pursuant to a Loan and Security Agreement with Wells Fargo Bank, National Association, as Administrative Agent, Collateral Agent and a Lender thereunder, JPMorgan Chase Bank, N.A. as a Lender, and PNC Bank, National Association, as a Lender. This new facility provides maximum credit of $200 million through May 31, 2013 and is available for working capital and general corporate purposes. The facility provides maximum borrowings equal to the lesser of $200 million or a percentage of eligible owned inventory, and contains a $10 million subfacility for letters of credit. The new credit facility agreement contains a restrictive financial covenant requiring us to maintain tangible net worth of not less than $200 million. Our tangible net worth was $402.5 million at January 29, 2011. Substantially all of our assets are pledged as collateral for outstanding borrowings under the new facility. Outstanding borrowings will bear interest at the prime rate or Libor plus 2.00% and the unused line fee is 0.25%.

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We did not utilize the new credit facility during fiscal 2010 and had no borrowings outstanding under the new credit facility as of January 29, 2011.

Seasonality

Our business is subject to seasonal fluctuation. Significant portions of our net sales and profits are realized during the fourth quarter of the fiscal year due to the holiday selling season. To a lesser extent, our business is also affected by Mothers’ Day as well as the “Back to School” season and Valentines’ Day. Any decrease in sales during these higher sales volume periods could have an adverse effect on our business, financial condition, or operating results for the entire fiscal year. Our quarterly results of operations have varied in the past and are likely to do so again in the future. As such, we believe that period-to-period comparisons of our results of operations should not be relied upon as an indication of our future performance.

Impact of inflation and changing prices

Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net sales if the selling prices of our products do not increase with these increased costs. In addition, inflation could materially increase the interest rates on our debt.

Off-balance sheet arrangements

Our off-balance sheet arrangements consist of operating lease obligations and letters of credit. We do not have any non-cancelable purchase commitments as of January 29, 2011. Our letters of credit outstanding under our revolving credit facility expired in September 2009; the balance was $0.3 million as of January 31, 2009.

Contractual obligations

We lease retail stores, warehouses, corporate offices and certain equipment under operating leases with various expiration dates through fiscal 2024. Our store leases generally have initial lease terms of 10 years and include renewal options under substantially the same terms and conditions as the original leases. In addition to future minimum lease payments, most of our lease agreements include escalating rent provisions which we recognize straight-line over the term of the lease, including any lease renewal periods deemed to be probable. For certain locations, we receive cash tenant allowances and we report these amounts as deferred rent, which is amortized on a straight-line basis as a reduction of rent expense over the term of the lease, including any lease renewal periods deemed to be probable. While a number of our store leases include contingent rentals, contingent rent amounts are insignificant.

The following table summarizes our contractual arrangements and the timing and effect that such commitments are expected to have on our liquidity and cash flows in future periods. The table below excludes variable expenses related to contingent rent, common area maintenance, insurance and real estate taxes. The table below includes obligations for executed agreements for which we do not yet have the right to control the use of the property as of January 29, 2011:

						**Less Than **				**1 to 3 **				**3 to 5 **				**After 5 **
		Total				1 Year				Years				Years				Years
		(In thousands)
Operating lease obligations(1)		$	720,772			$	102,798			$	202,018			$	178,907			$	237,049

(1)		Variable operating lease obligations related to common area maintenance, insurance and real estate taxes are not included in the table above. Total expenses related to common area maintenance, insurance and real estate taxes for fiscal 2010 were $22.4 million.

Critical accounting policies and estimates

Management’s discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principals (GAAP). The preparation of these financial statements required the use of estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. Management bases estimates on historical experience and other assumptions it believes to be reasonable under the circumstances and

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evaluates these estimates on an on-going basis. Actual results may differ from these estimates. A discussion of our more significant estimates follows. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the audit committee of the board of directors.

Inventory valuation

Merchandise inventories are carried at the lower of average cost or market value. Cost is determined using the weighted-average cost method and includes costs incurred to purchase and distribute goods as well as related vendor allowances including co-op advertising, markdowns, and volume discounts. We record valuation adjustments to our inventories if the cost of a specific product on hand exceeds the amount we expect to realize from the ultimate sale or disposal of the inventory. These estimates are based on management’s judgment regarding future demand, age of inventory, and analysis of historical experience. If actual demand or market conditions are different than those projected by management, future merchandise margin rates may be unfavorably or favorably affected by adjustments to these estimates.

Inventories are adjusted for the results of periodic physical inventory counts at each of our locations. We record a shrink reserve representing management’s estimate of inventory losses by location that have occurred since the date of the last physical count. This estimate is based on management’s analysis of historical results and operating trends. Adjustments to earnings resulting from revisions to management’s estimates of the lower of cost or market and shrink reserves have been insignificant during fiscal 2010, 2009 and 2008.

Impairment of long-lived tangible assets

We review long-lived tangible assets whenever events or circumstances indicate these assets might not be recoverable based on undiscounted future cash flows. Assets are reviewed at the lowest level for which cash flows can be identified, which is the store level. Significant estimates are used in determining future operating results of each store over its remaining lease term. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. We have not recorded an impairment charge in any of the periods presented in the accompanying financial statements.

Share-based compensation

We account for share-based compensation in accordance with the Accounting Standards Codificationtm (ASC) rules for stock compensation. Share-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized on a straight-line method over the requisite service period for awards expected to vest.

We estimate the grant date fair value of stock options using a Black-Scholes valuation model. The expected volatility is based on volatilities of our stock and a peer group of publicly-traded companies. The risk free interest rate is based on the United States Treasury yield curve in effect on the date of grant for the respective expected life of the option. The expected life represents the time the options granted are expected to be outstanding. We have limited historical data related to exercise behavior since our initial public offering on October 30, 2007. As a result, we have elected to use the shortcut approach to determine the expected life in accordance with the SEC Staff Accounting Bulletin on share-based payments.

See notes to financial statements, “Summary of significant accounting policies — Share-based compensation,” for disclosure related to the Company’s stock compensation expense and related valuation model assumptions. See Note 10 to our financial statements, “Share-based awards,” for disclosure related to our stock compensation expense and related valuation model assumptions.