filings.toolsItem 7. . Management’s Discussion and Analysis of Financial Condition and Results of Operations
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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.
Overview
We were founded in 1990 as a beauty retailer at a time when prestige, mass and salon products were sold through distinct channels – department stores for prestige products, drug stores and mass merchandisers for mass products and salons and authorized retail outlets for professional hair care products. We developed a unique specialty retail concept that offers All Things Beauty, All in One PlaceTM, a compelling value proposition and a convenient and welcoming shopping environment. We believe our strategy provides us with the competitive advantages that have contributed to our financial performance.
We are currently the largest beauty retailer in the United States and the premier beauty destination for cosmetics, fragrance, skin care products, hair care products and salon services. We focus on providing affordable indulgence to our guests by combining unmatched product breadth, value and convenience with the distinctive environment and experience of a specialty retailer. Key aspects of our business include: our ability to offer our guests a unique combination of more than 20,000 beauty products across the categories of prestige and mass cosmetics, fragrance, haircare, skincare, bath and body products and salon styling tools, as well as a full-service salon in every store featuring hair, skin and brow services; our focus on delivering a compelling value proposition to our guests across all of our product categories; and convenience, as our stores are predominantly 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 six strategic imperatives: 1) acquire new guests and deepen loyalty with existing guests, 2) differentiate by delivering a distinctive and personalized guest experience across all channels, 3) offer relevant, innovative and often exclusive products that excite our guests, 4) deliver exceptional services in three core areas: hair, skin health and brows, 5) grow stores and e-commerce to reach and serve more guests and 6) invest in infrastructure to support our guest experience and growth, and capture scale efficiencies. We believe that the expanding U.S. beauty products and salon services industry, the shift in distribution channel of prestige beauty products from department stores to specialty retail stores, coupled with Ulta Beauty’s competitive strengths, positions us to capture additional market share in the industry.
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Comparable sales is a key metric that is monitored closely within the retail industry. Our comparable sales have fluctuated in the past and we expect them to continue to fluctuate in the future. A variety of factors affect our comparable sales, including general U.S. economic conditions, changes in merchandise strategy or mix and timing and effectiveness of our marketing activities, among others.
Over the long-term, our growth strategy is to increase total net sales through increases in our comparable sales, by opening new stores and by increasing sales in our e-commerce channel. Operating profit is expected to increase as a result of our ability to expand merchandise margin and leverage our fixed store costs with comparable sales increases and operating efficiencies offset by incremental investments in people, systems and supply chain required to support a more than 1,200 store chain with a successful e-commerce business and competitive omni-channel capabilities.
Global economic conditions
Economic conditions in the U.S. continue to be uneven. Fiscal stress in Europe and economic uncertainty in the U.S. related to deficit issues, potential tax increases and federal spending cuts have resulted in significant fluctuations in the financial markets. 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
We have determined the operating segments on the same basis that we use 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 consumers, 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 e-commerce sales are recorded based on delivery of merchandise to the guest. 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 guest redeems the gift card. Company coupons and other incentives are recorded as a reduction of net sales.
Comparable 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 sales unless the store was closed for a portion of the current or prior period. Comparable sales include the Company’s e-commerce business. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales.
Measuring comparable sales 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 sales results:
| • | the general national, regional and local economic conditions and corresponding impact on customer spending levels; |
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| • | the introduction of new products or brands; |
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| • | the location of new stores in existing store markets; |
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| • | competition; |
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| • | our ability to respond on a timely basis to changes in consumer preferences; |
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| • | the effectiveness of our various marketing activities; and |
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| • | 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 substantially all vendor allowances, which are treated as a reduction of merchandise costs; |
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| • | warehousing and distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities and insurance; |
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| • | store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses and cleaning expenses; |
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| • | salon payroll and benefits; |
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| • | customer loyalty program expense; and |
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| • | shrink and inventory valuation reserves. |
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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; |
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| • | advertising and marketing costs; |
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| • | occupancy costs related to our corporate office facilities; |
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| • | stock-based compensation expense; |
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| • | depreciation and amortization for all assets, except those related to our retail and warehouse operations, which are included in cost of sales; and |
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| • | legal, finance, information systems and other corporate overhead costs. |
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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 expenses include 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 income, net includes both interest income and expense. Interest income represents interest from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense includes interest costs and unused facility fees associated with our credit facility, which is structured as an asset-based lending instrument. 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 30, 2016, January 31, 2015 and February 1, 2014 were 52 week years and are hereafter referred to as fiscal 2015, fiscal 2014 and fiscal 2013.
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As of January 30, 2016, we operated 874 stores across 48 states. The following tables present the components of our consolidated results of operations for the periods indicated:
| Fiscal year ended | ||||||||||||
| (Dollars in thousands) | January 30, 2016 | January 31, 2015 | February 1, 2014 | |||||||||
| Net sales | $ | 3,924,116 | $ | 3,241,369 | $ | 2,670,573 | ||||||
| Cost of sales | 2,539,783 | 2,104,582 | 1,729,325 | |||||||||
| Gross profit | 1,384,333 | 1,136,787 | 941,248 | |||||||||
| Selling, general and administrative expenses | 863,354 | 712,006 | 596,390 | |||||||||
| Pre-opening expenses | 14,682 | 14,366 | 17,270 | |||||||||
| Operating income | 506,297 | 410,415 | 327,588 | |||||||||
| Interest income, net | (1,143 | ) | (894 | ) | (118 | ) | ||||||
| Income before income taxes | 507,440 | 411,309 | 327,706 | |||||||||
| Income tax expense | 187,432 | 154,174 | 124,857 | |||||||||
| Net income | $ | 320,008 | $ | 257,135 | $ | 202,849 | ||||||
| Other operating data: | ||||||||||||
| Number of stores end of period | 874 | 774 | 675 | |||||||||
| Comparable sales increase: | ||||||||||||
| Retail and salon comparable sales | 10.0 | % | 8.1 | % | 6.1 | % | ||||||
| E-commerce comparable sales | 47.5 | % | 56.4 | % | 76.6 | % | ||||||
| Total comparable sales increase | 11.8 | % | 9.9 | % | 7.9 | % |
| Fiscal year ended | ||||||||||||
| (Percentage of net sales) | January 30, 2016 | January 31, 2015 | February 1, 2014 | |||||||||
| Net sales | 100.0 | % | 100.0 | % | 100.0 | % | ||||||
| Cost of sales | 64.7 | % | 64.9 | % | 64.8 | % | ||||||
| Gross profit | 35.3 | % | 35.1 | % | 35.2 | % | ||||||
| Selling, general and administrative expenses | 22.0 | % | 22.0 | % | 22.3 | % | ||||||
| Pre-opening expenses | 0.4 | % | 0.4 | % | 0.6 | % | ||||||
| Operating income | 12.9 | % | 12.7 | % | 12.3 | % | ||||||
| Interest income, net | 0.0 | % | 0.0 | % | 0.0 | % | ||||||
| Income before income taxes | 12.9 | % | 12.7 | % | 12.3 | % | ||||||
| Income tax expense | 4.8 | % | 4.8 | % | 4.7 | % | ||||||
| Net income | 8.2 | % | 7.9 | % | 7.6 | % | ||||||
Fiscal year 2015 versus fiscal year 2014
Net sales
Net sales increased $682.7 million, or 21.1%, to $3,924.1 million in fiscal 2015 compared to $3,241.4 million in fiscal 2014. Salon service sales increased $33.7 million, or 19.2% to $209.2 million compared to $175.5 million in fiscal 2014. E-commerce sales increased $71.2 million, or 47.5%, to $221.1 million compared to $149.9 million in fiscal 2014. The net sales increases are due to the opening of 100 net new stores in 2015 and a 11.8% increase in comparable sales. Non-comparable stores, which include stores opened in fiscal 2015 as well as stores opened in fiscal 2014, which have not yet turned comparable, contributed $306.5 million of the net sales increase, while comparable stores contributed $376.2 million of the total net sales increase.
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The 11.8% comparable sales increase consisted of a 10.0% increase at the Company’s retail and salon stores and a 47.5% increase in the Company’s e-commerce business. The inclusion of the e-commerce business resulted in an increase of approximately 180 basis points to the Company’s consolidated same store sales calculation for fiscal 2015 and 2014. The total comparable sales increase included a 3.4% increase in average ticket and an 8.4% increase in transactions. We attribute the increase in comparable sales to our successful marketing and merchandising strategies.
Gross profit
Gross profit increased $247.5 million, or 21.8%, to $1,384.3 million in fiscal 2015, compared to $1,136.8 million, in fiscal 2014. Gross profit as a percentage of net sales increased 20 basis points to 35.3% in fiscal 2015 compared to 35.1% in fiscal 2014. The increase in gross profit margin was primarily due:
| • | 20 basis points improvement in merchandise margins driven by our marketing and merchandising strategies, including improvement in e-commerce profit contribution; |
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| • | 30 basis points of leverage in fixed store costs attributed to the impact of higher sales volume, offset by; |
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| • | 30 basis points of supply chain deleverage related to the addition of our new Greenwood, Indiana distribution center. |
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Selling, general and administrative expenses
Selling, general and administrative (SG&A) expenses increased $151.3 million, or 21.3%, to $863.4 million in fiscal 2015 compared to $712.0 million in fiscal 2014. As a percentage of net sales, SG&A expense was 22.0% in fiscal 2015 and fiscal 2014. Compared to fiscal 2014’s SG&A expense, fiscal 2015 had 10 basis points of leverage in marketing expense attributed to strong sales growth, offset by 10 basis points of deleverage in corporate overhead expense primarily driven by higher consulting expense.
Pre-opening expenses
Pre-opening expenses increased $0.3 million, or 2.2%, to $14.7 million in fiscal 2015 compared to $14.4 million in fiscal 2014. During fiscal 2015, we opened 103 new stores, remodeled four stores and relocated five stores. During fiscal 2014, we opened 100 new stores and remodeled nine stores and relocated two stores.
Interest income, net
Interest income, net was $1.1 million in fiscal 2015, compared to $0.9 million in fiscal 2014. Interest income results from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense represents various fees related to the credit facility. We did not utilize our credit facility during fiscal 2015 or 2014.
Income tax expense
Income tax expense of $187.4 million in fiscal 2015 represents an effective tax rate of 36.9%, compared to fiscal 2014 tax expense of $154.2 million and an effective tax rate of 37.5%. The lower tax rate in fiscal 2015 is primarily due to a decrease in state taxes and increase in federal income tax credits compared to fiscal 2014.
Net income
Net income increased $62.9 million, or 24.5%, to $320.0 million in fiscal 2015 compared to $257.1 million in fiscal 2014. The increase in net income was primarily due to an increase in gross profit of $247.5 million, which was offset by a $151.3 million increase in SG&A expenses and a $33.3 million increase in income tax expense.
Fiscal year 2014 versus fiscal year 2013
Net sales
Net sales increased $570.8 million, or 21.4%, to $3,241.4 million in fiscal 2014 compared to $2,670.6 million in fiscal 2013. Salon service sales increased $29.7 million, or 20.4% to $175.5 million compared to $145.8 million
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in fiscal 2013. E-commerce sales increased $54.1 million, or 56.4%, to $149.9 million compared to $95.8 million in fiscal 2013. The net sales increases are due to the opening of 99 net new stores in 2014 and a 9.9% increase in comparable sales. Non-comparable stores, which include stores opened in fiscal 2014 as well as stores opened in fiscal 2013 which have not yet turned comparable, contributed $312.3 million of the net sales increase while comparable stores contributed $258.5 million of the total net sales increase.
The 9.9% comparable sales increase consisted of an 8.1% increase at the Company’s retail and salon stores and a 56.4% increase in the Company’s e-commerce business. The salon business contributed 10 basis points to the retail and salon comp of 8.1%. The inclusion of the e-commerce business resulted in an increase of approximately 180 basis points to the Company’s consolidated same store sales calculation for fiscal 2014 and 2013. The total comparable sales increase included a 4.3% increase in average ticket and a 5.6% increase in transactions. We attribute the increase in comparable sales to our successful marketing and merchandising strategies.
Gross profit
Gross profit increased $195.6 million, or 20.8%, to $1,136.8 million in fiscal 2014, compared to $941.2 million, in fiscal 2013. Gross profit as a percentage of net sales decreased 10 basis points to 35.1% in fiscal 2014 compared to 35.2% in fiscal 2013. The decrease in gross profit margin in fiscal 2014 was primarily due to 10 basis points of deleverage in merchandise margins driven primarily by product and channel mix shifts and converting the remaining 50% of our loyalty program members to the Ultamate Rewards loyalty program.
Selling, general and administrative expenses
SG&A expenses increased $115.6 million, or 19.4%, to $712.0 million in fiscal 2014 compared to $596.4 million in fiscal 2013. As a percentage of net sales, SG&A expenses decreased 30 basis points to 22.0% in fiscal 2014 compared to 22.3% in fiscal 2013. The leverage in SG&A expenses is primarily attributed to:
| • | 60 basis points in variable store and marketing expense leverage attributed to cost efficiencies and higher sales volume; offset by |
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| • | 30 basis points deleverage in corporate overhead expense primarily driven by higher variable compensation, consulting and depreciation expense. |
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Pre-opening expenses
Pre-opening expenses decreased $2.9 million, or 16.8%, to $14.4 million in fiscal 2014 compared to $17.3 million in fiscal 2013. During fiscal 2014, we opened 100 new stores, remodeled nine stores and relocated two stores. During fiscal 2013, we opened 127 new stores, remodeled seven stores and relocated four stores.
Interest income, net
Interest income, net was $0.9 million in fiscal 2014, compared to $0.1 million in fiscal 2013. Interest income results from short-term investments with maturities of twelve months or less from the date of purchase. Interest expense represents various fees related to the credit facility. We did not utilize our credit facility during fiscal 2014 or 2013.
Income tax expense
Income tax expense of $154.2 million in fiscal 2014 represents an effective tax rate of 37.5%, compared to fiscal 2013 tax expense of $124.9 million and an effective tax rate of 38.1%. The lower tax rate in fiscal 2014 is primarily due to a decrease in state taxes compared to fiscal 2013.
Net income
Net income increased $54.3 million, or 26.8%, to $257.1 million in fiscal 2014 compared to $202.8 million in fiscal 2013. The increase in net income was primarily due to an increase in gross profit of $195.6 million, which was offset by a $115.6 million increase in SG&A expenses and a $29.3 million increase in income tax expense.
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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 new brand additions, supply chain improvements, share repurchases and for continued improvement in our information technology systems.
Our primary sources of liquidity are cash on hand, short-term investments and 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 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, short-term investments, 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 2015, 2014 and 2013:
| Fiscal year ended | ||||||||||||
| (In thousands) | January 30, 2016 | January 31, 2015 | February 1, 2014 | |||||||||
| Net cash provided by operating activities | $ | 375,874 | $ | 396,592 | $ | 327,725 | ||||||
| Net cash used in investing activities | (278,958 | ) | (399,276 | ) | (226,024 | ) | ||||||
| Net cash used in financing activities | (140,225 | ) | (27,643 | ) | (2,700 | ) | ||||||
| Net (decrease) increase in cash and cash equivalents | $ | (43,309 | ) | $ | (30,327 | ) | $ | 99,001 | ||||
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 $761.8 million at January 30, 2016, compared to $581.2 million at January 31, 2015, representing an increase of $180.6 million or 31.1%. Average inventory per store increased 16.1% compared to prior year. The increase in inventory is primarily due to the following:
| • | approximately $75 million due to the addition of 100 net new stores opened since January 31, 2015; |
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| • | approximately $62 million due to increased sales, new brand additions and incremental inventory for in-store prestige brand boutiques; and |
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| • | approximately $43 million due to the opening of the Company’s fourth distribution center in Greenwood, Indiana. |
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We had a current tax liability of $12.7 million at the end of fiscal 2015 compared to $19.4 million at the end of fiscal 2014. The decrease in taxes payable is primarily due to an increase in tax deductible stock option exercises and a decrease in state taxes.
Deferred rent liabilities were $321.8 million at January 30, 2016, an increase of $27.7 million compared to $294.1 million at January 31, 2015. 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 100 net new stores opened since January 31, 2015.
Investing activities
We have historically used cash primarily for new and remodeled stores, supply chain investments, short-term investments and investments in information technology systems. Investment activities for capital expenditures
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were $299.2 million in fiscal 2015, compared to $249.1 million and $226.0 million in fiscal 2014 and 2013, respectively. Capital expenditures increased in fiscal 2015 compared to fiscal 2014 due to investments in information technology systems, merchandise fixtures and supply chain initiatives during 2015. During fiscal 2015, we opened 103 new stores, remodeled four stores and relocated five stores, compared to 100 new stores, nine remodels and two relocations during fiscal 2014 and 127 new stores, seven remodels and four relocations during fiscal 2013. During fiscal 2015, the average investment required to open a new Ulta store was approximately $1.2 million, which includes capital investment net of landlord contributions, pre-opening expenses and initial inventory net of payables. The average investment required to remodel an Ulta Beauty store was also approximately $1.2 million. Purchases of short-term investments were $130 million during fiscal 2015 and consist of certificates of deposit with maturities of twelve months or less from the date of purchase.
Capital expenditures for fiscal 2015, 2014 and 2013 and planned fiscal 2016 by major category are as follows:
| (in millions) | 2016 Budget | Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | ||||||||||||
| New, Remodeled, Relocated Stores | $ | 159 | $ | 122 | $ | 125 | $ | 140 | ||||||||
| Merchandising | 91 | 42 | 19 | 18 | ||||||||||||
| Information Systems | 58 | 63 | 45 | 41 | ||||||||||||
| Supply Chain | 46 | 49 | 46 | 10 | ||||||||||||
| Store Maintenance & Other | 37 | 23 | 14 | 17 | ||||||||||||
| $ | 391 | $ | 299 | $ | 249 | $ | 226 | |||||||||
Our future investments will depend primarily on the number of new, relocated and remodeled stores, supply chain investments and information technology systems that we undertake and the timing of these expenditures. Based on past performance and current expectations, we expect to self-fund future capital expenditures. We expect to spend approximately $391 million for capital expenditures in fiscal 2016. In 2016, new, remodeled and relocated stores and merchandising capital expenditure increases reflect the expansion of prestige boutiques and related in-store merchandising upgrades. In 2014, we embarked on a multi-year supply chain project which included adding capacity, with a fourth distribution center launched in August 2015 in Greenwood, Indiana, a fifth distribution center expected to open in 2016 in Dallas, Texas and system improvements to support expanded omni-channel capabilities.
Financing activities
Financing activities in fiscal 2015, 2014 and 2013 consist principally of capital stock transactions and the related income tax effects and our stock repurchase program. Purchase of treasury shares in fiscal 2015, 2014 and 2013 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 2015, 2014 and 2013. 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.
Share repurchase plan
On March 18, 2013, we announced that our Board of Directors had authorized a share repurchase program (the 2013 Share Repurchase Program) pursuant to which the Company could repurchase up to $150 million of the Company’s common stock. Repurchases pursuant to the 2013 Share Repurchase Program were made from time to time in the open market, in privately negotiated transactions or otherwise, at prices the Company deemed appropriate and subject to market conditions, applicable law and other factors deemed relevant in the Company’s sole discretion. The 2013 Share Repurchase Program did not have an expiration date, but provided for suspension or discontinuation at any time.
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On September 11, 2014, we announced that our Board of Directors authorized the 2014 Share Repurchase Program pursuant to which the Company could repurchase up to $300 million of the Company’s common stock. The 2014 Share Repurchase Program authorization revoked the previously authorized but unused amount of $112.7 million from the 2013 Share Repurchase Program. The 2014 Share Repurchase Program did not have an expiration date and could be suspended or discontinued at any time. On March 12, 2015, we announced that our Board of Directors authorized an increase of $100 million to the 2014 Share Repurchase Program effective March 17, 2015.
During fiscal year 2013, we purchased 500,500 shares of common stock for $37.3 million at an average price of $74.58 from the 2013 Share Repurchase Program. During fiscal 2014, we purchased 321,113 shares of common stock for $39.9 million at an average price of $124.31 from the 2014 Share Repurchase Program. During fiscal 2015, we purchased 1,034,418 shares of common stock for $167.4 million at an average price of $161.81 from the 2014 Share Repurchase Program.
On March 10, 2016, we announced that the Board of Directors authorized the 2016 Share Repurchase Program pursuant to which the Company may repurchase up to $425 million of the Company’s common stock. The 2016 Share Repurchase Program authorization revokes the previously authorized but unused amounts from the 2014 Share Repurchase Program. The 2016 Share Repurchase Program does not have an expiration date and may be suspended or discontinued at any time. As part of the 2016 Share Repurchase Program, we entered into an Accelerated Share Repurchase (ASR) agreement with Goldman, Sachs & Co. to repurchase $200 million of the Company’s common stock. Under the ASR agreement, we paid $200 million to Goldman, Sachs & Co. and received an initial delivery of 851,653 shares in the first quarter of 2016, which represents 80% of the total shares we expect to receive based on the market price at the time of the initial delivery. The final number of shares delivered upon settlement of the agreement will be determined with reference to the average price of the Company’s common stock over the term of the ASR agreement.
Credit facility
On October 19, 2011, we 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 Company and the lenders. The Loan Agreement extended the maturity of the Company’s credit facility to October 2016, provides maximum revolving loans equal to the lesser of $200 million or a percentage of eligible owned inventory, contains a $10 million subfacility for letters of credit and allows the Company to increase the revolving facility by an additional $50 million , 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.
On September 5, 2012, we entered into Amendment No. 1 to the Loan Agreement (the First Amendment) with the lender group. The First Amendment updated certain administrative terms and conditions and provides us greater flexibility to take certain corporate actions. There were no changes to the revolving loan amounts available, interest rates, covenants or maturity date under terms of the Loan Agreement.
On December 6, 2013, we entered into Amendment No. 2 to the Loan Agreement (the Second Amendment) with the lender group. The Second Amendment further extended the maturity of the facility to December 2018. 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 0.20%.
As of January 30, 2016 and January 31, 2015, we had no borrowings outstanding under the credit facility and the Company was in compliance with all terms and covenants of the agreement.
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
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affected by Mothers’ Day as well as the “Back to School” season and Valentine’s 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 potential future debt.
Off-balance sheet arrangements
As of January 30, 2016, we have not entered into any “off-balance sheet” arrangements, as that term is described by the SEC. We do, however, have off-balance sheet operating leases and purchases obligations incurred in the ordinary course of business as indicated within the contractual obligations table below.
Contractual obligations
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 30, 2016:
| (In thousands) | Total | Less Than 1 Year | 1 to 3 Years | 3 to 5 Years | After 5 Years | |||||||||||||||
| Operating lease obligations(1) | $ | 1,759,133 | $ | 238,837 | $ | 465,841 | $ | 406,819 | $ | 647,636 | ||||||||||
| Purchase obligations | 26,913 | 26,913 | — | — | — |
| (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 2015 were $52 million. |
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We lease retail stores, warehouses, corporate offices and certain equipment under operating leases with various expiration dates through fiscal 2028. 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.
Purchase obligations reflect legally binding agreements entered into by the Company to purchase goods or services. Excluded from our purchase obligations are normal purchases and contracts entered into in the ordinary course of business. The amount of purchase obligations relates to commitments made to a third party for products and services for a future distribution center for which a lease has been signed, advertising and other goods and service contracts entered into as of January 30, 2016.
As of January 30, 2016, the unrecognized tax benefit was $2.3 million, which is not included in the above table due to uncertainty regarding the realization and timing of the related future cash flows, if any.
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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 principles (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.
We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our lower of cost or market or shrink reserves. 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 2015, 2014 and 2013. An increase or decrease in the lower of cost or market reserve of 10% would have had no material impact on our pre-tax income for fiscal 2015. An increase or decrease in the shrink rate included in the shrink reserve calculation of 10% would have had no material impact on our pre-tax income for fiscal 2015.
Vendor allowances
The majority of cash consideration received from a supplier is considered to be a reduction of the cost of the related products and is reflected in cost of sales in our consolidated statements of income as the related products are sold unless it is in exchange for an asset or service or a reimbursement of a specific, incremental, identifiable cost incurred by the Company in selling the vendors’ products. We estimate the amount recorded as a reduction of inventory at the end of each period, based on a detailed analysis of inventory turns and management’s analysis of the facts and circumstances of the various contractual agreements with vendors. We record cash consideration expected to be received from vendors in net receivables at the amount we expect to collect. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our reduction of inventory. An increase or decrease in inventory turns of 5 basis points would have affected pre-tax income by approximately $3.3 million in fiscal 2015.
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 store level, which is the lowest level for which cash flows can be identified. 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 do not believe that there is a reasonable likelihood that there will be a material change in the future
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estimates or assumptions we use to calculate our impairment charges. We have not recorded any significant impairment charges in any of the periods presented in the accompanying consolidated financial statements.
Customer loyalty program
We maintain a customer loyalty program, Ultamate Rewards, in which program members earn points based on purchases. Points earned by members are valid for at least one year and may be redeemed on any product we sell. We accrue the cost of anticipated redemptions related to this program at the time of the initial purchase based on historical experience. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our redemption rates. Adjustments to earnings resulting from revisions to management’s estimates of the redemption rates have been insignificant during fiscal 2015, 2014 and 2013. If our redemption rate were to increase or decrease by 5%, it would have affected pre-tax income by approximately $4.1 million in fiscal 2015.
Share-based compensation
We account for share-based compensation in accordance with the Accounting Standards Codification (ASC) rules for stock compensation. Share-based compensation cost is measured at the 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 the historical volatility of the Company’s common stock. 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. The expected life of options granted is derived from historical data on Ulta Beauty stock option exercises. The historical exercise data is updated on an annual basis and the changes have not had a material impact on the calculation in any years presented.
Forfeitures of options are estimated at the grant date based on historical rates of the Company’s stock option activity and reduce the compensation expense recognized. The forfeiture rate is updated on an annual basis and the changes have not had a material impact on compensation expense recognized in any years presented. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our grant date fair value of stock options or forfeiture rate.
See Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Share-based compensation,” for disclosure related to the Company’s stock compensation expense. See Note 10 to our consolidated financial statements, “Share-based awards,” for disclosure related to our stock compensation expense and related valuation model assumptions.
Recent accounting pronouncements not yet adopted
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, issued as a new Topic, Accounting Standards Codification Topic 606. The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that we will recognize revenue when we transfer promised goods or services to customers in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. In August 2015, the FASB issued ASU 2015-14 Revenue from Contracts with Customers (Topic 606), which delayed the effective date of ASU 2014-09 by one year. With the deferral, the revenue recognition standard is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods with early adoption permitted for annual reporting periods beginning after December 15, 2016, including interim reporting periods. This standard allows for either full retrospective or modified retrospective adoption. We are currently evaluating the application method and the impact of this new standard on our consolidated financial position, results of operations and cash flows.
In June 2014, the FASB issued ASU No. 2014-12, Compensation – Stock Compensation, Accounting Standards Codification Topic 718. This update clarifies the accounting for share-based awards with performance targets.
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The standard will take effect for public companies for annual reporting periods beginning after December 15, 2015, including interim reporting periods. We will not be affected by this guidance as we currently account for these awards in a manner consistent with the new guidance.
In April 2015, the FASB issued ASU No. 2015-05, Customers’ Accounting for Fees Paid in a Cloud Computing Arrangement. This standard provides guidance to determine whether a cloud-based computing arrangement includes a software license. If a cloud-based computing arrangement includes a software license, the customer must account for the software element of the arrangement consistent with the acquisition of other software licenses. Otherwise, the customer must account for the arrangement as a service contract. The standard will take effect for public companies for annual reporting periods beginning after December 15, 2015, including interim reporting periods. Early adoption is permitted. We do not believe that the adoption of this ASU will have a material impact on our consolidated financial position, results of operations and cash flows.
In February 2016, the FASB issued ASU No. 2016-02, Leases, Accounting Standards Codification Topic 842. This standard will change the way all leases of one year or more are treated. Under this guidance, lessees will be required to capitalize virtually all leases on the balance sheet as a right-of-use asset and an associated financing lease liability or capital lease liability. The right-of-use asset represents the lessee’s right to use, or control the use of, a specified asset for the specified lease term. The lease liability represents the lessee’s obligation to make lease payments arising from the lease, measured on a discounted basis. Based on certain characteristics, leases are classified as financing leases or operating leases. Financing lease liabilities, those that contain provisions similar to capitalized leases, are amortized like capital leases under current accounting, as amortization expense and interest expense in the statement of operations. Operating lease liabilities are amortized on a straight-line basis over the life of the lease as lease expense in the statement of operations. The standard will take effect for public companies for annual reporting periods beginning after December 15, 2018, including interim reporting periods. We are currently evaluating the impact of this new standard on our consolidated financial position, results of operations and cash flows.
Recently adopted accounting pronouncements
In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes. The new standard requires that all deferred tax assets and liabilities, and any related valuation allowance, be reported as non-current in a classified balance sheet instead of separating deferred taxes and related valuation allowances into current and non-current amounts. The standard will take effect for public companies for annual reporting periods beginning after December 15, 2016, including interim reporting periods. Early adoption is permitted. As permitted, the Company adopted this standard, prospectively, in the fourth quarter of its fiscal year ended January 30, 2016. As a result of the adoption at January 30, 2016 current deferred income tax assets were classified as non-current liabilities on the Company’s consolidated balance sheets. The adoption of this standard did not have any other impact on our consolidated financial position, results of operations and cash flows.
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