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
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The following discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the 52 weeks ended January 31, 2016 (“fiscal 2015”), the 52 weeks ended February 1, 2015 (“fiscal 2014”), and the 52 weeks ended February 2, 2014 (“fiscal 2013”) should be read in conjunction with our Consolidated Financial Statements and notes thereto. All explanations of changes in operational results are discussed in order of magnitude.
OVERVIEW
In fiscal 2015, our net revenues increased 5.9% to $4,976,090,000 compared to $4,698,719,000 in fiscal 2014, with comparable brand revenue growth of 3.7%. This increase in net revenues was driven by a 6.4% increase in our e-commerce net revenues and a 5.4% increase in our retail net revenues, and included 26.8% growth in our international revenues. E-commerce net revenues generated 51% of our total company net revenues in fiscal 2015 compared to 50% of our net revenues in fiscal 2014.
In Pottery Barn, our largest brand, comparable brand revenues increased 1.9% in fiscal 2015 compared to fiscal 2014. This growth was primarily driven by our furniture, upholstery and textile collections, partially offset by softer sales trends in our gifting categories. In the Williams-Sonoma brand, comparable brand revenues increased 1.1% in fiscal 2015 compared to fiscal 2014. Growth in cookware, cutlery, tabletop and our Williams-Sonoma Home business drove these results. In West Elm, comparable brand revenues increased 14.8% in fiscal 2015 on top of 18.2% in fiscal 2014. Growth continued to be broad-based across categories. In Pottery Barn Kids, comparable brand revenues increased 2.2% in fiscal 2015 compared to fiscal 2014, primarily driven by our furniture, back-to-school and bedding categories. In PBteen, comparable brand revenues decreased 2.7% in fiscal 2015 compared to fiscal 2014. Strength in furniture, decorative accessories, and back-to-school categories were more than offset by weakness in our textiles and gifting collections. And in our emerging brands, Rejuvenation and Mark and Graham, net revenues increased 37.5%.
Additionally, in fiscal 2015, diluted earnings per share increased to $3.37, versus $3.24 in fiscal 2014 (which included a $0.04 benefit from our share of the VISA/MasterCard antitrust litigation settlement), and we returned $352,631,000 to our stockholders through stock repurchases and dividends.
As we look forward, in all of our brands we have targeted strategies and opportunities that we believe will allow us to profitably grow the business. We plan to improve our competitive positioning across product, service and value for our customers, and plan to expand our brands into new products and market segments through the expansion of proprietary products. We also plan to develop cross-brand initiatives to more fully engage with our customers and to leverage innovative marketing channels. We plan to invest in our high growth, newer brands, particularly West Elm, and expand our global reach through existing and new franchise relationships. In addition, we have identified four key strategies within our business to help us drive improvements across the company: re-asserting our product leadership, revolutionizing our approach to inventory, transforming our marketing, and changing our approach to real estate and the retail experience. We believe that collectively these strategies will extend our leadership position across our brands and in our supply chain.
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Results of Operations
NET REVENUES
Net revenues consist of e-commerce net revenues and retail net revenues. E-commerce net revenues include sales of merchandise to customers through our e-commerce websites and our catalogs, as well as shipping fees. Retail net revenues include sales of merchandise to customers at our retail stores and to our franchisees, as well as shipping fees on any products shipped to our customers’ homes. Shipping fees consist of revenue received from customers for delivery of merchandise to their homes. Revenues are presented net of sales returns and other discounts.
| In thousands | Fiscal 2015 | % Total | Fiscal 2014 | % Total | Fiscal 2013 | % Total | ||||||||||||||||||
| E-commerce net revenues | $ | 2,522,580 | 50.7% | $ | 2,370,694 | 50.5% | $ | 2,115,022 | 48.2% | |||||||||||||||
| Retail net revenues | 2,453,510 | 49.3% | 2,328,025 | 49.5% | 2,272,867 | 51.8% | ||||||||||||||||||
| Net revenues | $ | 4,976,090 | 100.0% | $ | 4,698,719 | 100.0% | $ | 4,387,889 | 100.0% |
Net revenues in fiscal 2015 increased by $277,371,000, or 5.9%, compared to fiscal 2014, with comparable brand revenue growth of 3.7%. This increase in net revenues was driven by a 6.4% increase in our e-commerce net revenues and a 5.4% increase in our retail net revenues. By brand, this increase was primarily driven by West Elm and Pottery Barn, with particular strength in furniture. Total fiscal 2015 net revenue growth also included an increase in our international revenues of 26.8%, primarily related to our franchise operations, and a 3.3% increase in retail leased square footage primarily due to 17 net new stores.
Net revenues in fiscal 2014 increased by $310,830,000, or 7.1%, compared to fiscal 2013, with comparable brand revenue growth of 7.1%. This increase was driven by a 12.1% increase in our e-commerce net revenues and a 2.4% increase in our retail net revenues. By brand, this increase was primarily driven by the West Elm and Pottery Barn brands. Total fiscal 2014 net revenue growth also included an increase in our international revenues of 9.4%, and a 2.2% increase in retail leased square footage primarily due to 16 net new stores.
The following table summarizes our net revenues by brand for fiscal 2015, fiscal 2014 and fiscal 2013.
| In thousands | Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | |||||||||
| Pottery Barn | $ | 2,074,051 | $ | 2,022,331 | $ | 1,910,978 | ||||||
| Williams-Sonoma | 993,609 | 994,651 | 978,002 | |||||||||
| West Elm | 821,136 | 669,074 | 531,305 | |||||||||
| Pottery Barn Kids | 640,073 | 624,594 | 597,628 | |||||||||
| PBteen | 253,602 | 260,617 | 246,449 | |||||||||
| Other_1_ | 193,619 | 127,452 | 123,527 | |||||||||
| Total | $ | 4,976,090 | $ | 4,698,719 | $ | 4,387,889 |
| 1 | Primarily consists of net revenues from our international franchise operations, Rejuvenation, and Mark and Graham. |
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Comparable Brand Revenue
Comparable brand revenue includes retail comparable store sales and e-commerce sales, as well as shipping fees, sales returns and other discounts associated with current period sales. Outlet comparable store net revenues are included in their respective brands. Comparable brand revenue excludes sales from certain operations until such time that we believe those sales are meaningful to evaluating the performance of the brand. Sales related to our international franchise operations have also been excluded as they are not operated by us.
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Comparable stores are defined as permanent stores where gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days.
| Comparable brand revenue growth (decline) | Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | |||||||||
| Pottery Barn | 1.9% | 5.8% | 10.4% | |||||||||
| Williams-Sonoma | 1.1% | 3.8% | 1.5% | |||||||||
| West Elm | 14.8% | 18.2% | 17.4% | |||||||||
| Pottery Barn Kids | 2.2% | 5.9% | 7.8% | |||||||||
| PBteen | (2.7% | ) | 5.7% | 14.1% | ||||||||
| Total | 3.7% | 7.1% | 8.8% |
E-COMMERCE NET REVENUES
| In thousands | Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | |||||||||
| E-commerce net revenues | $ | 2,522,580 | $ | 2,370,694 | $ | 2,115,022 | ||||||
| E-commerce net revenue growth | 6.4% | 12.1% | 13.1% |
E-commerce net revenues in fiscal 2015 increased by $151,886,000, or 6.4%, compared to fiscal 2014, led by West Elm, Williams-Sonoma and Pottery Barn Kids.
E-commerce net revenues in fiscal 2014 increased by $255,672,000, or 12.1%, compared to fiscal 2013, with increases across all brands, led by West Elm, Pottery Barn and Williams-Sonoma.
RETAIL NET REVENUES AND OTHER DATA
| In thousands | Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | |||||||||
| Retail net revenues | $ | 2,453,510 | $ | 2,328,025 | $ | 2,272,867 | ||||||
| Retail net revenue growth | 5.4% | 2.4% | 4.6% | |||||||||
| Store count – beginning of year | 601 | 585 | 581 | |||||||||
| Store openings | 34 | 35 | 30 | |||||||||
| Store closings | (17 | ) | (19 | ) | (26 | ) | ||||||
| Store count – end of year | 618 | 601 | 585 | |||||||||
| Store selling square footage at year-end | 3,827,000 | 3,684,000 | 3,590,000 | |||||||||
| Store leased square footage (“LSF”) at year-end | 6,163,000 | 5,965,000 | 5,838,000 |
| Fiscal 2015 | Fiscal 2014 | Fiscal 2013 | ||||||||||||||||||||||
| Store Count | Avg. LSF Per Store | Store Count | Avg. LSF Per Store | Store Count | Avg. LSF Per Store | |||||||||||||||||||
| Williams-Sonoma | 239 | 6,600 | 243 | 6,600 | 248 | 6,600 | ||||||||||||||||||
| Pottery Barn | 197 | 13,800 | 199 | 13,700 | 194 | 13,800 | ||||||||||||||||||
| Pottery Barn Kids | 89 | 7,500 | 85 | 7,600 | 81 | 7,900 | ||||||||||||||||||
| West Elm | 87 | 13,200 | 69 | 13,700 | 58 | 14,100 | ||||||||||||||||||
| Rejuvenation | 6 | 9,000 | 5 | 10,000 | 4 | 13,200 | ||||||||||||||||||
| Total | 618 | 10,000 | 601 | 9,900 | 585 | 10,000 |
Retail net revenues in fiscal 2015 increased by $125,485,000, or 5.4%, compared to fiscal 2014, primarily driven by West Elm. Retail net revenue growth for fiscal 2015 also included growth in our international revenues primarily related to our franchise operations, and a 3.3% increase in retail leased square footage primarily due to 17 net new stores.
Retail net revenues in fiscal 2014 increased by $55,158,000, or 2.4%, compared to fiscal 2013, led by West Elm and Pottery Barn, partially offset by a decrease in Williams-Sonoma due to store closures at the end of fiscal 2013.
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COST OF GOODS SOLD
| In thousands | Fiscal 2015 | % Net Revenues | Fiscal 2014 | % Net Revenues | Fiscal 2013 | % Net Revenues | ||||||||||||||||||
| Cost of goods sold_1_ | $ | 3,131,876 | 62.9% | $ | 2,898,215 | 61.7% | $ | 2,683,673 | 61.2% |
| 1 | Includes occupancy expenses of $631,817,000, $603,357,000 and $561,586,000 in fiscal 2015, fiscal 2014 and fiscal 2013, respectively. |
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Cost of goods sold includes cost of goods, occupancy expenses and shipping costs. Cost of goods consists of cost of merchandise, inbound freight expenses, freight-to-store expenses and other inventory related costs such as shrinkage, damages and replacements. Occupancy expenses consist of rent, depreciation and other occupancy costs, including common area maintenance, property taxes and utilities. Shipping costs consist of third party delivery services and shipping materials.
Our classification of expenses in cost of goods sold may not be comparable to other public companies, as we do not include non-occupancy related costs associated with our distribution network in cost of goods sold. These costs, which include distribution network employment, third party warehouse management and other distribution related administrative expenses, are recorded in selling, general and administrative expenses.
Within our reportable segments, the e-commerce channel does not incur freight-to-store or store occupancy expenses, and typically operates with lower markdowns and inventory shrinkage than the retail channel. However, the e-commerce channel incurs higher customer shipping, damage and replacement costs than the retail channel.
Fiscal 2015 vs. Fiscal 2014
Cost of goods sold increased by $233,661,000, or 8.1%, in fiscal 2015 compared to fiscal 2014. Cost of goods sold as a percentage of net revenues increased to 62.9% in fiscal 2015 from 61.7% in fiscal 2014. This increase was driven by increased shipping and fulfillment-related costs and higher franchise revenues, which have a lower gross margin.
In the e-commerce channel, cost of goods sold as a percentage of net revenues increased in fiscal 2015 compared to fiscal 2014 primarily driven by increased shipping and fulfillment-related costs, and an increase in occupancy expenses.
In the retail channel, cost of goods sold as a percentage of net revenues increased for fiscal 2015 compared to fiscal 2014 driven by higher franchise revenues and increased fulfillment-related costs, partially offset by the leverage of occupancy expenses.
Fiscal 2014 vs. Fiscal 2013
Cost of goods sold increased by $214,542,000, or 8.0%, in fiscal 2014 compared to fiscal 2013. Cost of goods sold as a percentage of net revenues increased to 61.7% in fiscal 2014 from 61.2% in fiscal 2013. This increase was primarily driven by lower selling margins.
In the e-commerce channel, cost of goods sold as a percentage of net revenues increased in fiscal 2014 compared to fiscal 2013 primarily driven by lower selling margins and an increase in occupancy expenses.
In the retail channel, cost of goods sold as a percentage of net revenues remained relatively flat in fiscal 2014 compared to fiscal 2013 due to an increase in occupancy expenses offset by higher selling margins.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
| In thousands | Fiscal 2015 | % Net Revenues | Fiscal 2014 | % Net Revenues | Fiscal 2013 | % Net Revenues | ||||||||||||||||||
| Selling, general and administrative expenses | $ | 1,355,580 | 27.2% | $ | 1,298,239 | 27.6% | $ | 1,252,118 | 28.5% |
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Selling, general and administrative expenses consist of non-occupancy related costs associated with our retail stores, distribution warehouses, customer care centers, supply chain operations (buying, receiving and inspection) and corporate administrative functions. These costs include employment, advertising, third party credit card processing and other general expenses.
We experience differing employment and advertising costs as a percentage of net revenues within the retail and e-commerce channels due to their distinct distribution and marketing strategies. Employment costs represent a greater percentage of net revenues within the retail channel as compared to the e-commerce channel. However, advertising expenses are higher within the e-commerce channel than in the retail channel.
Fiscal 2015 vs. Fiscal 2014
Selling, general and administrative expenses for fiscal 2015 increased by $57,341,000, or 4.4%, compared to fiscal 2014. Selling, general and administrative expenses as a percentage of net revenues decreased to 27.2% in fiscal 2015 from 27.6% in fiscal 2014. This decrease as a percentage of net revenues was primarily driven by the leverage of advertising expenses and employment costs, partially offset by litigation settlement income of $7,414,000 recorded in fiscal 2014 that did not recur in fiscal 2015.
In the e-commerce channel, selling, general and administrative expenses as a percentage of net revenues was relatively flat for fiscal 2015 compared to fiscal 2014 primarily due to advertising leverage, offset by an increase in employment costs associated with incremental labor costs in our supply chain.
In the retail channel, selling, general and administrative expenses as a percentage of net revenues decreased for fiscal 2015 compared to fiscal 2014 primarily driven by the leverage of employment costs due to higher franchise revenues.
Fiscal 2014 vs. Fiscal 2013
Selling, general and administrative expenses for fiscal 2014 increased by $46,121,000, or 3.7%, compared to fiscal 2013. Selling, general and administrative expenses as a percentage of net revenues decreased to 27.6% in fiscal 2014 from 28.5% in fiscal 2013. This decrease as a percentage of net revenues was primarily driven by greater advertising efficiency, lower general expenses, including litigation settlement income recorded of $7,414,000, and the leverage of employment costs.
In the e-commerce channel, selling, general and administrative expenses as a percentage of net revenues decreased in fiscal 2014 compared to fiscal 2013 primarily driven by greater advertising efficiency.
In the retail channel, selling, general and administrative expenses as a percentage of net revenues increased in fiscal 2014 compared to fiscal 2013 primarily driven by employment cost deleverage, partially offset by lower general expenses.
INCOME TAXES
Our effective income tax rate was 36.5% for fiscal 2015, 38.5% for fiscal 2014, and 38.4% for fiscal 2013. The decrease in the effective income tax rate in fiscal 2015 reflects fluctuations in the level and mix of earnings, as well as the favorable resolution of certain income tax matters.
LIQUIDITY AND CAPITAL RESOURCES
As of January 31, 2016, we held $193,647,000 in cash and cash equivalents, the majority of which is held in demand deposit accounts and money market funds, and of which $62,332,000 was held by our foreign subsidiaries. As is consistent within our industry, our cash balances are seasonal in nature, with the fourth quarter historically representing a significantly higher level of cash than other periods.
Throughout the fiscal year, we utilize our cash balances to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2016, we plan to use our cash resources to fund our inventory and inventory related purchases, advertising and marketing initiatives, property and equipment purchases, stock repurchases
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and dividend payments. In addition to our cash balances on hand, we have a $500,000,000 unsecured revolving line of credit (“credit facility”) that may be used to borrow revolving loans or to request the issuance of letters of credit. We may, upon notice to the administrative agent, request existing or new lenders to increase the credit facility by up to $250,000,000, at such lenders’ option, to provide for a total of $750,000,000 of unsecured revolving credit. During fiscal 2015, we had borrowings of $200,000,000 under the credit facility, all of which were repaid in the fourth quarter of fiscal 2015. During fiscal 2014, we had borrowings of $90,000,000 under the credit facility, all of which were repaid in the fourth quarter of fiscal 2014.
During fiscal 2014, we redeemed restricted cash deposits of $14,289,000 previously held under collateralized trust agreements. These deposits, which secured potential liabilities associated with our workers’ compensation and other insurance programs, were replaced with standby letters of credit. As of January 31, 2016, a total of $13,367,000 in issued but undrawn standby letters of credit was outstanding under the credit facility. Additionally, we had three unsecured letter of credit reimbursement facilities, which were amended during the year, for a total of $70,000,000, of which an aggregate of $6,088,000 was outstanding as of January 31, 2016. These letter of credit facilities represent only a future commitment to fund inventory purchases to which we had not taken legal title. We are currently in compliance with all of our financial covenants under the credit facility and, based on our current projections, we expect to remain in compliance throughout fiscal 2016. We believe our cash on hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations over the next 12 months.
Cash Flows from Operating Activities
For fiscal 2015, net cash provided by operating activities was $544,026,000 compared to $461,697,000 in fiscal 2014. For fiscal 2015, net cash provided by operating activities was primarily attributable to net earnings adjusted for non-cash items and an increase in accounts payable, customer deposits and income taxes payable, partially offset by an increase in merchandise inventories. This represents an increase in net cash provided by operating activities compared to fiscal 2014 primarily due to an increase in accounts payable and income taxes payable due to the timing of payments, partially offset by an increase in merchandise inventories.
For fiscal 2014, net cash provided by operating activities was $461,697,000 compared to $453,769,000 in fiscal 2013. For fiscal 2014, net cash provided by operating activities was primarily attributable to net earnings adjusted for non-cash items and an increase in customer deposits, partially offset by an increase in merchandise inventories. This represents an increase in net cash provided compared to fiscal 2013 primarily due to a decrease in inventory purchases and an increase in net earnings adjusted for non-cash items, partially offset by the timing of payments associated with accounts payable and accrued liabilities.
Cash Flows from Investing Activities
For fiscal 2015, net cash used in investing activities was $202,166,000 compared to $188,600,000 for fiscal 2014, and was primarily attributable to purchases of property and equipment. Net cash used in investing activities compared to fiscal 2014 increased primarily due to restricted cash receipts received in fiscal 2014 that did not recur in fiscal 2015.
For fiscal 2014, net cash used in investing activities was $188,600,000 compared to $190,624,000 for fiscal 2013, and was primarily attributable to purchases of property and equipment. Net cash used compared to fiscal 2013 decreased primarily due to restricted cash receipts, partially offset by an increase in purchases of property and equipment.
Cash Flows from Financing Activities
For fiscal 2015, net cash used in financing activities was $369,383,000 compared to $379,020,000 in fiscal 2014. For fiscal 2015, net cash used in financing activities was primarily attributable to the repurchase of common stock of $224,995,000 and the payment of dividends of $127,636,000. Net cash used in financing activities compared to fiscal 2014 decreased primarily due to a decrease in tax withholding payments related to stock-based awards.
For fiscal 2014, net cash used in financing activities was $379,020,000 compared to $355,376,000 in fiscal 2013. For fiscal 2014, net cash used in financing activities was primarily attributable to the repurchase of common
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stock of $224,377,000 and the payment of dividends of $125,758,000. Net cash used compared to fiscal 2013 increased primarily due to an increase in tax withholding payments related to stock-based awards.
Dividends
See section titled Dividends within Part II, Item 5 of this Annual Report on Form 10-K for further information.
Stock Repurchase Programs
See section titled Stock Repurchase Programs within Part II, Item 5 of this Annual Report on Form 10-K for further information.
Contractual Obligations
The following table provides summary information concerning our future contractual obligations as of January 31, 2016:
| Payments Due by Period_1_ | ||||||||||||||||||||
| In thousands | Fiscal 2016 | Fiscal 2017 to Fiscal 2019 | Fiscal 2020 to Fiscal 2021 | Thereafter | Total | |||||||||||||||
| Operating leases_2_ | $ | 257,805 | $ | 657,472 | $ | 305,376 | $ | 513,255 | $ | 1,733,908 | ||||||||||
| Purchase obligations_3_ | 765,417 | 9,388 | 654 | 318 | 775,777 | |||||||||||||||
| Total | $ | 1,023,222 | $ | 666,860 | $ | 306,030 | $ | 513,573 | $ | 2,509,685 |
| 1 | This table excludes $15.9 million of liabilities for unrecognized tax benefits associated with uncertain tax positions as we are not able to reasonably estimate when and if cash payments for these liabilities will occur. This amount, however, has been recorded as a liability in our accompanying Consolidated Balance Sheet as of January 31, 2016. |
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| 2 | Projected payments include only those amounts that are fixed and determinable as of the reporting date. See Note E to our Consolidated Financial Statements for discussion of our operating leases. |
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| 3 | Represents estimated commitments at year-end to purchase inventory and other goods and services in the normal course of business to meet operational requirements. |
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Other Contractual Obligations
We have other liabilities reflected in our Consolidated Balance Sheet. The payment obligations associated with these liabilities are not reflected in the table above due to the absence of scheduled maturities. The timing of these payments cannot be determined, except for amounts estimated to be payable in fiscal 2016, which are included in our current liabilities as of January 31, 2016.
We are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to commercial matters, operating leases, trademarks, intellectual property, and financial matters. Under these contracts, we may provide certain routine indemnification relating to representations and warranties or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.
Commercial Commitments
The following table provides summary information concerning our outstanding commercial commitments as of January 31, 2016:
| Amount of Outstanding Commitment Expiration By Period_1_ | ||||||||||||||||||||
| In thousands | Fiscal 2016 | Fiscal 2017 to Fiscal 2019 | Fiscal 2020 to Fiscal 2021 | Thereafter | Total | |||||||||||||||
| Standby letters of credit | $ | 13,367 | — | — | — | $ | 13,367 | |||||||||||||
| Letter of credit facilities | 6,088 | — | — | — | 6,088 | |||||||||||||||
| Credit facility | — | — | — | — | — | |||||||||||||||
| Total | $ | 19,455 | — | — | — | $ | 19,455 |
| 1 | See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements. |
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IMPACT OF INFLATION
The impact of inflation (or deflation) on our results of operations for the past three fiscal years has not been significant. However, we cannot be certain of the effect inflation (or deflation) may have on our results of operations in the future.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Consolidated Financial Statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. These estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ from these estimates.
We believe the following critical accounting policies used in the preparation of our Consolidated Financial Statements include the significant estimates and assumptions that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. See Note A to our Consolidated Financial Statements for a detailed description of each policy.
Merchandise Inventories
Merchandise inventories, net of an allowance for excess quantities and obsolescence, are stated at the lower of cost (weighted average method) or market. To determine if the value of our inventory should be reduced below cost, we consider current and anticipated demand, customer preferences and age of the merchandise. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or market reserves) and estimates of inventory shrinkage. We reserve for obsolescence based on historical trends, aging reports, specific identification and our estimates of future sales and selling prices.
Reserves for shrinkage are estimated and recorded throughout the year, as a percentage of net sales based on historical shrinkage results, expectations of future shrinkage and current inventory levels. Actual shrinkage is recorded at year-end based on the results of our physical inventory counts and can vary from our estimates due to such factors as changes in operations, the mix of our inventory (which ranges from large furniture to small tabletop items) and execution against loss prevention initiatives in our stores, distribution centers, off-site storage locations, and with our third party warehouse and transportation providers. Accordingly, there is no shrinkage reserve at year-end.
Our obsolescence and shrinkage reserve calculations contain estimates that require management to make assumptions and to apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. If actual obsolescence or shrinkage estimates change from our original estimate, we will adjust our reserves accordingly throughout the year. We have made no material changes to our assumptions included in the calculations of the obsolescence and shrinkage reserves throughout the year. In addition, we do not believe a 10% change in our inventory reserves would have a material effect on net earnings. As of January 31, 2016 and February 1, 2015, our inventory obsolescence reserves were $9,782,000 and $10,244,000, respectively.
Advertising and Prepaid Catalog Expenses
Advertising expenses consist of media and production costs related to catalog mailings, e-commerce advertising and other direct marketing activities. All advertising costs are expensed as incurred, or upon the release of the initial advertisement, with the exception of prepaid catalog expenses. Prepaid catalog expenses consist primarily of third party incremental direct costs, including creative design, paper, printing, postage and mailing costs for all of our direct response catalogs. Such costs are capitalized as prepaid catalog expenses and are amortized over their expected period of future benefit. Each catalog is generally fully amortized over a six to nine month period, with the majority of the amortization occurring within the first four to five months. Prepaid catalog expenses are
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evaluated for realizability on a monthly basis by comparing the carrying amount associated with each catalog to the estimated future profitability (net revenues less merchandise cost of goods sold, selling expenses and catalog-related costs) of that catalog. If the estimated future profitability of the catalog is below its carrying amount, the catalog is impaired accordingly.
Total advertising expenses (including catalog advertising, e-commerce advertising and all other advertising costs) were approximately $333,276,000, $330,070,000 and $325,708,000 in fiscal 2015, fiscal 2014 and fiscal 2013, respectively.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets.
We review the carrying value of all long-lived assets for impairment, primarily at a store level, whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Our impairment analyses determine whether projected cash flows from operations are sufficient to recover the carrying value of these assets. Impairment may result when the carrying value of the asset exceeds the estimated undiscounted future cash flows over its remaining useful life. For store impairment, our estimate of undiscounted future cash flows over the store lease term is based upon our experience, the historical operations of the stores and estimates of future store profitability and economic conditions. The future estimates of store profitability and economic conditions require estimating such factors as sales growth, gross margin, employment costs, lease escalations, inflation and the overall economics of the retail industry, and are therefore subject to variability and difficult to predict. Actual future results may differ from those estimates. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the asset’s net carrying value and its fair value. Long-lived assets are measured at fair value on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy. The fair value is based on the present value of estimated future cash flows using a discount rate that approximates our weighted average cost of capital.
During fiscal 2015, fiscal 2014 and fiscal 2013, we recorded expense of approximately $2,100,000, $241,000 and $561,000, respectively, associated with asset impairment charges related to our retail stores, all of which is recorded within selling, general and administrative expenses.
Goodwill
Goodwill is not amortized, but rather is subject to impairment testing annually (on the first day of the fourth quarter), or between annual tests whenever events or changes in circumstances indicate that the fair value of a reporting unit may be below its carrying amount. The first step of the impairment test requires determining the fair value of the reporting unit. We use the income approach, whereby we calculate the fair value based on the present value of estimated future cash flows using a discount rate that approximates our weighted average cost of capital. The process of evaluating the potential impairment of goodwill is subjective and requires significant estimates and assumptions about the future such as sales growth, gross margins, employment rates, capital expenditures, inflation and future economic and market conditions. Actual future results may differ from those estimates. If the carrying value of the reporting unit’s assets and liabilities, including goodwill, is in excess of its fair value, goodwill may be impaired, and we must perform a second step of comparing the implied fair value of the goodwill to its carrying value to determine the impairment charge, if any. At January 31, 2016 and February 1, 2015, we had goodwill of $18,703,000 and $18,740,000, respectively, included in other assets, primarily related to our fiscal 2011 acquisition of Rejuvenation Inc. We evaluated our goodwill for impairment and determined that the fair value of each reporting unit substantially exceeds its carrying value. Accordingly, we did not recognize any goodwill impairment in fiscal 2015, fiscal 2014 or fiscal 2013.
Self-Insured Liabilities
We are primarily self-insured for workers’ compensation, employee health benefits and product and general liability claims. We record self-insurance liabilities based on claims filed, including the development of those claims, and an estimate of claims incurred but not yet reported. Factors affecting these estimates include future
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inflation rates, changes in severity, benefit level changes, medical costs and claim settlement patterns. Should a different amount of claims occur compared to what was estimated, or costs of the claims increase or decrease beyond what was anticipated, reserves may need to be adjusted accordingly. We determine our workers’ compensation liability and product and general liability claims reserves based on an actuarial analysis of historical claims data. Self-insurance reserves for employee health benefits, workers’ compensation and product and general liability claims were $25,290,000 and $24,901,000 as of January 31, 2016 and February 1, 2015, respectively.
Income Taxes
Income taxes are accounted for using the asset and liability method. Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in our Consolidated Financial Statements. We record reserves for our estimates of probable settlements of foreign and domestic tax examinations. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. Additionally, our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of our earnings in various taxing jurisdictions.
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