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, as amended, 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 28, 2012. 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.

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 20,000 beauty products across the categories of cosmetics, fragrance, haircare, skincare, bath and body products and salon styling tools, as well as salon

Table of Contents

haircare products. We focus on delivering a compelling value proposition to our customers across all of our product categories. Our stores are predominately located in convenient, high-traffic locations such as power centers.

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 expanding operating margin. 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 10.9% fiscal 2011 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

Economic conditions in the U.S. continue to be uncertain. Fiscal stress in the U.S. and Europe has resulted in significant fluctuations in the U.S. stock markets and has negatively impacted consumer sentiment. While the U.S. credit markets have stabilized and credit availability has improved compared to the recent recessionary period, economic growth is expected to continue to be weak. Consumer spending habits are affected by levels of unemployment, unsettled financial markets, weakness in housing and real estate, higher interest rates, fuel and energy costs, and consumer perception of economic conditions, among others. Sudden negative changes in one or more of the factors that affect consumer spending could adversely affect consumer spending levels which could lead to reduced consumer demand for our merchandise and adversely affect our sales levels and financial performance.

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 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.

Table of Contents

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:

	Ÿ		the general national, regional and local economic conditions and corresponding impact on customer spending levels;

	Ÿ		the introduction of new products or brands;

	Ÿ		the location of new stores in existing store markets;

	Ÿ		competition;

	Ÿ		our ability to respond on a timely basis to changes in consumer preferences;

	Ÿ		the effectiveness of our various marketing activities; and

	Ÿ		the number of new stores opened and the impact on the average age of all of our comparable stores.

Cost of sales includes:

	Ÿ		the cost of merchandise sold, including all vendor allowances, which are treated as a reduction of merchandise costs;

	Ÿ		warehousing and distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities, and insurance;

	Ÿ		store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses, and cleaning expenses;

	Ÿ		salon payroll and benefits;

	Ÿ		customer loyalty program expense; and

	Ÿ		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:

	Ÿ		payroll, bonus and benefit costs for retail and corporate employees;

	Ÿ		advertising and marketing costs;

	Ÿ		occupancy costs related to our corporate office facilities;

	Ÿ		stock-based compensation expense;

	Ÿ		depreciation and amortization for all assets except those related to our retail and warehouse operations, which is included in cost of sales; and

	Ÿ		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.

Table of Contents

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 on hand and 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 28, 2012, January 29, 2011 and January 30, 2010 were 52 week years and are hereafter referred to as fiscal 2011, fiscal 2010 and fiscal 2009.

As of January 28, 2012, we operated 449 stores across 43 states. The following tables present the components of our results of operations for the periods indicated:

		Fiscal year ended
		January 28, 2012				January 29, 2011				January 30, 2010
		(In thousands, except number of stores)
Net sales		$	1,776,151			$	1,454,838			$	1,222,771
Cost of sales			1,159,311				970,753				846,202
Gross profit			616,840				484,085				376,569
Selling, general and administrative expenses			410,658				358,106				302,413
Pre-opening expenses			9,987				7,095				6,003
Operating income			196,195				118,884				68,153
Interest expense			587				755				2,202
Income before income taxes			195,608				118,129				65,951
Income tax expense			75,344				47,099				26,595
Net income		$	120,264			$	71,030			$	39,356
Other operating data:
Number of stores end of period			449				389				346
Comparable store sales increase			10.9	%			11.0	%			1.4	%

Table of Contents

		Fiscal year ended
(Percentage of net sales)		January 28, 2012				January 29, 2011				January 30, 2010
Net sales			100.0	%			100.0	%			100.0	%
Cost of sales			65.3	%			66.7	%			69.2	%
Gross profit			34.7	%			33.3	%			30.8	%
Selling, general and adminstrative expenses			23.1	%			24.6	%			24.7	%
Pre-opening expenses			0.6	%			0.5	%			0.5	%
Operating income			11.0	%			8.2	%			5.6	%
Interest expense			0.0	%			0.1	%			0.2	%
Income before income taxes			11.0	%			8.1	%			5.4	%
Income tax expense			4.2	%			3.2	%			2.2	%
Net income			6.8	%			4.9	%			3.2	%

Fiscal year 2011 versus fiscal year 2010

Net sales

Net sales increased $321.4 million, or 22.1%, to $1,776.2 million in fiscal 2011 compared to $1,454.8 million in fiscal 2010. Salon service sales increased $12.1 million, or 14.0% to $98.5 million compared to $86.4 million in fiscal 2010. The sales increases are due to the opening of 60 net new stores in 2011 and a 10.9% increase in comparable store sales which was primarily due to a 10.1% increase in store traffic. Non-comparable stores, which include stores opened in fiscal 2011 as well as stores opened in fiscal 2010 which have not yet turned comparable, contributed $168.4 million of the net sales increase while comparable stores contributed $153.0 million of the total net sales increase. We attribute the increase in comparable store sales to our successful marketing and merchandise strategies.

Gross profit

Gross profit increased $132.7 million, or 27.4%, to $616.8 million in fiscal 2011, compared to $484.1 million, in fiscal 2010. Gross profit as a percentage of net sales increased 140 basis points to 34.7% in fiscal 2011 compared to 33.3% in fiscal 2010. The increase in gross profit margin in fiscal 2011 was primarily driven by:

	Ÿ		80 basis points of leverage in fixed store costs attributed to the impact of significantly higher sales levels in fiscal 2011; and

	Ÿ		70 basis points improvement in merchandise margin due primarily to improved promotional pricing and a shift in category mix towards higher margin product compared with fiscal 2010.

Selling, general and administrative expenses

Selling, general and administrative (SG&A) expenses increased $52.6 million, or 14.7%, to $410.7 million in fiscal 2011 compared to $358.1 million in fiscal 2010. As a percentage of net sales, SG&A expenses decreased 150 basis points to 23.1% in fiscal 2011 compared to 24.6% in fiscal 2010. The leverage in SG&A expense was primarily driven by:

	Ÿ		70 basis points improvement in variable store and marketing expense leverage attributed to costs efficiencies and higher sales volume; and

	Ÿ		60 basis points in corporate overhead leverage, excluding the fiscal 2010 non-recurring compensation charge, attributed to higher sales volume.

Table of Contents

Pre-opening expenses

Pre-opening expenses increased $2.9 million, or 40.8%, to $10.0 million in fiscal 2011 compared to $7.1 million in fiscal 2010. During fiscal 2011, we opened 61 new stores, remodeled 17 stores and relocated 2 stores. During fiscal 2010, we opened 47 new stores and remodeled 13 stores and relocated 5 stores.

Interest expense

Interest expense was $0.6 million in fiscal 2011 and $0.8 million in fiscal 2010. Interest expense for both periods represents various fees related to the credit facility. We did not utilize our credit facility during fiscal 2011 or 2010.

Income tax expense

Income tax expense of $75.3 million in fiscal 2011 represents an effective tax rate of 38.5%, compared to fiscal 2010 tax expense of $47.1 million and an effective tax rate of 39.9%. The lower tax rate in fiscal 2011 is primarily due to a decrease in non-deductible compensation expense and increases in certain federal and state tax deductions and credits compared to fiscal 2010.

Net income

Net income increased $49.3 million, or 69.3%, to $120.3 million in fiscal 2011 compared to $71.0 million in fiscal 2010. The increase in net income was primarily due to an increase in gross profit of $132.7 million, which was offset by a $52.6 million increase in SG&A expenses and a $28.2 million increase in income tax expense.

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 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:

	Ÿ		120 basis points of leverage in fixed store costs attributed to the impact of significantly higher sales levels in fiscal 2010;

	Ÿ		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

	Ÿ		20 basis points of supply chain efficiencies on product handling automation, engineering efforts and higher sales volume.

Table of Contents

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:

	Ÿ		40 basis points improvement in marketing expense leverage attributed to costs efficiencies and higher sales volume; offset by

	Ÿ		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.

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.

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 on hand, 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.

Table of Contents

The following table presents a summary of our cash flows for fiscal years 2011, 2010 and 2009:

		Fiscal year ended
(In thousands)		January 28, 2012				January 29, 2011				January 30, 2010
Net cash provided by operating activities		$	220,887			$	176,543			$	172,827
Net cash used in investing activities			(128,636	)			(97,115	)			(68,105	)
Net cash provided by (used in) financing activities			50,302				27,740				(104,343	)
Net increase in cash and cash equivalents		$	142,553			$	107,168			$	379

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 $244.6 million at January 28, 2012, compared to $218.5 million at January 29, 2011, representing an increase of $26.1 million. The increase is due to the addition of 60 net new stores opened since January 29, 2011, offset by a 3.0% decrease in average inventory per store driven by our comparable store sales increases and management initiatives focused on leveraging store and supply chain inventories.

We had a current tax liability of $4.0 million at the end of fiscal 2011 compared to a prepaid asset of $10.7 million at the end of fiscal 2010. In fiscal 2010, we finalized the tax benefit estimates related to bonus depreciation on fixed assets and stock option exercises in the fourth quarter which resulted in tax deductions in excess of our year to date estimated tax payments. In fiscal 2011, we were able to better forecast the implications of those significant tax drivers as well as the resulting estimated tax payments.

Deferred rent liabilities were $163.5 million at January 28, 2012, an increase of $28.9 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 primarily due to the addition of 60 net new stores opened since January 29, 2011.

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 $128.6 million in fiscal 2011, compared to $97.1 million and $68.1 million in fiscal 2010 and 2009, respectively. Capital expenditures increased in fiscal 2011 compared to fiscal 2010 due to the increase in our 2011 new store program. During fiscal 2011 we opened 61 new stores, remodeled 17 stores and relocated 2 stores, compared to 47 new stores, 13 remodels and 5 relocation during fiscal 2010 and 37 new stores, 6 remodels and 1 relocation during fiscal 2009.

Financing activities

Financing activities in fiscal 2011 and 2010 consist principally of capital stock transactions and the related income tax effects, while financing activities in fiscal 2009 consisted principally of draws and payments on our credit facility and capital stock transactions. Common stock repurchased in fiscal 2011 represents the fair value of common shares repurchased from plan participants in connection with shares withheld to satisfy minimum statutory tax obligations upon the vesting of restricted stock.

We had no borrowings outstanding under our credit facility at the end of fiscal 2011 or 2010. The zero outstanding borrowings position is due to a combination of factors including strong sales growth, overall performance of management initiatives including expense control as well as inventory and other working capital reductions. We may require borrowings under the facility from time to time in future periods to support our new store program and seasonal inventory needs.

Table of Contents

Dividend

On March 8, 2012, we announced that our Board of Directors had declared a $1.00 per share special cash dividend to shareholders of record as of the close of business on March 20, 2012. The special cash dividend, which totals approximately $62 million, will be payable on May 15, 2012.

Our Board of Directors may determine future dividends after giving consideration to our levels of profit and cash flow, capital requirements, current and future liquidity, restrictions included as part of our credit facility as well as financial and other conditions existing at the time.

Credit facility

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.

On October 19, 2011, the Company entered into an Amended and Restated Loan and Security Agreement (the Loan Agreement) with Wells Fargo Bank, National Association, as Administrative Agent, Collateral Agent and a Lender thereunder, Wells Fargo Capital Finance LLC as a Lender, J.P. Morgan Securities LLC as a Lender, JP Morgan Chase Bank, N.A. as a Lender and PNC Bank, National Association, as a Lender. The Loan Agreement amended and restated the Loan and Security Agreement, dated as of August 31, 2010, by and among the lenders. The Loan Agreement extends the maturity of the Company’s credit facility to October 2016, provides maximum revolving loans equal to the lesser of $200,000 or a percentage of eligible owned inventory, contains a $10,000 subfacility for letters of credit and allows the Company to increase the revolving facility by an additional $50,000, subject to consent by each lender and other conditions. The Loan Agreement contains a requirement to maintain a minimum amount of excess borrowing availability at all times. Substantially all of the Company’s assets are pledged as collateral for outstanding borrowings under the facility. Outstanding borrowings will bear interest at the prime rate or Libor plus 1.50% and the unused line fee is 0.225%.

As of January 28, 2012 and January 29, 2011, the Company had no borrowings outstanding under its credit facility.

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 28, 2012.

Table of Contents

Contractual obligations

We lease retail stores, warehouses, corporate offices and certain equipment under operating leases with various expiration dates through fiscal 2027. 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 28, 2012:

(In thousands)		Total				Less Than 1 Year				1 to 3 Years				3 to 5 Years				After 5 Years
Operating lease obligations(1)		$	935,909			$	123,945			$	252,236			$	221,551					$	338,177

(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 2011 were $25.3 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 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 2011, 2010 and 2009.

Table of Contents

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.