filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
40K characters. Original on sec.gov · Markdown
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
| --- | --- |
The following discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the 52 weeks ended January 29, 2017 (“fiscal 2016”), the 52 weeks ended January 31, 2016 (“fiscal 2015”), and the 52 weeks ended February 1, 2015 (“fiscal 2014”) 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
Net revenues in fiscal 2016 increased by $107,722,000 or 2.2%, compared to fiscal 2015, with comparable brand revenue growth of 0.7%. This increase in net revenues was driven by a 4.4% increase in e-commerce net revenues (primarily driven by West Elm, Williams Sonoma and Rejuvenation), with particular strength in furniture. This net revenue increase was partially offset by a 0.1% decrease in retail net revenues (primarily in Pottery Barn and Williams Sonoma, partially offset by increases in West Elm and Rejuvenation). Total fiscal 2016 net revenue growth included a 7.5% increase in international revenues primarily related to our company-owned international operations.
In Pottery Barn, our largest brand, comparable brand revenues declined 3.5% in fiscal 2016 compared to fiscal 2015. This decrease was primarily driven by our furniture, decorative accessories and table top collections, partially offset by stronger sales in upholstery. In the Williams Sonoma brand, comparable brand revenues increased 1.3% in fiscal 2016 compared to fiscal 2015. Growth in cookware, cutlery, tabletop and our Williams Sonoma Home business contributed to these results. In West Elm, comparable brand revenues increased 12.8% in fiscal 2016 on top of 14.8% in fiscal 2015. Growth continued to be broad-based across categories, primarily furniture. In Pottery Barn Kids, comparable brand revenues declined 1.4% in fiscal 2016 compared to fiscal 2015. Strength in our furniture business was more than offset by softness in textiles and decorative accessories. In PBteen, comparable brand revenues declined 6.2% in fiscal 2016 compared to fiscal 2015. Strength in back to school and dorm categories was more than offset by weakness in textiles and out of stock inventory in key furniture collections and gifting categories. And in our emerging brands, Rejuvenation and Mark and Graham, net revenues increased 26.6%.
Additionally, in fiscal 2016, diluted earnings per share increased to $3.41, versus $3.37 in fiscal 2015, and we returned $284,811,000 to our stockholders through stock repurchases and dividends.
As we look forward to fiscal 2017, we plan to drive growth by focusing on our strategic priorities of innovation and operational excellence. We plan to increase our competitive advantage through innovation in e-commerce, our products and our services, as well as the retail experience. To accomplish this, we plan to invest in digital and online advertising initiatives. In Pottery Barn Kids and PBteen, we plan to drive innovation in product offerings across all stages of early life, and in Williams Sonoma, we plan to introduce high-quality products under the Williams Sonoma brand, as well as to develop innovative exclusives with our third party vendors. To enhance the customer experience in all of our stores, we plan to invest in point-of-sale technology and scheduling tools which will provide additional functionality and operational efficiencies. We plan to evaluate the role our retail stores can and should play and plan to invest in optimizing top-performing stores while closing underperforming stores. We also plan to continue to focus on operational excellence, driving strategies that directly improve our customers’ experience and value perceptions. We believe that collectively these strategies will extend our leadership position across all of our brands.
Table of Contents
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 2016 | % Total | Fiscal 2015 | % Total | Fiscal 2014 | % Total | ||||||||||||||||||
| E-commerce net revenues | $ | 2,633,602 | 51.8% | $ | 2,522,580 | 50.7% | $ | 2,370,694 | 50.5% | |||||||||||||||
| Retail net revenues | 2,450,210 | 48.2% | 2,453,510 | 49.3% | 2,328,025 | 49.5% | ||||||||||||||||||
| Net revenues | $ | 5,083,812 | 100.0% | $ | 4,976,090 | 100.0% | $ | 4,698,719 | 100.0% |
Net revenues in fiscal 2016 increased by $107,722,000 or 2.2%, compared to fiscal 2015, with comparable brand revenue growth of 0.7%. This increase in net revenues was driven by a 4.4% increase in e-commerce net revenues (primarily driven by West Elm, Williams Sonoma and Rejuvenation), with particular strength in furniture. This net revenue increase was partially offset by a 0.1% decrease in retail net revenues (primarily in Pottery Barn and Williams Sonoma, partially offset by increases in West Elm and Rejuvenation). Total fiscal 2016 net revenue growth included a 7.5% increase in international revenues primarily related to our company-owned international operations.
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 e-commerce net revenues (primarily driven by West Elm, Williams Sonoma and Pottery Barn Kids), and a 5.4% increase in our retail net revenues (primarily driven by West Elm), with particular strength in furniture. Total fiscal 2015 net revenue growth included a 26.8% increase in 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.
The following table summarizes our net revenues by brand for fiscal 2016, fiscal 2015 and fiscal 2014:
| In thousands | Fiscal 2016 | Fiscal 2015 | Fiscal 2014 | |||||||||
| Pottery Barn | $ | 2,024,218 | $ | 2,074,051 | $ | 2,022,331 | ||||||
| Williams Sonoma | 1,002,194 | 993,609 | 994,651 | |||||||||
| West Elm | 971,568 | 821,136 | 669,074 | |||||||||
| Pottery Barn Kids | 635,381 | 640,073 | 624,594 | |||||||||
| PBteen | 237,818 | 253,602 | 260,617 | |||||||||
| Other_1_ | 212,633 | 193,619 | 127,452 | |||||||||
| Total | $ | 5,083,812 | $ | 4,976,090 | $ | 4,698,719 |
| 1 | Primarily consists of net revenues from our international franchise operations, Rejuvenation, and Mark and Graham. |
|---|
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 to our international franchisees have also been excluded as their stores and e-commerce websites are not operated by us.
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.
Table of Contents
| Comparable brand revenue growth (decline) | Fiscal 2016 | Fiscal 2015 | Fiscal 2014 | |||||||||
| Pottery Barn | (3.5% | ) | 1.9% | 5.8% | ||||||||
| Williams Sonoma | 1.3% | 1.1% | 3.8% | |||||||||
| West Elm | 12.8% | 14.8% | 18.2% | |||||||||
| Pottery Barn Kids | (1.4% | ) | 2.2% | 5.9% | ||||||||
| PBteen | (6.2% | ) | (2.7% | ) | 5.7% | |||||||
| Total | 0.7% | 3.7% | 7.1% |
RETAIL STORE DATA
| In thousands | Fiscal 2016 | Fiscal 2015 | Fiscal 2014 | |||||||||
| Retail net revenues | $ | 2,450,210 | $ | 2,453,510 | $ | 2,328,025 | ||||||
| Retail net revenue growth (decline) | (0.1% | ) | 5.4% | 2.4% | ||||||||
| Store count – beginning of year | 618 | 601 | 585 | |||||||||
| Store openings | 29 | 34 | 35 | |||||||||
| Store closings | (18 | ) | (17 | ) | (19 | ) | ||||||
| Store count – end of year | 629 | 618 | 601 | |||||||||
| Store selling square footage at year-end | 3,951,000 | 3,827,000 | 3,684,000 | |||||||||
| Store leased square footage (“LSF”) at year-end | 6,359,000 | 6,163,000 | 5,965,000 |
| Fiscal 2016 | Fiscal 2015 | Fiscal 2014 | ||||||||||||||||||||||
| Store Count | Avg. LSF Per Store | Store Count | Avg. LSF Per Store | Store Count | Avg. LSF Per Store | |||||||||||||||||||
| Williams Sonoma | 234 | 6,600 | 239 | 6,600 | 243 | 6,600 | ||||||||||||||||||
| Pottery Barn | 201 | 13,900 | 197 | 13,800 | 199 | 13,700 | ||||||||||||||||||
| West Elm | 98 | 13,300 | 87 | 13,200 | 69 | 13,700 | ||||||||||||||||||
| Pottery Barn Kids | 89 | 7,400 | 89 | 7,500 | 85 | 7,600 | ||||||||||||||||||
| Rejuvenation | 7 | 9,100 | 6 | 9,000 | 5 | 10,000 | ||||||||||||||||||
| Total | 629 | 10,100 | 618 | 10,000 | 601 | 9,900 |
COST OF GOODS SOLD
| In thousands | Fiscal 2016 | % Net Revenues | Fiscal 2015 | % Net Revenues | Fiscal 2014 | % Net Revenues | ||||||||||||||||||
| Cost of goods sold_1_ | $ | 3,200,502 | 63.0% | $ | 3,131,876 | 62.9% | $ | 2,898,215 | 61.7% |
| 1 | Includes occupancy expenses of $664,177,000, $631,817,000 and $603,357,000 in fiscal 2016, fiscal 2015 and fiscal 2014, respectively. |
|---|
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.
Table of Contents
However, the e-commerce channel incurs higher customer shipping, damage and replacement costs than the retail channel.
Fiscal 2016 vs. Fiscal 2015
Cost of goods sold increased by $68,626,000, or 2.2%, in fiscal 2016 compared to fiscal 2015. Cost of goods sold as a percentage of net revenues remained relatively flat, increasing less than 10 basis points to 63.0% in fiscal 2016 from 62.9% in fiscal 2015. Higher selling margins from reduced shipping and fulfillment-related costs as a result of our focus on our supply chain and inventory initiatives were offset by an increase in occupancy costs related to investments in our supply chain.
In the e-commerce channel, cost of goods sold as a percentage of net revenues decreased in fiscal 2016 compared to fiscal 2015 primarily driven by higher selling margins from reduced shipping and fulfillment-related costs as a result of our focus on our supply chain and inventory initiatives, partially offset by an increase in occupancy costs related to investments in our supply chain.
In the retail channel, cost of goods sold as a percentage of net revenues increased in fiscal 2016 compared to fiscal 2015, primarily driven by occupancy deleverage and lower selling margins.
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 a reduction in advertising and employment costs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
| In thousands | Fiscal 2016 | % Net Revenues | Fiscal 2015 | % Net Revenues | Fiscal 2014 | % Net Revenues | ||||||||||||||||||
| Selling, general and administrative expenses | $ | 1,410,711 | 27.7% | $ | 1,355,580 | 27.2% | $ | 1,298,239 | 27.6% |
Selling, general and administrative expenses consist of non-occupancy related costs associated with our retail stores, distribution and manufacturing facilities, 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 2016 vs. Fiscal 2015
Selling, general and administrative expenses increased by $55,131,000, or 4.1%, in fiscal 2016 compared to fiscal 2015. Selling, general and administrative expenses as a percentage of net revenues increased to 27.7% in fiscal 2016 from 27.2% in fiscal 2015. This increase as a percentage of net revenues was primarily driven by severance-related reorganization charges of approximately $14,406,000 during fiscal 2016, as well as an increase in digital advertising expenses.
Table of Contents
In the e-commerce channel, selling, general and administrative expenses as a percentage of net revenues increased in fiscal 2016 compared to fiscal 2015 primarily driven by an increase in digital advertising expenses as a result of our focus on new customer acquisition, partially offset by the leverage of employment costs.
In the retail channel, selling, general and administrative expenses as a percentage of net revenues decreased in fiscal 2016 compared to fiscal 2015 primarily driven by the leverage of employment costs.
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.
INCOME TAXES
Our effective income tax rate was 35.3% for fiscal 2016, 36.5% for fiscal 2015, and 38.5% for fiscal 2014. The decrease in the effective income tax rate in fiscal 2016 reflects a one-time favorable tax adjustment. The decrease in the effective income tax rate in fiscal 2015 compared to fiscal 2014 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 29, 2017, we held $213,713,000 in cash and cash equivalents, the majority of which is held in demand deposit accounts and money market funds, and of which $72,995,000 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 2017, 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 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 2016, we had borrowings of $125,000,000 under the credit facility, all of which were repaid in the fourth quarter of fiscal 2016. 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 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 29, 2017, a total of $12,090,000 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 $6,565,000 was outstanding as of January 29, 2017. 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
Table of Contents
and, based on our current projections, we expect to remain in compliance throughout fiscal 2017. 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 2016, net cash provided by operating activities was $524,709,000 compared to $544,026,000 in fiscal 2015. For fiscal 2016, net cash provided by operating activities was primarily attributable to net earnings adjusted for non-cash items, an increase in deferred rent and lease incentives, as well as accrued salaries, benefits and other liabilities, partially offset by a decrease in income taxes payable. This represents a decrease in net cash provided by operating activities compared to fiscal 2015 primarily due to an increase in income taxes paid in fiscal 2016 compared to fiscal 2015.
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.
Cash Flows from Investing Activities
For fiscal 2016, net cash used in investing activities was $196,975,000 compared to $202,166,000 for fiscal 2015, and was primarily attributable to purchases of property and equipment. Net cash used in investing activities compared to fiscal 2015 decreased primarily due to a reduction in purchases of property and equipment.
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.
Cash Flows from Financing Activities
For fiscal 2016, net cash used in financing activities was $305,806,000 compared to $369,383,000 in fiscal 2015. For fiscal 2016, net cash used in financing activities was primarily attributable to repurchases of common stock of $151,272,000 and the payment of dividends of $133,539,000. Net cash used in financing activities compared to fiscal 2015 decreased primarily due to a decrease in repurchases of common stock.
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 repurchases 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.
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.
Table of Contents
Contractual Obligations
The following table provides summary information concerning our future contractual obligations as of January 29, 2017:
| Payments Due by Period_1_ | ||||||||||||||||||||
| In thousands | Fiscal 2017 | Fiscal 2018 to Fiscal 2020 | Fiscal 2021 to Fiscal 2022 | Thereafter | Total | |||||||||||||||
| Operating leases_2_ | $ | 268,593 | $ | 703,308 | $ | 322,910 | $ | 531,699 | $ | 1,826,510 | ||||||||||
| Purchase obligations_3_ | 973,102 | 8,889 | 871 | — | 982,862 | |||||||||||||||
| Total | $ | 1,241,695 | $ | 712,197 | $ | 323,781 | $ | 531,699 | $ | 2,809,372 |
| 1 | This table excludes $28.7 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 29, 2017. |
|---|
| 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. |
|---|
| 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. |
|---|
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 2017, which are included in our current liabilities as of January 29, 2017.
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 29, 2017:
| Amount of Outstanding Commitment Expiration By Period_1_ | ||||||||||||||||||||
| In thousands | Fiscal 2017 | Fiscal 2018 to Fiscal 2020 | Fiscal 2021 to Fiscal 2022 | Thereafter | Total | |||||||||||||||
| Standby letters of credit | $ | 12,090 | — | — | — | $ | 12,090 | |||||||||||||
| Letter of credit facilities | 6,565 | — | — | — | 6,565 | |||||||||||||||
| Credit facility | — | — | — | — | — | |||||||||||||||
| Total | $ | 18,655 | — | — | — | $ | 18,655 |
| 1 | See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements. |
|---|
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.
Table of Contents
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 facilities, off-site storage locations, and with our third-party warehouse and transportation providers. Accordingly, there is no shrinkage reserve at year-end. Historically, actual shrinkage has not differed materially from our estimates.
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 29, 2017 and January 31, 2016, our inventory obsolescence reserves were $13,770,000 and $9,782,000, 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 an individual 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 estimates of future 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
Table of Contents
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 2016, fiscal 2015 and fiscal 2014, we recorded asset impairment charges of approximately $1,765,000, $2,100,000 and $241,000, respectively, related to our retail stores, 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. We first perform a qualitative assessment to evaluate goodwill for potential impairment. If based on that assessment it is more likely than not that the fair value of the reporting unit is below its carrying value, a two-step quantitative test is necessary. The first step of the quantitative 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, exceeds its fair value, goodwill may be impaired. We then 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 29, 2017 and January 31, 2016, we had goodwill of $18,680,000 and $18,703,000, respectively, included in other assets primarily related to our fiscal 2011 acquisition of Rejuvenation Inc. In fiscal 2016, we performed a qualitative assessment of potential goodwill impairment and determined it was more likely than not that the fair value of each of our reporting units exceeded its carrying value. Accordingly, no further impairment testing of goodwill was performed and we did not recognize any goodwill impairment in fiscal 2016. In fiscal 2015 and fiscal 2014, we performed a quantitative goodwill impairment test and determined that the fair value of both our reporting units substantially exceeded their carrying value. Accordingly, we did not recognize any goodwill impairment in fiscal 2015 or fiscal 2014.
Self-Insured Liabilities
We are primarily self-insured for workers’ compensation, employee health benefits and product and general liability claims. We record self-insurance liability reserves 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 inflation rates, changes in severity, benefit level changes, medical costs and claim settlement patterns. Should a different number 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 workers’ compensation, employee health benefits and product and general liability claims were $24,988,000 and $25,290,000 as of January 29, 2017 and January 31, 2016, 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 the additional income tax liability that is more likely than not to result from the ultimate resolution of foreign and domestic tax examinations. At any one time, many tax years are subject to examination by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. We review and
Table of Contents
update the estimates used in the accrual for uncertain tax positions as more definitive information becomes available from taxing authorities, upon completion of tax examination, upon expiration of statutes of limitation, or upon occurrences of other events.
In order to compute income tax on an interim basis, we estimate what our effective tax rate will be for the full fiscal year and adjust these estimates throughout the year as necessary. Adjustments to our income tax provision due to changes in our estimated effective tax rate are recorded in the interim period in which the change occurs. The tax expense (or benefit) related to items other than ordinary income is individually computed and recognized when the items occur. 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.
Table of Contents
Previous: Item 6. SELECTED FINANCIAL DATA · Next: Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK